QB ASSET MANAGEMENTwww.qbamco.

com 1 See Important Disclosures at the end of this

report.March 2011In May 2007 we wrote a lengthy piece called “The Value of a Doll
ar” in which we argued the following:“Consistently excessive money and credit growth
has taken the US economy past the point of no return.What (policy makers) have
done consistently - and will continue to do - is inflate the money supply and pr
omote more credit, thereby sustaining asset prices at the expense of the purchas
ing power of the USdollar. We argue the US dollar will ultimately lose its statu
s as the world’s reserve currency. In fact, webelieve events currently unfolding m
ay be foreshadowing the dollar’s eventual demise and replacement.” This paper update
s those views and provides further perspective.Apropos of EverythingBy Lee Quain
tance & Paul Brodsky“Truth is tough. It will not break, like a bubble, at a touch.
Nay, you may kick it about all day, and it will beround and full at evening.” - O
liver Wendell Holmes, Sr.Each passing month brings wider and deeper global econo
mic imbalances accompanied by what we perceive to bea general misunderstanding o
f their cause and impact. The source of these imbalances is the global monetarys
ystem. It continues its trend towards demise, as it must, and current events ind
icate an acceleration of this trend.The current monetary paradigm was structured
and developed over the twentieth centuryby liberal democraciesfor liberal democ
racies that, through unified sovereign management and coordination, controlled t
he perceptionof value and how the free world would account for it. The system wa
s not structured to accommodate the dynamicshifts in global economics, trade inc
entives and political alliances brought about, ironically, by the consequences o
f democracy’s triumph and the emergence of large, formally closed economies into t
he global economy.Serious consideration as to the inadequacy of the current regi
me has not been addressed since the onset of creditweakness in 2007, which was a
nd remains a manifestation of a broader currency problem. Widely differingeconom
ic incentives and political agendas in developed and developing economies furthe
r suggest that a new,unified monetary system is highly unlikely without substant
ial friction first. We suspect broad acceptance of a newsystem will ultimately c
ome only after manifest crisis. “An event”; however, is not a necessary condition fo
r thedemise of the current monetary regime or, for investors, substantial asset
revaluation. This paper discusses:1. Allegory of the Cave:The current global mon
etary system – how it works and how it differs from themonetary system as it is wi
dely perceived, the incentive structure of various participants in thesystem, an
d the natural pressures on it to fail and change 2. Best Intentions & Unintended
Consequences:The new monetary regime we suspect the consensusof global policy m
akers would like to have, and why it will not happen3. Devaluation & Transformat
ion: The next global monetary system, and the implications for assetsand wealth
This report includes section 1 only. Contact Paul Brodsky(pbrodsky@qbamco.com)fo
r sections 2 & 3.
QB ASSET MANAGEMENTwww.qbamco.com 2 See Important Disclosures at the end of this
report.Allegory of the Cave The current global monetary system – how it works and
how it differs from the monetary system as it is widely perceived, the incentiv
e structure of various participants in the system, and the natural pressures on
it to fail and changeIn Plato’s Allegory of the Cave, it was suggested that men fo
rced to face a cave wall their entire lives would seeonly shadows of figures beh
ind their backs. That they could not see the actual figures led them to believe,
withoutdoubt, that the shadows were reality and that no other reality existed.
We use Plato’s allegory to describe thestark difference separating contemporary we
alth, money and the exchange of economic value from erroneouspopular perceptions
of them. The fundamental difference is profound and has led to an environment i
n whicheconomic, financial, political and even social incentives have been great
ly distorted and broadly misunderstood.Monetary DynamismIn 1913, the US federal
government became responsible for sponsoring one fungible US currency, replacing
theprevious system of disparate individual banknotes issued by independent bank
s. Treasury gave the FederalReserve System, a new privately-owned central bank c
reated by Congress, exclusive rights and discretion to printand manage the suppl
y of Federal Reserve Notes, now colloquially referred to as “dollars”. In that same
year, thegovernment instituted a federal income tax payable only in dollars (1%
of income), thereby ensuring the dollar’sbroad adoption.Dollars were made exchange
able for gold at a fixed price of $20.64/ounce, which was meant to enforce monet
arydiscipline on the banking system. This was thought necessary because excessiv
e credit extension or money printingwould dilute the purchasing power of each do
llar, in turn giving incentive to dollar holders to exchange theirdollars for sc
arcer gold. As bank regulator, the Fed was charged with making sure US banks kep
t adequate reservesto satisfy potential demands for gold in the event confidence
in the dollar declined.It did not work so well for the Fed (or, consequently, a
nyone else). From 1917 to 1929 the US monetary base grewquite substantially and
bank reserve ratios declined by 50%. The credit and asset bubbles this produced
led to abust in 1929, a sudden re-marking of asset values to reflect lower credi
t valuations, and economic dislocationsresulting from the underfunded lending sy
stem. The monetary discipline of the gold standard had been bypassedthroughout t
he 1920s by banks and regulators through acceptance of a policy of unreserved le
nding, not only inthe US but Europe as well. (We discuss this in more detail bel
ow.)Despite this, the US dollar would become the world’s reserve currency. The US
entered the two world wars afterother economic superpowers had already run up su
bstantial debts. America benefited from heavy exports, muchof it in food and mun
itions during the wars. In addition, the US offered potential dollar holders dee
p capitalmarkets, an established court system, and a powerful military. Finally,
and perhaps most important, the US hadaccumulated over 21,000 metric tons of go
ld, far larger than any other nation.As World War II drew to a close dollars wer
e broadly used in non-US bilateral trade, held in reserve by globalbusinesses an
d official accounts, and the primary currency used to quote the global exchange
of goods, servicesand assets. Thus, the US dollar was firmly established as the
world’s only reserve currency and its hegemony wasunchallenged. In 1944 in Bretton
Woods, New Hampshire, the US and the UK framed a new monetary orderintended to
govern commercial relations among free market economies in the post-War era. The
most importantoutcome of Bretton Woods was that major global currencies would b
e exchangeable into US dollars, which in turnwould be exchangeable into gold at
$35.00 (President Roosevelt devalued the dollar to $35/ounce in 1934).This syste
m would ostensibly maintain currency discipline among global sovereign trade par
tners. Again, if they didnot practice sound money policies then they would see t
heir currencies exchanged for gold. However, once againthe Bretton Woods system
did not address the fundamental flaw that allowed governments and banking system
sto ignore the gold-exchange discipline -- fractional reserve lending, which all
owed lending institutions to continuesynthesizing future demand for money by iss
uing credit that would not have to be exhausted. This allowed allgovernments and
banking systems to more or less cheat together, to manage money and credit grow
th beyond (orin spite of) contradictory natural commercial incentives. (We discu
ss this in more detail below.)
QB ASSET MANAGEMENTwww.qbamco.com 3 See Important Disclosures at the end of this
report.In 1961, Yale economist Robert Triffin warned that a national currency t
hat also serves as an international reservecurrency poses natural conflicts for
its policy makers, who must navigate both domestic and international aims.The sp
ecific dilemma would be that the flow of dollars into and out of the US could no
t occur at once to meetopposing objectives, and would thus create a wide and uns
ustainable negative balance-of-payments account forthe issuer of the reserve cur
rency.Indeed in the late 1960s, US trade partners began exchanging their dollar
reserves for official US gold holdingsafter the US ran significant deficits from
costs associated with domestic preferences -- executing the Vietnamconflict and
expanding entitlement programs. In 1971, after US gold reserves had already bee
n depleted from over21 thousand to about 8,300 metric tons, President Nixon defa
ulted on the dollar/gold exchangeability featurenegotiated in 1944 at Bretton Wo
ods. Dollars and all other global currencies had officially lost theirasset-back
ed status. Adebt-backed monetary system had begun.And so began the modern era i
n which there would be no explicit or implicit monetary discipline. Public, for-
profitbanking institutions had a license to effectively print the coin of all re
alms. Since 1971 commercial banks havebeen able to lend money into existence by
issuing unreserved credit. Since the 1980s, investment banks have alsobeen able
to do the same thing, by marketing structured fixed-income product to bond buyer
s through a “shadowbanking system”. By issuing debt without practical limitation gov
ernments could also spend without fear of immediate budgetary discipline. The co
mbination of a fractional reserve lending system and a debt based currencywas th
e perfect recipe for a super-cycle of credit boom and bust. Thus explains 1971 t
o 2011.The only thing more certain than periodic change in monetary regimes (191
3, 1944, 1971…) is the predictablepervasive certainty that it will not occur. This
time is no different. History and current conditions make a newglobal monetary
order a certainty and current conditions show clearly the transformation has alr
eady begun.Money, or So it SeemsUS dollars are debt, technically (Federal Reserv
e notes) and in practice. Their ongoing value is supported by asystem of governm
ent oversight that ultimately relies upon convincing private counterparties to u
se them intransactions. As all modern global currencies are directly or indirect
ly benchmarked to the US dollar, they too areunreserved debt, literally and func
tionally owed by sponsoring sovereign governments and backed by the full faithan
d credit of their taxpayers. The fundamental question all global commercial coun
terparties must answer upon each transaction is: “will mycurrency maintain its pur
chasing power until the next time I need it?” If a quorum of economic counterparti
esbegins to answer negatively, the currency in question will soon lose sponsorsh
ip and fail.The US government will sponsor about $2.7 trillion (after QE2) inbas
e money (currency in circulation pluselectronic bank reserves held at the Fed).
Though we and many others continually note how much the quantity of base money h
as risen (up from about $850 billion in 2008), the newly-bloated quantity of bas
e money still remainsvastly insufficient to settle all dollar-based transactions
. A generally-accepted system of credit extension and debtassumption has filled
the void separating the quantity of base money and the perceived exchange of val
ue forwages, goods, services and assets. This is a system of financial leverage
posing as money. (See “Leveraged Debt”.)In economies allowing lenders to create cred
it (and thus systemic debt) with little regard for their own reserves,actual mon
ey needed to back that credit (to repay the debt) must be created in the future.
The money simply doesnot exist when the credit is created. The more credit issu
ed by the banking system, the wider the gap separatingoutstanding debt and the b
ase money needed by borrowers to repay their obligations. It is a lending system
thatmust either fail or that must destroy the purchasing power of the currency
in which the debt is denominated.Onemay draw a straight line from a baseless mon
ey system to baseless credit, to boom and bust credit cycles, tooverleveraged ec
onomies, to credit deflation and then monetary inflation, and finally to monetar
y system demise. Indeed, history shows a perfect record of destruction of moneta
ry systems where assets and commerce are valuedin baseless currencies.