The Decay of Paper Currency

For anyone living in the 20th century, the rising cost of living is nothing new. Since the creation of the Federal Reserve, the dollar has lost about 95% of its purchasing power. Chris Mayer explores our other options for making sound investments…

Inflation, as it is commonly known, has not always been the normal state of affairs. As James Grant, editor of Grant’s Interest Rate Observer, has pointed out, "From George Washington to the A-bomb, prices alternately rose and fell… As Alan Greenspan himself has pointed out, the American price level registered little net change between 1800 and 1929."

The basic nature of our money assures it will lose value over time. It can be created nearly at will and it is left in the hands of government officials, who routinely spend more than they have. In such a state, a nation’s paper money has a shelf life like a fresh egg or a jar of mayonnaise. It doesn’t last forever. Unlike these foodstuffs, paper money has no printed expiration date.

According to economist Felix Somary, who experienced firsthand the devastating monetary inflations that destroyed the German mark in the 1920s, it took Rome four centuries to destroy its currency. Germany and Austria reached that point in just nine years, ending in the famous hyperinflations of the 1920s, and before that, Russia managed it in only five years. Everyone’s experience is different, but our collective experiments in paper money have not created a currency that increases in value over time.

The life and value of a monetary unit has less to do with the wealth of a country than with the simple facts of supply and demand. As the great Austrian economist Ludwig von Mises noted, "Even the richest country can have a bad currency and the poorest country a good one."

The Fall of the Dollar: The Pound

For some interesting insights into the flight of the dollar, I want to share some thoughts I recently read from Justin Mamis, author of several investment books and a longtime market adviser. Mamis was born during one of the great turning moments in stock market history – 1929.

Mamis talks about the experience of the dollar’s immediate predecessor as cock of the walk, the old British pound. The pound, the currency of choice for a long stretch of time before the American dollar, was the product of the British Empire. Imperial ambition and sound money, though, never mix, and the pound probably peaked somewhere before World War I. After World War II, Mamis notes, "The Empire peeled off like an onion into a grab bag of different independent countries… the Bretton Woods Agreement of July 1944 signaled the end of the British pound as the world’s reserve currency."

The British pound continued to weaken against the dollar over the ensuing years. Mamis notes: "Weakness, in a long-term sense, begets weakness, like the flaws in an incestuous genetic pool."

The dollar has been the world’s reserve currency, or currency of choice, since at least Bretton Woods. From this short collection of historical vignettes, we can make one safe assumption. As Mamis puts it, the status of being a "reserve currency is not a permanent appointment."

To pinpoint when the dollar’s status as the world’s currency of choice will end is an impossible task. These things tend to unfold over many years, and there does not appear to be any immediate contender ready to ascend to the throne. But that should not deter the investor from making the basic assumption that the dollar of a decade hence will buy less than a dollar of today.

I’ll include one last quote from Mamis, who advises us not to expect long-term trends to always be immediately apparent or obvious. "We must warn not to turn the next century’s global changes into something that has to be evident in its entirety all at once – or else denied. Nor will our concerns be proven instantly ‘wrong’ because the dollar finally has its oversold rebound." Well said.

The Fall of the Dollar: The Need For Sound Investing

This situation – the whittling away of the dollar – creates the need for sound investing. Basically, investors look to survive the ravages of inflation (and taxes – of which inflation is a most insidious type). Like the biting winds of nature that sculpt rock and carve stone, inflation and taxes will grind the greatest piles of fortune to dust over time. Preserving it, making it grow – essentially investing well – is the investor’s difficult art.

So should you put your money in euros, perhaps, or some other foreign currency? The euro may strengthen against the dollar, but I think the dollar and the euro share the same fate, like the passenger pigeon and the Carolina parakeet. The road to extinction may be of indeterminable length, but the final destination of that road is not in doubt. The same can be said of all our paper currencies, be they yen or pounds, pesos or ringgit. All of them are on the same slide.

But there are other ways to beat the decaying paper currencies that make up so much of our financial wealth. The idea of tangible asset investing, investing in stuff that has survived and prospered in a variety of conditions, should meet the challenge in the years ahead.

Often, I’ve looked at some great fortunes and drawn insights and lessons from those experiences. Recently, I came across an old book, originally published in 1907 and written by Gustavus Myers, called History of the Great American Fortunes.

It is a mammoth study of American wealth over the previous 200 years and deals with fortunes in shipping, land, fisheries, railroads, trusts, banks and other industries. I’ve only read a couple of the opening chapters, which happen to cover the shipping and land fortunes. But some of Myers’ observations got me thinking about the durability of some forms of investment over others. Shipping and land offer interesting contrasts.

Myers writes about the great fortunes of the shippers. "Enormous as were the profits of the shipping business, they were immediate only. In the contest for wealth, it was inevitable that the shipper should fall behind. Their business was one of peculiar uncertainties. The hazards of the sea, the fluctuations and vicissitudes of trade, the severe competition of the times exposed their traffic to many mutations." In other words, shippers’ fortunes came and went, like the late-1990s boom in tech stocks, the 1960s conglomerate boom or any number of investment crazes of years gone by.

Many shippers were aware of the vicissitudes of their business and often invested some piece of their fortunes in land, banks, factories, turnpikes, insurance companies and railroads. Those that didn’t didn’t last.

Contrast this with Myers’ observations on those fortunes built on land, primarily in commercial cities of importance:

The Fall of the Dollar: Fortunes Built On Land

Fortunes built on land in the cities were indued with a mathematical certainty and perpetuity. A lot of the tendencies and currents of the times favored the building up of an aristocracy based on the ownership of city property. With the progressing growth of commerce and population, with immigration continuing… every year witnessing a keener pressure for occupation of land, the value of this latter was certain to increase.

An investment in land was an investment in something that was real and often increased in value despite what its owners did with it. It could be titled and its ownership made certain – unable to be copied by a competitor.

One more quote from Myers, who draws this interesting conclusion:

A more formidable system for the foundation and amplification of lasting fortunes has not existed…And that it is pre-eminently so is seen in the fact that the large shipping fortunes of a century ago are now generally completely forgotten, as the methods then used are obsolete. But the land has remained land; and the fortunes then incubated have grown into mighty powers of great national, and some of considerable international, importance.

Now, I’m not concluding that land is a new surefire investment bound to make us all rich in time. But the best characteristics of land provide insight into what makes a resilient investment, able to hold its value in a variety of market conditions.

Land has some characteristics, such as its durability, relatively fixed supply and timeless qualities that have often made wonderful investments and formed the keystone to later fortunes.

To survive and prosper in the years ahead while the dollar crumbles, look for real assets that share these qualities.


Chris Mayer
for The Daily Reckoning
March 23, 2005 — London, England

Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is also the editor of the Fleet Street Letter.

Recently, Chris Mayer has launched a new trading service, CrisisPoint Trader, which utilizes a unique investment-timing tool. The core of this strategy is not new – it’s been around for over 100 years…and days before the wipeout of 1929, one of the earliest versions of this system warned a handful of investors to get out of stocks immediately – and those who listened actually locked in their profits before the disaster.

This 100-year-old system is the only trading tool that’s been successful enough to peg every one of the market’s major moves, and it could prove to be a very valuable device to investors in the upcoming months.

"Virtue is what used to pay," said professor Gordon Tullock.

Save your money, buy low/sell high, be nice to people, watch your back, mind your own business – this is the wisdom of the dead, the product of hundreds of generations of experimentation, innovation and observation.

One generation takes the virtuous path. The next is likely to slip off, honoring the old virtues in speech, but not in actions.

The oldest generation of Americans remembers the Great Depression. They borrowed reluctantly, saved eagerly, and made America the greatest power on earth. Their children still talked their parents’ talk – but didn’t mind walking off in a different direction when suited them. And their grandchildren? The newest generation seems to have no regard whatever for the virtues of their grandparents.

Two of five first time homebuyers put no money down, says today’s news. Many choose "interest only" mortgages…and a growing number choose the "minimum payment plan." All seem convinced that they have nothing to fear from debt. They do not hesitate to leverage themselves to buy real estate. Their parents and grandparents made good money on it, didn’t they?

Real estate used to pay in America. Depending on where and when you bought it, property prices generally kept up with inflation. In some areas, at some times, it surpassed CPI increases. Had your grandparents bought a stretch of land on the California or Florida coast, for example…and had your parents held onto it…today, you’d be happy to have it. Over the past century, America got rich…and American property prices generally rose with the economy.

Is. Was. Will be again. If only we could stop the verb tenses! But there’s no guarantee that the trends of the last 100 years will last 100 years more.

What made America rich were the virtues of parents and grandparents. Americans used to save their money. They used to be thrifty. They used to make things to sell to foreigners. Foreigners used to save their dollars so they could buy high-quality products, Made in USA. So much did they crave U.S. dollars that the American currency easily became the reserve currency of the entire world, and America became the world’s biggest creditor by lending dollars to foreigners. Now, it is the foreigners who lend. They save their dollars, not to buy U.S. goods, but to buy U.S. Treasury bonds…so that Americans can buy high-quality foreign-made goods! And now, America is the world’s biggest debtor.

What has happened? Do the virtues that "used to pay" pay no more? Or have the virtues that used to pay for Americans now pay for someone else?

Now, Americans talk the talk, but they no longer walk the walk of a prosperous people. Instead, they only pretend to respect the old virtues. They buy stocks – because stocks went up when America was virtuous. They buy property, because that, too, was a good investment. Stocks went up because they represented good businesses – like GM – that could make things at a profit. Property went up, too, because Americans were virtuous! They worked hard, saved, invested…as a result; there were more and more Americans with more and more money to spend.

But whither the virtues? The saving rate is the lowest ever. The lack of savings – along with a short-term, get-rich-quick attitude in business, over-regulation, red tape, and high wages – has wiped out America’s competitive advantage. When was the last time you saw a factory being built in the United States, dear reader? Today, America has all the troubles of its major competitors – and more. For not only has it lost its economic virtues, it has also given up its political virtues. Now, America no longer minds its own business. Instead, it undertakes to mind everyone’s business…and bears the cost of its meddling like limp flesh around its waist. Where the country used to be a slim and agile competitor, it is now larded down with so much legislation and world-improvement, it can barely move.

Of course, the virtues that made U.S. stocks and property investments pay off can still be found – overseas! It is as if they had outsourced. You can still see them. But they now travel with a Chinese, Japanese, or Indonesian passport and speak with an accent.

Don’t even bother to say "hello" – they won’t even recognize us anymore.

More news, from our team at The Rude Awakening:


Eric Fry, reporting from Manhattan…

"The chairman’s quarter-point rate hike – and his accompanying verbiage – stunned the gold market on Tuesday, while also rocking most other financial markets. After gold’s near-death experience this week, can we expect to see a newfound lease of life for the metal or a relapse into depression…?"


Bill Bonner, back in London:

*** We just received this from Chris Mayer, on his new service:

"CrisisPoint Trader is my vehicle for speculating. Investing is one thing and speculation is something different.

"CrisisPoint Trader deals in the guilty pleasures of speculation – the fatty foods and sweets of the financial world. I wouldn’t recommend you go out and put your whole net worth to work in CrisisPoint’s speculations, just as I wouldn’t recommend a diet consisting solely of doughnuts and chocolate, but in moderation, speculating can be very profitable and a lot fun.

"I’m exploring speculations in banking and finance, in some mortgage companies and in slumping homebuilder stocks. There are intriguing ideas here as well.

"And the CrisisPoint system that I created helps sift through thousands of stocks looking for those ‘crisis points,’ as I call them, when things can suddenly change in the direction of a stock’s price. The works of the old Dow Theorists inspired CrisisPoint Trader, and therefore has a pedigree not found in many other systems. Dow Theory has worked in real time, in real markets, with real people calling the shots. It’s not some back-tested system or some convoluted new creation.

*** As GM goes, so goes the nation. General Motors is in the news almost every day. People are wondering how it will get out of its jam. Today’s press tells us the company will sell part of its finance company, GMAC.

GM owes more than ever before. It has obligations to present and past employees that stretch decades into the future. And it grows less and less able to compete in the world economy. The Chinese are investing billions in their auto industry. In a few years, they will be able to make high-quality cars and trucks far cheaper than those GM produce.

What can GM do? We don’t know. Like the U.S. economy, the automaker has become dependent on cheap credit to keep going. But cheap credit is subject to verb tenses too. In June of ’04, the rate on home equity lines of credit was 4.7%. Now, the rate has moved up to 5.9%. GM, meanwhile, is paying 5.75%. How long will the company survive when it must pay 10%? How many first time homebuyers – who now make minimum payments and count on selling their houses at a profit in 24 months – will survive 10% mortgage rates?

Not that we are predicting 10% rates. We’re sticking with our "long, slow, soft slump" forecast – at least, until people begin laughing at us. This means low nominal rates for the foreseeable future. (We admit, however, that the furthest into the future that we can reliably see was yesterday.)

But inflation picked up last month. In February, the CPI rose at nearly a 5% annual rate. The Fed is said to be worried. Analysts wonder if there won’t be a 50 basis point boost in May, rather than the typical 25 bps hike. Either way, it seems like that the real cost of credit – for GM and for the nation – is going up.

*** The American press continues to tell us how superior the U.S. economy is to its European competitors.

Europe has no trade deficit. And Europeans, generally, are much less in debt than Americans. But Europe is "rigid," and besides the European Union is unworkable, they say. With so many cultures, languages, and jealous parliaments involved, European government is effectively gridlocked.

Of course, that’s what we like about it.

"I saw a copy of the proposed European Constitution yesterday," Elizabeth reports. "I don’t know how they expect anyone to vote to approve it. It’s completely incomprehensible."

Well, bravo to the Europeans. They have managed to create an unworkable system. The governments of Europe cannot agree on joining the United States in overseas interventions. Meanwhile, under the pressure of competition from the East (not from the United States) the Western European governments are slowly dismantling the worst of their domestic interventions from the last century. Several governments in Eastern Europe have put in flat rate tax system. Slovakia has a flat rate of 19%. Estonia and Russia also have simple, flat rate systems. President Chirac of France is worried; a "race to the bottom," he calls it. But it is forcing change in the high-cost, high-regulation economies. France voted this week to eliminate its 35-hour workweek. Germany is eyeing tax reductions. Investors take notice: You can buy major German companies at low P/E’s and high dividend yields. Watch this space for some recommendations.

The Daily Reckoning