Trust the Dollar?

WARNING SIGNS

— Forget not that Trust Thing–

THIS IS OUR NAKED EMPEROR MOMENT

What the Virtual Money trend can tell us about our “Real Money”

 

 

A CAUTION by

Jay B Gaskill

In the beginning, there was barter.  Before Europeans arrived in American, the aboriginal peoples used an informal trading system the scope of which was later detected when anthropologists discovered that crafts and other valuable goods had migrated through exchange trades for hundreds, even thousands of miles across the continent.  When a small tribe of Indians sold Manhattan Island to settlers for beads and trinkets, it was one of the earliest recorded currency frauds, just one in a series of “trust abuses” that would plague Western finance to the present day.

All civilizations depend ultimately on transactional trust.  Without that trust, our basic trading and other exchange relationships quickly fragment; and the general social order devolves into a turbulent stew of thievery, chaos and decline.

Early banking evolved from trusted trade brokers who kept careful books and maintained a reputation for honesty.  Governments followed in their wake, creating currencies anchored (at first) in concrete items of well-established value.

ENTER FIAT MONEY

Fiat – an authoritative or arbitrary order.

Fiat Money – Money that a government has declared that must be accepted as legal payment for any debt, the value of which is not backed up by any actual commodity. Fiat is Latin “it shall be”. Fiat money is faith money as in “full faith and credit”

 

U. S. Constitution, Article I, Section 8:The Congress shall have power to lay and collect Taxes…To coin money, regulate the Value thereof

 

 

 ENTER THE WORLD ECONOMY

 

When the USA was very new on the world stage, our international borrowing was a delicate matter with potentially dire consequences.  The money actually had to be paid back, principally from our export trade-earnings.  For debtor nations like the early post-colonial US, the books had to be kept in rough balance. A deadbeat former colony could quickly find itself crushed by repayment taxes, frozen out of international transactions or both.

Flash forward to the 21st century.  International transactions are so commonplace that they affect every American purchase from beer to hybrid cars.

Decades of irresponsible public borrowing have flourished because there is no large-scale, truly-local economy left in the international system.  Every major nation-state is both producer and customer and is dependent of other producer and consumer nations. Neither the production nor the consumption sectors can long exist without the other.  As a result, improvident borrowing –as subsidized by the device of making more fiat money, is more tolerated and accountability for sovereign debt seems ambiguous.  The specter of governments suffering immediate consequences for large unpaid loans is less common; the repayment issues are handled via adjustments in interest rates, changes over time in the trade balance, debt load and so on.

But the piper must be paid. Eventually there are painful consequences, as the Greek debacle has reminded us.

Many experts still tell us that the USA’s position in the world economy is “safe” because the dollar is still the world’s “reserve currency”.  But they are saying only that US currency has so far remained the most desirable currency in a mix where almost every player is overextended.

This is a weak reassurance, much like saying that, yes the American emperor actually has no clothes, but he is preening in a bath house where all the attendees are stark naked as well.

 

What is missing from this naïve, “no-worries” narrative?  The understanding that the US system is safe only because everyone who now loves the dollar is ignoring the fact that the entire economic system crucially depends on transactional trust.  Whenever that trust collapses, entire economies can go south.  So far, a few bubbles (dot com and real estate mortgages) have collapsed. Among our elites, that damage was considered manageable”.  If that reassurance was true, why are we being told that the current pattern of chronic, low wage underemployment may be the “new normal”?

ENTER BITCOIN AND THE VIRTUAL CURRENCIES

 

“ALL currencies involve some measure of consensual hallucination, but Bitcoin, a virtual monetary system, involves more than most. It is a peer-to-peer currency with no central bank, based on digital tokens with no intrinsic value. Rather than relying on confidence in a central authority, it depends instead on a distributed system of trust, based on a transaction ledger which is cryptographically verified and jointly maintained by the currency’s users.”

From The Economist

http://www.economist.com/news/technology-quarterly/21590766-virtual-currency-it-mathematically-elegant-increasingly-popular-and-highly

In other words, virtual money is a form of barter secured by an electronic bookkeeping system that is inter-convertible into various traditional currencies, as needed, or none of the above if the users end up bartering, say, oil for eggs. Thus, at least potentially, virtual money could become the gold standard of international commerce, provided its system retains sufficient credibility to warrant general trust.  The surge of virtual currencies early in the 21st century is less a measure of how much this “cool”, computer money can be trusted, as much as it is a sign of the declining trust in the various traditional sovereign currencies. 

Other virtual currencies based on the Bitcoin model are proliferating – among them are Litecoin, Namecoin and Peercoin.

Bitcoin is the major crypto currency. The term refers to a peer to peer, decentralized exchange model where cryptology validates the transactions and protects against counterfeiting.  http://en.wikipedia.org/wiki/Cryptocurrencies

Bitcoin is an economic pebble compared to the currencies of major governments. But it is a fast growing player.  Recently, a man accidently disposed of his laptop, forgetting that the hard drive contained a Bitcoin “wallet” worth $9 million.

http://www.forbes.com/sites/kellyphillipserb/2013/11/30/from-treasure-to-trash-man-tosses-out-bitcoin-wallet-on-hard-drive-worth-9-million/

All governments get in debt, and all government debt affects the value of the government’s currency vis a vis other currencies.  One all-too-easy solution to excessive government debt is chronic deficit spending, eventually leading to rampant inflation, currency devaluation and worse.  Examples include the failed 20th century “Banana” Republics of Latin America, and the pre-Hitler Weimar Republic in Germany.  In spite of these cautionary tales, major governments, notably ours, continue to press the limits of prudence.

At his writing, the US sovereign debt was 17.2 trillion dollars, about $150,000 per person. The overall public debt is running close to 72% of the annual gross domestic product. The annual interest expense for that debt, the service charge, is the one annually appropriated item in every federal budget that must be paid. Currently, the cost of our debt service is about $240 billion dollars, roughly equal to the entire cost of the U. S, Army. After the overall military budget (DOD appropriations, including Army, Air Force, Navy), the federal debt service is the second largest appropriation in the budget. …And just under half of US federal government debt is owed to foreign entities, principally the government of mainland China.

 

THE COMING INVASION OF REALISM

 

Realism is dependable. It always arrives to pierce our fantasy bubbles, whether it rides on the back of a disaster or as a storm-warning that drives a sudden course-correction.  Whether realism will arrive in time to head off a pending monetary/fiscal collapse remains an open question.

The international economic system is based on currency transactions among countries that, for the most part, are pressing the limits of acceptable borrowing and fiat money expansion policies. 

There are consequences: Entrepreneurs must live with the ongoing risk that circumstances in the world economic system can trigger disastrous currency devaluation at any moment.  This fact colors every international transaction.  That risk causes major business players to hesitate to enter into long term projects without securing political guarantees from local governments.

But political guarantees, like hostage negotiations, inevitably lead to the irrational allocation of precious resources. Two features of the entanglement of politics with long term private investments have conspired to hinder the emergence of a truly healthy American economy:   (1) Private investors are discouraged from investing in long term projects at all; (2) … those who do “play ball” with the politicians  more often than not end up seriously compromising otherwise sound business models.

Worries about currency instability result in an overemphasis on short term, quick revenue projects. The few long-term ones inevitably seek political cover, which leads to ill-conceived, and poorly executed business models.  In this way, the potential instability of the world economic system caused by over-reliance on fiat money is primary among the root causes of the “new normal” – chronically underpaid, underemployment.

A case in point: Silicon Valley is a rapid-result oriented economic test bed that produces more one-off millionaires than long term, well-paying jobs. The great majority of Google employees, for example, do not earn enough to own homes in Silicon Valley.

Granted, businesses around the world still prefer to be paid in dollars, but that enthusiasm is dwindling. The trend away from the dollar-as-favored- reserve is bound to accelerate if the US continues to play the “trust us” game to the very edge of incredibility.  At the current rate of dwindling confidence, the dollar’s role as the world’s “reserve currency” has a sell-by date.

This, then, is the main attraction of Bitcoin and the other virtual currencies[1]. Virtual currencies are a rapidly growing finance-model because the world economy’s Emperors are naked – and almost everybody knows it.  The virtual currency pitch is compellingly simple: Why not deal with a smaller, more manageable, “naked” (but well secured by encryption) currency regime, one that is inherently free from excessive political meddling, one where values are tied to the traded commodities themselves.

I have just described something that either looks like a very attractive alternative to the increasingly unreliable world currency system, OR as the single greatest threat to its continuation.

If present trends continue, virtual currencies will inevitably be recognized as a threat to the entire international system. Why?  Because these currencies are the first leaks in a large unstable dam, the edifice of international trade relationships.  At the moment, the aggregate size of virtual currencies is not enough to crack the dam.  But, as anyone who has studied the economic bubble phenomenon knows, that can change on a proverbial dime.

This possible threat leaves the USA and the other world currency players with essentially two choices: [1] Return to more conservative borrowing and monetary policy before one’s national transactional credibility is irrevocably damaged; [2] suppress the virtual currency alternatives.

Fictional Armageddon scenarios portray the survivors turning to barter. Don’t assume that major businesses have not thought this through. Here is the question that some savvy business analysts are already secretly asking themselves: If there is a currency collapse affecting our enterprise, how can a Bitcoin Wallet (or other virtual currency) allow is to continue to function?

To the extent that the question just posed is taken seriously by more and more businesses; and to the extent that the USA and other players fail to reverse the practices that are undermining trust in their own currencies, the political response is easy to predict:  We may see serious government attempts to “regulate” and ultimately suppress the emerging virtual currencies before the USA or the EU (assuming it even survives as an economic player) can recover a sufficient measure of fiscal and monetary sanity to put out the fire.

I do not profess to know the future, but the wise investor keeps one principle in mind: When complacency and reality collide, reality wins.

JBG

 

COPYRIGHT © 2013 BY JAY B GASKILL

FIRST PUBLISHED ON THE POLICY THINK SITE

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[1] I know that the crypto currencies are also useful for money laundering. This is an obvious rationale for government regulation (read political management) of virtual money, if not its outright illegalization.