Tim Price

INVESTMENT SPECIAL: Folding money

When politicians devalue the currency, hard assets are the answer

Forget Bernie Madoff. The biggest Ponzi scheme in history is unfolding before your very eyes. If you have money in the bank, you will be a victim.

The rot set in on 15 August 1971. That was the date on which the Nixon administration, reeling from the costs of the Vietnam war, unilaterally took the dollar ‘off gold’, ending fixed convertibility between the US currency and the precious metal. From that day to this, the currencies of the world have been backed by nothing more substantial than politicians’ promises.

It was not always thus. Throughout history, man has used a variety of things as money, including cattle, shells, tobacco and cotton. But over time, precious metals won out over all their rivals on account of their scarcity, durability and beauty. Paper money itself is a comparatively recent phenomenon. We use it today as a matter of course and convenience. But unbacked paper (‘fiat’) money is a distinctly modern experiment, and one that looks set to end in tears.

As the second protagonist in today’s Ponzi scheme, enter the banks. The modern banking system operates on what is called a fractional reserve basis: only a fraction of a bank’s deposits are kept as liquid reserves. The rest are lent out, re-deposited, and re-lent elsewhere. This mechanism normally works tolerably well, though in the event of a systemic loss of confidence, it has the unfortunate side-effect of bank runs, as the example of Northern Rock testifies.

There is one huge side-effect of fiat money and fractional reserve banking, however: inflation. Monetary purists point out that inflation is not just defined as a rise in the prices of goods and services; rather, it is the rise in the money supply that tends to ignite the rising prices.

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