The Illusion of Capital

The world’s “faith-based” monetary system is breaking down before our eyes. Don’t be caught off guard.

Last week’s euphoria over the Euro bailout turned around sharply this week on news that the political situation in Greece is worsening. That’s been the pattern for months.

The grim reality is that “rescue plans” can’t fix what’s broken. The Western nations are suffocating under mountains of debt…and there are only two known “cures”: default or inflation.

The default option is quick, direct and painful…but very effective. The inflation option is slow, indirect and somewhat less painful…but very ineffective. Inflation is more an anesthetic than a genuine cure, which is the reason why politicians prefer it to an outright default.

So it should be little surprise that the politicians of the euro zone have been signaling very clearly that they intend to “inflate away” the Greek-cum-Italy crisis. They will embark on a European version of Ben Bernanke’s quantitative easing tactic — i.e. print money to buy the bonds of troubled PIIGS governments.

Since the default option in not on the table, the PIIGS crisis won’t be close to resolved until we see the ECB overtly or covertly monetize a lot more PIIGS debt. The math doesn’t work without heavily diluting the wealth of eurozone savers via inflation.

We will see much more debt monetization; this week’s interest rate cut from the ECB was just the start of monetary easing in Europe. On this subject, I dug from my files a piece I wrote for Strategic Investment in March 2007.

Here is an excerpt from this essay, which has become even more relevant today than when it first appeared three and a half years ago:

I think more clearly on a train. The rumbling helps focus my mind… Passengers are very much a part of their landscape, yet detached — a perfect occasion to sit back and think about the world that flies past the window.

Here in America, the world that flies past the window is one in which capitalism has become a wealth-transfer process instead of a wealth-creation process. Without genuine wealth-creation, however, the US dollar’s value will become increasingly suspect.

A few weeks ago, as I was rolling up the tracks from Baltimore to New York, my gaze landed on an oil refinery. A little while later, I spotted a casino. Then I started to think about these two very different forms of capitalism — one that relies on an intensive investment of physical capital and one that relies almost entirely on paper money.

Is one of these forms of capitalism inherently better than the other? Does one of them produce a more enduring prosperity?

Yes, to both questions.

Passing by Sunoco’s Marcus Hook Refinery, you can’t help but admire this feat of engineering. Situated on the Delaware/Pennsylvania border, this 800-acre campus covered in miles of steel pipe has the capacity to crack 175,000 barrels of crude oil into refined products in a single day.

Harrah’s Chester Casino & Racetrack does not produce gasoline. It does not produce anything…except a transfer of wealth. It stands in stark contrast to the refinery. The only similarity between the two is that you wouldn’t want either in your backyard.

Yet in the all-important calculation of gross domestic product (GDP), a dollar pumped into Harrah’s one-armed bandit is treated the same as a dollar Sunoco invests in maintaining its refinery. For those who only look at surface numbers, GDP can be a very misleading gauge of economic health. In itself, it tells you nothing about capital formation.

Will America’s capital formation process continue in a sustainable manner when investment dollars are constantly diverted away from refineries because they are too “capital-intensive?”

The ability to cheaply unleash crude oil’s chemical energy is made possible by intellectual capital that has compounded over the years, thanks to consistent investment in research. This intellectual capital translates into material wealth when it’s combined with physical investment in steel, concrete, and the like. Productivity improves as this process of intellectual and physical investment is repeated and refined over time.

Compare this with intellectual capital stored in the minds of mathematicians writing algorithms for Harrah’s computerized slot machines. Casinos are good businesses because the house always wins. But aside from the entertainment value they provide, they do not add to the capital base of the US economy.

Instead, casinos are a vehicle to transfer wealth from gamblers to Harrah’s shareholders. While this casino’s perpetual profits add to overall corporate earnings numbers, does it really create wealth?

Who contributes more to the wealth creation process in the United States — the maintenance worker at Sunoco’s refinery or the Ph.D. mathematician writing algorithms for Harrah’s?

As I consider this question, our train approaches the Philadelphia stop. The urban decay surrounding the University of Pennsylvania’s ivy-draped buildings comes into focus. Ghosts of factories long dormant stand hollow.

This landscape must represent the picture of progress to proponents of the “information economy.” Most Penn students are trained for roles in finance, medicine, and law, while most residents of surrounding communities face a bleak future in this very same information economy.

Someone in China is able to undercut entry-level manufacturing wages by 90% in order to earn a standard of living that approaches the US poverty level. This leaves non-information workers the option of working in un-exportable service industries.

Not all of us can enjoy the privilege of thinking for a living. But all Americans do have the right to vote, and we have every reason to expect a louder populist voice at the ballot boxes as we head down the bumpy transition to an information economy. As most populist politicians have done in the past, they will make promises that can be paid only through newly printed paper money.

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.

But 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?

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.

Investors should expect the current momentum behind populist political movements in the US to grow stronger. This will be bad for the dollar, bad for longer-maturity bonds and bad for the 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.

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.

Gold is no longer $620 an ounce, like it was when I wrote this essay. But neither is gold $3,000 an ounce, which is where it will likely be if I revisit this essay again in 2014. But however high the gold price may climb from here, one thing is clear: The faith-based monetary system is breaking down. Gold will not break down with it.


Dan Amoss,
for The Daily Reckoning