Paper Money is a Claim on Wealth

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.”


Dan Amoss, CFA
for The Daily Reckoning
March 15, 2007

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, and this month, I have a new gold stock to recommend to my Strategic Investment subscribers.

Editor’s Note: 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.

Blustery March winds blew through global markets again yesterday.

At one point, the Dow was sold off to under 12,000, before recovering; and the London stock exchange took a beating too.

Investors are “jittery” says the Financial Times, over the subprime crisis in the United States. European and Asian stock markets suffered their second biggest losses of the year yesterday.

One thing is clear – volatility has returned. That long, lazy, self-assured and complacent period that annoyed us for so long seems to be over. And good riddance.

We are literary economists and market voyeurs, here at the Daily Reckoning. We like action…something to look at…someone to laugh at. For instance, there is now a restaurant in NYC that now boasts a ‘luxury pizza’ topped with (among other things) crème fraiche, eight ounces of caviar, and four ounces of lobster tail. And the price tag for this edible extravagance…$1,000. We’re not sure, but this seems like a bit too much…and a bit too late.

We like a good comedy as well as a good tragedy…a story with some excitement and drama…something that causes our ribs to heave and someone who gets what he has coming to him. And at last, we seem to be getting one.

For months…no years…we have been watching…waiting…hoping. “Something has to give…” we kept saying. “When the end comes…” we warned ominously. “This can’t go on forever…” we wrote so many times we began to wonder if it was true.

Well, the end may still be far away. But at least a few more people can see it coming. They’ve seen prices go up and down sharply. It doesn’t take too much imagination to see them going down decisively.

Which means that the price of insurance is going up.

“Banks face rise in cost of default protection,” says the FT. Credit Default Swaps are going up. So is the protection available to the average investor. Yesterday, the VIX reached its highest level since June of last year.

What is gratifying about this sort of action is that it has genuine heroes and cads…people whom the gods reward for their virtue or destroy for their vices. Take New Century Financial, for example. Teetering on the edge of bankruptcy, we regretted that we couldn’t give it a push. But yesterday, along came Barclay’s bank to do what we couldn’t. The British bank demanded $900 million, and wants it right now.

But don’t worry about Barclay’s. “All of our exposure to U.S. subprime lending is fully collateralized…” it told the press. “We do not envisage any material losses due to exposure to the sector.”

We are not privy to the details. But we can also perfectly well imagine that Barclays is misinformed. All the subprime debt was fully collateralized. That was not the problem. The problem was that the collateral was fraudulent.

Encouraged by rising property prices, aided and abetted by appraisers, mortgage brokers, and real estate agents, enabled by ‘low document’ lending procedures – neither the subprime collateral, the subprime securitized debt, nor the subprime borrowers were worth what they said they were worth. Now, with property prices falling in many parts of the country, it may be impossible to unload the foreclosed houses for anything near to what lenders had expected – especially if subprime troubles spread into the rest of the mortgage market.

“The reliance on judgment and reason will be pushed aside,” said 80-year-old economist Henry Kaufman in New York on Tuesday night. What we found interesting was his use of the future tense, referring to the growing tendency to replace wisdom and experience in the financial markets with sharp calculations. If there is a half a point of yield to be gained by exchanging yen for ringgit…buying emerging market bonds…leveraging with zlotys and hedging with euros…even though the old timers might judge it too risky or too complicated, the mathematicians will find it irresistible.

We fuddy-duddy literary economists are not the ones who have made money in this liquidity bubble. We’re not complaining. Our gold rose from a low of $252 in 1999 to around $645 last time we looked. But the real money was made by those who reached for yield, leveraged it up and sold it on. Yesterday, we learned that Goldman Sachs actually outperformed analysts’ expectations. Yes, the master of the masters of the universe masterfully masterminded a masterstroke…theirs is a masterpiece of…well, never mind.

The report referred to earnings ‘in the first quarter.’ The quarter ended on February 23…only four days later world markets sold off on panic following a 9% drop in the Shanghai composite index. And what’s this? On February 27 Goldman was down 12% from its all-time high of 222.75 made on Feb. 22.

Talk about nice timing.

There’s something screwy about the whole spectacle. The numbers – for all their pretended precision – never seem to add up. How can you have a ‘quarter’ that ends in February? How could the whizzes on Wall Street make such errors about the value of their subprime debt?

Still, who says the top is in? Who says America is in decline? Who says the liquidity bubble is over? Who says there isn’t more money to be made?

We literary economists don’t presume to know and don’t pretend to care. But the show is definitely getting more interesting.

More news:


Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…

“This year, I’ll have to change that a bit, and wonder if this will be an Ides of March for the housing market, with the subprime meltdown as housing’s Brutus… Once a close friend of the housing market boom, but now the thing that brings it down.”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig


And more thoughts…

*** Friend and oft contributor to the Daily Reckoning, Jim Rogers spooked markets yesterday with these comments, made to a reporter from Reuters:

“‘You can’t believe how bad it’s going to get before it gets any better,’ the prominent U.S. fund manager told Reuters by telephone from New York.

“‘It’s going to be a disaster for many people who don’t have a clue about what happens when a real estate bubble pops.

“‘Real estate prices will go down 40-50 percent in bubble areas. There will be massive defaults. This time it’ll be worse because we haven’t had this kind of speculative buying in U.S. history…

“‘When markets turn from bubble to reality, a lot of people get burned.'”

*** The world’s second largest economy looks like a much better bet for investors than its first largest one. While the rest of the world enjoyed one sunny day after another, poor Japan remained in darkness. Its stocks crashed. Its property crashed. Its consumer prices crashed. This went on for, what?…14 long years? Nothing seemed to come from Japan but good cars and bad news.

But in 2005, the rising sun began to peek over the horizon. Stocks soared 40%. Consumers and businessmen seemed to recover some of their old bonsai spirit. Last year, stocks rose again…though much less than in 2005. And now the economy is expanding nicely.

But what attracts our attention today is Japan’s property market, where prices are still going down! Japan, and Japan alone, is still bucking the worldwide trend towards higher prices for immoveable objects. Its property is down 32% since 1997. Last year, the stuff fell another 2.7%. By contrast, U.S. housing rose 102% during the last 10 years. This was modest compared to Ireland, with a 253% increase…and South Africa, where prices jumped 351%.

For a contrarian, what’s not to like in Japan? The currency has been going down for years. Speculators are short the yen…hundreds of billions of dollars worth. Stocks are still less than half what they were 17 years ago. And the Japanese economy…after a long period of on-again, off-again deflation…finally seems to be growing at decent rates.

It is America, Britain, China and the other high-fliers that a contrarian should be wary of. A few years ago, we wrote a book, with Addison Wiggin, predicting that the United States would follow Japan into a long, dark slump. We were surely early…but we’re still not convinced we were wrong.

*** “Zimbabwe sinks into hell of hyperinflation,” says the lead editorial in today’s Financial Times. You know the story already, dear reader. Inflation is running at more than 1,700% in the country…and seems to be out of control.

Also out of control are Zimbabwe’s police, who rounded up protestors the other day – including the man who seems most likely to replace the current president – and beat them up. The challenger, Morgan Tsvangirai, was then hauled before the courts and charged with inciting people to commit acts of violence. But it was obvious to everyone – including the judge, who promptly ordered the defendant to the hospital – that Tsvangirai, with his swollen and beaten head, was not so much the inciter of violence as the victim of it.

But then comes the most remarkable part of the editorial. Here, on the very Ides of March, the FT is prodding Cassius and Brutus to stick the knife into a lawfully elected president of a sovereign, democratic state! “Get involved now,” it urges neighboring South Africa, “while the Zimbabwe state can still be saved.”

Our friend Michel is still puzzling over the issue. He took out a dictionary to get a definition for democracy and found this: “A government where the people exercise sovereignty.” If we recall correctly, Robert Mugabe was elected by the people of Zimbabwe to run the state. According to the press reports at the time, the election was as honest as most below the Sahara…and probably not much more dishonest than some above the Rio Grande. Maybe a few voters were roughed up. Maybe more were discouraged from taking to the polling stations. But there is no such thing as an election that functions perfectly.

Whatever can be said for the election, Robert Mugabe has been running the state…into the ground. There is no doubt about that. And to the extent that the people of Zimbabwe elected him…or even tolerated him…they get what they deserve.

What’s more, there’s no definition of democracy that we know of that permits a foreign people to “get involved” in the misgovernment of another democratic state…or even in an undemocratic state. And in every example we’ve heard of – whether of the Napoleonic army in Spain or the Bushian army in Iraq – the results have been disastrous. Nevertheless, that is the central inspiration of America’s ‘Wilsonian’ foreign policy…and the fervent wish of every addled neo-conservative in Washington.

The Daily Reckoning