October 1, 2007 – It has been a long-running debate. Most everyone recognizes that the US economy is unsustainable because of too many years of overspending, under-saving and over-borrowing. So when will the piper eventually be paid, and what will be the result? Another deflation like the Great Depression? Or severe inflation, perhaps even hyperinflation like that experienced by Weimar Germany?
My answer to these questions has been consistent. We first have to ask by what currency you are measuring prices. If one looks at prices in terms of dollars, I expect severe inflation leading to the collapse and abandonment of the dollar, repeating the outcome of this country’s first national government’s experiment with fiat currency. I’m of course referring to the continental.
There will be a different result, however, if we calculate prices in terms of gold. In that case we will see deflation. Prices will go down, which is another way of saying that each unit of currency – for example, a gram of gold or an ounce of gold – will purchase more.
As explained last month, M3 – the total quantity of dollars in circulation – has been resurrected, so I have my trusty roadmap back. We can once again closely track what is happening to the dollar by watching the annual growth rates of M3, but the return of M3 also enables something else. We can answer the seemingly endless inflation/deflation debate.
The antagonists to this debate agree that the dollar is headed for trouble, but they disagree on the inevitable outcome. Will the mismanagement of the dollar end in deflation as the mountain of dollar denominated debt collapses reducing the money supply, or will it end in inflation as the Federal Reserve pumps up the money supply in order to bail-out debtors – and in particular, the US government – with an endless quantity of newly created dollars?
The reality is that this debate is a red herring. Only half the question is being addressed, namely the supply of money. In other words, the debate centers on whether the supply of dollars will increase or decrease. What about demand? The antagonists to this debate ignore demand by assuming that the demand for dollars will continue to grow. But what if it doesn’t? What if it drops? In the end, demand is more important than supply.
A good example to prove this point is the collapse of the Argentine peso several years ago. Foreign holders of pesos were the first to recognize that it was overvalued. So they sold their pesos, putting pressure on the peso in the foreign exchange markets, which was the beginning of a flight from this currency. The demand for pesos was dropping as foreigners dumped it.
This flight to safer alternatives began even though the Argentine monetary authorities clamped down on the rate of growth of pesos, and as the crisis deepened the quantity of pesos in Argentine M3 actually declined by 30%. Nevertheless, the inflation rate soared toward 50% p.a. How was that possible with such a sharp decline in the quantity of pesos?
The answer is that the demand for pesos declined even more rapidly than the supply of pesos. In other words, there was a flight from the currency, which is precisely what is happening with the dollar – though so far at a much slower pace. But that pace will soon change. The willingness of people and companies (and even central banks) to hold dollars is declining, so demand for the dollar and its exchange rate are falling. But I expect that the demand for the dollar will eventually plummet as years of overspending, under-saving and over-borrowing in the US eventually take their toll on an over-valued currency.
The peso experience explains how a flight from the currency begins. The foreign exchange markets are the most sensitive and responsive to changes in a money’s supply, and particularly its demand. Foreign holders of the peso had less need for pesos than Argentines, who in addition to holding the peso for liquidity and/or investment purposes also needed this currency for day-to-day living.
Foreign holders may be enticed to hold the currency longer if interest rates rise, but it is only a stop-gap measure (and keep in mind that the Fed in any case is cutting interest rates). The value of the peso declined because of foreign selling, as foreign holders dumped the currency and moved into other, safer alternatives. Eventually the Argentines caught on to what was happening, just like Americans are now beginning to catch on to what is happening to the dollar. The demand for dollars will eventually plummet just as the demand for pesos plummeted.
This example of the peso explains how a flight from the currency ends – the currency loses purchasing power, which is what we usually call inflation. What’s more, the currency no longer serves as a useful tool in commerce. I expect a similar result for the dollar.
So to me the answer is clear. It seems logical that dollar inflation will be the result, and probably hyperinflation. But let’s look at this supply demand equation in greater detail to explain why I expect demand for the dollar to plummet.
The subprime crisis was a spark that increased uncertainty, which has created a crisis among banks. They are now worried about the creditworthiness of their peers and therefore wary of lending to each other. In short, they don’t trust each other, and given their interdependence on funding, their concern increases the possibility of a bank failure. Central banks are injecting liquidity, but that will not cure the problem. Banks needs to again trust one another, but that is not likely to happen soon because there are huge black-holes on bank balance sheets, which when cumulatively totaled mean that there is a black-hole on the dollar’s monetary balance sheet.
Monetary Balance Sheet of the US Dollar as of October 31, 2007
(denominated in billions of units of account called dollars)
|Gold @ $672.65||$175.9||Federal Reserve Notes||$758.4|
|IOU’s Owed to Banks||12,006.7||Bank Deposits||11,424.2|
|Assets Backing the $||$12,182.6||M3||$12,182.6|
The above table puts into perspective one undeniable fact about the dollar. Though we often lose sight of this fact that the dollar is merely a creation of accounting, it is important to recognize that the dollar is in essence nothing but a liability of the financial institutions that create dollars. These institutions are the Federal Reserve and the nation’s banks. Though the credit worthiness of Microsoft, GE and dozens of other corporations may be better than most banks, MSFT and GE are not part of the money-issuing monopoly. They do not have the privilege of issuing liabilities that circulate as currency.
Because the dollar is a liability (i.e., someone’s promise), the quality of the dollar is only as good as the assets on the monetary balance sheet. It is these assets that give the dollar its value, a recognition based upon the most fundamental accounting premise that liabilities are only as good as the assets supporting them. If the assets did not have value, then the liabilities we call dollars would have not have any value either and would not circulate as currency.
The 12,182.6 billion of dollars circulating as currency (i.e., M3) take two forms. First, there are the liabilities of the Federal Reserve, the notes that we use as cash currency. Presently there are 758.4 billion of dollar-denominated Federal Reserve notes circulating as currency. Then there are the 11,424.2 billion of dollars issued by the banks, which are a deposit currency that circulates with checks, wire transfers and other forms of bank-to-bank payments.
Turning to the asset side of the monetary balance sheet, there is $175.9 billion worth of gold in the Federal Reserve. This dollar value is calculated by using the August 2007 month-end gold-to-dollar exchange rate of $672.65 per ounce of gold, multiplied by the Federal Reserve’s claim to the 261.5 million ounces of gold comprising the US gold reserve. The other assets are the $12,006.7 billion of IOU’s owed to the banks by the various individuals, businesses and governments who have borrowed money from the banks.
While we often speak of the quantity of money – M3, or presently $12,182.6 billion – we rarely if ever hear about the quality of money. But the assets of the monetary balance sheet in fact determine whether the dollars that circulate as currency are fairly valued, over-valued or under-valued. And the dollar’s valuation can be determined by one very important question.
Are these IOU’s on the monetary balance sheet really worth $12,006.7 billion? That is the single question of paramount importance.
There are, no doubt, some bad loans in these assets — some large portion of subprime loans and countless billions of loans made to people and companies in financial trouble are unlikely to be repaid. For years the market has ignored these low-quality and no-quality problem assets but is now paying attention. The subprime mess has caused everyone to focus on the quality of bank assets, which is one reason the gold price is rising.
It is a basic fact of accounting that balance sheets are always in balance. Assets must always equal liabilities and equity. Sometimes arcane accounting practices (like the many nuances often employed to determine whether to carry assets at book or market value) distort this relationship between assets and liabilities. These distortions in the balance sheet of companies have presented opportunities for legendary investor Warren Buffett and lesser well-known investors to seek out hidden value in a company. But what is true for any one company’s balance sheet is also true for an aggregate of bank balance sheets and their mix of assets and liabilities.
Balance sheets must always balance. And there are two alternatives to bring a monetary balance sheet back into balance.
The obvious alternative is for the price of gold to rise, offsetting the deterioration in the value of the IOU’s. For example, if the true value of the IOU’s is only $11,800 billion, then the value of the gold in the Federal Reserve has to rise by $206.7 billion to $382.6 billion, which would mean a gold price of $1,463 given the 261.5 million ounces in the US gold reserve.
The other alternative is that if the value of assets decline by $382.6 billion, then liabilities have to decline by $382.6 billion, causing a decline in M3. This example explains what happened in the US during the Great Depression. The failure of thousands of banks because of the imprudent loans they made and other reasons caused the liabilities of these banks to also become worthless, which in turn caused M3 to decline back then by approximately one-third. When these banks collapsed and went into bankruptcy, their liabilities became essentially worthless, which directly reduced M3.
Similarly, this gap between assets of lesser value and outstanding liabilities also exists in the banking system today. The only difference between these two examples is the monetary standard – the US was on a gold standard in the 1930’s and today it is not. Thus, without the gold standard and the ability to redeem dollars for gold, there is no mechanism that forces a reduction in liabilities when asset quality becomes doubted. So instead of the US gold reserve being reduced by redemptions as occurred in the 1930s, today the price of gold is rising to bring the monetary balance sheet back into balance. Balance is not being restored by a reduction in liabilities because government policy since the 1930’s has been that depositors will not lose the dollars they have on deposit in their bank.
Thus, to summarize, assets are now less than liabilities because of the ‘black-hole’ created by subprime and other non-repayable loans, which is an imbalance in the monetary balance sheet that the market never ignores. The price of gold is rising to bring the monetary balance sheet back into balance. The rising gold price is filling the big hole in the balance sheet by replacing assets that no longer have any value.
Lastly, you may be wondering why I have ignored bank equity from the above balance sheet. The reason is simple. There isn’t any available equity.
It must be recognized that banks are highly leveraged, over 20-to-1. Thus a 5% decline in assets will wipe out a bank’s equity. So between their illiquid assets that cannot readily be turned into cash and the probable losses that will occur in an economic downturn leading to a bust in their loan portfolio, banks will be lucky to have any equity left. And this analysis ignores their huge derivatives portfolio, which the collapse of Long Term Capital Management made clear is a catastrophe waiting to happen and will further erode bank capital in any monetary crisis.
Therefore, the monetary balance sheet is an accurate portrayal of the dollar and the thin thread of weak promises upon which the dollar is hanging. This thin thread points out the fragility of banking, and in my view it is destined to snap, like it did in the 1930’s. That this ‘snap’ seems to me inevitable is one of the reasons why I have repeatedly warned that the dollar will meet the same fate as the Argentine peso or America’s first experiment with paper money, the continental. The prudent way to be prepared for that collapse is to hold gold and silver.