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The Money Illusion

What is the Money Illusion? It is the belief that in increasing a nation's money supply, government is able to augment over-all economic well-being.

Consider the following analogy. Is it possible to increase the water level of a swimming pool by taking water from one end and pouring it into the other? The answer is evident: obviously not. Any water taken from the South end draws water from the North, East and West ends. In fact, this operation will always produce a net loss due to the cost of moving water from one end to the other and the physical loss of water incurred while handling.

Government subsidies are nothing more than another example of resource redistribution. Governments take money created by the private sector and give it to approved projects, public and private. No new wealth is created, just as the water level does not rise in the swimming pool.

If A, B and C are taxed to give a subsidy to Z, it is clear that the overall wealth of A, B, C and Z has not increased. A portion of A, B and C’s wealth has simply been moved to Z. To argue that this is a net benefit to society presupposes that politicians and bureaucrats are more competent decision-makers than individuals operating in a free market. It elevates political coercion over individual freedom.

To finance their programs, governments have three sources of income: taxes, borrowing and inflating the money supply. Taxes are taken under threat of force, borrowing is a delayed tax that must be paid with interest, while inflation increases the money supply thereby lowering the value of existing monetary units. When the state spends borrowed money, it consumes wealth it did not create in just the same way it spends money raised by taxation. Government borrowing is generally facilitated by the third income source, monetary inflation. This can be accomplished in one of two ways, by printing money or by creating bookkeeping entries when extending credit. In the case of credit, new money is created as follows. A borrower signs a promissory note for x amount. The bank takes the note and, on its books, credits the borrower’s account for x amount. This bookkeeping entry is then treated as a money equivalent and is traded back and forth within the banking system so that the original x amount multiplies. The illusive bookkeeping money is literally created out of thin air and is backed by central bank-issued paper redeemable in nothing.

There are two central truths about inflation: 1. Inflation is an increase in the money supply and 2. Credit is money. All other things being equal, an increase in the money supply will cause prices to rise while a contraction of the money supply will cause prices to fall

In almost all countries today, central bank policy and the money supply are controlled by a small elite group. When this group increases the money supply, society as a whole does not benefit. The opposite is true. It is government and the establishment controlling it that benefit from access to newly-created money. And when it is spent, the purchasing power of existing monetary units decreases. This new purchasing power is stolen goods. It does not create any new wealth or any real honest demand. Real demand is created by producing what the free market will pay for. The ability to exchange real production is real demand. Inflating the money supply does not create any new service or product.

Spending by the holders of newly-created money masquerades as real demand from the income of the politically well-connected when in fact it is capital stolen from the holders of existing monetary units. Taxing by theft of the purchasing powering of existing money is the most devious and dishonest way to raise government revenue. It harms honest savers and elevates theft to statecraft. The government sets a very bad example. The harm done far exceeds any other form of taxation. It misallocates resources by sending false signals to economic players during the boom phase and thus results in serious misallocation of resources that must necessarily be liquidated during the bust phase.

It is true that you can keep warm by burning your neighbor’s furniture in the fireplace but you should not therefore conclude that you have discovered a new economic law that will result in a permanently high plateau for share or real estate prices. It is very dangerous to base your financial planning on such illusions. If enough people are deluded by such fallacious reasoning, it may even result in a worldwide financial crisis.

There are three major reasons why the money fallacy persists. The first is historical. All money has its origins in the marketplace as the most accepted commodity for use in indirect exchange. Gold and silver have historically enjoyed the widest acceptance as commodity money. They are valued for use in ornamentation, dentistry, electronics etc. They are useful as a medium of exchange and a store of value.

With Nixon’s closing of the gold window at the New York Federal Reserve on August 15, 1971 the US$ lost its last link to gold. Curiously, the reserve status of the US$, though battered, has continued more or less intact until now. How can this be explained?

Governments are not able to define what money is. However, once the marketplace defines money, governments are able to debase it. They can today, through legal tender laws, force people to accept paper receipts as money in part because the receipts were once good for the delivery of a certain amount of gold. This is true even though they are no longer redeemable for anything. The public does not yet fully understand that today’s paper money does not have the commodity value of gold or silver, that in reality, it has no commodity value beyond the value of paper. The fact that the US$ was once a receipt for gold supports the fallacy that an increase in the amount of monetary units increases wealth. This was partly true when the monetary unit was gold. It is not true of today’s money. Failure to understand this truth contributes to support of policies calling for monetary inflation.

The second reason this money illusion exists is because people tend to and want to believe that what is good for them as individuals is good for everyone in society. It is true that if I receive a sum of newly created money and spend it to buy a house, car etc., my living standard has increased. It is not however true that this has increased the living standards of society as a whole. The swimming pool analogy applies here. The increase in the money supply did nothing to increase the amount of goods and services produced. Nor did it do anything to create new demand. It merely stole part of the purchasing power of existing monetary units and transferred it to the politically well-connected at the expense of everyone else. It is not always true that what is to the advantage of one person is to the advantage of the group. Greed may distort perception but a distorted perception does not change reality.

The third illusion is the fallacy of The Good Tsar, Our Dear Leader and all other forms of idol worship including substituting The State for G-d. The illusion that the ruling group has society's interests at heart is essential to the continued rule of the establishment. If the common person knew that he was being milked by a parasitic ruling cabal, the establishment would soon be replaced. Slavery is dependent on the consent of the slave. This is true of all forms of exploitation and oppression. In a democracy, consent is engineered through control over mass media. It appears that consent has seriously deteriorated during the current financial crisis and multi trillion dollar transfers to the establishment ruling class. Still, on balance the illusion is holding. Obama has been served up as the new icon worthy of worldwide mass worship and it appears that a large proportion of the American and world public have accepted him as such.

To summarize: The money illusion is the fallacy that a society can increase its gross domestic product, its well being, by increasing the money supply. This illusion has wide support within society because of the following three errors.

  1. The historical fallacy: What was true about money used in the past is true about money used today; or, that there is an inherent value in today’s money beyond the value of paper.
  2. The what is good for the individual is good for society as a whole fallacy or, one person’s ability to steal the purchasing power of the larger group's money supply is good for society.
  3. The idolatry fallacy. That our dear rulers have our best interests at heart; or, that those who have organized and operate a deceptive banking system have done so and continue to do so for the benefit of society and not for their own narrow interests.

The truth is not complex. Real demand is created by production. Monetary inflation is used to steal the purchasing power of existing money. Government policy promotes and protects this theft for the benefit of the establishment that controls government. The money illusion is used to hide these truths.

Money is one half of every transaction. The monopoly right to issue a nation’s currency is the most valued and has been the most fought over political privilege. Since the issuance of new monetary units steals the purchasing power of existing units it is necessary to hide what is really happening: theft. This is why 97% of what is written about economics is deliberately intended to mislead. If you understand what is really happening, you have a significant advantage in investing, business and life. There are economic laws that are as immutable as the law of gravity and there are cycles that are related to sun spots, weather and human emotions. Unless, however, you are reading the 3% of what is written that is true, you will be at a very serious disadvantage to those who know what the facts are and so understand what is really happening. In making investment decisions, we are competing with everyone else. Knowing what most people do not know is desirable. Knowing what decisions people are making based on illusion is important. They will most likely lose money. Being on the other side of their trade should be profitable.

A panic is when people realize that the wealth is gone. The wealth was stolen years earlier when the newly-created money was spent. Today’s panic is simply the emotional reaction to that realization. If you do not suffer from the money illusion, you will understand. There is no, zero possibility of increasing living standards for society as a whole by repeating the earlier theft through more monetary inflation as most of the world's governments are now doing. When a critical mass of people understands that, paper money will be rejected and the crack up boom will begin. At that point, paper money may quickly lose all value and the establishment may be forced to introduce a new currency backed by real value. Alternatively, we may see the introduction of a new totalitarianism and a long and deep depression. Current government responses do not bode well for an early end to the crisis. The one exception is Iran. It has recently been reported that Iran has spent $75 billion to convert all of its foreign currency reserves to gold and they are not keeping that gold in European or American banks. If they start minting gold coins, we may see a new world reserve currency emerge.

The recent strength of the US$ is a short term bear market rally based on the need to repay US$ debts. It is a classic short covering rally. When that plays out, the US$ will trade sharply lower. Now is a good time to decrease exposure to US$ based assets and to increase exposure to hard assets. Gold mining shares, in November 2008, present an exceptional value relative to risk. In January 2011, they are substantially higher but still provide, relative to current denominated assets, good long-term value.

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