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Economics

Eggs in two baskets

Supporters of sound currency have a pretty good idea about what’s wrong with the present paper currency and banking arrangements. They also have clear views on what should replace it, although some put more emphasis on gold, others on baskets of commodities.

I remember the excitement I felt as I first read Friedrich Hayek’s The Denationalisation of Money. My preference was for gold, though the fluctuations of the early 1980s made me aware that reintroducing the Gold Standard could be turbulent. It would be politically “courageous” if not a sure election loser.

After grasping the idea that a basket of goods could be more stable than gold on its own, I eagerly turned to the last page. I hoped to find a compelling step-by-step guide to how to bring this “standard” currency into existence.

To put it mildly, I was disappointed.
Continue reading “Eggs in two baskets”

Economics

More Bread and Circuses

Editor’s note: We’re grateful to Tim Price of PFP Group for this article. PFP has made this document available for your general information.

“Lower borrowing and a smaller deficit mean less debt.”
- George Osborne, British Chancellor, in his 2014 Budget Speech.

“Bingo ! Cutting the bingo tax and beer duty – To help hardworking people do more of the things they enjoy.”
- Asinine Conservative post-budget advertisement.

“Bingo ! I say, you there ! How is your whippet ? Jolly good, jolly good. Carry on.”
- Inevitable twitter response via #torybingo.

“..beer, and above all gambling, filled up the horizon of their minds. To keep them in control was not difficult.”
- George Orwell, ‘1984’.

“Mad piece of theatre over the petty cash”
- Headline to Matthew Engel’s budget review in the Financial Times.

Continue reading “More Bread and Circuses”

Economics

Amazon Prime cheaper in commodity terms

 

amazonprimecostcomparison

Incoming from Dave Doctor at Monetary Choice:

The dollar price of Amazon Prime, the two-day delivery program for Amazon, rises on April 17th to $99, from the original $79 price set in 2005, a 25 percent increase. However, when measured in gallons of gas and pounds of coffee, the price or cost declined, by 27 percent in gas and 53 percent in coffee. This is not surprising since Amazon is much more efficient now. The dollar price rose because there are twice as many dollars, created by banks to fund the U.S. federal government’s deficit and low-interest loans, all at the expense of savers.

Economics

On the subject of free trade and world peace

Richard Cobden was renowned for his role in the Anti-Corn Law League, campaigning against import tariffs. He was also a champion of the idea that peace would be strengthened by more individual business contacts across national borders.

I think it’s fair to say that Cobden would support the European Commission’s plan to scrap trade barriers between the European Union and the Ukraine announced last week. The Ukraine is not threatening war against any European Union countries and such boost to trade as will happen between now and September would tend to help peace and democracy in the region.

But surely it would be counter-productive to re-introduce barriers to trade with the Ukraine when the six months are up? And couldn’t similar arrangements be offered to Russia if its government decided to stop its own mercantile approach?

Economics

John Butler: Bitcoin, the Monetary Touchstone

Click to download PDF

Click to download PDF

Is Bitcoin a sound form of alternative money? Does it provide a viable, alternative store of value with gold? These are questions that John Butler answers in his latest Amphora Report, which is reprinted below. This article offers a useful background to the thinking behind Bitcoin and it’s potential as a disrupter of fiat currencies.

BITCOIN: THE MONETARY TOUCHSTONE Created in 2008 by the mysterious ‘Satoshi Nakamoto’, in the past few months bitcoin has gone from a fringe financial technology topic to a mainstream media phenomenon. The debate is now raging as to whether bitcoin is, or is not, a sound form of alternative money. As the Amphora Report has, from inception, focused regularly on monetary theory and the financial market implications of activist central banking, in this edition I survey a handful of prominent, diverging views on bitcoin and then share some of my own thoughts. In brief, I believe that bitcoin’s ‘blockchain’ technology enables a low-cost payments system capable of disintermediating the banking industry, but I do not believe bitcoin presents a viable, alternative store of value on par with gold. In any case, bitcoin serves as a monetary ‘touchstone’ of sorts, distinguishing those who lean toward economic and monetary authoritarianism from those who favour market-based organisation instead.

TO UNDERSTAND BITCOIN ONE MUST FIRST UNDERSTAND MONEY

Satoshi Nakamoto, the initially mysterious and now legendary creator of bitcoin, finally became a mainstream celebrity last week, having been ‘outed’ by US periodical Newsweek. Many who have followed the bitcoin story, however, find Newsweek’s claim rather dubious and instead believe that ‘Satoshi Nakamoto’ is a pseudonym adopted by either a single individual or team responsible for researching and publishing the original 2008 paper describing the specific, ‘blockchain’ algorithm behind bitcoin.

I have no strong opinion on Newsweek’s specific claims, nor on who, or what group, created bitcoin, although I am curious, for reasons that will become apparent. More important is to understand whether bitcoin could function as a sound, alternative money.

To begin, we need first consider why an alternative money would ever be necessary in the first place. Well, repeatedly throughout history, due to financial pressures, governments have chosen to debase their coins or inflate their paper currencies to service or settle their debts, by implication appropriating the wealth of prudent savers in the process. Wars, for example can be expensive and most large debasements in history have occurred either during or following major wars, in particular in those countries on the losing side of the conflict. But even the winners can succumb, as Rome demonstrated in the 3rd century or as the victorious WWI powers did in the 1920s and 1930s.

To continue reading, download the Amphora Report here (PDF): Amphora Report, Vol 5, 12 March 2014.

Economics

Pop!

Editor’s note: We’re grateful to Tim Price of PFP Group for this article. PFP has made this document available for your general information.

“10th March 2000: NASDAQ closes at a record 5048.62, up 24.1% for the year to date — after gaining 86.5% in 1999. A conference on optical fibre stocks sells out nearly every hotel room in Baltimore, the biggest stocks on NASDAQ trade at an average of 120 times earnings, and 15% of NASDAQ’s value is made up of companies less than two years old that have never earned a profit. James J. Cramer, author of the eponymous column “Wrong!” for TheStreet.com, writes that a revival of value stocks “will only happen when the Brocades and Broadcoms blow up. And I don’t see that happening any time soon.” In fact, says Cramer, he’s tempted to short-sell Warren Buffett’s Berkshire Hathaway, betting that the great value investor’s shares are “ripe for the banging.” BancOne fund manager Chris Guinther sums it all up: “In today’s market, it pays to be aggressive.” Today is the absolute peak of the market bubble: In one of the worst crashes in history, NASDAQ plunges 60.6% over the next 12 months. And Cramer’s “Red Hots”? Brocade unravels by 67.1%, Broadcom collapses by 84.1%. Meanwhile, Berkshire Hathaway gains 72.2% over the year to come.” 

- ‘This day in financial history’ on JasonZweig.com.

“The Fed and the other major central banks have been planting time bombs all over the global financial system for years, but especially since their post-crisis money printing spree incepted in the fall of 2008. Now comes a new leader to the Eccles Building who is not only bubble-blind like her two predecessors, but is also apparently bubble-mute. Janet Yellen is pleased to speak of financial bubbles as a “misalignment of asset prices,” and professes not to espy any on the horizon.

“Let’s see. The Russell 2000 is trading at 85X actual earnings and that’s apparently “within normal valuation parameters.” Likewise, the social media stocks are replicating the eyeballs and clicks based valuation madness of Greenspan’s dot-com bubble. But there is nothing to see there, either–not even Twitter at 35X its current run-rate of sales or the $19 billion WhatsApp deal. Given the latter’s lack of revenues, patents and entry barriers to the red hot business of free texting, its key valuation metric reduces to market cap per employee–which computes out to a cool $350 million for each of its 55 payrollers.” - ‘Yellenomics: the folly of free money’ by David Stockman.

Trying to time the markets is either next to impossible, or simply impossible. Either way, we think it’s impossible, so we don’t try. And since we don’t short stocks, the path of least resistance when it comes to equity market investing is

a) Avoid obvious overvaluation, and
b) Concentrate on apparently dramatic undervaluation.

If in doubt, the best policy is always to ask ‘What would Ben Graham have done ?’ and then just do that. (And conversely, if Ben Graham would never have done it, then don’t do it either.) And David Stockman isn’t the only person who detects evidence of a bubble in Big ‘Tech’. V. Prem Watsa of Fairfax Financial Holdings points to the highly speculative valuations currently on offer in the ‘social media’ and ‘other tech / web’ space. For example:

Data courtesy Fairfax Financial Holdings Ltd, March 7 2014.

It’s fairly safe to assume that Ben Graham would not have given ownership of these companies at current valuations his uninhibited endorsement. Indeed, as he once said,

“Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes — in fact, very frequently — they make mistakes by buying good stocks in the upper reaches of bull markets.”

So in summary, here are the cardinal errors:

i) Buying rubbish (or speculative nonsense);
ii) Overpaying for quality.

Avoiding the first error is relatively easy, subject to the vagaries of subjective judgment. Avoiding the second, however, may be difficult, perhaps impossibly so, when our monetary overlords at the central banks are hopelessly distorting the price of money. The prudent response, we feel, is to lean that much more heavily on the side of caution by only even considering out-and-out deep value – at least within the context of the listed equity markets. And it is worth repeating Graham and Dodd’s 1934 definition from ‘Security Analysis’:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” [Emphasis ours.]

Quite which operations in today’s marketplace will turn out to be speculative is not yet known to anybody. But the law of gravitation, egged on by the madness of crowds, will doubtless reveal its secrets to us before too long. The ‘social media and other tech / web space’ seems as good a place as any to expect to see investment operations smashed against the rocks before the year is out.

But as we suggest, overpaying for quality may be an inevitable risk in a financial world in which hopes and fears over QE, Zero Interest Rate Policies and banking system solvency (and the threat of depositor bail-ins) dominate more objective fundamentals such as corporate profits growth (or lack thereof). Groupthink alone is sufficient to cause unhealthy dislocations when gravitational forces ensue. We suspect that global megacap consumer brands may now be an unhealthily crowded trade – the sort of investment that makes sense at first glance given the problems highlighted at the beginning of this paragraph, but unhealthily crowded nevertheless. They certainly have been before. Take the ‘nifty fifty’ growth stocks of the early 1970s. Coca-Cola was one such stock. When the forces of recession arrived on the back of the Russian gas embargo Arab oil embargo, Coke’s stock managed to lose over two thirds of its value.

The real thing: Coca-Cola share price, 1973-1974

The real thing: Coca-Cola share price, 1973-1974

Coke wasn’t alone. Over the same period, Disney also lost over two thirds of its value. Blue-chip IBM survived relatively unscathed: it only lost 57%. Note that this isn’t a prediction for the next bear phase – but we would suggest that the social media sector, being inherently more flimsy, has that much further to fall.

Where are we currently finding ‘deep value’ ? In pockets of the mid-cap market throughout Asia, notably in Japan, and also, ahem, in Russia, which we note has now replaced gold as the most reviled part of the global asset marketplace. But we also note that gold seems to have turned a corner after its annus horribilis in 2013. As does its kissing cousin, silver. Since we bought both for very specific reasons, and the underlying fundamentals for holding both have if anything only strengthened even as their prices melted last year, we’re unlikely to be selling either any time soon. And of course the miners of each have also seen their share prices recover some, though so far only some, of the ground they lost, but again we’re in the sector for the long haul. We think money printing is in and of itself inflationary. We also think that central banks may soon have to go ‘all-in’ in their fight against deflation. We think they are destined to lose control of the markets before they are ultimately proved wrong in any case, but who knows ? This is what happens when you allow economic policy wonks unfettered power to experiment on complex markets with unproven (and unprovable) models and make-it-up-as-you-go-along monetary policy on the hoof. Since this is destined to end badly, apart from diversifying sensibly into non-equity assets, it makes sense to seek shelter – in equity terms – in those things most worthy of Ben Graham’s affection. Or in the words of Ben Graham’s most celebrated acolyte, Warren Buffett,

“We don’t have to be smarter than the rest. We have to be more disciplined than the rest.”

And

“We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”

Economics

Is inflation good for economic growth?

After settling at 3.9% in July 2011 the yearly rate of growth of the consumer price index (CPI) fell to 1.6% by January this year. Also, the yearly rate of growth of the consumer price index less food and energy displays a visible downtrend falling from 2.3% in April 2012 to 1.6% in January.

US CPI

On account of a visible decline in the growth momentum of the consumer price index (CPI) many economists have concluded that this provides scope for the US central bank to maintain its aggressive monetary stance.

Some other economists, such as the president of the Chicago Federal Reserve Bank’s Charles Evans are even arguing that the declining trend in the growth momentum of the CPI makes it possible for the Fed to further strengthen monetary pumping. This, Evans holds, will reverse the declining trend in price inflation and will bring the economy onto a path of healthy economic growth. According to the Chicago Federal Reserve Bank president the US central bank should be willing to let inflation temporarily run above its target level of 2%. He also said that an unemployment rate of about 5.5% and an inflation rate of about 2% are indicative of a healthy economy.

But how is it possible that higher price inflation will make the economy stronger? If price inflation slightly above 2% is good for the economy, why not aim at a much higher rate of inflation, which will make the economy much healthier?

Contrary to Evans a strengthening in monetary pumping to lift the rate of price inflation will only deepen economic impoverishment by allowing the emergence of new bubble activities and by the strengthening of existing bubble activities.

It will increase the pace of the wealth diversion from wealth generators to various non-productive activities, thereby weakening the process of wealth generation.

Evans and other economists are of the view that a strengthening in monetary pumping will strengthen the flow of monetary spending, which in turn will keep the economy stronger.

On this way of thinking an increase in the monetary spending of one individual lifts the income of another individual whose increase in spending boosts the incomes of more individuals, which in turn boosts their spending and lifts the incomes of more individuals etc.

If, for whatever reasons, people curtail their spending this disrupts the monetary flow and undermines the economy. To revive the monetary flow it is recommended that the central bank should lift monetary pumping. Once the monetary flow is re-established this sets in motion self-sustaining economic growth, so it is held.

Again we suggest that monetary pumping cannot set in motion self-sustaining economic growth. It can only set in motion an exchange of something for nothing i.e. an economic impoverishment.

As long as the pool of real wealth is still growing monetary pumping can create the illusion that it can grow the economy. Once however, the pool is declining the illusion that the Fed’s loose policies can set in motion an economic growth is shattered.

If on account of the deterioration of the infrastructure a baker’s production of bread per unit of time is now 8 loaves instead of 10 loaves and the shoemaker’s production per unit of time is now 4 pair of shoes instead of 8 pair of shoes, then no amount of money printing can lift the production of real wealth per unit of time i.e. of bread and shoes. Monetary pumping cannot replace non-existent tools and machinery.

On the contrary the holders of newly printed money who don’t produce any real wealth will weaken the ability of wealth generators to produce wealth by diverting to themselves bread and shoes thereby leaving less real wealth to fund the maintenance and the expansion of the infrastructure.

Now, Fed officials give the impression that once they put the economy onto the so called self-sustained growth path the removal of the monetary stimulus will not generate major side effects. Note that a loose monetary policy sets in motion bubble activities. The existence of these activities is supported by the monetary pumping, which diverts to them real wealth from wealth generating activities.

Once monetary pumping is aborted bubble activities are forced to go under since they cannot fund themselves without the support of loose monetary policy – an economic bust ensues. The illusion that the Fed can bring the economy onto a self-sustaining growth path is shattered.

Summary and conclusion

On account of a visible decline in the growth momentum of the US price index many economists have concluded that this provides scope for the US central bank (the Fed) to maintain its aggressive monetary stance. Some economists such as the president of the Chicago Federal Reserve Bank, Charles Evans, even argue that the declining trend in the growth momentum of the CPI makes it possible for the Fed to further strengthen monetary pumping. This, it is held, will reverse the declining trend in price inflation and will bring the US economy onto a path of healthy economic growth. We suggest that contrary to Evans a strengthening in monetary pumping will only deepen economic impoverishment by allowing the emergence of new bubble activities and by the strengthening of existing bubble activities.

Peace

Chuck Hagel Propels Barack Obama Into History

With his thoughtful restructuring of America’s military, secretary of defense Chuck Hagel — a Republican — has cemented Obama’s signature legacy: restoring America to a peacetime footing.  Obama’s bringing American troops home from two wars, and, now, reducing the military to a strong, but proportionate, peacetime footing, was not easy.

Doing so required something of a political miracle.  Obama, with a critical assist from Hagel, is pulling it off.

This columnist has critiqued many of Obama’s initiatives.  The president’s follies in other areas detract from but do not diminish his real achievement here.

Bringing about peace is remarkable, historic, and transformational.  Future historians almost certainly will scratch their heads as to how Obama’s own White House wrapped the boss’s prestige around Obamacare, a botch, rather putting to the fore the president’s greatest achievement.

An aside.  Current events in Crimea are unlikely to destroy Obama’s achievement.  While Kiev, understandably, and the West express alarm … what’s happening now in Ukraine presents more as chess rather than hand grenades.  Putin is an autocrat (and geopolitical chess grandmaster), yet no brutal tyrant in the Stalin mode. Russian military intervention in Crimea appears based on securing a fundamental Russian asset — its sole warm water port — and protection of ethnic Russians living there.

President Reagan’s stated reason for invading Grenada (and deposing the government there, something Putin studiedly has not shown signs of attempting in Ukraine) was to protect 800 American medical students.  Putin is not neo-imperialist.  This predicament is likely to end with a Russian-led bailout of an insolvent Ukraine.  The severe difficulties in Ukraine shall pass without reigniting the Cold War.

Meanwhile, over two years ago, Obama astutely observed, in a speech before the United Nations General Assembly, that “the tide of war is receding. …  Moreover we are poised to end these wars from a position of strength.”

The world’s prevailing geopolitical winds truly, now, are winds of peace, not war. (This columnist originally missed Obama’s relevance to the process, for which he duly hereby issues a correction.) Obama promised to align America with the winds of peace in ways that his rivals for office simply did not.  The electorate wants peace.  Obama alone caught the political wave of peace.  He rode it to election … and re-election.  In great measure Obama is fulfilling his commitment to peace.

As shrewdly noted by columnist Adil E. Shamoo in consortiumnews.com,

If a Republican were president — say Sen. John McCain, who lost to Obama in 2008, or Mitt Romney, who failed to unseat him in 2012 — he would have found a way to keep as many as 30,000 American combat troops in Iraq, making Iraq a violent client state rather than the distant disaster it is today. Troops would continue coming home in coffins, and Iraq would feel the wrath of continued air strikes and raids.

If Hillary Clinton had won the primary in 2008 and became president, she would have rallied to keep combat troops in Iraq, too….

If a Republican or Ms. Clinton were president, American troops would still be in Afghanistan ….

Secretary of defense Chuck Hagel’s plan declared on February 24th  to reduce the military budget to the lowest level since before World War II seals Obama’s real legacy.  For Hagel to have done this in a way that enjoys a broad-based, at least tacitly bipartisan, recognition — that the restructuring will not undermine American security — is an impressive achievement.

At Obama’s bidding, Hagel’s judicious slimming down, restructuring, and modernizing of America’s force structure, together with Obama’s winding down the presence of American troops in Iraq and Afghanistan, is an impressive, historic, legacy.  The emergence of peace was foreshadowed by the 2009 award to the newly fledged President Obama of the Nobel Peace Prize.  He has delivered, impressively.

Obama’s successful confrontation with, and victory over, the Military-Industrial complex is striking.  Peace is in the sweet spot of American, and world, priorities.

Peace, not the benighted Obamacare, is Obama’s signature initiative. Continuing to defend, and even feature, the botched Obamacare likely will cost the Democrats control of the US Senate this year.

Meanwhile, virtually unadvertised, Obama is making good on his promise of ushering in a wave, and likely an era, of peace  This columnist is a Tea Party Patriot, right wing conspirator, Republican Party loyalist, and Obama opponent. It is with some trepidation, therefore, that he points out something that, if noticed by the Democrats, might be used to avert the onrushing Democratic Party rout. (The captains of the Other Team reportedly do not routinely read here — their loss — so making this observation is not a reckless act.)

Hagel’s speech cements President Obama’s legacy.  Hagel:

Our force structure and modernization recommendations are rooted in three realities:

  • First, after Iraq and Afghanistan, we are no longer sizing the military to conduct long and large stability operations;
  • Second, we must maintain our technological edge over potential adversaries;
  • Third, the military must be ready and capable to respond quickly to all contingencies and decisively defeat any opponent should deterrence fail.

Accordingly, our recommendations favor a smaller and more capable force – putting a premium on rapidly deployable, self-sustaining platforms that can defeat more technologically advanced adversaries.

The forces we prioritized can project power over great distances and carry out a variety of missions more relevant to the President’s defense strategy, such as homeland defense, strategic deterrence, building partnership capacity, and defeating asymmetric threats.  …

Our recommendations seek to protect capabilities uniquely suited to the most likely missions of the future, most notably special operations forces used for counterterrorism and crisis response.  Accordingly, our special operations forces will grow to 69,700 personnel from roughly 66,000 today.

Thus has the Republican Secretary Chuck Hagel cemented the Democratic President Obama’s legacy.  Both thereby make a great contribution to America’s well being and, likely, to history.  Guiding America home to, or at least toward, a peacetime footing — not Obamacare — is Obama’s signature achievement.  It is one that deserves recognition from conservatives and libertarians as well as progressives … and from all Americans.

This article was previously published at Forbes.com.

Economics

Speech to the Brazilian Chamber of Commerce in London

Last week I spoke to a small group in London about the current monetary situation and the outlook for gold. The speech lasts about 20 minutes and the video can be found here:

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Economics

Do equities (and real estate) give you inflation protection?

Hyperinflation in Hungary, 1946. (Photo by Mizerak Istvan)

Hyperinflation in Hungary, 1946. (Photo by Mizerak Istvan)

Confronted with the possibility that the endgame of the present experiment in extreme monetary accommodation may be higher inflation and even currency disaster, many private investors and portfolio managers respond that they should be okay, since their wealth is protected through allocations to equities and real estate. In contrast to cash and fixed income securities, which are certain to get obliterated in an inflationary environment, equities and real estate are considered some form of ‘hard’ or ‘real’ asset, not just nominal paper promises. “Why should I own gold? A well-diversified portfolio of top international companies should give me good protection against any major disaster,” a senior portfolio manager told me. “I don’t know about gold. What’s so special about it? But I own real estate. If we enter a high inflation scenario, real estate will maintain its value”, a private investor said. But how probable is it that those strategies are going to work?

The wages of fear

Let us consider the overall backdrop first. Most experiments with unconstrained paper money in history ended in hyperinflation and currency collapse. Those that didn’t were terminated by a political decision to return to commodity-linked, inelastic money voluntarily, a move that required a combination of economic literacy and political backbone that I will leave to the reader to assess if it can be found in sufficient measure among today’s political and bureaucratic elite. Our present fiat money experiment is close to 43 years old and showing signs of serious strain: For a number of years now central banks have been manoeuvring themselves into a corner where they must keep rates at zero and keep propping up certain asset prices through targeted money printing operations to maintain the mirage of the system’s solvency, and there are little signs that any of them is going to find a way out anytime soon.

I know, I know, there are two alternative memes making the rounds presently. One maintains that a deflationary correction is more likely than inflation. The other that a recovery is on track and that this will allow central banks to pull back. The former is not entirely silly. One of the side-effects of relentless bubble blowing is indeed that Mr. Market will occasionally insist on deflating the bubbles. But then the global monetary politburo that holds the keys to the printing presses knows better what the world needs and won’t let Mr. Market do his work. Thus, money-printing will continue. Remember Mr. Bernanke and his apodictic declaration that a ‘determined’ government can always create higher inflation. The second meme is popular but silly, and not the topic of this essay.

The first thing to say is that the idea of equities being a good protector against monetary disaster sounds too good to be true. Here is an asset class that benefits immensely from the current policy of “quantitative easing” and interest rate repression, as even the most hardened believers in equity-markets as disinterested and trustworthy barometers of economic health will find it hard to argue that present valuations purely reflect solid company fundamentals, yet equities should also do well when the recovery finally enters self-sustainable speed and the central bankers exit, and even offer protection for when central bankers don’t exit and we finally go into inflationary meltdown. – Wow! Stop the presses! Here is an asset class that you cannot lose with. (Well, maybe with the exception of the deflationary collapse.)

We should maybe get a tad suspicious if an asset class claims to be the winner in all seasons. Maybe the explanation is psychological. People like to own assets that are sufficiently mainstream, which means they have done well in the past, and assets that offer an income stream (dividends or interest payments), because even if they attach (as I do) a meaningful probability to high inflation and even to currency disaster, the timing of it all is difficult and waiting is so much easier when you are sitting on an income stream. I suspect that there could be an element of wishful thinking at work when investors argue that equities offer disaster protection as well. Like most other people I, too, want to have it all but I believe the universe was not quite so kind to us and arranged things differently. Usually, life requires harsher trade-offs. So at present, the returns from rising equity markets and the paltry returns from fixed income are the ‘wages of fear’ that investors get paid for driving nitroglycerin-filled trucks through the financial jungle, just as in Henri-George Clouzot’s eponymous 1953-classic.  Remember: the way to hell is paved with positive carry!

Equities versus gold

I am not denying that equities do have, in principle, the potential to offer some degree of protection against inflation and other financial calamities imposed by government. A reader from Germany recently wrote to me how his father had managed to protect large chunks of his personal wealth through World War II and subsequent currency reform by holding shares in some of Germany’s top companies (and diligently avoided bonds – in particular government bonds!). There can be little doubt that owning claims to the capital of well-established productive concerns is superior to owning securitised promises of politicians. But what about equities versus gold? In my view, gold is still the essential self-defense asset against fiat money disaster, certainly in case of hyperinflation but probably even in a deflationary calamity.

If you own gold you own a universal monetary asset, a global, inelastic and apolitical form of money. Its value is not derived from any specific enterprise, any industry or nation, or any issuing authority. It is nation-less, boundary-less, completely global in its appeal – an international and for all I can say ‘eternal’ form of money. (I like Bitcoin but I don’t think it is quite up there yet.) If you own equities instead you hold claims on the future income stream of specific and hopefully continuingly productive enterprises. Shares are not just claims on any “hard” assets that a company may own, such as land or factory buildings but constitute claims on the future profitability of particular business models. But inflations are macro-economic fiascos. They are disasters, and disasters of a peculiar kind. Some firms may indeed benefit, at least initially, from rising and even high inflation but for many companies inflation will create severe problems. Many companies will indeed go under.

One of the many problems with inflation is that it greatly complicates economic calculation (to the point of making it almost impossible), and that it encourages entrepreneurial error. It can, of course, be said that encouraging entrepreneurial error is the very modus operandi of any policy of easy money: artificially low interest rates ‘work’ by creating an illusion of high savings availability, of a low time preference of the public that should enhance the feasibility of long term investment projects. Via low interest rates entrepreneurs are lured into investment projects that are bound to lack, in the long run, the necessary support from the public’s true voluntary savings. ‘Easy money’ encourages investment always and everywhere under false pretences. But the point here is that, once inflation really kicks in, the errors are likely to compound.

A common problem of calculation under inflation is that many companies will report ‘phantom’ or ‘apparent’ profits, which result from rising sales revenue being booked as income while the also rapidly rising replacement costs for machinery or semi-finished goods are often not fully reflected in depreciation charges, and often remain difficult to ascertain anyway as high inflation is also volatile inflation. Some of what is shown as profit will ultimately simply constitute ‘eating into capital’. Long term planning and economic calculation are greatly disrupted by inflation. In any case, inflation will create some winners but also many losers, even to the point of company failures. High inflation economies are sick economies and usually not a good place to invest.

Historical example: Germany 1918-1923

In 1931 the Italian economist and statistician Costantino Bresciani-Turroni published a study of Weimar Germany’s descent into hyperinflation under the title Le Vicende del Marco Tedesco, which was translated into English under the title The Economics of Inflation, and published in 1937. Among many other things, Bresciani-Turroni also looked at how equities fared: in rapidly depreciating paper money terms, in dollar terms (which means versus gold), and relative to the wholesale price index.

Such studies must always be taken with a generous helping of salt, for a number of reasons. First, history can tell us what happened (in specific and always unique instances) but not what must happen (as a general rule). The social sciences know no laboratory experiments. The next inflationary meltdown may look different from this one. There is no reason to believe that what was observed in Germany at the time must be prototypical for all currency collapses going forward. Second, any study that uses historical data, meaning statistics, is potentially subject to challenges on account of the methodologies used and the accuracy of the underlying data, and this is the case many times over when data series are of such staggering volatility and even somewhat dubious reliability as they are in the case of Germany’s quick descent into monetary chaos. Be that as it may, the study is still very interesting.

Sensibly, Bresciani-Turroni starts his account in the summer of 1914, when Germany left the international gold standard to allow for inflationary war financing. As almost always in the history of money, the state decreed to get rid of the gold anchor so that it could fund itself by printing money freely, and not, as the fairy tales that modern macroeconomists tell themselves will have it, because the gold standard was oh so inflexible and deflationary, which it was, of course, but that was a good thing.

Bresciani-Turroni takes the average of an official German stock index for the year 1913, the last gold standard year, as the base and sets it at 100. He then charts the index in paper mark prices through to 1923, and also calculates the index adjusted for the mark’s steep depreciation versus the dollar, and adjusted according to the index of wholesale prices.

I give you the conclusion right away: If you had held paper marks throughout you would have lost everything. Paper marks became worthless by the end of 1923. Equities did much better but over the whole period underperformed the dollar (and thus gold) and the wholesale price index. By the end of 1923, the stock index that was on average 100 in 1913 stood at 26.80 if adjusted for the dollar exchange rate, according to Bresciani-Turroni’s calculation. In gold-terms you had thus lost more than 70 percent of your purchasing power by staying invested in German equities. Adjusted for wholesale price inflation, the index stood at 21.27. Yes, you avoided total annihilation of your wealth but you were still almost 80 percent poorer measured in the real prices of goods and services and also about 70 percent poorer in gold terms.

What is also fascinating is the sheer volatility of the stock market throughout that period. In 1918, the year of the armistice, the index dropped 30 percent in nominal terms, more than 50 percent in dollar terms, and more than 40 percent when adjusted for inflation. In nominal terms, the index reached a low of 88 in late 1918 (remember: the average of 1913 = 100) and never looked back. It rose to 127 by the end of 1919, 274 by the end of 1920, 731 by the end of 1921, 8,981 by the end of 1922, and it finally reached 26,890,000,000,000 (that is 26.89 trillion) by the end of 1923. Yet, it still underperformed gold and wholesale prices.

In 1919 the nominal index rose 30 percent, yet in gold/dollar terms German equities lost more than 70 percent that year. The years 1920 and 1921 are of particular interest. Inflation had set off a speculative frenzy in Germany. “Playing” the stock market had suddenly become a national obsession. Over those two years the nominal stock index did indeed keep pace with the ongoing destruction of the German Mark. By the end of 1921, you would have even come out slightly ahead of gold and overall prices when compared to early 1920 as a starting point. However, this changed again dramatically in 1922 when the German public shifted its focus to foreign exchange and gold as protectors of their real wealth. Although the nominal stock index grew more than tenfold in 1922, German equities lost 70 percent of their value in gold terms and in wholesale items. The public turned their back on stocks as they sensed that Germany was heading for economic ruin. In October 1922 stock prices were in fact so depressed that some truly bizarre situations occurred:

“…all the share capital of a great company, the Daimler, was , according to the Bourse quotations, scarcely worth 980 million paper marks. Now, since a motor-car made by that company cost at that time on an average three million marks, it follows that ‘the Bourse attributed a value of 327 cars to the Daimler capital, with the three great works, the extensive area of land, its reserves and its liquid capital and its commercial organization developed in Germany and abroad.’”

In 1923, stocks did again remarkably well. In what looks like a classic “crack-up boom”, in which everybody desperately tries to get out of paper currency and rushes to buy just anything, the equity index did outperform gold, dollar, and wholesale prices. Despite this impressive sprint, equities were still, over the entire period, a suboptimal tool for wealth protection.

Some observations on real estate

Interestingly, owning real estate proved disastrous for many people in Weimar Germany. There is no detailed analysis in Bresciani-Turroni’s study but the anecdotal references are hardly encouraging. Rents were regulated by law and in the rapid inflation of 1922 and 1923 could apparently not be adjusted quickly enough. Real estate became a zero-yielding asset while maintenance costs exploded:

“In 1922 and 1923, because of the rapid depreciation of the mark, the old house-rents became ridiculous. Consequently the value of houses fell considerably. Many landlords, for whom houses were now valueless because the rents did not cover maintenance expenses, were forced to sell them.”

Germany’s hyperinflation was an economic, social and political disaster. It impoverished large sections of the German middle class, in particular those who were conservative with their finances, who saved and who entrusted their savings to the state-sponsored financial infrastructure: banks, insurance companies, government bonds, mortgage bonds. Real estate investments offered poor protection and even equities were suboptimal. Having gold bars stored in a Swiss safe deposit (or even a German one) would have done the trick.

Again, history does not – usually – repeat itself. Next time things may unfold differently. Yet, gold certainly remains my favorite asset.

This article was previously published at DetlevSchlichter.com.