The Central Bank Economic Confidence Game

By John Schroder

Here is a philosophical question for you.  What gives paper currency used as money its value?  It is not backed by gold, silver, a claim on real estate or anything else that is real and tangible.  It is true that the US Dollar was at least backed somewhat by oil since about 1971 in the sense that all petroleum purchases needed to be conducted in USD, but even that paradigm is coming to a close now as the two top petroleum exporters (Russia and Saudi Arabia) now are taking payment in other currencies.  So why do people believe paper currency has any value at all?  After all, it is only paper, well actually more of cloth really, and we now have plastic currency in Australia (and very recently in the UK now as well). The answer is confidence, nothing more.  Actually more like blind faith, as in religion.  This is why we said it was a philosophical question and not one of provable science or even economics (true economics is based upon reality, not esoteric theism).  But keep the term confidence in mind because current central bank policies in the developed Western world have this idea as its core goal.  Stated another way, we can loosely borrow the quote from the esteemed gentleman from Lithuania on the European Central Bank board and say that these central banks wish to magically extend the illusion.

I Am Not Crazy About Reality, But It’s Still The Only Place To Get A Decent Meal – Groucho Marx

Interestingly enough, there is talk of eliminating all physical paper (and now plastic) so that the only remnant of what we consider to be money, or a representation of money, exists as an abstract thought in the form of digital or electronic numbers on a device screen.  They want to make sure we cannot even touch it anymore.  So what then gives us solace to even think a few digital indicators on some electronic device is safe and has value?  Once again, confidence, and realize the three-letter word spelled using the first letters of that longer word.

The problem for individual citizens and investors is twofold.  First off, if all cash is eliminated and only remains in digital form then any and all opportunity of escaping the matrix, so to speak, is completely gone.  They can impose negative interest rates and all kinds of financial mayhem and there is nothing you can do about it when there is no more physical form of currency.  Secondly, they can really go hog wild with digital money creation, although truth be told they already have.  In terms of US Dollars, the US Federal Reserve tells us there is US$1.4 Trillion worth of physical paper Federal Reserve Notes in existence as of June 2016.  However, the US Dollar money supply has been expanded (digitally) by over US$6 Trillion since 2008 and is now estimated to now total in excess of US$10 Trillion.  If you consider the fact that the US Federal Reserve has expanded their own balance sheet by US$4 Trillion due to so-called QE purchases (more than the actual existence of all physical paper money in the world) then you can understand how digital money creation has been utilized (created digitally out of thin air to purchase real assets, or claims on assets, such as financial securities).  And if we look at this as a sort of leverage ratio, we can say the digital leverage is 10 times the actual amount of physical money or currency stock in existence.

The Digital World Versus The Real One

In theory, unlike some form of paper currency backed by gold or silver, fiat paper money can only or should only be expanded in tandem with GDP growth, otherwise you run the risk of devaluation vis-à-vis the value of the entire economy.  And that is what in theory the fiat paper money represents, the value of the entire economy as a whole.  And so here is another question for you.  Have the European and US economies expanded, contracted or remained stagnant since 2008?  And regardless of your answer, has the money supply indeed been expanded far and behind what that numerical answer is?

If the currency is backed by a precious metal (and redeemable for same) then of course more of the physical metal must be acquired before any more paper or substitute representations of that underlying metal can be created.  This is the complaint and restraint of using such a system.  Even if the economy does grow and more currency in circulation is needed, this can only be done by expanding the gold or silver supply being held by whatever said central bank in their vaults.

Regardless, there are many financial analysts and economic prognosticators that opine this current system or group of policies cannot go on forever and something has to give.  After all, if it were really true that economic prosperity could be achieved by simply creating an infinite amount of currency (digital or otherwise) then the only thing any country would need is a printing press (or a good computer system).  But alas that pesky thing known as reality comes back to haunt us.

However, we have to admit that living in a fake world of virtual reality or digital fantasy is more fun than the real thing.  And not only that, you get to have various lives in the make-believe world, what we would call a do-over when we were kids playing games whereby things did not go exactly as some would have liked.  The real world of course has its restraints and constraints.  In the real world one plus one still equals two, water is still wet and the sky blue (unless you live in China whereby the sky is a funky gray color).  In terms of economics and finance, balance sheets matter in the real world as does profit and loss.  In the digital world of avatars and electronic fantasy, everything and anything goes with no rules, no constraints.

Economic Confidence Must Be Earned !

However, there is nothing wrong with physical paper or digital representations of the real economy or real tangible assets providing it is correct and honest.  After all there certainly is a tremendous convenience using such a system in terms of trade settlements, making payments and so on.  But, if for example, you have US$1 Trillion Dollars worth of gold or silver and issue US$2 Trillion worth of physical or digital representations, you have committed a fraud.  Likewise, under a fiat system, if you create such same currency in excess of GDP growth or even the total value of the economy itself, that is also a form of fraud albeit one more difficult to prove because of the esoteric nature of calculating the value of an economy.

The central banks of the developed world are of course focused on keeping the digitally induced economic fantasy alive.  The idea and philosophy is that if equity and debt markets can be kept elevated then this alone will provide confidence (there’s that word again) to the general public so they can believe the economy is actually sound.  And so the theory goes, if the average citizen believes, they will continue to spend and borrow as if the future is so bright you need to wear sunglasses.  US Federal Reserve Chairwoman Janet Yellen has now gone so far as to suggest the US Central Bank directly buy stocks as has the central bank of Japan has been doing (how’s that working out?).  And none other than former director of the US President’s National Economic Council and current Harvard University Professor Lawrence Summers concurs (but this also is a guy that wants to eliminate physical cash as well, so take that for what it’s worth).

Saner and sounder minds think there will be a reckoning, adjustment or some kind of reset resulting from all this final fantasy adult play.  A forced pulling of the plug on the play station box to use a metaphor.  Some are predicting a coming new dual currency system in the US (a domestic US Dollar, which would be the proverbial bathroom tissue currency and another separate international US Dollar, which supposedly would be the real deal).  Likewise we have heard rumblings about an EU split resulting in a new so-called Nordic Euro for the northern European nations (with presumably a separate Euro for the southern nations if not even a return to their previous domestic currencies).  China and Russia are rumored to want some kind of gold backed trade settlement system to alleviate the risk of getting paid in monopoly money from another country and we would presume they want to see gold as the global central bank reserve and not another fiat currency.

The Chinese currency was recently added to the IMF SDR basket, although no surprise there as everyone that has been watching this knew that it was coming.  However, while an interesting change for the IMF SDR basket, we do not see any earth shattering changes to come out of it, at least on the individual consumer or national level.  What is an SDR really?  It is an index of other fiat currencies.  It is not a currency used by individual citizens.  So, we see this as nothing more than a symbolic recognition of China’s growing importance in the world economy.

Getting back to the idea of pumping up stock markets, stock indexes and bond markets, what are all these things really?  Digital and or paper representations, nothing more.  If you own 10,000 shares of Coca-Cola stock, is there a fleet of soda delivery trucks driving around with a sponsored-by signage on the side with your name printed on it?  If the company were to declare bankruptcy, does such an event give you the right as supposed partial owner of the company to raid the warehouse and haul off US$200,000 worth of product?  Of course not.  Ownership of stocks and bonds, be it in paper or digital form is nothing more than a representative claim against the entity issuing such certificates or contracts.  And we would argue artificially and falsely manipulating such digital markets do not reflect real world economic reality, not will they force the real world to confirm to the fantasy digital world (unless you decide to ingest LSD, magic mushrooms or peyote in which case you might experience your dog or cat speaking to you in flawless mandarin, a whole other level of psychosis altogether).  In fact, there is a gross disconnect in the world today between what those paper or digital assets are supposed to represent and what is going on outside of the fantasy matrix the developed world’s central banks have helped create.

Here is something about confidence, faith and trust (terms which are interchangeable for the sake of our discussion) that should be understood.  It must be earned, constantly.  Participants in the economy at all levels must be assured that markets and those charged with supervision are honest and truthful in what they are doing and what they are reporting.  As we have already said, there is nothing wrong with digital, electronic of paper representations providing they reflect reality and are indeed honest representations of the underlying asset, commodity or whatever the case may be.  Politicians and central bankers can assume the average citizen is a rube or just plain dumb, but lacking a doctorate degree does not mean a person lacks common sense.  For these central bankers, we can only offer the follow advice: Overestimate your own supposed brilliance and cleverness and underestimate the average citizen’s ability to see through all the elfin magic at your own peril.

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About The Author: This article was written by John Schroder of Ascot Advisory Services. John’s firm has been helping clients in the Dominican Republic for the last 17 years with residency application services, naturalized citizenship filing, banking assistance and legal services pertaining to real estate (title transfers, legal representation at closing, sales contract review). You can contact him by telephone at 809-756-1917 or click the about the author link above to reach a contact page to send an email directly.