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A farewell to central banking

A farewell to central banking
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First Published: Wed, Mar 19 2008. 12 33 AM IST

(Imaging by: Malay Karmakar / Mint)
(Imaging by: Malay Karmakar / Mint)
Updated: Wed, Mar 19 2008. 12 33 AM IST
Amid the meltdown in financial markets around the world over the last few months, gold stood out as a beacon and continued its upward journey to touch a milestone of $1,000 per ounce last week. As I have explained in my previous articles, this is but one small step in what is going to be an inexorable run over the next decade. Far more important than the psychological effects of the $1,000 level, this is the first salvo that Mr Market has fired against central bankers indicating that their days of debasing the currencies under a fiat currency system are numbered. Or paraphrasing Neil Armstrong, “Gold at $1,000 is one small step for the gold investor, but a giant leap for monetary freedom”.
(Imaging by: Malay Karmakar / Mint)
What the investor needs to remember is that the different currencies—whether it is the US dollar, the Indian rupee or even the venerable Swiss franc—are all just pieces of paper with no definitive linkages to a tangible underlying asset. It is just the misplaced confidence among the general public that keeps the system from imploding under what would eventually be a stampede out of paper currencies/financial assets into real assets. We witnessed a similar situation during the 1970s when gold moved from $35 to $850 in a few short years. It was then left to Paul Volcker to raise the Fed funds rate to 22% to quell inflation and restore confidence in paper currencies. We have now come full circle to the 1970s’ economic scenario of stagflation as far as the US is concerned.
With one important difference: The destruction in the value of financial assets over the next few years is far more likely to happen behind the scenes, i.e., through a massive decrease in purchasing power, than through nominal declines in asset prices. In some sense, we have already seen a harbinger of this over the last six years. If we price the US equities in gold rather than in dollars, then we have already witnessed a close to 75% decline in the last six years (the Dow Jones Industrial Average, or DJIA, was worth about 44 ounces of gold in 2002 when DJIA was 12,000 and gold was 260. Today, DJIA is still at 12,000 while gold has gone up to 1,000, leading to fall in the DJIA: gold ratio from about 45 to 12).
This behind-the-scene decline is likely to accelerate in the years ahead as central bankers continue to pump inflation (though they would euphemistically refer to it as “liquidity”) into the system. The reader might be tempted to think that given the fact the US equities have already lost 75%, how much more can it lose from the current levels? Is it not a classic case of closing the barn doors after all the horses have bolted?
The answer is a definitive no. While the situation today is most certainly not the ground floor for tangible assets, we are still in the early stages. US equities could easily lose “another 90%” from current levels to attain a DJIA:Gold value of “1” over the next decade. Whether there are nominal declines in DJIA is just a function of how much inflation the Fed manages to create. But for sure, gold would rise substantially to reflect the inflation created by the central bankers.
The math behind the fact that gold has to rise much higher is fairly straightforward. The current stock of gold bullion in the world is around 2 billion ounces and, at a price of $1,000 an ounce, this just accounts for $2 trillion of paper currencies floating around the world. The total stock of money in the world would easily be upwards of $50 trillion and so we have quite some distance to be covered in ensuring an asset-backed currency system. But in my view, the biggest factor in driving the price of gold higher in the years ahead is not the current stock of money, but the future inflation that is in store, given the money policies that are being pursued around the world.
In trying to determine as to what lies ahead on the monetary front, who better to quote than Ron Paul? In what is now increasingly being viewed as “graduate lessons in history and economics” to Ben Bernanke, Ron Paul asked: “I find it so fascinating that the chairman of the Federal Reserve, who is in charge of the money, what the money supply is, saying that we do not deal with the value of the dollar. But you admit that you have a responsibility for prices. But how can you separate the two? Prices are a mere reflection of the value of the dollar. Currently, M3 as measured by private sources is running at 16%...this is inflation... it will lead to higher prices. To continue to debase the currencies is so destructive...it destroys the incentive to save...and if we do not save, we do not have the capital. Then it just puts more pressure on the Federal Reserve to create ‘capital out of thin air’…this usually goes into the malinvestments, i.e., the Nasdaq bubble and the housing bubbles. Once the market demands a correction, what tool do you have left? Let’s keep pumping…pump, pump, pump.”
So what does this imply for the common man? Ironically, the biggest losers on account of the above policies would be the people who have their savings in terms of paper currencies in general and the dollar in particular. Barring a 180 degrees shift in monetary policy, Bernanke is set on course for a complete destruction in the purchasing power of the dollar. And the price of gold has pretty much indicated that in the rapid appreciation it has shown over the last few years. Whether the central bankers have the integrity to accept the innate inadequacies of the policy that they are pursuing is another matter altogether.
After all, different people at all points of time in history have tried out various fiat currencies under the influence of misguided hope rather than economic logic and the end result has always been complete destruction of value. And in each and every instance without exception, the cause for destruction has been inflation, i.e., creation of excess credit. Mark Twain once said, “History does not repeat itself, but it does rhyme”. As far as the monetary system based on fiat currencies is concerned, history is repeating itself exactly to the “T” and yet, our central bankers refuse to learn.
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First Published: Wed, Mar 19 2008. 12 33 AM IST