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Published by: walker0869 on Apr 22, 2011
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 QB ASSET MANAGEMENTwww.qbamco.com 1 See Important Disclosures at the end of thisreport.March 2011In May 2007 we wrote a lengthy piece called “The Value of a Dollar” in which we argued the following:“Consistently excessive money and credit growthhas taken the US economy past the point of no return.What (policy makers) havedone consistently - and will continue to do - is inflate the money supply and promote more credit, thereby sustaining asset prices at the expense of the purchasing power of the USdollar. We argue the US dollar will ultimately lose its status as the world’s reserve currency. In fact, webelieve events currently unfolding may be foreshadowing the dollar’s eventual demise and replacement.” This paper updates those views and provides further perspective.Apropos of EverythingBy Lee Quaintance & Paul Brodsky“Truth is tough. It will not break, like a bubble, at a touch.Nay, you may kick it about all day, and it will beround and full at evening.” - Oliver Wendell Holmes, Sr.Each passing month brings wider and deeper global economic imbalances accompanied by what we perceive to bea general misunderstanding of their cause and impact. The source of these imbalances is the global monetarysystem. It continues its trend towards demise, as it must, and current events indicate an acceleration of this trend.The current monetary paradigm was structuredand developed over the twentieth centuryby liberal democraciesfor liberal democracies that, through unified sovereign management and coordination, controlled the perceptionof value and how the free world would account for it. The system was not structured to accommodate the dynamicshifts in global economics, trade incentives and political alliances brought about, ironically, by the consequences of democracy’s triumph and the emergence of large, formally closed economies into the global economy.Serious consideration as to the inadequacy of the current regime has not been addressed since the onset of creditweakness in 2007, which was and remains a manifestation of a broader currency problem. Widely differingeconomic incentives and political agendas in developed and developing economies further suggest that a new,unified monetary system is highly unlikely without substantial friction first. We suspect broad acceptance of a newsystem will ultimately come only after manifest crisis. “An event”; however, is not a necessary condition for thedemise of the current monetary regime or, for investors, substantial assetrevaluation. This paper discusses:1. Allegory of the Cave:The current global monetary system – how it works and how it differs from themonetary system as it is widely perceived, the incentive structure of various participants in thesystem, and the natural pressures on it to fail and change 2. Best Intentions & UnintendedConsequences:The new monetary regime we suspect the consensusof global policy makers would like to have, and why it will not happen3. Devaluation & Transformation: The next global monetary system, and the implications for assetsand wealthThis report includes section 1 only. Contact Paul Brodsky(pbrodsky@qbamco.com)for sections 2 & 3.QB ASSET MANAGEMENTwww.qbamco.com 2 See Important Disclosures at the end of thisreport.Allegory of the Cave The current global monetary system – how it works andhow it differs from the monetary system as it is widely perceived, the incentive structure of various participants in the system, and the natural pressures onit to fail and changeIn Plato’s Allegory of the Cave, it was suggested that men forced to face a cave wall their entire lives would seeonly shadows of figures behind their backs. That they could not see the actual figures led them to believe,withoutdoubt, that the shadows were reality and that no other reality existed.We use Plato’s allegory to describe thestark difference separating contemporary wealth, money and the exchange of economic value from erroneouspopular perceptionsof them. The fundamental difference is profound and has led to an environment in whicheconomic, financial, political and even social incentives have been greatly distorted and broadly misunderstood.Monetary DynamismIn 1913, the US federalgovernment became responsible for sponsoring one fungible US currency, replacingtheprevious system of disparate individual banknotes issued by independent banks. Treasury gave the FederalReserve System, a new privately-owned central bank created by Congress, exclusive rights and discretion to printand manage the supply of Federal Reserve Notes, now colloquially referred to as “dollars”. In that same
year, thegovernment instituted a federal income tax payable only in dollars (1%of income), thereby ensuring the dollar’sbroad adoption.Dollars were made exchangeable for gold at a fixed price of $20.64/ounce, which was meant to enforce monetarydiscipline on the banking system. This was thought necessary because excessive credit extension or money printingwould dilute the purchasing power of each dollar, in turn giving incentive to dollar holders to exchange theirdollars for scarcer gold. As bank regulator, the Fed was charged with making sure US banks kept adequate reservesto satisfy potential demands for gold in the event confidencein the dollar declined.It did not work so well for the Fed (or, consequently, anyone else). From 1917 to 1929 the US monetary base grewquite substantially andbank reserve ratios declined by 50%. The credit and asset bubbles this producedled to abust in 1929, a sudden re-marking of asset values to reflect lower credit valuations, and economic dislocationsresulting from the underfunded lending system. The monetary discipline of the gold standard had been bypassedthroughout the 1920s by banks and regulators through acceptance of a policy of unreserved lending, not only inthe US but Europe as well. (We discuss this in more detail below.)Despite this, the US dollar would become the world’s reserve currency. The USentered the two world wars afterother economic superpowers had already run up substantial debts. America benefited from heavy exports, muchof it in food and munitions during the wars. In addition, the US offered potential dollar holders deep capitalmarkets, an established court system, and a powerful military. Finally,and perhaps most important, the US hadaccumulated over 21,000 metric tons of gold, far larger than any other nation.As World War II drew to a close dollars were broadly used in non-US bilateral trade, held in reserve by globalbusinesses and official accounts, and the primary currency used to quote the global exchangeof goods, servicesand assets. Thus, the US dollar was firmly established as theworld’s only reserve currency and its hegemony wasunchallenged. In 1944 in BrettonWoods, New Hampshire, the US and the UK framed a new monetary orderintended togovern commercial relations among free market economies in the post-War era. Themost importantoutcome of Bretton Woods was that major global currencies would be exchangeable into US dollars, which in turnwould be exchangeable into gold at$35.00 (President Roosevelt devalued the dollar to $35/ounce in 1934).This system would ostensibly maintain currency discipline among global sovereign trade partners. Again, if they didnot practice sound money policies then they would see their currencies exchanged for gold. However, once againthe Bretton Woods systemdid not address the fundamental flaw that allowed governments and banking systemsto ignore the gold-exchange discipline -- fractional reserve lending, which allowed lending institutions to continuesynthesizing future demand for money by issuing credit that would not have to be exhausted. This allowed allgovernments andbanking systems to more or less cheat together, to manage money and credit growth beyond (orin spite of) contradictory natural commercial incentives. (We discuss this in more detail below.)QB ASSET MANAGEMENTwww.qbamco.com 3 See Important Disclosures at the end of thisreport.In 1961, Yale economist Robert Triffin warned that a national currency that also serves as an international reservecurrency poses natural conflicts forits policy makers, who must navigate both domestic and international aims.The specific dilemma would be that the flow of dollars into and out of the US could not occur at once to meetopposing objectives, and would thus create a wide and unsustainable negative balance-of-payments account forthe issuer of the reserve currency.Indeed in the late 1960s, US trade partners began exchanging their dollarreserves for official US gold holdingsafter the US ran significant deficits fromcosts associated with domestic preferences -- executing the Vietnamconflict andexpanding entitlement programs. In 1971, after US gold reserves had already been depleted from over21 thousand to about 8,300 metric tons, President Nixon defaulted on the dollar/gold exchangeability featurenegotiated in 1944 at Bretton Woods. Dollars and all other global currencies had officially lost theirasset-backed status. Adebt-backed monetary system had begun.And so began the modern era in which there would be no explicit or implicit monetary discipline. Public, for-profitbanking institutions had a license to effectively print the coin of all realms. Since 1971 commercial banks havebeen able to lend money into existence by

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