 Paper Money
is a Claim on Wealth
Dan Amoss, CFA
The Daily
Reckoning
Mar 19, 2007
The Daily Reckoning PRESENTS: What are the long-term costs of paper
monetary systems? How can an economy develop in a healthy, sustainable
manner when wealth's scale constantly changes? Dan Amoss looks
to answer these questions - and more - below
Paper money is popular under
democracies. Under the control of a central bank, paper money
provides modern economies with the illusion of great flexibility
and resilience. Without the rigidity of the gold standard, bad
bank loans are easily swept under the rug. This prevents the
possibility of setting a Depression-era bank failure into motion.
Contrary to popular opinion,
paper money is not wealth. Paper money is a claim on wealth.
It only has value to the extent that it can be exchanged for
things - a bushel of corn, a gallon of gasoline, a dental cleaning,
or an Intel microprocessor.
When the government prints
more money, it gives a public fixated on asset prices the illusion
that they are growing wealthier, when, in fact, they are growing
poorer. As paper money becomes more and more plentiful, the producers
of valuable products will eventually demand more units of money
in exchange for their product or service.
Daily celebrations of new Dow
records fail to recognize the inflation behind this index's move
upward. Dr. Marc Faber is on public record talking about a potential
"Dow 100,000" scenario. This scenario is possible if
current trends continue. But we must remember that under this
scenario, the price of everything will be increasing dramatically,
leading to lower living standards.
Food Is Wealth, Pesos Are Not
A stark example of consumer
price inflation leading to declining living standards is the
recent tripling of corn tortilla prices in Mexico. Protesters
have marched on Mexico City, demanding that the government do
something about it.
Mexico's fairly socialist economy
has produced a situation in which many citizens' incomes rely
heavily on the government's entitlement spending. Mexican monetary
policy must remain loose to keep the system afloat. The supply
of pesos in circulation has been growing 15-20% over the past
year.
Misjudging the root cause of
tortilla price increases - an exploding money supply - populist
politicians have blamed "monopolistic" tortilla companies
like Grupo Gruma and have enacted price controls that will only
worsen the future supply picture.
Once the stage for easy pesos
was set, the final catalyst that sparked the Mexican tortilla
price explosion was the U.S. government's boneheaded policy of
subsidizing corn-based ethanol. Demand from dozens of new ethanol
plants has stretched the U.S. corn market to its limit. High
corn prices have attracted all excess supply away from international
markets, causing a shortage in Mexico's regular imports from
the U.S.
Paper money inflation is not
confined to Mexico. Loose U.S. monetary policies and ethanol
subsidies are combining to form a future perfect storm in the
price of basic food ingredients. Those holding their breath for
imminent Fed rate cuts will probably have to hold it beyond this
year's corn harvest.
The average Mexican citizen
facing spiraling food costs doesn't seem to care about housing
prices or rallies in the Mexican stock exchange. Will Americans
be facing this situation at some point in the future?
The Global Economy Floats on a Sea
of Paper Money
Over the past decade, a few
billion new capitalists began their quest to achieve Western
living standards. They will demand energy and industrial metals
on an unprecedented scale, and the best way for investors to
benefit from this trend is to own shares in the companies fulfilling
this demand.
This capitalist revolution
is well under way and nothing short of an economic meltdown will
stop it. Just in case the economic machine that funds mortgage
payments and all other manners of debt begins to sputter, central
banks will slash interest rates yet again.
But unlike the 2001-2003 series
of rate cuts, long-term rates are more likely to increase as
CPI fears mount, causing demand for long-term bonds to dry up.
If that were to occur, the
U.S. Federal Reserve would implement Chairman Bernanke's well-outlined
"unconventional monetary policies." This would involve
a new role for the Fed: buyer of last resort for bonds of any
maturity. And lest you think the Fed could ever run out of money,
check to see what institution guarantees the value of the "Federal
Reserve notes" sitting in your wallet. If necessary, the
Fed can use its ability to create an unlimited amount of this
paper to keep the debt pyramid solvent.
If this scenario were to develop,
the U.S. dollar would quickly be added to history's long list
of worthless paper currencies. Under the status quo, the U.S.
dollar's rate of decay will depend on public perception of inflation,
and perceptions are likely to worsen after this year's corn crop.
Thanks to corn-based ethanol
subsidies, a huge portion of the country's corn-derived food
supply - everything from sweeteners in packaged foods to chicken
and beef - will suffer from shortages and price increases. Much
of this will be passed onto the consumers who can least afford
it. So investors should expect the current momentum behind populist
political movements to grow stronger. This will be bad for longer-maturity
bonds and the overall stock market, but good for gold prices.
The global economy now floats
on a sea of paper money. This grand monetary experiment has been
in place for only a few decades - a mere tick in the clock of
civilization. We know how this show ends, having seen previews
in Weimar Germany and several banana republics.
Will the price of gold ultimately
increase from its current $620 to $3,000 per ounce? I expect
that it will. A better way to frame this large number is to flip
the ratio from dollars per ounce to "ounce per dollars."
Regards,
Dan Amoss, CFA
for The
Daily Reckoning
P.S. Investors who hold gold
will be very reluctant to sell it when dollar holders around
the world anticipate the endgame of paper monetary systems. For
its holders, gold will serve as a solid bridge on the journey
from this monetary system to the next. Steady accumulation of
gold-related investments remains a prudent strategy.
Dan Amoss, CFA
is managing editor for Strategic Investment and a contributing
editor for Whiskey & Gunpowder. Dan joined Agora Financial
from Investment Counselors of Maryland, investment advisor for
one of the top small-cap value mutual funds over the past 15 years.
Dan brings to
Strategic Investment the unique experience of an institutional
background and a drive to seek out the most attractive investments
within favored "big picture" trends. He develops investment
ideas for SI readers with a global network of geopolitical and
macroeconomic analysts. Dan holds the Chartered Financial Analyst
designation, a professional designation widely recognized within
the investment community.
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