Just an illusion

“Fiat currencies don’t float. They just sink at different rates.” – Unknown.

Money illusion affects people, and markets, in different ways. The primary form of money illusion, of course, is that we always believe we have more money than we actually do – too much month left, in other words, at the end of our money. Other current examples of money illusion include thinking that a 2 bedroom flat in Chesterford Gardens, Hampstead is worth £1,400,000 in September when it isn’t selling in November for £1,200,000 (according to PropertySnake). Or that the fair market value for responsibility for an $8 billion writedown and the biggest quarterly loss in your brokerage’s 93-year history is an early bath bonus of +$161.5 million. (To be fair to Stan O’Neal, when he promised in December that Merrill Lynch’s $1.3 billion acquisition of subprime mortgage lender First Franklin would provide “revenue velocity”, he didn’t explicitly state whether those increasingly rapid revenues would be positive or negative, though now we know.) But perhaps the most dramatic form of money illusion is the belief that a 2.6 inch x 6.1 inch 1 gram rectangle of linen and cotton that costs 4.2 cents to manufacture and that represents ‘money’ without any material backing is worth anything at all.

Financial markets have started to get wise to this ‘money’ fabrication business. One might almost say that this process of enforced wisdom-getting has accelerated. The ‘velocity’ ((c) Stan O’Neal) of ‘money’ may be increasing, but its direction would appear to be: downhill. Say you want to invest your ‘money’ in a barrel of WTI crude oil. In 2002, you would have needed to part with 20 of your 1 gram rectangles of 25% linen, 75% cotton. Now, to buy the same barrel of oil, you need to part with over 90 of those same rectangles. Of course, given that the composition of this barrel is unchanged, the apparent deterioration in value of those rectangles probably makes you happier to part with them to exchange them for something at least more tangible and economically useful. “Parting is such sweet sorrow,” as that great behavioural economist Shakespeare once wrote. Amazingly, we can also use these rectangles to purchase finite assets with a several thousand year history of acting as a store of value though admittedly, now that everyone has woken up to this rectangle depreciation story, it costs more of them to do so. Seven years ago, you could have bought an ounce of pure gold with just 257 green rectangles. Now it takes almost 800 of them to secure access to that same ounce. It’s as if the market had belatedly discovered that green rectangles and money were not necessarily the same thing.

The prices of other assets as expressed in green rectangles have also been on the rise. As Manuel Hinds and Benn Steil reminded readers in last week’s Financial Times (“History’s warning about the price of money”),

“People react to the “growing insolvency” of a reserve currency, such as the dollar, by acquiring “gold, land, houses, corporate shares, paintings and other works of art having an intrinsic value because of their scarcity”.. Indeed, this is the story of our present decade, one in which alternatives to the dollar as a store of value have soared even while the CPI has remained subdued.”

It is the reference to the CPI that throws you off your stride. Notwithstanding the hedonic adjustments and other statistical legerdemain that have created inflation ex-inflation, official inflation rates, that handily excise troublesome price rises in obviously trivial sectors like food and energy, have been the dogs that haven’t barked. Yet. As Hinds and Steil point out, there are historical precedents:

“This phenomenon is well-known in developing countries, where asset booms combined with low CPI inflation have preceded monetary and financial crises. In Mexico, for example, share prices rose 12-fold between January 1989 and November 1994, while inflation fell from 35% to 7%. Inflation then soared as the Tequila crisis exploded.

“Prices of shares and real estate more than doubled from 1993 to 1996 in Indonesia and South Korea while CPI inflation rates were declining. In May 1997, just weeks before the currencies collapsed, inflation was only 4.5% in Indonesia and 3.8% in South Korea.”

Comparisons between Indonesia and South Korea on the one hand, and North America on the other, are obviously unfair. Investors are queuing up to invest into Asia. Notwithstanding the recent flood of foreign investment, we are a long way from the end game there. Less so for the US, whose currency is being dumped by legions of investors in favour of euros, shares, oil and gold. Not to worry, though: the US Treasury Secretary reminded investors last week that the United States is committed to a strong dollar policy. He just didn’t say whose dollar.

To this extent, the extraordinary bull run by equities in the teeth of a US property market slowdown, in the midst of a significant dollar depreciation, and in the face of a raging gale in credit markets is explicable, inasmuch as it reflects the last gasp of investors determined to spend their rectangles on something, indeed anything, as opposed to other rectangles.

History may not repeat itself, but previous events set an ominous precedent. As Hinds and Steil also point out, between August 2001 and August 2007, the dollar price of gold rose by 144%, versus a rise in CPI of just 17%. In two periods, from 1971 to 1975 and from 1977 to 1980, “the increase in the price of gold and other commodities presaged substantial increases in CPI inflation as well as significant falls in the international value of the dollar.” While the dollar then survived as the least-worst standard of value, it did so in part because of Paul Volcker’s discipline (as opposed to Greenspan’s and Bernanke’s indiscipline) at fighting inflation, and in part because no other currencies were up to the task. We now have a world of euros (and, ultimately, yuan) and a liquid supply of gold – what Hinds and Steil call “a viable private alternative that has permanent intrinsic value”.

The Weimar era hyperinflation is not the only example in Europe of currency value dwindling away into absurdity, nor is it the most recent. In Yugoslavia by the early 1990s, the government had exhausted its hard currency reserves and started pillaging the hard currency savings of its citizens. Restrictions were imposed on private hard currency savings in government banks. There was a run on all goods, notably gasoline. All government gasoline stations were eventually closed and gasoline became available only from roadside entrepreneurs operating a) a parked car and b) a plastic canister of gasoline. According to Thayer Watkins of the Department of Economics, San Jose State University, this gave rise to at least one tragic episode. After repeated attempts to withdraw his Deutsche Mark deposits from a government bank, one man announced that he was going to kill himself in front of a government building by dousing himself with gasoline and setting fire to himself. On the appointed day he turned up with a canister of gasoline. The media were in attendance. As were the police, who promptly arrested him. Soon afterwards, the television station received a number of calls asking what had happened to the canister of gasoline. In another alleged incident as the supply of goods continued to diminish, someone passed by a queue of pensioners waiting in line for mundane supplies. This person was carrying bags of groceries from the free market. Two pensioners got so upset at seeing someone else with household goods that they had heart attacks and died on the spot. By the end of December 1993, the exchange rate was 1DM=3 trillion dinars. By January 4 of 1994 it was 1DM=6 trillion new dinars. The government then announced a new new dinar equivalent to 1 billion of the old dinar. By mid-January the rate was 1DM=700,000 new new dinars and soon 10 million new new dinars. On January 24 the government introduced the super dinar, equivalent to 10 million new new dinars.

All of which is not to suggest that the US dollar is going to go the way of the old dinar, only that in matters of fiat currency even more than in commodities, price changes can go further and faster than ever seems remotely possible in reality. Until such time as the Bush administration genuinely engages with an ever-weakening dollar (“our currency, but your problem”, in the words of the Nixon administration), investors will find some solace in inflation-protected debt and precious metals.

Comments

[David Wozney]

A “Federal Reserve Note” is not a U.S.A. dollar. In 1973, Public Law 93-110 defined the U.S.A. dollar as having the value of 1/42.2222 fine troy ounces of gold.

[contrdictifier]

Good to see you mention PropertySnake. An interesting site that received a legal notice from Rightmove to stop using its data. When the rightmove figures were allowed, a very scary picture emerged of the housing market.

The emperor has no clothes.

Enjoy the blog, keep it up!

[Jack S]

Is this a sort of long way of saying that I should buy gold now?

[timprice]

..and silver and some of the other precious metals, probably yes - provided one can live with the inevitable volatility and average in over time, given the almost parabolic nature of recent price rises.