A massive transfer of wealth

Paul van Eeden
Jan 21, 2007

A government report in Britain showed consumer prices in that country rose at their fastest pace in a decade: up 3% from a year earlier boosted by higher transport and furniture costs. Because this increase in consumer prices exceeded the median estimate of economists' predictions, of 2.9%, the market reacted by selling British bonds and driving up interest rates. Higher interest rates increase the yield on British debt, supposedly making pound denominated debt investments more attractive, so the British pound rallied against the dollar this week.

I almost fell off my chair laughing when I read this on Bloomberg.

Higher prices for goods and services are usually the result of monetary inflation. When the money supply is increased, the value of all the money outstanding is diminished by an equivalent amount requiring more units of currency to pay for the same goods and services. If inflation is a concern in Britain it means the pound is becoming worth less, so why would that entice investors to buy pounds and pound denominated bonds?

Investors, it seems, prefer to ignore such trivia and focus instead on the immediate yield they can get on their money. I believe that's because most of the money being invested today is "managed" by "professionals". Gone are the days when people took responsibility for their own investments.

Money managers are only concerned with relative performance, not absolute gains. Let's go back to the inflation in Britain to see this in real life. The theory is that if the pound is being devalued more rapidly then British interest rates should rise to compensate for the devaluation of the pound. If British interest rates rise then one could, theoretically, make more money owning pound denominated bonds than owning, say, US dollar denominated bonds that pay less interest. But this theory ignores the real return on investment.

British inflation rates as measured by M3 or M4 are running at over 12% per annum. That means the amount of pounds in existence is increasing by that amount per year and therefore, all else being equal, the pound should be losing about that much in value. Just like in the US, you don't necessarily see the entire loss of buying power when you just look at consumer price indices because of the way these indices are compiled and calculated, but that doesn't mean the devaluation isn't there.

The yield on a two-year British bond is about 5.38%. Taking into account only the change in the British consumer price index, which is 3%, one would conclude that the bond is returning a real 2.38% return. But the change in the consumer price index is not the rate of inflation; it is the rate at which the very specific basket of goods and services that make up the index is changing. The pound is being devalued at a rate of over 12% per year and a two-year bond is yielding less than 6%. That means bond investors lose over 6% and they don't even know it.

In the US the inflation rate of the dollar as measured by M3 is about 10%. The US consumer price index rose 3.3% in 2006 and a US two year bond yields around 4.85%. Again, it appears that the real rate of return on the bond is 1.55% but in reality the return is a negative 5%.

Pound denominated bonds appear to be a better investment than US denominated bonds if we look at their yields versus their respective consumer price indices: 2.38% real rate of return on the British bond versus 1.55% for the US bond. Since both the nominal interest rate and the apparent real interest rate on British bonds (as judged from two year issues) are higher than their US counterparts I would expect the pound to rise against the dollar. If, however, we look at real interest rates by comparing the true monetary inflation rates of the currencies then we see that the pound is being devalued at a faster pace and that British bonds offer lower real interest rates. If this condition persists then the pound could well end up falling against the dollar at some point.

Yet we also have to keep in mind other factors like fiscal deficits and trade deficits. At the moment the US is in such bad fiscal shape, and is deteriorating so rapidly, that I cannot see the dollar gaining on the pound in spite of higher pound inflation rates.

The fiscal situation in the US is dire. I urge you to read Ben Bernanke's testimony before Senate's Budget Committee:

It's not a long speech and given that Bernanke is probably the most informed person in the world when it comes to the US monetary and fiscal situation it is well worth reading.

Once you have read it, consider that fiat currencies around the world are being devalued at a rapid pace and that investors who have relegated their life savings to professionals are being hosed because they are actually losing money while they think they are making money. You can see why I believe a massive transfer of wealth lies ahead, from those who do not understand the true nature of fiat money to those who do, and are taking steps to safeguard their capital.

The breakdown of the Bretton-Woods Accord in 1971 created the most wide-spread and large-scale experiment with fiat money in history. We are in uncharted territory and the majority of our financial, business and political leaders have no clue what is going on. Gold is the only form of money that cannot be created by fiat and does not represent another's liabilities. Gold's price reflects the true devaluation of fiat currencies and remains our best guardian against the ravages of fiat money inflation.

Conferences:
I will be speaking at the Vancouver Resource Investment Conference this weekend, the 20th to the 22nd, and at the Mineral Exploration Roundup (also in Vancouver) on February 1st. For more information please visit my website at http://www.paulvaneeden.com/pebble.asp?relid=1.

Paul van Eeden
email: pve@publishers-mgmt.com

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