Paper Money Games

Fiat Currency: Common type of currency issued by official order, and whose value is based on the issuing authority’s guarantee to pay the stated (face) amount on demand, and not on any intrinsic worth or extrinsic backing. All national currencies in circulation, issued and managed by the respective central banks, are fiat currencies.
— www.businessdictionary.com

Fiat Money: Type of currency issued by governments as legal tender, the value of which is based solely on decree or law rather than on actual coin or precious-metal reserves (called specie), and the redemption of which is not guaranteed by the government.
— encarta.msn.com

Competitive Currency Devaluation Ramps Up

We’re of the belief that it’s wise to seek out the observations of those outside the U.S. if you want to get a more complete view of what’s going on in the world. And this includes economics. To those who feel recovery is on the way – we say, not so fast. A quick scan of the world shows us that things are not so rosy everywhere – and we believe investors should proceed with eyes wide open.

On April 10, 2009 in a piece titled “Race to the Bottom” we warned competitive global currency devaluation was upon us – and that foreigners would not idly stand by as the U.S. debases the Dollar in its attempts to inflate (print) its debt away. In a recent piece in the Telegraph.co.uk titled “Euro at $1.50 is ‘disaster’ for Europe” Ambrose Evans-Pritchard writes:

“‘The euro at $1.50 is a disaster for the European economy and industry,’ said Henri Guaino, right-hand man of (French) President Nicolas Sarkozy.’ …What concerns European policymakers most is the lockstep rise against China’s yuan. Beijing has clamped the yuan firmly to the weak dollar for over a year, quietly benefiting from the export advantages… French finance minister Christine Lagarde said it was intolerable that Europe should ‘pay the price’ for a dysfunctional link between the US and China. ‘We want a strong dollar, and we have reiterated it again in the strongest manner.’ …Europe and Japan are now the last two blocs standing as everybody else lets their currencies fall… Brazil has become the latest country to intervene, resorting to controls to cap the real after its 42pc rise against the dollar since March… Switzerland is openly intervening to hold down the franc in order to stave off deflation. Canada and New Zealand have talked down their currencies. Britain and Sweden have opted for stealth devaluations… Korea, Thailand, Taiwan, the Philippines, Indonesia and Russia have all been buying dollars to stem their currencies’ rises…”[1]

As we read about the competitive currency destruction above, we can’t help but wonder about the fate of investors whose savings are denominated in paper money.

And, in our opinion, those who wait for a strong-Dollar policy to be instituted by the U.S. may not want to hold their collective breath. With a staggering national debt, a massive deficit, along with the potential for more bailouts – we believe the U.S. Government will choose to continue to print money. In our opinion, it’s either that – or raise taxes and cut spending – both dramatically. And we think neither politicians nor constituents have the will, or the stomach for either of those options. If the U.S. keeps printing, we’d not be surprised to see other countries continue to follow suit to protect their export-based economies. To us, this is simply a function of a world without gold-backed currencies. If this scenario continues to play out – those who hold paper money may want to beware.

Over the past 40 years the Dollar has gained and lost value against other nations’ money. And we ask ourselves – does the Dollar really “strengthen” if it gains value against other currencies which have simply sped up their devaluation process? As we compare prices of anything today against their 1970 (let alone 2000) prices in dollars – and ask ourselves if the Dollar has really gotten “stronger” – our opinion is “absolutely not.” Instead, we see a Dollar which buys far less today than it has in the past. Over time it has simply fallen in value more quickly or more slowly than other paper money which is falling in value too.

As to whether the Dollar retains its status as the dominant currency of the world – we’re more concerned about what the dollar will buy in the future if world currencies continue to be devalued by their respective governments. In other words, what good would it be to be the strongest among the weaker than today? Our answer is “not much” – especially if you can find other alternatives.

Spoiled Brits and Nervous Germans

In Britain we learn the Government is struggling to fight the national financial crisis.[2] The falling pound has helped exports, but “The pound never stops where you want it to,” stated Sir Howard Davies, Director of the London School of Economics[3] – in a warning that perhaps should be listened to in the U.S. as the Dollar plummets. Even more interesting is the apparent phenomena of British citizens seemingly against even a small amount of cut-backs.[4] Professors are preparing to strike for 8 percent wage hikes – and polls now show 48 percent of the public are against spending cuts of any sort.[5] We wonder what would happen in the U.S. if broad-based spending cuts in entitlements were proposed.

In Germany we hear “There is still a significant risk of further shocks to the international financial system,” according to a warning from a panel advising the government.[6] Their report also stated, “Credit to non-financial firms has clearly been declining. Financial conditions are likely to worsen further. Banks are facing large write-offs on toxic debt and a rising toll of company insolvencies… There is a major danger that already tight financing conditions could lead to a credit crunch next year…”[7] Interesting indeed.

As always – our goals are to first and foremost acknowledge the facts – and then, to get on the right side of the trade. Thus…

While there is a lot of tough reality going on out there – we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another. And bull markets are what we hunt.

As we enter this critical time – now, more than ever – we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group
www.ernharth.com

Go to www.ernharth.com/economic-commentaries to read past articles from our Economic Commentary series.

1. www.telegraph.co.uk; “Euro at $1.50 is ‘disaster’ for Europe”; October 20, 2009
2. www.telegraph.co.uk; “Ex-FSA chief Sir Howard Davies sees ‘dramatic’ risks for Britain”; October 15, 2009
3. Ibid.
4. Ibid.
5. Ibid.
6. www.telegraph.co.uk; “German ‘Wise Men’ fear credit crunch in 2010″; October 15, 2009
7. Ibid.