Copyright 2012 by John T. Reed

The woman who sat next to me during our first year at Harvard Business School tells me ,

you really should take a look at Barron's this weekend and read Stephanie Pomboy's interview – on US economy – you will agree with most of what she believes…"Coming: The End of Fiat Money"

I do agree with her analysis of the unsustainability of current U.S. fiscal and monetary misbehavior. I recommend your read her article. It will sound familiar if you have been reading my stuff on this subject lately. I never heard of Pomboy until the email from my MBA section mate.

I am currently reading my fourth book on historical hyperinflation in Germany and Latin America. I surmise that Pomboy has read none of them. She needs to.

Her analysis is correct. But her conclusions about what’s going to happen when the ’flation hits the fan are incorrect. Indeed, I will say she is woefully ignorant of the dynamics of the politician-hyperinflation combination.

Back to a gold standard

She says the run on the dollar will force countries back onto the gold standard. She’s nuts.

Look at the time line of monetary crises in the history chapter of my How to Protect Your Life Savings from Hyperinflation & Depression.

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If there is one phrase that characterizes the gold standard it is “Been there. Done that.”

The first item in that timeline is 4,000 BC and is about gold bars with the pharaoh’s name on them. And in 1999, Switzerland was the last country to leave the gold standard.

A gold standard—which is printed on the actual paper currency, simply says that you can turn in that paper currency and receive a certain weight of pure gold for it.

Every country got off it for two reasons:

1. People and countries actually present their paper dollars for conversion to gold whenever the market price of gold goes above the fixed conversion rate—which is a common occurrence. The gold standard in the minds of politicians seems to be something they have, but that you are not supposed to take advantage of—sort of like those changes in the tax law that they proudly call “incentives” when they enact them but angrily condemn as “loopholes” when you actually use them. For about 40 years, the U.S. government would not let private citizens turn in paper currency for gold, but foreign governments still could. Then France—no surprise there, they have never gotten over Waterloo—and some others started demanding gold for their paper U.S. dollars. Nixon, then the president, ended the U.S. gold standard completely in response on August 15, 1971.

2. A gold standard prevents federal politicians from using “printing” money to avoid raising taxes or cutting spending. That is its virtue, but politicians have no virtue and they are not going to pass a law that forces them to vote again and again for cuts to entitlements and tax increases. Did Pomboy just arrive from Mars or some parallel universe where politicians do the right thing in spite of it ending their careers?

From an economic standpoint, gold does not work because the economy sometimes expands faster than the gold supply. Not having enough money to match the increased number of transactions causes deflation, better known as depression. It is sort of the equivalent of the economy growing faster than the oil supply. Oil is used for vehicle fuel, heat, electricity, plastic. If you can’t get enough of it, people get laid off, prices fall because of lesser demand due to the layoffs, etc. You can’t make plastic without oil and you can’t do all sorts of transactions without money.

Also, gold is just one commodity. The basic concept of a commodity standard actually makes sense. It have been employed many times throughout history. But you need more than one commodity. A market basket of many commodities and manufactured products—like an honest consumer price index—might work. Under that system, any general price increase in the CPI would be greeted by automatic reduction in money supply and vice versa.

My guess, and it is only that, is that the free banking era was the answer. In that, which is how Zimbabwe recently ended its famous hyperinflation, the federal government simply gets out of the money business. The residents of the country can use whatever currency they want, including gold. We had that in the U.S,. roughly speaking, from 1832, when President Andrew Jackson vetoed renewal of the Bank of the United States charter to 1913 when the Federal Reserve Act was enacted. During the Civil War the federal government enacted the legal tender laws and issued hyperinflated greenback dollars. There was also a post-Civil War gold standard that wreaked some havoc inspiring William Jennings Bryan’s famous “Cross of Gold” speech.

My position is repeal the legal tender laws. Let the American people use whatever money they want: gold, Canadian dollars, Swiss francs, etc. That way if the U.S. government tries to “print” too much money, Americans and others will simply start rejecting U.S. dollars or discounting them. The legal tender laws make either illegal at present.

Fiat money works quite well if the government in question behaves. It comes in convenient denominations, unlike gold which is too expensive to buy, say, a gallon of milk, with it. Also, fiat money requires no assayer to confirm what it is. Those are two extremely important issues and they are why you almost never see mention of gold being used as a currency or store of value in books about hyperinflation in Germany or Latin America or Zimbabwe. What everyone wanted in those countries during hyperinflation was the fiat money of countries that were not hyperinflated. Actually, in the 1920s, U.S. dollars and other were on the gold standard but that fact was not the only reason Germans wanted U.S. dollars.

Pomboy sees to say that since fiat money allows governments to print too much money, they will. I disagree. The history seems to say that some governments are more dysfunctional than others—like those in Latin America. They abuse their legal tender power, but not all countries do. The U.S. behaved fairly well for decades, but the Entitlement mentality of too many Americans has ended that period of good behavior. Too bad, but don’t be an idiot and respond with denial. I recommend the currencies of Australia, Canada, New Zealand, and Switzerland at present and I bought those currencies. They are all fiat money, but their governments at present simply are not behaving the way Pomboy seems to predict, nor is there any evidence that they will hyperinflate in the near future. Their debt-to-GDP ratios are so low that they are under no pressure to hyperinflate. In contrast, Japan, the PIIGS countries, and the U.S. are behaving irresponsibly. Hyperinflation comes from politician behavior and national character, not solely from legal ability to print too much money.

Pomboy says,

I would own gold versus developed-market currencies.

My article on the disadvantages of gold still stands as I wrote it years ago. She needs to read it.

She also says,

You want to be long emerging-market creditor currencies, versus developed-market debtors.

In other words, she recommends you sell, say, your Australian dollars (21% debt-to-GDP ratio) and replace them with Brazilian reals. Brazil is a BRIC, a Latin American country with an embarrassing economic history. The joke about Brazil is that it is a country that has a great future and always will. I have been hearing about its great future for my entire life. It is big, has lots of natural resources, lots of people but the typical Latin American history of military coups and dictatorships, economic crises and high inflation. The current president of Brazil is Dilma Rouseff, a former Marxist guerilla. ???

How a publication like Barron’s can publish such nonsense with a straight face is beyond me.

Pomboy also recommends investing in oil. And how does one do that? By purchasing oil futures? Oil company stock? There is a lot of basis risk in that. Also, oil prices recently fell because of the widespread stagnant economies around the world. If we get hyperinflation or another financial crisis that is worse than the present situation, won’t people drive less and buy more sweaters and take other ratios to reduce their oil usage?

The rest of Pomboy’s investment advice sounds like something from the Mad Men or disco era: large cap multinationals and such. I recall no one regretting not having bought such traditional investments in books about German and Latin American hyperinflation. What they regretted was not buying foreign currencies and not owing more fixed-rate debt. Their lesser regret was not having bought more hard assets when they could. During hyperinflation securities with all their counterparty risk and exchange risk and political risk bore little consistent resemblance to Pomboy’s current vision of their future inflation crisis performance.

John T. Reed