A Tale Of Two Currencies

In the world of fiat currencies, 2014 was the best of times and the worst of times. On the one hand, we had Japan’s Shinzo Abe and his Keynesian cohorts, who have relentlessly devalued the Yen with the hope that a cheap currency would eventually ring in the best of times. On the other hand we have the heavily-sanctioned country of Russia, where ironically the international community has sought to punish the nation by dramatically reducing the value of the Ruble. This has threatened a return to the worst of times, leading their central bank to frantically raise interest rates in an attempt to avert hyperinflation and a currency crisis. 

In a time when currencies are backed by nothing, a strange dichotomy exits. When the markets brace for a worldwide slowdown, as they have these past few days, the Japanese yen finds a bid.  The markets perception trumps reality, the belief still exists that the yen is a tertiary reserve currency to the dollar and the Euro.  Markets appear willing to put aside Japan’s fervent proclivity to devalue their currency, extraordinarily high debt to GDP ratio, strikingly aged population and its succession of lost decades; and just pile into the yen for safety.  In other words, the markets are still willing to seek refuge in the yen-lifeboat, even as the captain is letting out all the air. 

The genuine factors that drive a currency’s valuation are the level of real interest rates and a nation’s fiscal condition.  In the end, the value of a currency is determined by market psychology.  And, as people lose faith in a currency, they eschew it in favor of another fiat currency and/or a hard asset.  No fiat currency is immune from the inevitable perception of its intrinsic worth. But is inflation just caused by the weakening of a domestic currency against other currencies?

Some academics mistakenly argue that the U.S. cannot experience runaway inflation because the dollar would not be sold in favor of the yen or ruble, for example. To prove this conclusion false let’s look at a world where there is only one currency. There was a time when most of the known world used a single currency--the Roman Denarius.  And, although Rome did have centuries of prosperity, wasteful government spending on “bread and circuses” forced the steady devaluation of the currency.  The Denarius, which began as a 4.5 gram silver coin, eventually was diluted with base metals. Copper was blended in with the silver so that although the coin itself weighed the same, the amount of silver in it became less and less with each successive emperor.  Throughout the first century the Denarius contained over 90% silver, but by the end of the second century the silver content had fallen to less than 70%.  A century later there was less than 5% silver in the coin and by 350 AD it was all but worthless.

The US dollar, despite its status as the world’s reserve currency also had its bout with intractable inflation.  Coming out of WWII, the US was established as a global leader and the dollar was THE reserve currency.  The Bretton Woods agreement, established that the U.S. would hold gold, giving foreign countries the option to buy gold at a fixed price of $35 an ounce.

For three decades this arrangement worked well, until the market’s perception of the dollar changed.   In America, the 1960’s was a tumultuous time--social unrest and the Vietnam War resulted in runaway government spending.  The wars on poverty and Vietnam were Johnson’s version of “bread and circuses.” Fiscal and monetary imprudence sowed the seeds of inflation.

Foreigners always had the option to sell their dollars for gold at $35 an ounce.  And during the period of 1969-1971, until the run on gold forced Nixon to close the gold window, they continually made that trade.  The preference for a hard asset, such as gold, and a lack of demand for the dollar created a large dollar surplus. The result was the stagflation of the 1970’s. 

The 1970’s and early 1980’s proved the dollar can fall out of favor despite its status as the world’s reserve currency. It also clearly demonstrates that fiat currencies aren’t only valued against each other, but also intrinsically against hard assets such as gold. 

Since 2008 there has once again been a strong demand for our dollars and bonds.  This has given the Federal Reserve carte blanche to increase its Balance Sheet and has allowed our Treasury to run up an untenable amount of debt. Today, our government’s “bread and circuses” makes the 1960-70’s look like a small clown with a crumb.  But, the markets perception for now is to cling to the dollar for safety, despite the crumbling fundamentals supporting it. 

In truth, the demand for the dollar, or any fiat currency, can last longer than the intrinsic value would deem prudent.  But the market eventually has a way of sinking up with the intrinsic value.  Fundamentals catch up regardless of a currency’s reserve status, even if there is no better alternate currency available. Just like the Roman currency, the true value of the dollar will ultimately emerge. 

Once this occurs the Federal Reserve will not be able to bring interest rates up to 20% and squeeze the excess dollars out of the system, as it did under Paul Volker in the early 1980’s. This is because total debt was 150% of GDP during Volker’s tenure, unlike the 330% we suffer today. Double digit interest rates today would lead to an unprecedented deflationary depression. Therefore, the Fed will be left with only two alternatives—continue down the road to hyperinflation or explicitly default on the debt.

We will eventually come to realize the age of perceived central bank wisdom, was the age of foolishness.  And the wisest investment strategy will be one that can not only prosper from our current false spring of hope, but can also protect from the inevitable winter of despair.    

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Michael Pento produces the weekly podcast “The Mid-week Reality Check”, is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”