Your National Debt and
Funny Money

Promises, promises, promises!
Today governments guarantee payment of the value of bank notes which has a legend on it saying 'I promise to pay the bearer the sum of...' the face value of the note.

Originally the system was that the government would redeem the note for a fixed weight of gold.

The Gold Standard
This fixed price for a known weight of gold was the 'gold standard' where the government maintained a fixed price for an ounce of gold. As government borrowing increased beyond the asset value of governmental assets, there was a natural upward tug for valuation of gold, real estate and so on, as the value of the paper currency became devalued and bought less and less. More money was required to buy the same thing--inflation or appreciation, call it what you will.

America ends the gold standard in 1971
The gold standard parity was maintained by 44 governments around the world under a system called the Bretton Woods agreement of 1944. The chief features of the Bretton Woods system were an obligation for each country to adopt a standardized gold price monetary policy.

This policy ensured that each country maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and the ability of the International Monetary Fund (IMF) to bridge temporary imbalances of payments. The value at that time was fixed at US $35 per troy ounce of gold.

Then, on August 15, 1971 President Nixon of the USA unilaterally terminated convertibility of the dollar to gold. This 'Nixon Shock' created the situation whereby the United States devalued it's debt, and the dollar became the sole backing of currencies and a reserve currency for the member states. This had to happen in the face of increasing financial strain attributable to the dubious and profligate American financial policies.

• The 'strain' then was, that because of excess paper money printed by the USA and it's hugely expanding national debt, other countries started to demand gold in exchange for the American debt that they held. This situation is being repeated again today where global inflation due to American debt has decimated world economies.

Today's banknotes are valued artificially as gold is not any more the standard that backs government banknotes. This is another reason that gold prices keep going up over time.

Prudent money management has eluded governments over the past few centuries for the same reason that the French economy went broke by 1720 because of the Mississippi Bubble, which was the forerunner of the modern paper money system. (More about this further down this page.) The temptation for politicians to print more money than the real worth of assets, goods, services represented by the paper money is too great for them to pass up. This is to the ultimate detriment of all of us.

• A nation's enterprise value or gross domestic product (GDP) is the value of all goods, services and financial dealings including all debt domestic and international. Printing and circulating more paper money than the GDP value is equivalent to selling the same product more than once to different people and then naturally defaulting on delivery.

Getting Buffaloed!
This is similar to the buffalo scam going on a few years back under the government-sponsored agricultural loan schemes.

The scam was that, against the purchase of a buffalo, the person would get loans from say 2 different banks at low rates. The same buffalo had magically multiplied to double in value while remaining the one. The banks collectively had this one buffalo as 2 buffaloes and valued them as such in their books of accounts.

'2-for-1'
In effect this is what governments do when they print more money than the real value of what the money represents. This fake '2-for-1' is short-changing the people. This is the so-called 'inflation' cost where things begin to cost more than earlier because extra money is circulating in the economy without any assets backing it. The current rate of total national debt outstanding is around 80% of the GDP, and the current budget deficit for 2010 is estimated at being 6%, but may well turn out to be higher.

• In other words, the real worth of a 100 rupees is only 20 rupees in terms of the the true value of the GDP. Or, we could say that what should cost 20 rupees is costing a 100 rupees--or that 20 buffaloes are masquerading as a 100! This is accumulated and ongoing inflation which is reflected in escalating prices and cost of goods and services.

Your National Debt
Ultimately you pay for the national debt in terms of higher prices, eroding money value, erosion of savings and higher taxes. You are not insulated from the folly of greedy and self-serving politicians who mismanage and misuse public funds. Ultimately we all have to pay.

Minting Money

• Gold, on the other hand retains it's value over time in the sense that it continues to buy the same type of goods and services it did 500 or a 1,000 years ago. In addition to the Italian holiday example above, consider that an excellent Roman toga in ancient Rome cost about one ounce of gold. Today, despite inflation and the national debt, a first class Armani suit ensemble would cost around $1,100--or one ounce of gold at today's prices.

  The rising price of gold reflects that the purchasing power of paper money has reduced—it takes more paper money to buy the same amount of gold. In other words, gold appreciates over time.

• Gold does not give a financial return or interest, but maintains its value over time (appreciates), while 'fiat' paper money value deteriorates.

  Therefore for over 5,000 years gold has remained a storehouse of value while many fiat paper money regimes have come and gone while others exist today in a collapsed form (Greece, Japan and other countries) or a collapsing form as shown graphically further on in this article. National debt fueled by paper money can only end badly for the general citizenry, as it has in the past.

The Ascent of Money
Professor Niall Ferguson talks about this in his Emmy Award winning BBC and PBS series--'The Ascent of Money.'

This series is occasionally broadcast by Fox History in India. You can watch a free Q&A webinar with Professor Ferguson at this PBS link. It addresses some questions in the wake of the current American led economic downturn and it's current national debt picture.

In a recent Ascent of Money episode about financial bubbles, the professor takes a hard look at the origins of the widespread use of paper money, and the invention of the first joint stock or publicly traded company.

The first big Government IPO and financial bubble
John Law (c. 1671–1729), a Scotsman, created the first huge public asset bubble--the 'Mississippi Bubble' of 1719.

This bubble led to the collapse of the French economy and then, indirectly, to the French Revolution.

Law studied banking and is described as a convicted murderer, a compulsive gambler and a financial speculator--a flawed financial genius.

Louis XIV's wars had left France financially and economically decimated--the national debt was horrendous. Law was appointed the Controller General of Finance where he proposed replacing gold with paper credit and then increasing the supply of credit. He also proposed to reduce the national debt by replacing it with shares in economic ventures.

• Your government is doing just this today--selling off government owned economic ventures (Public Limited companies) through overpriced IPO's to the people through the share market. The response of the public has been wary and lukewarm. Some recent overpriced IPO's include companies like Oil India and NMDC (National Mineral Development Corporation).

  The majority of these IPO stocks were sold to institutional investors (with difficulty) including other government owned companies, which in turn bought these with government credit--Another '2-for-1' type of scam which is paid for by the public in the form of higher prices for the products these companies sell--petroleum products, metals and minerals. All this increases the the public national debt.

• Update: Here is an interesting article about how the LIC of India is bailing the government out, precisely as mentioned above.

Lies, damned lies and statistics!
Although Law's theories ultimately failed disastrously, these were considered as 300 years ahead of their time. Today's financial mavens consider him a brilliant economist. In his book-- 'John Law: Economic Theorist and Policy-Maker', A. E. Murphy (Oxford University Press, 1997) says Law "captured many key conceptual points which are very much a part of modern monetary theorizing".

These failed and cheating concepts are still being promoted today by deluded economists and cynical politicians. Murphy's book is credited for majorly changing opinion about Law from con-man and crook to important economic theorist who went from living like a multimillionaire, to end his life in poverty in Venice.

A book by Charles Mackay published about John Law over a 100 years later in 1848 makes an interesting account of Law and his times. Appropriately titled 'Memoirs of Extraordinary Popular Delusions and the Madness of Crowds' it is as timely a read today as when first published. Apparently, Popular Admiration of Great Thieves (chapter 14) holds true today as well! A quotation famously attributed to British Prime Minister Benjamin Disraeli (1804-1881) says it all: "There are three kinds of lies: lies, damned lies, and statistics."

• In other words, the paper money and debt-driven economic downturns of world economies, India's national debt economy included, are following the same pattern of artificially created boom and bust. Shakespeare had it right--
  'Neither a borrower nor a lender be;
  For loan oft loses both itself and friend,
  And borrowing dulls the edge of husbandry.'

  Governments have certainly lost the edge of husbandry, or the careful management and conservation of resources of the economy. By issuing government paper without adequate asset or resources backing it, the government creates conditions for inflation, deflation, recession and generally the reduction of purchasing power and monetary value.

  The growing national debt is evidence of this.

The Worldwide National Debt
Porter Stansberry's S&A Digest of March 10 talks about this and refers to a graphic chart by Doug Casey on the national debt position of countries.

I am reproducing this chart and have added a marker for India's financial situation based on data from governmental statistics and other economic data. India's debt situation is at least as bad as the French and Eurozone countries.

Our cumulative national debt is running at about 80% of annual GDP (total value of goods and services for the year for the country). The 2010 budget deficit is estimated at about 6%. From the chart below it is evident that we, along with France and the Eurozone are just under the line that separates us from the really bankrupt nations—such as the USA, Portugal, Ireland, Greece and Spain.

The American financial fraternity sarcastically refers to the last 4 nations as the "PIGS" countries. With the USA now weighing in as a huge national debt country whose monetary policies triggered the current worldwide financial crises, they would now have to change the PIGS acronym from 'you PIGS' to 'US-PIGS'!

The European Commission's late 2009 forecast for the Eurozone countries' national debt and budget deficits is as dismal as anyone's.

• The bottom line seems to be that only 'real' assets and enterprise activity will retain value as paper backed values will evaporate as unsustainable public debt overtakes nations.

(Updated July 2010)The current national debt of countries as a percentage of the annual GDP is charted here . The GDP is the total value of goods and services a nation produces. By this standard our national balance sheet is rather poor, despite all the hype claiming good management of the county's finances.

Saving Ourselves
In practical terms it means to put one's savings in safe money instruments and investments, allowing for both short-term expenditure needs and longer-term capital safety and income needs.

• As an incentive for savings, the government guaranteed Public Provident Fund (PPF) is one of the best saving schemes available. The principal amount is tax deductible up to Rs. 70,000/- per year, and currently returns 8% annually tax-free. PPF amounts are not subject to wealth tax and cannot be attached for any debts.

Total deductions in all tax saving instruments are available up to Rs. 100,000/- per year per taxpayer. These include National Savings Certificates, post office savings, RBI and other bonds, life insurance premiums, equity linked savings schemes of mutual funds.

• Other savings one should look at having include short-term requirements such as living expenses and contingencies for 6 to 12 months. These should be easily encashable and would typically be bank or safe corporate or government guaranteed fixed deposits, and short-maturity government debt through debt mutual funds.

Longer term savings can be:

• Gold and silver bullion.
• Investing in income bearing assets like real-estate that would appreciate in time.
• Some exposure to stocks of suitable companies. These are, of course not risk-free, but depending on one's risk appetite one may invest systematically for the longer term over a period of time. An easier way to do this is to buy into one or two mutual funds that have a suitable risk profile. Value Research Online gives comprehensive information about mutual funds.
• Insurance is very strongly sold as a 'savings'/investment ('money-back') product whereas it is not so. Selling insurance such as ULIPs or 'money-back' plans as savings or investment plans is a downright cheating proposal. Click here to read about why to avoid ULIPs.
• Savings should be considered entirely separate from life insurance. The cheapest and most useful form of life insurance is term life insurance. To create long-term savings it is better to invest in mutual funds that are balanced between equity and debt exposure, and invest in them in a systematic investment plan (SIP) on a monthly or quarterly basis. You can find details about well performing hybrid mutual funds at this link at Value Research Online.

  Go to this link for how to maximize small savings.