Is the unbridled creation of credit and money since the U.S. Gold reserve requirement elimination Act of 1968 and the subsequent breakdown of the 1971 Bretton Woods Agreement destined to lead the world’s developed economies to a disastrous choice between hyperinflation and economic depression? This is a distinct possibility, according to author and economist Richard Duncan, who believes that the global economy is on the brink of a global depression as countries have shifted from a gold-backed currency to one that is driven by credit creation and consumption. In his book, The New Depression: The Breakdown of the Paper Money Economy (John Wiley & Sons, 2012), Duncan presents an engrossing and thought-provoking history of the demise of gold reserve requirements and the subsequent expansion of the credit bubble as banks created credit almost at will. He argues that when the U.S. ended the requirement that dollars be backed by gold reserves, it ushered in an era of pure fiat money, money that was money only because the government said it was. In other words, money backed by nothing except the willingness of someone to accept it. Constraints on money creation were thereby removed, and the U.S. dollar’s gold backing went from 25 cents per dollar in 1968 (it had been almost 100 percent in 1949) to a small fraction of a cent today. At the same time, the U.S. Federal reserve Board repeatedly lowered the reserves that banks were required to hold against bank deposits. These reserves and vault cash have declined from 7 percent of total assets in 1968 (17 percent in 1949) to under 0.6 percent today. Total debt in the U.S., which averaged 150 percent of GDP during the period from 1946 to 1970, has reached 360 percent of GDP today.

Duncan notes that the U.S. economy has grown, particularly in the past three decades, to a large extent on the basis of debt creation and consumption, not primarily as a result of capital formation and investment. He also argues that debt, because of its liquidity and ubiquity, has become a kind of money and that capitalism as we knew it has been transformed into “credit- ism.” Duncan’s analysis raises several interesting questions: is fiat money creation undermining public confidence in paper currencies and fuelling the desire among investors to accumulate gold? Are central banks being allowed to play with fire by being accorded such freedom to print fiat money? Is there a better way of disciplining the creation of fiat money? And, finally, is some form of hybrid gold/silver/commodities-backed standard for currencies a potential solution?

We found Duncan’s analysis intriguing, so we decided to ask investment industry leaders for their views on the impact of fiat money and the future of the global economy. Are we indeed on the brink of a global depression or hyperinflation, as Duncan suggests? Or are such concerns overblown? Irrespective of the perspectives one is inclined to take on these issues, all would agree with one conclusion: confidence in banks and the financial system is fragile since the financial crisis of 2008. As a result, the pressure on central banks to avoid any serious mistakes is greater now than it has ever been.

Avery Shenfeld, Chief Economist at CIBC

Many investors would answer yes to these questions, and they have taken market positions aggregating many billions of dollars to reflect their views. However Avery Shenfeld, Chief Economist at CIBC, believes there is no need to ring any alarm bells. He notes that the U.S. Federal reserve Board (the “Fed”) is not directly printing money when it engages in quantitative easing. Rather, it is buying bonds in exchange for reserve deposits at the Fed. These reserves do not count as part of the money supply. Technically, they can enhance money supply growth since reserves are required to be held against banks’ assets, so an increase in reserve balances gives banks the potential to lend more, and loans create deposits at banks (for the borrower) that do count in the money supply. But Shenfeld observes that U.S. banks have more than uS$1.5 trillion in excess reserves, so reserves are therefore not the binding constraint determining lending growth. (He cites capital requirements and risk tolerance as the currently operative constraints.) M2 growth (the broadest measure of money growth now tracked) is not running at a historically atypical rate at present. In essence, he states there is no massive expansion of the money supply underway, and there is plenty of time to prevent one, should lending activity accelerate.

While a government might be tempted to monetize its debt and let inflation run higher than target in the next expansion in order to shrink debt relative to nominal GDP, Shenfeld states that there is no suggestion currently that the Fed would go along with the idea.

Shenfeld acknowledges that quantitative easing could lead to inflation if it is inadequately unwound when the economy starts accelerating, but he states that there is no evidence at present that central banks are going to make that mistake. He suggests that when the Fed does begin to tighten, perhaps in 2015, it will likely be a great disappointment to those now stocking up on inflation hedges, such as gold.

James Davis, CFA, Vice-President, Strategy & Asset Mix and Chief Economist at Ontario Teachers’ Pension Plan

Like Shenfeld, James Davis is also of the view that money creation is not currently a threat, adding that when it comes to bank loans and leases, annual growth in the U.S. has actually declined since the abandonment of the gold standard, averaging only 8 percent since 1971 compared to 11 percent from World War ii to 1971. He notes that money creation is driven by the demand for credit and that reserves play no direct role in the credit creation process other than to accommodate the demand for credit at the central bank’s targeted policy interest rate.

On commodity-backed currencies, Davis notes that they have been attempted on numerous occasions throughout history, all ending with the same result—dissolution and abandonment as they tend to generate financial market instability and worsen the consequences of economic downturns. Davis acknowledges that a gold-type standard may indeed reduce the government’s ability to alter the money supply, but it increases the ability of external factors to do so at the same time. A massive new gold discovery for example can cause the money supply to increase and introduce an inflationary impulse. Or, conversely, hoarding gold creates a deflationary event. This raises the question of whether it is wise to hand over “control” of our own money supply to external people/factors/events, just for the sake of keeping it away from our own elected government.

“Requiring a central bank to print money to increase government’s purchasing power invariably ignites a hyperinflationary firestorm. The result through history has been toppled governments and severe threats to societal stability.” – Alan Greenspan

Finally, Davis argues that over the long term, the viability of fiat currencies will depend on the continued ability of a country to produce output and governments’ ability to provide sound steward-ship of the money that is backed by this productive output, i.e., stable inflation. A deterioration on either of these fronts will put the currency’s viability at risk, whether it is backed by a scarce commodity such as gold or by a government’s word and promise of stability.

Laurence Booth, CIT Chair in Structured Finance, Rotman School of Management

So, is the U.S. caught in a choice between depression and hyperinflation? According to Laurence Booth, this dire set of alternatives is unrealistic: “The U.S. is in a classic Keynesian liquidity trap where the velocity of money has collapsed and there is still a 6% to 7% output gap. So the possibility of a significant pickup in U.S. inflation is zero as the assumptions required for the quantity theory of money (simple monetarism) are not met.” In the eurozone, Booth believes there is no chance of a depression where labor is mobile. Spain and Greece, however, are stuck with rigid labor markets and, in his view, will be stuck with high unemployment as a result.

Is there a better way of disciplining the creation of fiat money? Booth argues there are two main macroeconomic tools: fiscal and monetary policy. To remove one of them by removing fiat money (monetary policy) would mean a return to the severe business cycle fluctuations we had in the 19th century and force all adjustments to be akin to what Greece and others are going through now. It would leave us at the mercy of random shocks in the creation of hard money, i.e., gold and silver.

Spain suffered huge inflation when it discovered the gold and silver mines of the new world. “Going back to a gold/silver standard would condemn future generations to suffer the same fate in reaction to future macroeconomic shocks,” Booth states.

Mark Carney, Bank of Canada governor and future Governor of the Bank of England

The view that current monetary policy can successfully balance inflation control and economic growth stimulus is shared by Bank of Canada Governor and future Governor of the Bank of England, Mark Carney, who, speaking on the topic of the international monetary system, recently rejected the need for either a return to a “barbaric relic” (the gold standard) or for the creation of a new “utopian central bank.” He argues instead that countries can and must restore their faith in the adjustment process under the current system. Carney maintains that the common lesson of the gold standard, the Bretton Woods system, and the current hybrid system is that it is the adjustment mechanism that ultimately matters, not the choice of reserve asset (which, for now, he believes should continue to be the U.S. dollar and SDRs, with potential future augmentation with other currencies). He advocates intensifying global actions to improve the resiliency of the world’s financial institutions, improving financial infrastructure and transparency, and reducing the interdependence between financial institutions as part of prudential management of systemic risk, with the role of the international Monetary Fund as a contingent supplier of liquidity being enhanced.

Putting the Genie Back in the Bottle

In his book, The New Depression: The Breakdown of the Paper Money Economy, author Richard Duncan argues that the global economy stands on the precipice of widespread economic disaster. With the demise of the gold standard and the rise of credit-driven monetary policy, Duncan paints a dark picture of the state of money in world today. We asked him whether he sees a better way to tame the paper money tiger. While he doesn’t think it’s possible to put the paper money genie back in the bottle, he does believe it’s time for some visionary thinking about how to fix the problems we face today, especially in the U.S. economy. Our questions and his responses are below.

Is there a better way of disciplining the creation of fiat money?

There used to be: it was the gold standard. Under the gold standard, the government could not create money because there were constraints around how much credit could be created. But there is no going back now. It would be like trying to shove the genie back in the bottle—the bottle would break. We can’t just suddenly cut off credit expansion cold turkey without it collapsing everything around it.

Is some form of hybrid gold/silver/commodities-backed standard for currencies a potential solution?

That would lead us to the same problem. We have become addicted to credit, and a rapidly increasing amount of it. In fact, right now our whole economic system depends on a rapid expansion of credit. If we cut that off in any way, then the economy collapses into depression.

Rather than going that way, we need to come up with new ideas and go into unchartered territory, taking advantage of the government’s ability to borrow at such low interest rates. The U.S. should use this opportunity to restructure its economy and develop industries so it can compete with low-cost labor in the developing world, solar energy, nanotechnology, and biotech. Right now, the U.S. has a chance to take advantage of the free money that is running out of our ears by the trillions. It could take it and use it wisely to create miracles. We could create a new industrial revolution and such a boom that the problems of our generation would be over.