There is a clear link between our system of fiat (paper) money, the supply of money and credit in an economy, and the 30-year boom that came to a dramatic end in 2008. It's only by understanding this link that investors (and anyone with wealth) can appreciate just how fragile our financial system is, and what to do to protect themselves from its inevitable collapse.
First, we need to establish the link between fiat money and the amount of money in an economy.
Today, for the first time in history, we have a situation where all the world's currencies are fiat, which means they are money only because of government edict, i.e. because the law says so. None of these currencies have any intrinsic value, nor are they backed by any kind of reserves, such as gold or silver, or any other portable, durable, easily divisible item that is likely to be accepted as payment.
In the words of Federal Reserve Chairman, Ben Bernanke, "US dollars have value, only to the extent that they are strictly limited in supply." Therefore, as more dollars, euros, or British pounds are created, their value declines.
What this means is that when a government wants to pay for a new welfare program or campaign promise, there is nothing to stop them from creating more dollars, euros, or British pounds to pay for it, and they can do so essentially at the touch of a button.
Now that we have established the link between fiat money and the supply of money in an economy, we need to examine the link between the amount of money in the economy, and the boom-bust cycle that culminated in the global financial crisis of 2008. This is a process which is best described by the Austrian theory of the business cycle.
The Austrian theory of the business cycle makes the case that interest rates play a vital role in a healthy economy. That's because interest rates coordinate production over time. For example, when consumers save their money rather than spending it, interest rates have a natural tendency to decline because there is an abundance of available capital.
It's these low interest rates that encourage businesses to borrow money and begin expanding and developing new products. This is precisely the time when they should be expanding, because it's the time when consumers are saving, and therefore they will have money to spend on new goods and services at some time in the future.
Conversely, when consumers decide to spend their money today, rather than saving it, the supply of available capital falls, and so interest rates rise. This, in turn, discourages businesses from borrowing money to expand, which is a good thing because consumers won't have the money to buy their products when their expansion is complete.
So as we can see, by sending signals about the cost of borrowing, interest rates play a vital role in a healthy economy.
The problem arises when central banks intervene in the free market and artificially suppress interest rates, which is what they are doing today, and what they've done for the past thirty years.
When central bankers push down rates artificially, they send false signals to businesses encouraging them to borrow money to expand, because it's cheap to do so. The problem is, consumers aren't saving so they won't be able to buy the goods and services these companies produce once their expansion is over.
So by interfering in the free market to stimulate what they call "aggregate demand," politicians and central bankers actually perpetuate the boom, causing even greater misallocations of capital and malinvestment. Eventually, when the artificial boom finally turns to bust, as the laws of nature say it must, the bust is much bigger than it otherwise would have been had the politicians let the market correct itself.
Unfortunately, it was John Maynard Keynes, rather than the Austrian economists like Friedrich Hayek and Murray Rothbard that won the intellectual debate, and so we continue to follow a broken economic model which has been completely discredited.
The bottom line
What all this means is that politicians and central bankers will go to extraordinary lengths to try to resurrect the artificial boom and keep the credit bubble expanding. They will continue to punish savers and encourage investors to take risks. They will keep the price of money (interest rates) artificially low for as long as they can. And they will continue to bailout insolvent nations, banks and companies.
Eventually, however, there will be a trigger that bursts the credit bubble. Perhaps it will be another financial crisis, or perhaps the OTC derivatives market will blow up, or maybe the trigger will be a war.
Regardless of the trigger, the important thing to realize is that our current system of fiat money, fractional reserve banking, too-big-to-fail, crony capitalism and Keynesian economic doctrine is not sustainable. And when the bubble finally bursts, we will experience a severe deflationary depression during which we will hopefully redesign our economic system, starting with our broken money. Then, and only then, can we begin a new cycle of true lasting prosperity.
In order to protect themselves from this inevitable collapse, investors need to consider holding a portion of their wealth in physical gold and silver outside the banking system. Once they have accumulated this safety net, they can then begin looking at other assets that are likely to do well during this period.