November 23, 2011

The Death of Paper Money

“If ever again our nation stumbles upon unfunded paper, it shall surely be like death to our body politic. This country will crash.”
–George Washington

The Death of Paper Money (Not Backed By Gold)

Voltaire, who wrote, “Paper money eventually returns to its intrinsic value – zero,” was, in my opinion, right on the mark for no other reason than history shows us this is the case.  It seems a natural habit of governments to destroy currencies.  When the Romans were no longer able to afford their military machine, along with buying off the populace with bread and circuses – they began watering down the precious metals content of their coins to ultimate extreme debasement.[1]  The Song Dynasty in China first issued paper money (the Jiaozi) during the 10th century A.D.[2]  Inflation resulted, and the notes had to be retired.[3]   During the succeeding Yuan dynasty founded by Kublai Khan another paper currency, the Chao, was issued[4].   By the end of that dynasty, hyperinflation reigned which the successive Ming Dynasty ended by banning the use of paper money[5].

The United States’ first attempt at paper money not backed by gold was the Continental during the Revolutionary war.[6]  The resulting debasement/hyperinflation of that currency resulted in the saying, “Not worth a Continental.  Due to first hand experience with paper money, the founding fathers of the United States made sure to back the Dollar with gold and silver.  This limited the over-spending/printing/inflating power of the government – and maintained the integrity of the currency.  Today, the Dollar is no longer backed by gold, money printing continues unfettered, and the U.S. national debt breaks through the stratosphere.

During the French Revolution the Assignat and succeeding Mandat were so inflated/debauched they became worthless.[7]  Napoleon, as First Consul in 1801 finally put an end to the madness by introducing the 20 franc gold piece and made it law that soldiers, contractors, and merchants could only be paid in gold.[8]  It has been suggested the inflation of the French Revolution brought on the Reign of Terror and set the French back a generation.[9]  Perhaps more than one generation when you look at the devastation wrought by Napoleon and his wars on not only the French – but the rest of Europe.  One only needs to fast forward 100+ years to Germany to see a similar pattern of hyperinflation (Weimar), subsequent totalitarianism, and human suffering on a previously unimaginable scale.

War does not have to be the result for a generation to lose itself financially via government hyperinflation of the currency.  Just talk to someone who lived through it in Brazil in the 1990’s, or Argentina 10 years ago.

I believe there is only one form of money with integrity.  Thomas Jefferson wrote, “Specie [gold and silver coin] is the most perfect medium because it will preserve its own level; because, having intrinsic and universal value, it can never die in our hands…”

When history speaks repeatedly, I listen.

And Now…

Europe appears to melting down before our eyes.  Greek, Italian, Spanish and French debt is being shunned as borrowing costs have risen dramatically.[10]  One wonders if there would be any buyers of Spanish and Italian debt if not for European Central Bank (ECB) purchases.  (Who would buy U.S. Treasury debt at current rates if not for the Federal Reserve Bank)?  The cost of credit default swaps (CDS) insuring against the default of European national debt has risen to all time highs.[11][12]  The cost of CDS linked to the senior debt of 25 banks and insurers as indicated by the Markit iTraxx Financial Index increased to record levels.[13]  Euro-debt of any sort is becoming increasingly avoided.

Over-indebtedness and subsequent massive government money printing has gotten the developed world into the financial mess it’s currently in.  I believe more of the same will not cure the problem – it will only exacerbate it.  To not print will likely result in a painful, deflationary regression to the mean.  A painful medicine.  Something I believe central banks and governments will avoid like the plague.  Yet they continue to dither.  They don’t even seem capable of doing the wrong thing right.  In Europe the Germans say “nein” to money printing (at least for now) – while the Latin countries and Euro-banks beg for a massive bailout.  In the U.S. the national debt continues to break through record highs while the “Super-Committee can’t even agree on one single spending cut.[14]

I believe a blizzard of money is coming, and that it’s important to ultimately own what does well when paper money dies.  However, right now, increasingly it’s beginning once again (as in 2008) to look like politicians/central-bankers/financial technocrats may wait too long to pull the money-printing trigger.  Post Lehman in 2008 resulted in a significant downdraft (collapse) in the prices of equities and commodities.  This time it could be far worse.  And something we want to avoid.

For now caution reigns supreme until government money printers (to the tunes of $trillions) show their hands – or don’t’.  As always, I believe opportunity exists in either scenario.

As always, I maintain my positive outlook.  That outlook is based on my belief a bear market in one thing is often a bull market in another.

As we enter this critical time – now, more than ever – I 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.

Sincerely,

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

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