In today’s issue:
- Five types of monetary system
- Why do they matter to investors?
- Which system will we turn to next?
Yesterday, we looked at why our monetary system is about to die. And why this will radically alter how you should invest for the next few decades.
So, how should you invest for the coming reset?
That depends on what sort of monetary system we adopt next…
There are plenty of options to choose from. Money is a surprisingly fickle creature. All sorts of monetary systems have existed in the past. And technology has created some entirely new options we might choose in the future as well.
You can sort them into five groups.
- Commodity money, like gold and silver coins
- Precious metals backed money, when each banknote represents a redeemable amount of gold or silver
- Free banking, when private banks create their own forms of money
- Government-controlled fiat money which is unbacked by anything of intrinsic value
- Independent central bank-controlled fiat money which is also unbacked
We obviously live under option five today. But how did we get here?
If you can answer that, you’ll quickly realise that we might soon be in for another round of change…
Monetary revolutions do happen
Hundreds of years ago, nobody trusted governments or banks with abstract forms of paper of money. We demanded real money – coins made of valuable metal like gold and silver.
It was a simple system. Until you try to conduct large-scale trade.
And so the idea of paper money that’s redeemable in precious metals emerged. It was a lot easier to make transactions with.
As ever, it was the private sector that came up with the innovation. Banks simply issued their own paper currency. Before the government decided it wanted the power for itself.
But Scotland still had a system of free banking until 1844. That’s why Scottish banks still have their own banknotes today. (This caused several hours of chaos for me at an Australian airport’s customs office once.)
For decades, the English system of government money relied on precious metals backing. The government promised to redeem its banknotes for some measure of gold and/or silver.
The amounts you could redeem it for might change. And whether the government could live up to its promise might change. But precious metals still played some sort of role in reining in government spending.
That lasted until the World Wars. Then the UK went off the gold standard. And never quite returned fully. Instead, we adopted the US dollar standard. Just as the gold-backed pound had been the global currency, the gold-backed US dollar became the next one.
Of course, not everyone trusted the pound or the US dollar. But they could ask for their cash, meaning gold, if they wanted to redeem it.
One day the French tried to redeem their US dollars for gold. And President Richard Nixon closed the gold redemption window instead of handing it over.
At that moment we crossed into a government-controlled monetary system. Nothing backed our money anymore. The result was terrible inflation in the 70s.
People eventually realised that you can’t trust politicians with a printing press when there’s no requirement to back the money with gold. They’ll print too much. And so we handed the power over to independent central banks instead. Because academics are better with money than politicians…
That’s the evolution of our monetary system. A severely simplified version, anyway. But notice how much it has changed over time. And how many different setups there are.
The first point to grasp is, monetary revolutions do happen.
Why do they matter to investors?
Each of these systems defines which set of investments perform well. Consider our current monetary system, for example. What influence does it have on how our wealth grows?
We live under a currency system controlled by the central bank. The supply of money and the price of money (the interest rate) are both controlled by the Bank of England. But there is no limit to how much money they can create.
That is very favourable to property investors. Because the property sector is the one most exposed to interest rates. And it benefits from inflation by devaluing debt.
Our common global currency system uses the US dollar, and has for 80 years now. We call this system the Bretton Woods System. And it gives the US economy an unfair advantage. That’s one reason why it performs so well and why its financial markets are so dominant.
By the way, when former MP Steve Baker discovered he’d lost his seat in the last election, what did he choose to tell a TV audience about? He warned about the end of the Bretton Woods System! Another sign we are on the cusp of change…
But, if you ask me, the Bretton Woods System ended decades ago when President Richard Nixon ended the US dollar’s convertibility into gold. An entirely new global trading system was born.
It is controlled by the US central bank, the Federal Reserve. When it changes interest rates or the money supply, it doesn’t just affect the US. It affects the global trading system.
That’s why the US sub-prime bubble was actually a global phenomenon. The Federal Reserve had kept interest rates too low for too long, inflating a vast bubble in asset prices. It explains why all investors must all pay attention to what’s going on in the US.
The Bretton Woods System also radically changed in several other ways. We saw fixed exchange rates, floating exchange rates and a mix of the two, for example. That’s a radically different set of monetary systems to live under. I suspect it benefits the UK economy greatly by allowing us to devalue the pound whenever our economy gets into trouble.
What next?
Investors who want to know what sort of environment they will be doing their investing in need to understand the monetary system they live in. And, if it’s about to change, what the next system might look like. It’ll define which asset classes rise and fall.
I’ll reveal the answers to those questions soon.
Until next time,
Nick Hubble
Editor, Fortune & Freedom
