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The Fiscal Fallacy & Fiat Currency

American Gold CoinAugust 20, 2014 | by Steve McCurdy

Fiscal Policy and Monetary Policy

Fiscal policy and monetary policy are the two tools used by Governments to achieve economic objectives. The primary objective of fiscal policy is to increase the aggregate output of the economy by regulating spending and taxation, and the primary objective of the monetary policies are to maximize employment and price stability by regulating interest and inflation rates. In the United States,


fiscal policy is the responsibility of the Federal Government and monetary policy is the responsibility of the Federal Reserve.

End of the Gold Standard – 1971

On August 15, 1971 President Richard Nixon “closed the gold window.” The public at large didn’t know what “closing the gold window” meant, and not even professional financial observers grasped the enormous implications Nixon’s decisions would have on the world’s financial future. What Nixon’s decision really represented was a default by the United States on the Bretton Woods Agreement of 1944, which had made the US dollar the world’s reserve currency, and which allowed foreign countries to convert their holdings of US dollars into gold. Simply stated, Bretton Woods had made all world currencies convertible into US dollars, and all US dollars held by foreign countries convertible into gold. The end of Bretton Woods meant that for the first time in history the entire world was on a pure fiat currency monetary system, backed by nothing but faith.

Figure 1 – US Federal Debt, 1966 through 2011

With the restraints imposed by a gold-backed currency no longer in place, politicians were suddenly free to promise new social programs, start new military campaigns, and expand government bureaucracies by borrowing money, rather than by increasing taxation. A flood of paper money was unleashed globally, and that trend has grown exponentially ever since. 

Fiscal Policy since 1971

On August 15, 1971, the national debt of the United State stood at $436 billion. As this article is written it stands at $17.607 trillion, meaning the national debt has multiplied by more than 40 times. Figure 1, above provides a visual look at the growth of the debt by year since 1966. The vertical green line marks the date of the “Nixon Shock” as it is now known. Figure 2 below shows the annual budget deficits or surpluses by year starting in 1901. One can see that for most of the 70-year period from 1901 through 1971 the country basically had balanced budgets with the notable exceptions of World Wars I and II. Under the gold standard, stability was clearly the rule, not the exception. The period 1972 through 2011 speaks for itself.

Figure 2 – US Federal Budget Deficit/Surplus by Year

The growth of the money supply closely parallels that of the national debt, and the unrestrained creation of money since 1971 has seriously eroded the purchasing power of virtually all currencies. Most people regard inflation as the cost of living measured by the Consumer Price Index (CPI). The correct definition, however, is an increase in the money supply leading to higher prices. In most of the world’s industrialized countries the money supply is growing at twice the rate of the CPI, and this represents a subtle form of taxation. Figure 3 below illustrates the steady decline in the purchasing power of the US dollar since the closing of the gold window.

Purchasing Power of US Dollar
Figure 3 – Decline in Purchasing Power, US Dollar  

One of the other unintended consequences of rapid expansions of the money supply is that they lead to market bubbles. The first Greenspan expansion of the money supply after the 1987 stock market crash fueled the “ bubble” and led to Greenspan’s characterization of the bull market as “irrational exuberance.” The NASDAQ had climbed to 5,000 by March, 2000, and then the bubble burst and the market lost 75% of its value. The mistake was repeated when new money creation fueled the housing bubble, which of course ended in the sub-prime mortgage crisis of 2007 and 2008.

Fiscal Policy Since 2008

A gold standard imposes strict discipline on both fiscal and monetary policy and conversely the replacement of a gold standard with fiat currency takes away that discipline. One of the unforeseen results of Nixon’s decision has been that governments, including the US government, have gradually abandoned the use of an annual budget as an important fiscal tool. The popular alternative to budgeting today is “raising the debt limit.” As long as new money can be created out of thin air, the debt limit can be raised at the stroke of a pen, and there is no need for a budget. Spending is no longer constrained by revenues, but only by the debt limit.  In recent years the political party in power has not bothered to submit a budget at all. Since 2011 the country’s fiscal policy has been governed by the “Budget Control Act,” which is government-speak for “Sequestration.”

The US National Debt today stands at $17.607 trillion, which is approximately 2.4 X larger than 2004 number of $7.379 trillion. The country’s deficit for 2014 (fiscal year ending 9/30) is expected be about $732 billion, up more than 5% from 2013. In four of the last six years, annual deficits have exceeded $1 trillion. (Deficits for 2013 and 2014 were down somewhat as the result of the legally mandated Budget Control Act (Sequestration)).  As of July 15, the actual US unemployment rate as measured by U-6 was 16.2%. Given these abject numbers, it is fair to say that there is no longer any discipline in fiscal policy.

Reserve Currency Status

Although the demise of Bretton Woods untethered the world from the gold standard, the US Dollar remained the world’s reserve currency, and in much of the world it still is. Shortly after Bretton Woods was signed in 1944, the US gold reserves peaked at 21,682 tons, much of it confiscated from private US citizens by FDR. This gold horde dwarfed that of any other country, and no other country possessed the financial credentials to become a reserve currency. By 1960 the gold horde was down to 15,821 tons, and when Nixon took action 1971 it had dwindled to about 8,500 tons, down 60% from the peak but still the largest in the world.Since 1971 the US gold reserves have been cloaked in great secrecy, and have never been audited. The Treasury still lists the same 8,500 tons on its balance sheet, although virtually all gold watchers are highly skeptical of this number.

The BRICs countries (Brazil, Russia, China and India) have been buying huge amounts of gold over the last 10 years, and many observers believe that their aggregate gold reserves have now surpassed those of the US. The BRICs are discussing setting up their own monetary fund and their won settlement bank, and they are increasingly entering into global trade contracts not settled in US dollars.
It is only a matter of time before the US dollar loses its place as the world’s primary reserve currency, an event which will have serious implications for the dollar’s value. When the endgame for the world financial crisis finally arrives, many will point back to August 15, 1971 as the day that it all began.

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