Money Printing, Brazilian Style

I am pleased to share with you this guest commentary by John Lee of Mau Capital Management LLC. He makes a very insightful observation that is not widely recognized or well understood, but is of importance to every American. In the essay below, he says: "The end effect of issuing Treasury notes is no different from direct money printing. Money printing is cleverly disguised through these tiered levels of the banking system..."

To explain this point, the framers of the Constitution crafted that document to limit the powers of the federal government. One of those limitations was the power to "coin money". Thus, it is patently obvious that the federal government was not empowered to "print" money. Further, in Article I, Section 10, the framers specifically prohibited any of the States from issuing "Bills of Credit", which was their 18th century term for paper currency.

The framers well understood the pitfalls of fiat currency not redeemable into gold or silver, having lived through the collapse of many colonial government currencies as well as the continental, the paper currency of the first national government, the Continental Congress. Rather than paying in gold or silver coin to settle its obligations, the Continental Congress printed ever greater amounts of continental paper currency to pay its bills. So in effect, bills were not paid. The payment obligation imposed by those bills was not extinguished. Rather, the form of the obligation of the Continental Congress just changed, as its countless bills were simply turned into paper currency without any reduction in its debts. Bills for goods and services provided to the Continental Congress were 'paid' with continental paper currency. It was in effect a paper bill for a paper currency swap, with disastrous results that the framers wanted to prevent from happening again.

So historically in the US, it wasn't the US Treasury, but rather commercial banks that provided paper currency, until the creation of the Federal Reserve in 1913. It commandeered for itself the paper currency issuing function. So to understand John Lee's point, think about what the Fed does.

Without getting into all of the detailed mechanics of the process, in effect the Fed buys debt from the US government with newly printed paper currency and newly created deposit currency it puts into the banking system. While the Continental Congress only dealt in paper currency, modern economies deal in two - paper currency and deposit currency. The latter where money moves around within the banking system, has become a vastly more important medium in transactions than cash.

After receiving these two forms of currency from the Federal Reserve, the US government then 'pays' its bills. So instead of issuing paper currency itself to pay its bills as the Continental Congress did, which would contravene the Constitution, the Federal Reserve turns the US government debt it purchases into paper currency called Federal Reserve Notes, which is the title on each piece of paper-cash in your pocket. It is Federal Reserve Notes that then circulate as bills of credit, rather than US government issued paper currency. This two-step process allows the federal government to deviously sidestep the important 'money' creation limitation imposed on it by the Constitution. But these Federal Reserve Notes are in effect "Bills of Credit", as John Lee explains: "The end effect of issuing Treasury notes is no different from direct money printing. Money printing is cleverly disguised through these tiered levels of the banking system..."

Though the spirit and intent - if not the letter - of the Constitution has been broken with the Federal Reserve's money printing process, the system worked well enough under the gold standard. When the dollar's direct link to gold was jettisoned in August 1971, the last remaining discipline on the money creation process went with it. Ever since, the US dollar has been structurally no different than the continental. The US government is paying its bills with debt, not money - with bills of credit, not gold or silver (or any tangible asset for that matter). The US dollar is therefore on the same path taken by the continental, and in my view will therefore end up in the same place - the fiat currency graveyard.

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Money Printing, Brazilian Style
by John Lee
Mau Capital Management LLC

"It is well enough that people of the nation do not understand our
banking and monetary system, for if they did, I believe
there would be a revolution before tomorrow morning."
Henry Ford

When a government spends more than it collects, logically, there is a gap to fill.

Depending on the sophistication and popularity of the government, it can fill this gap in 2 ways:

1. Issue IOUs (Treasury Notes) to raise money
2. Print Money

When the government of Brazil ran a large budget deficit in the 1990s, it began to print money and spend it. Hyperinflation followed and they eventually replaced the old "cruzeiro real" currency with the new "real".

Of course, the banking systems of developed Western nations are a lot more sophisticated and governments are disciplined with their spending, right?

The above charts clearly demonstrate that over the last decade the US Treasury's IOU's are being issued at a more rapid pace than they are being repaid. The debt growth rate is now higher than GDP growth, a recipe for an eventual hyperinflationary outcome.

Institutional and central banks around the world are mainly an extension of their respective governments. Through fractional reserve banking, those banks have unlimited supply of paper money to buy things, including the purchase of IOUs issued by the government or anyone else.

Banks can issue dollars at no cost, and lend it to the US government through various public and private vehicles. The end effect of issuing Treasury notes is no different from direct money printing.

Money printing is cleverly disguised through these tiered levels of the banking system, that's why so few care, and hence the quote from Henry Ford above.

While some supply-side economists argue that enhanced budget-deficit spending is for the good of the people and therefore shouldn't be frowned upon so much, central banks and governments have now taken advantage of the financial illiteracy of the public to another level.

With millions of Americans now unable to meet house payments, and mortgage-backed securities liquidity completely dried up, the government and the Fed are taking unprecedented fiscal and monetary steps to maintain the fragile fiat money system.

1. They are looking into "forgiving" a certain amount of mortgage loans by distressed borrowers on a nation-wide scale.
2. They have injected about half a trillion dollars into the banking system, allowing any outfit qualified as an "institution" to borrow as much as needed, with the option to extend repayments until the they have the ability to pay.

In plain English, this is akin to saying that:

• because everyone is so indebted,
• but we the government still need to keep the system going,
• to the consumers we will just forgive some of your loans so your debt can come to a reasonable level and you can begin borrowing again; and
• to the institutions, we will lend you as much as you need for as long as you need until whatever problems you have go away.

All the checks and balances in maintaining even the illusion of a sound banking system have been blown away, and we are seeing direct money printing in its naked form.

There is only one place to go to preserve wealth in times like this: Gold

Witnessing the breach of key resistance level of $700, we are ready to embrace the most spectacular rise in gold since the gold bull started in 2001 at $250. Gold is primed for $850 and beyond in 2007. We see now as the optimal entry point on the following chart:

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JOHN LEE is the founder of Mau Capital Management LLC of Point Roberts, Washington, which manages the Golden Omega Fund LP, a fund focusing on small-cap precious and base metal mining companies.

Published by GoldMoney
Edited by James Turk, alert@goldmoney.com

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