From Greshams Law to Keyser Söze.

April 29, 2013

During 1690's Battle of Quebec, fought between the colonists in New England and the colonists of New France, a colonial raiding party from New England determined to test the French resolve.
The colonists gathered a small army and marched to Quebec. The plan? Kick butt and take names, grab all the plunder possible, and return home. The soldiers would be paid from the riches they plundered.
Robert Burns wisely explained that, "The best laid plans of mice and men oft go astray." Unfortunately, Burns wrote those words nearly one-hundred years later. Leaving our raiding party without such conventional wisdom. But, I do digress.
The English colonists headed north, engage the enemy, and proceeded to get their collective tails kicked. And so, with kicked tails between their legs, they returned to Boston. Only then did the real problem present itself.
How would the raiding party organizers, bent on paying soldiers from its plundered loot, pay the well-armed, foul-tempered mercenaries now back in Boston?
Well, in this case, they determined to print a bunch of paper currency that would be backed by a deposit of actual value - like gold or silver. The paper currency was declared to be legal tender, good for all debts public and private. It was dispensed to the failed raiders. And mutiny was avoided.
Yet, history is replete with the example of negative repercussions. Nasty consequences that hit one upside the head, like a boomerang tossed and forgotten.
As the colonists spent their paper currency in the taverns, blacksmiths, foundries, milliners, weavers and wigmakers throughout greater Boston, the local economy thrived. As it did, Gresham's Law (which would not be coined for another 170 years) kicked in.
Gresham's Law states that, "When a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation." In other words, "Bad money drives out good". And so it did.
As the colonists spent their new money, and the local economy boomed, people hoarded their gold and silver. Why spend your treasure when the temporary paper treasure worked so well?
Yes, inflation was a problem. But the three- to four-year boom in economic activity trumped all else. The economy was humming. Until it wasn't. For just as the blacksmith, milliner, wigmaker and tavern owner began to feel rich, things cooled off (the law of mean reversion).
The colonists? They felt a bit hung over following the massive consumption binge they'd enjoyed. Soon, people became a bit morose. Feeling poor, and bored.
Seeing people poor and bored, the government responded in the way that governments often do. "Consequences be damned," the government said. "Turn on the spigots!"
And they did. Only, they (being the Americans they would soon become) made it bigger. Because bigger is always better (the law of Texas).
Now, according to another law, Newton's famous Second Law (force = mass x acceleration) if you double the amount while keeping the same value per unit, you end up with four times the power providing eight times the effect. Or something like that.
So instead of providing the same stimulus as the first money printing, the second iteration provided twice the fun. Of course, people continued to hoard gold, silver and other items of value. Why not? My five and nine year old sons would take monopoly money to Toys R Us if I let them. Why would English colonists act differently?
And so on, and so forth. For 271 years.
In 1971, those colonists, long dead, had given way to an entire nation. Allegedly, the world's strongest, most economically viable nation. But, in 1971, that nation, like those colonists, could not pay its bills.
Well, what is good for the goose is good for the gander. So, the government studied its playbook and pulled out a page from nearly three centuries before.
They began printing money. Lots of it. Only, because of another rule, which I'll coin the Law of the Public Sector (One must either go big or go home), the government went big. Really big. Leaving the gold standard. And officially mandating the floating, unbacked, unpegged U.S. dollar as the world's central reserve currency.
The result? Same as it ever was.
Economic booms and busts. Inflation and deflation. Good times followed by bad. Which leads to today.
After eradicating the gold standard, the U.S. government gained the ability to print money whenever it chooses to. Further, the U.S. government went on to become the world's largest hoarder of gold reserves.
The disconnect is striking. And largely unheralded by a public contentedly focused on fast food, flat screens and F150s.
Since 2009, the U.S. government has conducted the greatest display of dollar production the world has ever known. The monetary base has grown from roughly $600 billion to over $3 trillion.
What should one expect when that stimulus wears off? And, why has this greatest of all printing parties not yielded more economic productivity?
Because as the volume of money grows, so do debts and the costs of servicing them, not to mention the cost of maintaining all of that consumption. None of which provides real economic strength.
Nor has it made us wealthier. If that were the case, would record numbers of U.S. households be collecting food stamps, unemployment and disability insurance?
Such stimulus does not help the poor. Nor the middle class. The U.S. policy of print and spend benefits only three classes of citizens:
1) Wall Street's banks, which borrow money at the low interest rates and loan money at higher rates,
2) The wealthy, who don't use debt and pay cash for everything. And in this environment, cash is easy to come by.
2) D.C. and the political class, who get credit for playing the same ineffective shell games that their colonial brethren used to no real long-term benefit (underscoring yet another universal law, that history never stops repeating itself).
Meanwhile, the poor saps in the middle class feel wealthier, for a short time, as they're able to finance their $35,000 cars by effectively paying $80,000 over an eight-year period.
As they borrow money for useless university degrees that leave them $150,000 in debt with few job prospects nor ability to pay off the debt.
The middle class becomes enslaved to their creditors, who become the beneficiaries of all of their mistakes.
In the 1995 crime thriller, The Usual Suspects, a dark, mysterious criminal name Kaiser Söze works behind the scenes to manipulate everything to his favor. Seemingly, he is known by all, yet seen by none.
In the film's climactic scene, Kevin Spacey's character, Verbal, explains how Söze systematically accomplished his grand design.
"The greatest trick the devil ever pulled was convincing the world he didn't exist." (click here)
In other words, Verbal theorizes that Kaiser Söze, like the devil, becomes all the more powerful by disappearing. By convincing naive colleagues and adversaries that his is not real, his power is leveraged. Enabling him to operate in the shadows. Away from the spotlight. An urban legend for gangsters. More specter, than man.
Likewise, the greatest trick the Fed ever pulled was convincing a naive middle class that the gold standard was unnecessary. A relic of a forgotten age. Long past having any real value. And so the Fed co-opted one of the least understood yet most powerful functions in the world. The ability to print money. The power to effectively create and destroy the world's central reserve currency.
One minute? The dollar was tied to a gold standard. And like that, poof. It's gone.

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