When Dreams Become Nightmares

January 12, 1998 – The Great Depression had ended before I was born, but this traumatic collapse that unhinged the world economy in the 1930’s has had a profound influence on my life. Worried that a depression may repeat, when still young I learned to fear it.

This emotion was the common thread I received from nearly everyone I ever spoke to about the Depression – from my parents, other members of my family, and dozens of other individuals who lived through this convulsion. And as I grew older, fear was also a common thread in many of the books that I read about this monetary and financial debacle from the 1930’s.

As a consequence, it became an objective of mine to understand the causes and the essential nature of the Great Depression. I reasoned that if I learned how and why it happened, I need not fear it. This understanding of its causes would enable me to protect myself from the economic and financial repercussions of any future Great Depressions, however unlikely one may be.

Ironically, as my knowledge of money and banking grew over the years, it became clear to me that another Great Depression is inevitable. The reason is that the inherent flaw in the monetary and banking system that created so much chaos in the 1930’s is still very much a part of the financial system today.

At the moment, the flaw is largely ignored, but it is still there nonetheless with all of its mighty capacity to wreak havoc.

And it does occasionally poke its nose through the surface to remind us of that potential. Events such as the collapse of the Herstatt Bank in 1974, the rapid inflation like that experienced in the late 1970’s, and the savings and loan debacle of the 1980’s are only three of many examples of monetary pathology that prove the potential for danger is still there. But as bad as these events were, none of them had the potential to cause a 1930’s-type financial and economic collapse – unlike the crisis now unfolding in Asia. The potential for a collapse as severe as the 1930’s grows daily as the Asian woes deepen.

Not since the 1930’s has the inherent flaw in the monetary and banking system been poised to do so much damage – credit is collapsing in Asia. And banking systems – and national currencies – are built upon credit, which is the fatal flaw.

Credit inevitably comes to be doubted, and when it does, monetary turmoil is the result. Money should be based upon assets of substance, not IOU’s.

Like speech, money is a mental tool that we use to communicate with others. For instance, using the mental process of speech we use language to communicate our thoughts and feelings. With money we communicate our subjective judgments of value on a multitude of goods and services, and we use currency to provide the physical means to enable us to act upon these judgments. Currencies, as with languages, vary from country to country.

On a deeper level, money meets two important requirements.

First, money must be easily exchangeable for other assets. For this reason, money is generally referred to as the most marketable – i.e., liquid – good or service in the marketplace. To meet this liquidity test, money must be readily acceptable in exchange for all other goods and services.

Second, money must have substance, or in other words, it must be an asset so that in an exchange of money for a good or service, substance is exchanged for substance. Only in this way can the exchange be extinguished, which means that it ends at the moment of the transaction without any ongoing and lingering obligation. Transactions are only extinguished when goods or services are exchanged for other goods or services.

National currencies fail to meet this second requirement for money because they are void of substance – they are nothing but promises created by banks “out of thin air”. National currencies are essentially not money. They used to be claims to money (substance) because currencies at one time could be redeemed for an asset of value – historically Gold or Silver fulfilled this redemption role which enabled anyone to turn the currency they held back into substance. But today currencies are only a vague promise.

For example, anyone today who accepts a national currency in payment of goods or services, receives the payment obligation of the financial institution issuing the currency used in the transaction. He does not receive “substance”. Because national currencies can no longer be redeemed for Gold and/or Silver, substance can only be received in one way. The original exchange is not extinguished until the national currency is eventually passed on in a new exchange for goods or services.

But until this national currency is subsequently exchanged in this way, the holder of that currency – whether wittingly or not – has given up the substance represented by his marketable good or service in return for just a promise to pay, and a promise is not substance. A promise to pay something is very different from having the thing promised actually in hand.

When national currencies could be redeemed for Gold and/or Silver, they were claims to money (substance) – the claims enabled the currency to be redeemed for something of value. The issuer of that currency promised to deliver Gold or Silver on the demand for redemption by the holder of the currency. But today, national currencies are not even claims to money; they have been moved further away from money. For example, a US Dollar is a claim on a promise to repay a debt, and there is no direct claim to Gold or Silver or any other asset of substance. A Dollar note (cash currency) or the book entry generated in a bank’s financial statement (deposit currency) itself is void of substance. Anyone who receives a Dollar knows only that he has someone’s promise, namely, to maintain the value of that currency until it can be exchanged for something of value.

Therefore, national currencies are inherently inferior to an asset currency like a Gold or Silver coin, because the holder of asset currency knows with certainty that his currency has value because of what it is, not what it promises. Nevertheless, national currencies are readily accepted in the marketplace.

They meet the liquidity test because they are forced into general circulation by government decree through the enactment of legal tender laws. Only in unusual circumstances – for example, during a monetary crisis – are these legal tender laws widely ignored, which then threatens the ongoing circulation of the currency that caused the crisis.

We are now seeing those unusual circumstances in Asia. There is a growing flight from currency. People want substance, not promises.

Throughout Asia store shelves are being made bare because consumers realize that staples are more valuable than promises.

Shopkeepers realize that their inventory is more valuable than the promises of those who create the currency so they don’t restock their shelves. Economic activity suffers.

These defective national currencies circulating in Asia threaten to unhinge their domestic economies, which today are very much interconnected to the rest of the world by trade and capital flows. So however goes the Rupiah, Baht, Won, Ringit and the others, so goes the Hong Kong Dollar, Yen and the US Dollar – much like the example of the proverbial butterfly that flaps its wings in China which creates a wind current that eventually results in storms in Great Britain. And storms throughout Europe and North America there will no doubt be.

In Asia today, dreams about wealth and the good life are rapidly becoming nightmares about making ends meet, paying bills, meeting the payroll, and/or trying to realize hard-earned savings. The 1930’s are now being painfully relived in Thailand, Indonesia and Korea. And I fear, the 1930’s are again coming to Europe and North America – today’s credit collapse in Asia is tomorrow’s troubles for the American banking system and the US Dollar.