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Sunday, November 1, 2009

The U.S. Dollar and Fiat Currency Systems

A fiat (Authorization or sanction: ie. - government fiat.) currency system is a monetary system that is not backed by anything other than pure faith in the political system that issues it. Every world currency in existence is a fiat system. A faith system. You cannot redeem your dollars for gold. Your dollars are only "worth" what we deem them to be via collective social sentiment. In other words as long as society views fiat currencies as having real value, they continue to function. As long as confidence remains high, fiat currencies can function quite well. It boils down to having faith in the government entity backing the fiat system. It is a fact of history that every fiat currency in the long history of mankind has either collapsed or been replaced.

Again, fiat currencies are a worldwide phenomenon. So when thinking about any particular currency, you must always have a point of reference to the other currencies. Which currency, when the chips are down and social turmoil is threatening the fabric of modern societies the world over, will people turn to in the end?

I tend to agree with Mish on the "watched boiling pot" theory in that the U.S. dollar is not likely to be the first point of concern when it comes to the world's coming fiat currency crisis. In that respect lets look at the "other" world currencies and take a cursory look at the system of faith that may or may not exist in backing them and just how fragile and easily that allegiance may break.

The Euro is extremely vulnerable to a quick extinction. Never before has a fiat system been forced upon such a hugely disparate and uncommon heritage as the Euro, save the Russian Ruble. Having faith in the Euro comes down to having faith in the European forced political system accomplished slowly over time, often in the dark of night under the guiding hand of bureaucrats . These people were not directly elected, yet they grabbed power nonetheless. But I suspect it is a fragile power.

Europe has no strong common defense nor the will to use it. The United States has been Europe's defense for decades and continues to be. To have full faith in the Euro it is required to have faith in yet another "paper system"; the myriad of treaties and bureaucratic "decrees" that bind the European political system together. If one looks at it logically, it is ironic that to have faith in the Euro comes down to maintaining faith in the United States to continue to defend Europe militarily.

But the threat to the Euro probably doesn't reside from without, it likely resides from within. Europeans went to war with each other time and time again over millennium. The inequalities of the current currency system as it is applied over the differing participating countries has the potential to spark unprecedented civil unrest. The Euro is not old at all so most will remember fondly of their "old" currencies and own interests when stuff truly hits the fan.

What it comes down to is that the Euro is extremely young and untested in times of civil unrest. Will the German government, who have subsidized Europe for decades feel the need to stand up and assert themselves yet again (rightly or wrongly) and feel the pangs of resentment that are more easily invoked than one can imagine? Think the Italian parliament members deeply care for the plight of the Spaniards (who also experienced a housing bubble) when they themselves are in a dire straights financially? Or the Irish? Or vice versa? And what of the French? If any country is capable of a devastating spate of civil unrest, for whatever reason, look no further than France. They are constantly challenged from within.

And is it not the irony of all ironies that the European "parliament" and the carefully placed political seats of power resides in a country, Belgium, that was itself a forced union and in this very modern day and age can barely keep itself from breaking apart politically?

Will any reader of this blog commit their fortunes to the fate of the Chinese communist government? China has taken on more debt than should be possible for such a corrupted and crony system, particularly a communist political system. And on top of that, they have 1.2 billion souls to keep "in line". The potential for massive unrest is great. The myth of "decoupling" is indeed a myth.

Intractably linked with feeding the US with cheap consumer goods, the peak of that has come and gone. It didn't help that there are so many product disasters from the killing of pets with poisoned food to the irreparable damage of hazardous drywall products that now infest a portion of recently built American "McMansions".

When we used to make fun of Japanese products for being inferior in the 60's and 70's, they worked very hard to correct them and make them better. The Chinese government's way? Their answer is to hang, until death, the culprits who managed to get caught. Justice maybe, but it kind of puts a crimp in things if your a Chinese manufacturing manager.

Besides, American basement and attics are full of Chinese products collected over the last decade. We have simply had enough. The American consumer is in full retreat.

This is an interesting currency. Most people that read this blog probably realize that Japan has gone through a devastating deflation over the last 2 decades and it is reflected in its stock market. In an effort to stave off collapse, they have also taken on unprecedented debt. Yet it has not worked.

Um ok. Again, is anyone, other than third world countries forced to do so, going to commit their fortunes to the fate of Russia? The Russian system practically invented cronyism and corruption from the dawn of time. This fact does not engender much deep faith. But again, like the Euro, Russia's system is a hodgepodge of disparate peoples and interests. The breakup of the Soviet Union may have only been but an opening act. They entirely depend on the fate of oil. An impending price collapse in oil back to even $25 a barrel will cripple their cash flow without mercy.

The United Kingdom either wisely or unwisely decided not to convert to the Euro. Only time will tell. At any rate, if you are alarmed at the rate the United States is taking on debt, the Brits have us beat in that department hands down. The British pound, I think, is one of the most vulnerable currencies out there. Faced with a housing bubble to match our own and then some, Britain is the pinnacle of the "Nanny States". Socialized to the fullest yet having a connected cronyist system that mirror's America's, is a recipe for social unrest disaster. The UK has their own major ongoing banking crisis and there is probably no cure but total default.

I have some faith in the Australian system. I am biased. I admire Aussies. Good or bad, they remind me of a young America. Like America, they have resources to fall back on, many of them no doubt untapped. After all, they have their own continent. They have some military muscle and the will to defend themselves. The Australians have fought alongside the United States more than any other country. I happen to think, the coming supercycle (b) wave bull market in the coming decades will very much involve Australia. (who knows, maybe it has the best chance to survive any nuclear fallout "accidents") They too will not escape the coming pain, but I think they will weather it better than most. Their political system is fairly robust and capable of weathering the storm. Is it any accident that they too use the term "dollar"?

I am sorry, I meant to mention the Indian Rupee. However I admit I do not have a ready opinion on how effectively it will maintain as a fiat currency in times of social unrest or outright war although India is indeed subject to extreme unrest in certain parts due to ethnic tensions and terrorist bombings. Nor do I have even a cursory understanding of any inherent structural or debt problems but as with any fiat currency I would guess there are plenty enough problems.

I have always admired India greatly as a nation and people. However, if any place worries me, the potential for serious war in that part of the world is number one on the list considering Pakistan, Iran, et al. India's large population, like China, is no doubt a challenge for the nation. But it has also been a strength.

However, I think if you put all the nuclear nations in a grab bag, and picked the most likely top two to having a nuclear war, India and Pakistan may top the list. And it probably wouldn't be India's fault. That's right behind Israel and Iran. I hope I am way off base here on this.

If I have missed your favorite fiat currency system here is a list for you to pick:

Needless to say, just as Mish proposes, there is more likely to be a serious crisis starting in a minor unwatched currency such as Eastern Europe rather than the dollar. Perhaps then it sparks a "domino effect". The bottom line is that I don't have any more faith in the above currencies more than the US dollar.

A fiat currency system comes down to having a belief in the government that sponsors it. But when assurances and hope collapses, it turns to fear. And when fear takes over, you run to the perceived safety of those that you deem are capable of protecting you. The United States, again rightly or wrongly, is the world's reserve currency because we have the most military muscle and a certain willingness to use that muscle. We may be bankrupt, however our ships, and aircraft are stocked with ammo and well maintained. Our military is highly disciplined and trained to follow orders to the end.

Our victory in Europe and Japan paved the way for reserve currency status. And that will not easily change once the next military crisis comes. It will only reinforce the status quo.

For those saying that the US Dollar will "collapse" without first referencing and considering the likely fate of all the other world currencies first is not perhaps thinking things through enough.

Social unrest is no doubt coming to many societies in the world including here in America. Yet we are one of the oldest surviving political systems in the world. We hopefully are mature enough to get through it all. But other countries are not as robust. This will help determine the fate of their fiat currency systems.

It comes down to the fact that the world has gotten ahead of itself and too complicated. Its fiat currencies are bloated with debt (and even greater promises of future debt) that can never hope to be repaid. Things are too intertwined and no one knows how to control the monster we have created. The only real answer is to destroy the debt, break the future debt promises, and simplify the financial systems and throw the corrupt in jail. But of course the world's governments will do the opposite and fight it all the way. In fact one can easily predict they will grab more power as a result (which they already clearly have). How well that massive power grab works out in the long run is also predictable: It will only be tolerated for so long.

"Financial innovation" is just another term for "Ponzi".

Unfortunately the world's political systems have not taught people to stand on their own two feet. World society has instead conditioned the individual that the "state" is always the answer. When that inevitably fails, what effect will that have on an already naturally occurring downward turn in social mood?

The great Grand Supercycle wave III that powered mankind for the past several centuries has ended. A correction of the entire 200+ year wave is required. We try and cheat nature's laws yet in the end, I strongly suspect we cannot. We certainly have never been able to before. The Romans are proof of that.

But looking around the world, we are pretty much all in the same boat which is no coincidence. The dollar may not be worth much in the end, but neither will anyone else's currencies. Its all relative. I think any logical thinking on the matter will yield the same basic result.

The charts show a great wave 3 for the dollar likely to come. B waves don't usually retrace so deep, but wave 2's do. In fact, out of all the world's fiat currencies, the US dollar may in fact be the last one standing. Not that you and I won't suffer though.
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