Big Macs and a 1% Currency

Federal Reserve Governor Ben Bernanke’s November 21 address has been poked, prodded, and thoroughly hashed-out here in The Daily Reckoning. It’s clear the speech was a watershed event. A “tipping point” event, if you will.

Yet Bernanke’s statement is hardly the first of its kind: time after time, governments have shown a willingness to destroy their currencies to pay debts. Total wipeouts have occurred. Germany couldn’t pay its war debts in 1922, so it cranked up the printing presses to print money. By the end of 1923, prices had risen 20-billion-fold…and the savings of an entire nation were wiped out.

This same kind of destruction continues all over the world today. For example, I remember taking $20 out of a cash machine in Indonesia during the Asian crisis in 1998…and then watching the bank machine spit out 250,000 Indonesian Rupiah. I practically needed a wheelbarrow. During that time, the wealth of an Indonesian fell by more than 80% in two years as the currency fell in value. Today, an Indonesian makes something like $200 a month.

You’d need that same wheelbarrow in Venezuela. When I was there a decade ago, the exchange rate was about 100 Venezuelan bolivars to 1 dollar. Today, Venezuela’s nutty dictator has cranked the printing presses up…and the exchange rate has fallen to 1,300 bolivars to the dollar. That means, thanks to government printing of money, Venezuelans need to make twelve times more money today than they did a decade ago to buy one dollar.

Purchasing Power Parity: Sacrificing the Dollar

The value of the US dollar, and hence the accumulated wealth of those holding dollar-based assets, is now under the same threat. I’m not suggesting wild printing like I’ve described. But it’s clear that Governor Bernanke is willing to sacrifice the value of the US dollar to accomplish his objectives.

The dollar could lose up to half its value. Said another way, your wealth (in dollars) could be cut in half. The thing is, most Americans won’t even realize it…or even understand that it happened.

Let’s say it’s March of 1985 and you’ve just landed in Europe for a one-year assignment. As a banker hands you a whopping 28,000 Swiss francs in exchange for 10,000 U.S. dollars, you’re feeling like a rich American. You travel in luxury during your stay, and you pick up a Rolex watch for a steal while you’re there.

In March of 1988 your company sends you to Switzerland again. You hand over your $10,000 once again…but this time, you receive only 14,000 Swiss francs.

“You must be making a mistake,” you say to the banker. “No mistake,” he says. “The dollar lost half its value in three years.” You’re flabbergasted. You can buy only half as much stuff this time around. And everything is twice as expensive in dollar terms as it was on your last trip just three years earlier.

It’s not really twice as expensive. Prices of Rolexes in Switzerland didn’t go up. It just takes you twice as many dollars to buy that same watch. From 1985 to 1988, this really happened. The purchasing power of the dollar was effectively cut in half. The wealth of many Americans was crushed.

Purchasing Power Parity: Unchanged Gold

But what if you had your money in gold during that time? Gold nearly doubled, rising from a low below $300 to nearly $500 an ounce. In reality, gold didn’t rise – what happened was the dollar fell. It took a lot more dollars to buy one ounce of gold. But in terms of Swiss francs, gold was basically unchanged.

Still, 1988 was ancient history, right?

The truth is, we haven’t had to care about the dollar for a long time – seven years to be exact. In 1995, then Treasury Secretary Robert Rubin instituted America’s “Strong Dollar Policy.” And the dollar has been strengthening since.

With seven years of strengthening, the dollar is now expensive, and has likely peaked. It wouldn’t be unrealistic to see dollar purchasing power dip significantly again. It’s already happening. A year ago a dollar would have bought 1.7 Swiss francs. Now it’s closer to 1.4. So what’s going on?

The easiest way to address this question is to take a look at two different factors. While doing my Ph.D. work on international currencies, I found that there are only two clear things that affect the value of a “rich country” currency. The first is “purchasing power” relative to other currencies. The second is “real interest rate differentials”.

Purchasing Power Parity: The Price of a Big Mac

You’ll hear a lot of discussion about budget deficits and current account deficits. But they don’t matter. At least not nearly as much as purchasing power and real interest rates.

The concept of purchasing power parity is simple. Think of it this way…the price of a Big Mac should be roughly the same wherever you are. The ingredients are homogenous, cheap, and widely available. And so driving across the border from the U.S. to Canada, you shouldn’t see a huge difference in Big Mac prices. But sometimes, you do.

In fact, right now a Big Mac is US $0.37 cheaper for Americans in Canada than it is in the U.S. So, if you’re planning a trip to Niagara Falls, you can check out the falls from the U.S. side. But make sure you spend all your money on the Canadian side. You’ll save a heck of a lot of money.

Should a McDonalds in Niagara Falls Canada sell a burger for US $0.37 less than a McDonalds in Niagara Falls New York? Does this discrepancy in prices in rich countries make sense? Not in the long run. In the long run, currencies revert back to equal values – to their purchasing power parities. Of course, that long run can be a very long time. But they always return.

Purchasing Power Parity: Interest Rate Differentials

The second thing to consider is interest rate differentials. Money flows to where it’s treated best. All things being equal, if one country is paying 5% interest, and another is paying 1%, money will flow to the country paying 5%. That flow will cause the value of the 5% currency to increase as people flock to it. It’s simple supply and demand.

Based on the only two factors that I’ve found to influence the value of a rich-world currency – purchasing power parity and interest rate differentials – the U.S. dollar is likely in trouble. Our Big Macs are expensive, and the U.S. is a 1% currency.

Take a look at what’s really happened to the dollar over the past months. Since Bernanke’s speech, the dollar has fallen against the major currencies and commodities, like gold. Gold is now at 6-year highs versus the dollar.

The logic is simple…no matter what happens right now, gold should rise. If the Fed prints money, that creates “money” inflation – which means there will be more dollars in the world, but the same amount of other stuff, like gold. This drives the price of gold higher.

On the flip side, if we fall into deflation, gold will do well also. For many reasons, the folks at the Fed are seriously afraid of deflation. So if we dip into a period of falling prices, expect the Fed to print money to offset it. The expectation of the Fed’s actions alone will be enough to drive the price of gold higher.


Steve Sjuggerud
for the Daily Reckoning
February 14, 2003

P.S. This development creates a dilemma for American investors. We need to find a place where the Big Macs are cheap…and a place that pays great interest on our money.

Looking at these two considerations, I think I’ve found the perfect investment destination. In this country, a Big Mac is an astounding US$0.87 cheaper than a Big Mac in the U.S. – a 35% discount. It’s also got a whopping threefold advantage over the U.S. in interest rates.


– Owning stocks is no longer investing, it’s self-inflicted terrorism. Every day, it seems, the stock market strikes terror anew in the hearts (and wallets) of investors. Fear holds sway in the financial markets; greed is nowhere to be found. Fearful investors avoided stocks yesterday and unloaded dollars. The Dow dipped 8 points to 7,750 and the Nasdaq shed 1 point to 1,277. The greenback also came under pressure, falling more than 1% to $1.083 per euro.

– Meanwhile, fear inspired some buying in the markets for gold, crude oil and Treasury bonds. Gold for April delivery recouped $4.70 of the $10.00 it lost on Wednesday, to finish the New York Trading session at $357.70. Crude oil prices soared well above $36 a barrel, gaining 63 cents to $36.40 a barrel. The bond market also attracted buyers, as the yield on the 10-year T-note dropped to 3.87% from 3.93% on Wednesday.

– Here in New York yesterday, there was no escaping the terrorism-induced signs of anxiety. Police were visible everywhere; chatter about a possible terrorist attack was incessant; and CNBC covered the topic ad nauseum – as only CNBC can do – and even went so far as to poll its viewers, “Have you purchased duct tape in the last week?” Here’s an idea: let’s use a small part of our growing national duct tape stockpile to seal the mouths of CNBC personalities…

– J.P. Morgan Chase is slimming down and dressing for success…” Saddled with too much real estate in Manhattan, J.P. Morgan Chase is cutting back,” the NY Daily News reports. “The bank – which posted a $387 million loss last quarter – now has more office space than it needs.” Therefore, Morgan is planning to sell 23 Wall Street, the building directly across the street from your co-editor’s former office at 30 Wall.

– [An Historical Digression: Ironically, the landmark building at 23 Wall, which once symbolized the prestigious Morgan financial empire, was the target of New York’s most infamous terrorist attack prior to September 11th.

“On Thursday, Sept. 16, 1920,” historian Daniel Gross recounts, “a simple wagon, pulled by an old, dark bay horse, made its way through a crowded Wall Street. At about noon, it came to a stop about 100 feet west of the corner of Wall and Broad streets, the section of Lower Manhattan cobblestone that had recently emerged, in the words of the author John Brooks, as ‘the precise center, geographical as well as metaphorical, of financial America and even of the financial world.’

“To the south stood 23 Wall Street. Known simply as ‘The Corner’, the fortress-like structure housed J.P. Morgan & Co., the world’s most powerful financial institution. To the north stood the U.S. Assay Office [i.e. 30 Wall], where workers were moving some $900 million in gold bars. Next to it stood the U.S. Sub-Treasury, the building now known as Federal Hall, fronted by its statue of George Washington. Around the corner stood the New York Stock Exchange.

“As the bells of Trinity Church gently tolled noon, the driver released the reins and fled. Within seconds, the wagon delivered its lethal carg hundreds of pounds of explosives. Shrapnel – bits of iron made from window sash weights – tore through flesh, concrete, stone and glass. Windows shattered throughout a half-mile radius, showering glass missiles onto busy streets. Awnings 12 floors above street level caught fire. Joseph P. Kennedy, then a young stockbroker, was thrown to the ground by the concussive force.”

Still today, the exterior of 23 Wall Street remains pockmarked by the effects of the blast. Morgan never repaired the building facade.]

– Additionally, Morgan is poised to unload about two million square feet of sublease space onto a market that is already drowning under 10.9 million square feet of ‘Class A’ sublease space.

– Meanwhile, Morgan’s traders and research analysts have been told to clean up their act…literally. “J.P. Morgan traders and research analysts, used to polo shirts and chinos during the investment banking boom years, have been told to get a shave and a shoe shine,” the Financial Times reports. In a three-page memo, David Hitchcock, one of the bank’s corporate mucky-mucks, upbraids the bank’s equity sales team for failing to show a “professional face at all times”.

– “It has to be said,” Hitchcock writes, “that under ‘dress down’, your dress code in some cases led to ‘dress collapse’. Shaving, polishing your shoes and being smart add to the professional tone. Also, any good electrical shop will sell you a steam iron…Try and smarten up.”

– Incredibly, Hitchcock also finds it necessary to ban the use of Gameboys in research meetings, reminding his well- paid, well-educated charges to “take written notes”. Research analysts using Gameboys?…Hmmm…That explains everything!

– Mr. Hitchcock also urges his staff to treat clients like “guests”. Says Hitchcock, “I want you all to behave to these people like they are guests in your house. Treat them as you would like to be treated yourself.”

– Hitchcock’s got a pretty novel idea, but it may not be that easy to elevate the Wall Street mindset. Having grown accustomed to treating clients like the Huns treated female captives, trying to treat clients like “guests” might feel a bit awkward. What’s more, the “guests” might be a little slow to warm up to Morgan’s enlightened hospitality.

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