Wednesday, January 28, 2009

Endgame 7: The Dollar, Bad Money and Purchasing Power

As all currencies' relative purchasing power has declined since 1998 when priced in gold, many are asking: when will the dollar fall in half? When will it go to zero? No one knows the answers to specifics, but we do know that "bad money drives out good money." That truism suggests several likely scenarios based on history.

We all want to know what's going to happen to the value of paper money--and when. Yes, it's easy to predict it will all go to zero, but that skirts the reality that relative value and purchasing power are constantly shifting.

Thus the dollar has strengthened hugely from last summer when measured in oil or grains, and has actually improved versus gold as well. The pound has plummeted when measured in dollars, and tidy sums were made by those buying dollars at its relative bottom.

What rarely gets any attention is the politics of paper money and relative value. Many commentators talk about the government's need to inflate currency so as to pay off debt with "cheaper" dollars/euros/yen/yuan etc., but few ask this key question: What policy benefits the top 1% who own 3/4 of all productive assets?

If you (and your family) control $100 million+ in productive assets, then elected officials/the government listen to your needs. Thus we can safely predict a few things:

1. The benefits of whatever action the government might take will accrue to the top 1% which owns most of the productive assets (that is, income-producing). The effects on the government itself and the economy at large are secondary.

2. Bad money will drive out good money.

Put another way: if the dollar going to zero will wipe out a huge percentage of the wealth of the top 1%, then the dollar will not go to zero.

Many assume the dollar will go to zero and gold will then reign supreme. While it is true gold is a store of value which can't be depreciated by fiat (though governments can arbitrarily set the price and then confiscate all privately held gold, as the U.S. government did in 1934), it is inherently unproductive.

That is, it is too heavy and prone to theft to be useful as a means of trading exchange; even in the 1500s, letters of credit worked much better than physical gold.

It does not produce income like real estate, ships, fields, mines, factories, R&D facilities, etc.; it is in a very real sense "dead money." As historian Fernand Braudel explained in Volume 3 of his 3-volume masterwork The Structures of Everyday Life (Volume 1) , The Wheels of Commerce (Volume 2) and The Perspective of the World (Volume 3) much of the decline of the East (China and India) during the rise of Capitalism/the European Renaissance can be traced to their demand to be paid in silver or gold only.

Think about it. The precious metals went into Indian and Chinese Imperial/feudal vaults and stayed there, doing absolutely nothing, while the Europeans took their letters of credit, capital raised by stocks, futures contracts, insurance/hedges, trade routes, etc.--all the mechanisms of modern capitalism which increase the velocity and utility of money--and built trade-based empires.

The piles of gold and silver were trapped capital on a vast scale, essentially dooming the Chinese and Indian empires to capital-poor, trade-poor, credit-poor decline.

Thus we should focus not just on stores of value but on means of exchange. And that brings us to bad money driving out good. Historian David Hackett Fischer explains how this works in his endlessly insightful history of economic cycles, The Great Wave: Price Revolutions and the Rhythm of History . In the old days, gold and silver coinage would get devalued in one of two ways. Merchants and others would shave off infintesimal slices of metal from the coins, reducing their value over time, or the issuers of the coinage (the royalty) would remint coins with less precious metal and more base metal.

Naturally, as a merchant or trader or farmer, you would try to get rid of the shaved or debased coins and hoard the "full value" ones. Thus bad money (of reduced value) would drive out good (full-value) money.

The idea of inflating/depreciating your way to prosperity is old indeed. Hundreds of years ago the same game was played: the government/crown spent more than it collected in taxes and revenues, and so it borrowed from (often Dutch) private banks. As its debts mounted, the allure of issuing new depreciated coinage --that is, to pay off the debts with less gold and more lead--became ever more compelling.

But of course all the players knew what was going on, and the endgame was the crown defaulted on its debt and the game started over with new full-value coinage/money.

Now Spain had the good fortune to find staggering sums of "free money": the silver and gold extracted from its New World conquests. Unsurprisingly, most of this precious metal ended up in the hands of the Crown's creditors. Once borrowing gets "easy"--and who wouldn't consider a semi-annual fleet of treasure ships good collateral?--then debts mount even faster than the treasure being offloaded from the galleons.

Fast-forward to the present. Hmm, sound familar? The American Empire has had good collateral for quite some time; people have reckoned that the U.S. will make good on its debts one way or the other. (A little conquest never goes out of fashion.) But there was always the immense productivity of the American economy and land as backup collateral to the government, and in a very important sense that is still the collateral beneath the profligate government we have elected since 1981.

Borrow and spend, borrow and spend, brawk! The parrot stays on its perch regardless of which party holds sway. Why? Because borrowing is so "easy".

The other reason people place value in the dollar is they have no choice if they want to maintain a mercantilist, export-based economy. As I have covered here many times, economies from Germany to China are essentially based on exports. If exports falter, there is no Plan B. As the global economy has followed this same model everywhere-- Japan showed everyone how protecting domestic production and exporting excess production could enrich a nation very quickly--then the sole end buyer has been the U.S.

For this reason, I am wary of calls for the dollar to fall in half or zero. Compared to currencies based on a failing export model of growth, the U.S. currency is looking pretty good; in very base terms, its collateral is viewed as superior to others based on commodities which can plummet 80% in a few months (see oil exporting nations) or export models in a global recession (see China).

In other words, no matter how much gold you have in the vaults, you still need a medium of exchange.

The important book The Dollar Crisis: Causes, Consequences, Cures makes a strong case for the thesis that no nation can run deficits on the order of 5% of GDP for very long before its currency collapses; and this certainly has the weight of history behind it.

But when the entire world other than the U.S. is counting on asset bubbles and exports to fuel growth, then the case can also be made that in a world of bad choices (i.e. fiat currencies), there are good reasons to hold one's nose and hold dollars as a better bet than all the others.

As I have also posited here many times, this need for a means of exchange could be filled by a private, transnational trading currency based on gold or a basket of commodities. Many commentators foresee the Gulf oil states or China creating a gold-backed currency, but the problem with this scenario is they simply don't own enough gold to back a practical currency.

As I noted in Friday Quiz: How Much Gold Does the U.S. Government Own? (January 23, 2009), the U.S. does own enough gold to back a currency capacious enough to handle global trade--once gold rises to $10,000 per ounce.

The Gulf oil exporters could back a currency with oil, but if recent volatility is now the norm, the wild swings in oil valuation would render such a currency awfully risky to hold.

It may well be that we shall see a mix of various currencies, each of which plays a slightly different role in the global economy. Thus a private currency backed by 500 tons of gold (supposedly the amount now held by the gold exchange traded fund GLD) could play a role as a store of value.

But the problem with any gold-backed currency is as old as money itself: bad money will drive out good money. Thus when offered a choice, I will hoard my gold-backed "quatloos" and offer my dollars/yen/yuan/euros in exchange for something tangible. I will only offer up my "real money" if the seller insists, and there is simply no alternative to the immensely profitable goods he is offering.

But then the capital trap opens up for the seller: if the seller hoards the "good money" as a store of wealth, he is doomed to a store of value in a vault with no income or velocity and thus no productivity.

There are of course many other moving parts, as described in books such as Power and Prosperity: Outgrowing Communist and Capitalist Dictatorships and The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities , but let's return to the political question: what policy best serves the interests of those holding 3/4 of all productive assets? That elite needs a functioning currency which can be exchanged for goods and services; that is, after all, the basis of income.

So while the endgame of all debased/fiat currencies is the same--they will drive out good money to the point of default/collapse--it isn't as easy as just hoarding physical gold, because it has never made a practical means of exchange and because the temptation to sink it in a capital trap is so great.

At some point, governments will re-issue new currency/coinage in a vain attempt to restore value. If their policies are prudent and their borrowing trivial, that might well work for quite some time. Or perhaps gold will rise to $10,000 per ounce, high enough that a practical gold-based currency (or currencies) will be issued in such vast sums that it won't be driven out by bad money.

Right now, the only hoard of gold large enough to back a currency of global proportions sits in Fort Knox. Maybe when gold is $10,000 per ounce, perceptions of the value of fiat currencies will change and the wisdom of a can't-be-depreciated-by-fiat currency will be recognized.

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