How do all of those surplus countries play into this falling dollar picture? Remember, former Fed chairman Alan Greenspan observed that in economics, the sum of all surpluses equals the sum of all deficits.

So when a surplus country stops investing that surplus in U.S. dollars, its currency will increase against the dollar. This realization has profound implications. Not only does the dollar continue to fall against other currencies; as it does so, it accelerates the undesirability of pegging currencies to U.S. currency or investing in Treasury bonds and other debt. In other words, it becomes less and less viable for foreign investors and central banks to fund ever – growing U.S. debt.

This is not just a problem of U.S. consumer debt trends. We may be the addicts, but we have codependents and enablers around the world. Just as the U.S. consumer is addicted to spending excesses, foreign exporters have become addicted to selling goods to Americans. The problem is with sellers, as well as buyers. The governments in those other markets are as concerned about the U.S. dollar’s fall as Americans are (or should be). Why? The fall of a dollar is the same thing as a rise in other currencies. So the competitiveness of the foreign export economy is damaged more and more as their own currencies increase in value. Just as a falling dollar hurts the buyer (Americans), a rising currency hurts the seller (foreign economies) in the same degree.

The United States is only one side of the problem. As the consumer, our dollars have tremendous influence throughout the world, if only because so many central banks (e.g., China’s) have pegged their currency to the dollar – and at the same time many exporting nations are seeing their currencies going up in value, making it untenable to continue exporting at the same rates as in the past. So we have, through trillions of dollars of debt accumulation, created a de facto dollar standard in much of the world economy.

The debt is based, however, on a worldwide bubble economy, perhaps the biggest bubble in world history. The whole theory behind this comprehensive “bubblization” (a new word for you, referring to the combination of federal deficit, trade, mortgage, housing, dollar, and credit bubbles all working together) has grown out of the economic theories of the Fed. Although Mr. Greenspan was the chief culprit behind the theory that spending is good, more spending is better, and the most spending is best, we can’t pin the whole thing on him. Like the U.S. consumer, he had enablers and codependents everywhere. His helpers include an array of bankers, corporate executives, and investors – all buying into the Greenspan version of the U.S. economy and how it just might work.

Now Mr. Bernanke, who happily puts himself out there as the leading economic forecaster and wise man, also contends that bubbles can’t be recognized until they burst. That’s like saying you can’t tell that your house is on fire just because smoke is billowing from the windows; you have to wait until it bursts into flame. The truth is, bubbles are easily recognizable well in advance of bursting, but we cannot know when they will burst. The dollar bubble is going to burst, and that is inevitable. The effects on the economy of that burst are going to be serious. As long as investors, consumers, and business managers continue to base our financial decisions on assets of inflated and unrealistic value, we are denying this inevitable outcome. The more we depend on those inflated values, the more damage we will suffer when the bubble bursts.

In the case of Japan in the recent past, its pattern was somewhat different from the U.S pattern of today. Japan’s deficit budget spending went into business investment, which in turn expands productivity and trade profits. Spending on business equipment and plans, commercial buildings, and other production – based infrastructure had a specific effect: When Japan’s economy slowed down, it merely came to a halt and has remained chronically slow ever since. In comparison, U.S. deficit spending is overwhelmingly going into consumer spending with very little business investment or consumer savings to offset that trend. Thus, the U.S. trend in GDP is led by consumption and not by investment. So the use of deficit spending has everything to do with the consequences of deficits, and ultimately with the effect of a dollar crash. Unlike Japan’s economy, which merely flattened out as a consequence of deficit spending, the U.S. economy is likely to see a more devastating change in the entire economic landscape – with the accompanying price inflation we have to expect as an outcome.

Addison Wiggin
for The Daily Reckoning Australia

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Pretty faces, angry rappers, desperate U.S. retailers, happy shopaholic tourists, and Canadians who have finally turned the tables on us...we wondered what on earth is happening, as 2007 drew to a close and this new edition of The Demise of the Dollar goes to press.

Although Gisele has denied making any such claim about her payment currency of preference (and has stated that she is happy to earn salaries in a variety of currencies), the fact that this story spread like wildfire through media outlets from Bloomberg and CNBC to E! News and People speaks volumes. The dollar has little credibility on the streets of New York - or pretty much on any street around the world. The twilight of the Great Dollar Standard Era is upon us. The euro is now worth almost 50 percent more than the U.S. dollar, and in Great Britain, you can get two U.S. dollars for every British pound.

In 2007, the famous refrain in the poem by Emma Lazarus describing the flood of foreigners streaming to U.S. shores needs to be updated to "Give me your tired, your rich, your huddled masses yearning to shop free." Seven out of every $10 that fuels our gross domestic product (GDP), the measure of a nation's productivity and hence security, comes - not from goods and services that we produce and sell - but from shopping. We're addicted to cheap credit.

American consumers face the spectre of losing value in their retirement savings, finding out they cannot live on a fixed income, and suffering from chronic hyperinflation. These changes are unavoidable. Today, the problem is compounded because the U.S. dollar's value is falling. It all involves productivity changes in the United States. We have not competed with the manufacturing economies in other countries, and that is why our credit (i.e., our dollar) is suffering.

Any number of things could create a sudden, wrenching drop in the dollar's value. Consider the following three possibilities:

1. Foreign countries drop their U.S. dollar reserves. We depend on foreign investment in our currency to bolster its value or, at least, to slow down its fall. When that thinly held balance changes, our dollar loses its spending power.

At a November 2007 meeting of the Organization of Petroleum Exporting Countries (OPEC)'s 13-member cartel, Iranian President Mahmoud Ahmadinejad, whose country already receives payment for 85 percent of its oil exports in nondollar currencies, urged other countries to follow suit and "designate a single hard currency aside from the U.S. dollar...to form the basis of our oil trade." "The empire of the dollar has to end," chimed in Venezuela's Hugo Chavez; his state oil company changed its dollar investments to euros at his order - er, request.

Rumors are circulating that the Bank of Korea, after selling off $ 100 million worth of U.S. bonds in August 2007, is getting ready to sell $1 billion more, and if Washington forces trade sanctions, China, which threatened recently to cash in $900 billion of U.S. bonds, will probably follow suit.

In Russia, Vladimir Putin's dream of a stock market to trade the country's natural resources in rubles is not so far-fetched; in 2005, Russia, the world's second-largest exporter of oil, followed South Korea's lead and ended the dollar peg. And once again, Sudan is hinting that it will impose trade or financial sanctions against companies that do business with the United States - only this time, the words just might have teeth. As other countries follow suit, the dollar - and your spending power - drops. What does this mean? You will need more dollars to buy things than it takes today.

2. Oil prices increase catastrophically. We - and our real inflation rate - are at the mercy of Middle East oil. In 2005, we couldn't imagine what would happen if the price of oil were to double - or triple; but that's exactly what has happened in 2007 as oil kept flirting with $100-a-barrel prices. Our vulnerability is not imaginary. For example, if terrorists were to contaminate large reserves with nuclear radiation, the supply of oil would drop and prices would rise. We are all aware of our vulnerability and dependence on oil, but we don't like to think about it. Rising oil prices affect not only what you pay at the pump, but many other prices as well: nonautomotive modes of travel, the cost of utilities, and local tax rates, for example. It all adds up to unquestioned "pain at the pump" for American consumers. By September 2007, gasoline averaged $ 2.78 a gallon - double 2002's price. "Pain at the pump" leads to "pain in the pocketbook," as consumers know. You're not seeing double in the checkout line at the grocery store - costs really are double. There was a 5.6 percent increase in 2007, compared with 2.1 percent for all of 2006.

3. The double whammy of trade and budget deficits. We're living beyond our means. It's as simple as that, and something is going to give. The federal budget deficit - annual government spending that is higher than tax revenues - adds to the national debt at a dizzying rate, making our future interest burden higher and higher every day. Our trade deficit - bringing more things in from foreign countries than we sell to the same countries - has turned us into a nation of spendaholics.

We've given up making things to sell elsewhere, closed the store, and gone shopping. But we're not spending money we have; we're borrowing money to spend it. In 2006, the trade and budget deficits doubled the deficits of 2001. Any head of a family knows that this cannot go on forever without the whole thing falling apart - and yet, that is precisely what we are doing on a national scale.

Even as our economy burns, our political leaders fiddle. They point to economic indicators to prove that our economy is strong and getting stronger. This information would be valuable...if only it were true.

Politicians like to measure the economy with esoteric indicators. For example, we are told that consumer confidence is up. Well, confidence is all well and good, but what if it isn't accurate? Yankee optimism has achieved a lot in the past 200 years, but it alone is not going to prevent the current dollar crisis from getting worse and worse.

Does this mean that the United States is finished? No, but it does mean that our long history of economic power and wealth is being eroded from within. For most people, the real state of our economy is measured in one way: jobs. Sure, the number of jobs rises every month, but the complete truth is not as reassuring. We are losing high-paying jobs in manufacturing and replacing them with low - paying jobs in health care, retail, and other menial job markets. Our mantra of "Yankee ingenuity can accomplish anything" is gradually being replaced with a new mantra: "Would you like fries with that?"

Regards,

Addison Wiggin
The Daily Reckoning Australia

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• Australian Trade Deficit Grows for 75th Consecutive Month
• Australian GDP is Doing Better Than the U.S.

The trade deficit—the excess of imports over exports—has a direct and serious effect on the value of U.S. dollars. As long as we continue having big trade deficits, it means we’re spending more money overseas than we’re making at home. Our manufacturing profits are lower than our consumption. If your family’s budget has a “trade deficit” of sorts, you’ll soon be in trouble. If your spouse spends $4,000 for every $2,000 you bring home, something eventually gives way. This is what is going on with the trade deficit.

In fact, the trade deficit is one of the most important trends in the economy, and the one most likely to affect the value of the dollar. Combined with our government’s big budget deficit, the trade deficit only accelerates the speed of decline in our dollar’s value. Speaking in terms of spending power of the dollar, the trade deficit is the third rail of the economy. Here is what has been going on: The United States used to produce goods and sell them not only here at home, but throughout the world. We led the way, but not anymore. The shift away from dominance in the production of things people need has allowed other countries (most notably, China and India) to pass us up, and now the U.S. consumer has become a buyer instead of a seller.

This international version of conspicuous consumption is financed not from the profits of commerce, but from debt. Let’s think about this for a minute. If we were buying from domestic profits, the trade deficit wouldn’t be such a bad thing. It would mean we were spending money earned from domestic productivity. But this is not what is going on. We are going further and further into debt to buy goods from other countries.

American wealth is being transferred overseas and, at the same time, Americans are sinking deeper into debt. This is taking place individually as well as nationally. Consumer debt (you know: credit cards, mortgages, lines of credit) is growing to record levels, and the federal current account deficit is moving our multi trillion-dollar national debt into new high territory.

Sure, we should be concerned about retirement income from savings, investments, pension plans, and Social Security. But a bigger danger is that, even with a comfortable retirement nest egg by today’s standards, what if those dollars are worthless when we retire? What then?

The big question today is, how long can this debt-driven economy continue? If you quit your job and refinance your home, you could live for a while on the money. The higher your equity, the longer you would be able to spend, spend, spend. But then what?

This is precisely what is going on in the U.S. economy and, at some point very soon, we are going to have to face up to it and change our ways. The trade deficit is the best way to track what’s going on. Returning to the analogy of quitting your job and living off of your home equity, you may stay home all day and order an endless array of electronics, furniture, toys, computers . . . in other words, you could consume goods in place of working. But remember, you didn’t win the lottery; you are financing this “new plan” with borrowed money. The lender will want that repaid. So this individual version of a trade deficit (the deficit between generating income and spending money) is what is happening on a national level in the United States.

This is the problem that is directly affecting the value of the dollar; and the situation is getting worse. We know that the dollar is in trouble because we see it depreciating against the floating currencies of other countries. America has a lot of wealth, but that wealth is being consumed very quickly. History shows that no matter how rich you are, you can lose that wealth if you’re not productive. Meanwhile, the dollar’s value falls and - in spite of the Fed’s view that this is a good thing - it means our savings are worth less. Your spending power falls when the dollar falls, and as this continues, the consequences will be sobering.

The dollar’s plunge has taken many people, currency experts of banks included, by surprise. For many of them, it is still impossible to grasp. Some talking head on CNBC said that he was at a complete loss to understand how such weak economies as those seen in the European Union could have a strong currency. For America’s policy makers and most economists, the huge trade deficit is no problem. They find it natural that fast-growing countries import money while slow-growing economies export money. At least, that is the recurring theme.

So Americans traveling abroad may continue to complain that “it has become so expensive to travel in Europe” as though the problem were somehow the fault of the Europeans. But in fact, it is the declining spending power of the dollar that is to blame, and not just the French, the Italians, and the residents of the so-called “chocolate making” countries.

This problem is pegged not to some speculative or fuzzy economic cause, even though the concept of currency exchange rates continues to mystify. A historically large trade deficit is at the core of the declining dollar. Somebody needs to get over the notion that our economy is strong and other economies are weak, merely because this is America. In the United States, the reason for the trade deficit is not a high rate of investment as we see in some other countries, but an abysmally low level of national savings. We are spending, not producing.

A second argument offered by some is that “capital flows from high-saving countries to low-saving countries, wanting to grow faster.” Under this reasoning, a deficit country, looking at both consumption and investment, is absorbing more than its own production. But whether this is good or bad for the economy depends on the source and use of foreign funds. Do those funds pay for the financing of consumption in excess of production (as in the United States) or for investment in excess of saving? That is the key question that ought to be asked in the first place about the huge U.S. capital imports.

To quote Joan Robinson, a well-known economist in the 1920–1930s close to John Maynard Keynes: “If the capital inflows merely permit an excess of consumption over production, the economy is on the road to ruin. If they permit an excess of investment over home saving, the result depends on the nature of the investment.”

The huge U.S. capital inflows (economic jargon for money coming into the country), accounting now for more than 5 percent of gross domestic product (GDP), have not financed productive investment. America’s net investments are among the lowest in the world, meaning we prefer spending and borrowing over actual production and growth. The huge capital inflows have not helped finance a higher rate of investment. America has been selling its factories and financial assets to pay for consumption.

It’s helpful to use a real means for measuring economic strength. Money coming here from overseas finances higher personal consumption. The steep decline in personal saving is a symptom of our spending, and along with that habit we have lower capital investment and a growing federal budget deficit. The U.S. economy has for years been the strongest in the world, leading the rest of the countries. Our Daily Reckoning newsletter routinely gets reader responses saying, in effect, “How dare you impugn the superiority of the American economy! How dare you!”

We’re rather thick-skinned so the insults bounce off rather easily. But “facts are stubborn things.” The fact that the U.S. economy has outperformed the rest of the world in the past several years is easily explained. Our credit machine has been operating in overdrive nonstop.

It is geared to accommodate unlimited credit for two purposes— consumption and financial speculation. Let’s look at these two things a little more deeply. Credit is not the same thing as production, despite the fuzzy logic you get from the financial media. There is a severe imbalance between the huge amount of credit that goes into the economy and the minimal amount that goes into productive investment. Instead of moving to rein in these excesses and imbalances, the Greenspan Fed has clearly opted to sustain and even to encourage them. Today it is customary to measure economic strength by simply comparing recent real GDP growth rates. It is pointed to as proof and applauded by U.S. economists when U.S. economic growth outscores Europe— like some kind of dysfunctional futbol match.

Financial speculation is equally unproductive. An investor puts up capital to generate a sustained and long-term growth plan. For example, buying and holding stocks is a form of investment and a sign that the investor has faith in the management of that company. peculators don’t care about long-term growth. They want to get in and out of positions as quickly as possible, make a profit, and repeat the process. So speculative profits—especially those paid for with borrowed money—tend to be churned over and over in further speculation and increased spending. None of that money goes into investment in the long-term sense. The speculator is invested in short-term profits, nothing more. Even so, the speculator is today’s cowboy, the risk-taking, living-on-the-edge market hero willing to take big chances. He is seen as a guy with big stones because he’s staring the prospect of loss right in the eye.

Regards,

Addison Wiggin
The Daily Reckoning Australia

• None Found

The Industrial Revolution moved economic power in ways that continue to affect economic balances to this day. And now we face another great shift, away from US dominance of world markets and toward new leaders - China and India.

The economic reality - a type of geography - is changing. As a consequence, real estate speculation in New York, Chicago, and Los Angeles may be replaced with more global interest in the new real estate markets - in Beijing, Shanghai, and Bombay. Who knows? We can only anticipate how changes will occur based on what we observe today. Does this mean the age of America is ending? No, it simply means that economic muscle will be flexed by someone else in the future. This is a trend. And like all trends, they are more easily viewed in historical perspective but harder to judge from their midst.

When we look at trends in dollar values, we can observe that incomes have not declined. That's great. But we also see that prices have risen faster than incomes. So with decreased buying power (caused by this disparity) we have seen a decline in income in terms of what really counts. It takes more dollars to buy the same thing (in other words, prices are higher) but incomes have not risen to meet that price inflation. That's what happens when the value of the dollar declines.

Economic history is a history of bubbles - and of bursts. The great disservice being done to United States citizens by the financial media is that they are not being offered the opportunity to learn from what is going on. They are losing buying power, but apart from a few painful spikes at the gas pumps, it's invisible.

In the Great Dollar Standard Era, the problem is global. While there is, of course, more to it than just the value of the US dollar, here is how it works:

1. The dollar's value falls due to Fed policy, liberal credit, and artificially low interest rates.

2. Eventually, we cannot afford to buy as many foreign goods.

3. Foreign manufacturers, unable to sell at previous levels, have excess inventory, which causes an inflationary outcome.

4. Foreign governments, in an effort to counteract this inflation, blame the fallen dollar for the problem and begin moving out of US instruments.

5. As debt returns to the United States, our system is unable to absorb it. This creates more severe recession in America.

The whole thing is connected. This is similar to what happened worldwide at the end of the 1920s.The worldwide depression had numerous aspects, but most notable among them were two things: a huge transfer of funds from World War I reparations, and far too much credit that went beyond the borrowers' ability to repay. All of that credit - essentially, funny money - also creates a fake demand.

We see the effects of this policy in housing as severely as anywhere. The whole housing bubble mess is traced back to the origin - a Fed policy encouraging debt spending as a means to artificially create the appearance of productivity. This Fed policy has included four aspects:

1. The Fed has lent money below inflation. Fed lending rates have been far below inflation (even as measured by the consumer price index, not to mention any real inflationary measurements). In a very real sense, the Fed has lost money on these loans. When inflation is higher than the lending rate, it is a loss. Just as a business cannot stay open when it sells goods below cost, the Fed cannot continue to hold the view that it isn't real money. The point is, the money lent out at bargain rates is real credit, and that is corrupted when it is given away cheaply.

2. The low interest rates have created the housing bubble without any corresponding investment. It is basic: if you borrow money to invest in productivity (new plants and equipment, for example) it is a profitable use of money. But those low interest rates have gone, instead, into cheap long-term mortgages. Current homeowners have refinanced, and many first- time buyers have gotten into the market because low rates make housing affordable.

3. The mortgage bubble has inflated the housing market in an exaggerated fashion, creating the illusion of equity. All of that cheap money has created two troubling changes in housing. First is higher demand for owner-occupied housing based on the low cost of borrowed money rather than on any real market forces. Second is the resulting equity buildup from rapid expansion of market value in residential property. But it is as fake as the low interest rates. Like all pyramid schemes, the whole thing will eventually crumble under its own weight. We do not have an endless supply of new home ownership demand; quite the contrary. The baby boomers mostly own homes already, and a smaller population of people coming into home ownership age will ultimately result in an oversupply of housing stock. Once the mortgage bubble bursts, we can expect to see several consequences:

• Defaults on existing loans. As rates on variable mortgages begin to rise right up to their cap rates, we'll see many of those marginal loans go into default. Many Americans are barely able to afford the mortgage payments they are making based on low interest qualification. But as the Fed finally faces reality and allows interest rates to rise, those variable increases will kick in as well. Many existing loans will be defaulted as a result.
• Reduced market value from oversupply of housing. The oversupply in building will become suddenly obvious. At some point, when the bubble bursts, everyone will realise that too many homes were built too quickly, and the anticipated demand simply isn't there. The result: those skyrocketing market values will disappear.
• Abandonment of no-equity properties. The reduced market value in homes is not going to be limited to a simple supply and demand cyclical change. For investors, reduced demand and flat or falling prices may be viewed as a cyclical and natural effect. But when the supply-and-demand cycle has been manipulated through interest rate policy, we have to expect a more wrenching effect. For those who enter into the housing market when prices are inflated, the day arrives when they realise that real equity is below zero.

There remains no incentive to continue making payments, notably when lenders are raising rates and when the dollar's buying power is tumbling. In such a severe condition, marginal buyers are going to simply walk away from their properties. Why stay when there is no equity - or worse, minus equity?

• Secondary market fallout from these changes. Where does all of that mortgage debt end up? It isn't held by your local bank or savings and loan. It all gets sold to Ginnie Mae, Freddie Mac, and other mortgage pools, who then package it up and sell it on to investors, many of them from Europe and Asia. Imagine how those pools will perform when the foreclosure rate rises and when - at the same time - market values fall. A high rate of foreclosures in an overbuilt market spells disaster in the housing sector.

While a normal supply and demand cycle may last three to five years on average, this downturn could be severe, going much longer into the future. The actual length of the housing recession would depend on how decisively the Fed will be willing to act and to fix the problem.

4. The lack of investment and a flat manufacturing trend are damaging the US competitive position in the world market. Imagine an economic situation in which enterprising homeowners refinanced their homes when rates fell, invested the money in small business expansion, and created an internationally competitive economic climate.

Well, this is the rosy picture the Fed hopes will eventually emerge from its monetary policies. By artificially lowering interest rates and enabling homeowners to get at their equity, the idea is that on a broad range of economic trends (housing, business investment, savings, etc.) there will be a strong growth spurt, an economic recovery that will return the United States to its leading position. But the lack of investment is doing great damage. The whole thing is credit-based, starting with the Fed losing on below-inflation loans and ending up with credit based spending but no real productivity.

It appears that Federal Reserve policy has been premised on the idea that lower interest rates bring down inflation. Yet there is no evidence of that in economic history. It has always been an effective policy to raise rates to slow down inflation, just as lead rods are moved into the radioactive core of a reactor to cool down the chain reaction.

Higher rates put a damper on spending. This has been recognised widely, so the Fed policy - based on the idea that lower rates are "good for the economy" - is baseless. In fact, it is damaging. The housing market and its mortgage bubble will most likely be the first and most visible victims of this policy.

Regards,

Addison Wiggin
The Daily Reckoning Australia

• None Found

And Cerberus — the three-headed dog who guards the gates of Hades — gets to keep the car company. Cerberus now owns the Chrysler, Dodge and Jeep makes, and Chrysler Financial. They just bought GMAC financing, the only part of GMC worth a spit. And they’re looking at the 2005 bankruptcy Oscar winner, Delphi.

Look for Cerberus to come out strong next year with a new and improved debt-free global automaker for sale… and a fistful of performance fees stuffed into its own pockets.

Addison Wiggin

• None Found

What kinds of events could do the same thing to the U.S. dollar, and what can you do today to position yourself strategically? The potential fall of the U.S. dollar is good news if you know what steps to take today. We're not as insulated as many Americans believe. In the 1930s, 20 percent of all U.S. banks went broke and 15 percent of life savings went up in smoke. After the emergency measures put into effect by President Franklin D. Roosevelt through the Emergency Banking Relief Act of 1933, confidence was restored with another piece of legislation: the 1933 Glass-Steagall Act. This bill created the Federal Deposit Insurance Corporation (FDIC), insuring all U.S. bank deposits against loss.

The severity of the growing situation had been seen well in advance. The financial newspaper Barron's, established in 1921, editorialized in 1933 that: "Since early December, Washington had known that a major banking and financial crisis was probably inevitable. It was merely a question of where the first break would come and the manner of its coming."

Two weeks earlier, the same column cautioned its readers that when the dollar begins to lose value, this leads to a series of "flights" - from property into bank deposits, then from deposits into currency, and finally from currency into gold.

We can apply these astute observations from 1933 to today's currency situation. The government, anticipating a flight from currency into gold, had already made hoarding gold or even owning it illegal. The second step - insuring accounts in federal banks - helped to calm down the mood. By preventing the panic, currency stabilized. But in those times, we were still on the gold standard. The currency in circulation was, in fact, backed by something. Remember, that riverboat gambler who keeps asking for ever-higher markers will eventually run out of credit. At some point the casino boss realizes that his ability to repay is questionable. Maybe those markers are just a heap of IOUs that can never be cashed in.

In the 1930s, the causes of the Great Depression were complex but related to a series of obvious abuses in monetary, financial, and banking policies. History has simplified the issue by blaming the Depression on the stock market crash (which takes us back to the explanation that "wet sidewalks cause rain"). The stock market crash, one of many symptoms of policies run amok, has lessons for modern times. The unbridled printing of money - expansion of the "IOU economy" - is good news for those who recognize the potential for gold.

We hear experts on TV and in the print media shrugging off the deficit problems. "Our economy is strong and getting stronger" is the mantra of those with a vested interest in keeping dollars flowing: Wall Street brokers and analysts, for example. But we cannot ignore the facts. The federal deficit is growing by more than $40 billion per month. It is not realistic to point to this economy and say it's doing just fine.

Gold is the beneficiary of reckless monetary policies and the War on Terror. Check the average value of an ounce of gold over the past decade. It has been rising steadily since the end of 2001. The cause of this change in gold's price may be attributed at least partly to the attack on the World Trade Center. But it reflects equally on the Fed's monetary policies and spiraling debt-based economic recovery. During the same period that gold prices have begun to rise, we should also take a look at the trend in money in circulation.

This is troubling for the dollar but - again - great news for gold. Remember what the world economic and political situation was like in the early 1970s: a weakening dollar, easy money, and international unrest. Sound familiar? We're back in the same combination of circumstances that were present when gold prices went from $35 to over $800 per ounce.

The numbers prove that gold is going to be the investment of the future. World mining in gold averages 80 million ounces per year, but demand has been running at 110 million ounces. So if central banks want to hold the value of gold steady, at least 30 million ounces per year must be sold into the market. This creates a squeeze. As the dollar weakens, central banks will want to increase their holdings in gold bullion, not sell it off.

This is why gold's price has started to rise and must continue to rise into the future. As long as that demand grows - and it will rise as the dollar's value continues falling - the price of gold simply has to reflect the forces of supply and demand.

But, you might ask, why do central banks want to hold down the value of gold? We have to recognize how this whole money game works. Most world currencies are off the gold standard, following the U.S. example. So as gold's value rises, it competes with each country's currency. Of course, the trend toward weakening currencies and the continuing demand for gold mean that the growth in gold's value could continue strongly for many years to come.

When the United States removed its currency from the gold standard, it seemed to make economic sense at the time. President Nixon saw this as the solution to a range of economic problems and, combined with wage and price freezes, printing as much money as desired looked like a good idea. Unfortunately, most of the world's currencies followed suit. The world economy now runs primarily on a fiat money system.

Fiat money is so-called because it is not backed by any tangible asset such as gold, silver, or even seashells. The issuing government has decreed by fiat that "this money is a legal exchange medium, and it is worth what we say." So lacking a gold backing or backing of some other precious metal, what gives the currency value? Is there a special reserve somewhere? No. Some economists have tried to explain away the problems of fiat money by pointing to the vast wealth of the United States in terms of productivity, natural resources, and land. But even if those assets are counted, they're not liquid. They're not part of the system of exchange. We have to deal with the fact that fiat money holds its value only as long as the people using that money continue to believe it has value - and as long as they continue to find people who will accept the currency in exchange for goods and services. The value of fiat money relies on confidence and expectation. So as we continue to increase twin deficit bubbles and as long as consumer debt keeps rising, our fiat money will eventually lose value. Gold, in comparison, has tangible value based on real market forces of supply and demand.

The short-term effect of converting from the gold standard to fiat money has been widespread prosperity. So the overall impression is that U.S. monetary policy has created and sustained this prosperity.

Why abandon the dollar when times are so good? This is where the great monetary trap is found. If we study the many economic bubbles in effect today, we know we eventually have to face up to the excesses, and that a big correction will occur. That means the dollar will fall and gold's value will rise as a direct result.

The sad lesson of economic history will be that when the gold standard is abandoned, and when governments can print too much money, they will. That tendency is a disaster for any economic system, because excess money in circulation (too much debt, in other words) only encourages consumer behavior mirroring that policy.

Thus, we find ourselves in record-high levels of credit card debt, refinanced mortgages, and personal bankruptcies - all connected to that supposed prosperity based on printing far too much currency: the fiat system.

We can see where this overprinting will lead. As debt grows relative to gross domestic product (GDP), we would expect to see positive signs elsewhere, such as a growth in new jobs. But like a Tiananmen Square Rolex watch deal, the value simply isn't there. Job growth is slow but, in reality, there is a decline in earnings. High paying manufacturing jobs have been replaced and exceeded by low-paying retail and health care sector jobs, so even if more people are at work, real earnings are down. Instead of simply measuring the number of jobs, an honest tracking system would also compare average wages and salaries in those jobs. Then we would be able to see what is really going on - more low-paying jobs being created, replacing high-paying jobs being lost.

Addison Wiggin
The Daily Reckoning

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It was a significant opportunity. But it fell short of what could have been achieved. It was a turning point in monetary history, however.

The result of this international meeting, the Bretton Woods Agreement, had the original purpose of rebuilding after World War II through a series of currency stabilization programs and infrastructure loans to war-ravaged nations. By 1946, the system was in full operation through the newly established International Bank for Reconstruction and Development (IBRD, the World Bank) and the International Monetary Fund (IMF).

What makes the Bretton Woods Agreement so interesting to us today is the fact that the whole plan for international monetary policy was based on nations agreeing to adhere to a global gold standard. Each country signing the agreement promised to maintain its currency at values within a narrow margin to the value of gold. The IMF was established to facilitate payment imbalances on a temporary basis.

This system worked for 25 years. But it was flawed in its underlying assumptions. By pegging international currency to gold at $35 an ounce, it failed to take into effect the change in gold's actual value since 1934, when the $35 level had been set. The dollar had lost substantial purchasing power during and after World War II, and as European economies built back up, the ever-growing drain on U.S. gold reserves doomed the Bretton Woods Agreement as a permanent, working system.

This problem was described by a former senior vice president of the Federal Reserve Bank of New York:

"From the very beginning, gold was the vulnerable point of the Bretton Woods system. Yet the open-ended gold commitment assumed by the United States government under the Bretton Woods legislation is readily understandable in view of the extraordinary circumstances of the time. At the end of the war, our gold stock amounted to $20 billion, roughly 60 percent of the total of official gold reserves. As late as 1957, United States gold reserves exceeded by a ratio of three to one the total dollar reserves of all the foreign central banks. The dollar bestrode the exchange markets like a colossus."

In 1971, experiencing accelerating depletion of its gold reserves, the United States removed its currency from the gold standard, and the Bretton Woods Agreement was no longer workable.

In some respects, the ideas behind Bretton Woods were much like an economic United Nations. The combination of the worldwide depression of the 1930s and the Second World War were key in leading so many nations to an economic summit of such magnitude. The opinion of the day was that trade barriers and high costs had caused the worldwide depression, at least in part. Also, during that time it was common practice to use currency devaluation as a means for affecting neighboring countries' imports and reducing payment deficits. Unfortunately, the practice led to chronic deflation, unemployment, and a reduction in international trade. The lessons learned in the 1930s (but subsequently forgotten by many nations) included a realization that the use of currency as a tactical economic tool invariably causes more problems than it solves.

The situation was summed up well by Cordell Hull, U.S. secretary of state from 1933 through 1944, who wrote:

"Unhampered trade dovetailed with peace; high tariffs, trade barriers, and unfair economic competition, with war... If we could get a freer flow of trade ... so that one country would not be deadly jealous of another and the living standards of all countries might rise, thereby eliminating the economic dissatisfaction that breeds war, we might have a reasonable chance of lasting peace."

Hull's suggestion that war often has an economic root is reasonable given the position of both Germany and Japan in the 1930s. The trade embargo imposed by the United States against Japan, specifically intended to curtail Japanese expansion, may have been a leading cause for Japan's militaristic stance.

Another observer agreed, saying that poor economic relations among nations "inevitably result in economic warfare that will be but a prelude and instigator of military warfare on an even vaster scale."

Bretton Woods had the original intention of smoothing out economic conflict, in recognition of the problems that economic disparity causes. The nations at the meeting knew that these economic problems were at least partly to blame for the war itself, and that economic reform would help to prevent future wars. At that time, the United States was without any doubt the most powerful nation in the world, both militarily and economically. Because the fighting did not take place on U.S. soil, the country built up its industrial might during the war, selling weapons to its allies while developing its own economic strength. Manufacturing by 1945 was twice the annual rate of 1935-1939.

Due to its economic dominance, the United States held the leadership role at Bretton Woods. It is also important to note that the United States owned 80 percent of the world's gold reserves at the time. So the United States had every motive to agree to the use of the gold standard to organize world currencies and to create and encourage free trade. The gold standard evolved over a period of hundreds of years, planned by a central bank, government, or committee of business leaders.

Throughout most of the nineteenth century, the gold standard dominated currency exchange. Gold created a fixed exchange rate between nations. Money supply was limited to gold reserves, so nations lacking gold were required to borrow money to finance their production and investment.

When the gold standard was in force, it was true that the net sum of trade surplus and deficit came out to zero overall, because accounts were eventually settled in gold - and credit was limited as well. In comparison, in today's fiat money system, it is not gold but credit that determines how much money a country can spend. So instead of economic might being dictated by gold reserves, it is dictated by a country's borrowing power. The trade deficit and the trade surplus are only "in balance" in theory, because the disparity between the two sides is funded with debt.

The pegged rates - the value of currency to the value of gold - maintained sensible economic policy based on a nation's productivity and gold reserves. Following Bretton Woods, the pegged rate was formalized by agreement among the leading economic powers of the world.

The concept was a good one. However, in practice the international currency naturally became the U.S. dollar and other nations pegged their currencies to the dollar rather than to the value of gold. The actual outcome of the Bretton Woods Agreement was to replace the gold standard with the dollar standard. Once the United States linked the dollar to gold at a value of $35 per ounce, the whole system fell into place, at least for a while. Since the dollar was convertible to gold and other nations pegged their currencies to the dollar, it created a pseudo-gold standard.

The British economist John Maynard Keynes represented Great Britain at Bretton Woods. Keynes preferred establishing a system that would have encouraged economic growth rather than a gold-pegged system. He favored creation of an international central bank and possibly even a world currency. He proposed that the goal of the conference was "to find a common measure, a common standard, a common rule acceptable to each and not irksome to any."

Keynes' ideas were not accepted. The United States, in its leading economic position, preferred the plan offered by its representative, Harry Dexter White. The U.S. position was intended to create and maintain price stability rather than outright economic growth. As a consequence, Third World progress would be achieved through lending and infrastructure investment through the IMF, which was charged with managing trade deficits to avoid currency devaluation.

In joining the IMF, each country was assigned a trade quota to fund the international effort, budgeted originally at $8.8 billion. Disparity among countries was to be managed through a series of borrowings. A country could borrow from the IMF, which would be acting in fact like a central bank.

The Bretton Woods Agreement did not include any provisions for creation of reserves. The presumption was that gold production would be sufficient to continue funding growth and that any short term problems could be resolved through the borrowing regimens.

Anticipating a high volume of demand for such lending in reconstruction efforts after World War II, the Bretton Woods attendees formed the IBRD, providing an additional $10 billion to be paid by member nations. As well-intended an idea as it was, the agreements and institutions that grew from Bretton Woods were not adequate for the economic problems of postwar Europe. The United States was experiencing huge trade surplus years while carrying European war debt. U.S. reserves were huge and growing each year.

By 1947, it became clear that the IMF and IBRD were not going to fix the problems of European postwar economic woes. To help address the issue, the United States set up a system to help finance recovery among European countries. The European Recovery Program (better known as the Marshall Plan) was organized to give grants to countries to rebuild. The problems of European nations, according to Secretary of State George Marshall, "are so much greater than her present ability to pay that she must have substantial help or face economic, social, and political deterioration of a very grave character."

Between 1948 and 1954, the United States gave 16 Western European nations $17 billion in grants. Believing that former enemies Japan and Germany would provide markets for future U.S. exports, policies were enacted to encourage economic growth. During this period, the Cold War became increasingly worse as the arms race continued. The USSR had signed the Bretton Woods Agreement, but it refused to join or participate in the IMF.

Thus, the proposed economic reforms turned into part of the struggle between capitalism and Communism on the world stage.

It became increasingly difficult to maintain the peg of the U.S. dollar to $35-per-ounce gold. An open market in gold continued in London, and crises affected the going value of gold. The conflict between the fixed price of gold between central banks at $35 per ounce and open market value depended on the moment. During the Cuban missile crisis, for example, the open market value of gold was $40 per ounce. The mood among U.S. leaders began moving away from belief in the gold standard.

President Lyndon B. Johnson argued in 1967 that:

"The world supply of gold is insufficient to make the present system workable - particularly as the use of the dollar as a reserve currency is essential to create the required international liquidity to sustain world trade and growth."

By 1968, Johnson had enacted a series of measures designed to curtail the outflow of U.S. gold. Even so, on March 17, 1968, a run on gold closed the London Gold Pool permanently. By this time, it had become clear that maintaining the gold standard under the Bretton Woods configuration was no longer practical. Either the monetary system had to change or the gold standard itself would need to be revised.

During this period, the IMF set up Special Drawing Rights (SDRs) for use as trade between countries. The intention was to create a type of paper gold system, while taking pressure off the United States to continue serving as central banker to the world. However, this did not solve the problem; the depletion of U.S. gold reserves continued until 1971. By that time, the U.S. dollar was overvalued in relation to gold reserves. The United States held only 22 percent gold coverage of foreign reserves by that year. SDRs acted as a basket of key national currencies to facilitate the inevitable trade imbalances.

However, the Bretton Woods Agreement lacked any effective mechanism for checking reserve growth. Only gold and the U.S. asset were considered seriously as reserves, but gold production was lagging. Accordingly, dollar reserves had to expand to make up the difference in lagging gold availability, causing a growing U.S. current account deficit. The solution, it was hoped, would be the SDR.

While these instruments continue to exist, this long-term effectiveness can only be the subject of speculation. Today SDRs make up about 1 percent of IMF members' nongold reserves, and when in 1971 the United States went off the gold standard, Bretton Woods ceased to function as an effective centralized monetary body. In theory, SDRs - used today on a very limited scale of transactions between the IMF and its members - could function as the beginnings of an international currency. But given the widespread use of the U.S. dollar as the peg for so many currencies worldwide, it is unlikely that such a shift to a new direction will occur before circumstances make it the only choice.

The Bretton Woods system collapsed, partially due to economic expansion in excess of the gold standard's funding abilities on the part of the United States and other member nations. However, the problems of currency systems not pegged to gold lead to economic problems far worse.

Addison Wiggin
The Daily Reckoning

Editor's Note: Addison Wiggin is the editorial director and publisher of The Daily Reckoning. Mr. Wiggin is also the author, with Bill Bonner, of the international bestseller Financial Reckoning Day and the upcoming thriller Empire of Debt. Mr. Wiggin is frequent guest on national radio and television programs. 

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