This is an appendix to Chapter 2, "The Big Cycle of Money, Credit, Debt, and Economic Activity." It is intended to look at the concepts expressed in that chapter in a more granular way and to show you how these concepts are consistent with the actual cases that are behind the concepts. While in this appendix we will get a bit more into the mechanics and specifics than we did in Chapter 2, it is written in a way that should be both palatable to most people and specific enough to satisfy the needs of skilled economists and investors. If you find that the material that you are reading is getting too wonky for your taste just stick to reading that which is in bold and you should be just fine.
Rather than carefully examining the whole cycle (which we will do in the Part 2 examinations) we will focus exclusively on big devaluations and end of reserve currency periods because a) the dollar, euro, and yen are in the late stages of their long-term debt cycles when the debts denominated in them are high, real interest rate compensations for holding these debt assets are low, and large amounts of new debt denominated in them are being created and monetized--which is a higher-risk confluence of circumstances, and b) such big devaluations and/or the loss of reserve currency status by the leading reserve currencies would be the most disruptive economic event we could imagine.
As previously explained, there is a real economy and there is a financial economy, which are intertwined but different. The real economy and the financial economy each has its own supply and demand dynamics. In this section we will focus more on the supply and demand dynamics of the financial economy to explore what determines the value of money.
Printing and Devaluing Money Is the Easiest Way out of a Debt Crisis
While people tend to think that a currency is pretty much a permanent thing and believe that "cash" is the safe asset to hold, that's not true because all currencies devalue or die and when they do cash and bonds (which are promises to receive currency) are devalued or wiped out. That is because printing a lot of currency and devaluing debt is the most expedient way of reducing or wiping out debt burdens. When the debt burdens are sufficiently reduced or eliminated, the credit/debt expansion cycles can begin all over again, as described in Chapter 2.
As I explained more comprehensively in my book Principles for Navigating Big Debt Crises than I can explain here, there are four levers that policy makers can pull to bring debt and debt-service levels down relative to the income and cash-flow levels that are required to service one's debts:
- Austerity (spending less)
- Debt defaults and restructurings
- Transfers of money and credit from those who have more than they need to those who have less than they need (e.g., raise taxes)
- Printing money and devaluing it
Austerity is deflationary and doesn't last long because it's too painful. Debt defaults and restructurings are also deflationary and painful because the debts that are wiped out or reduced in value are someone's assets; as a result defaults and restructurings are painful for both the debtor who goes broke and has their assets taken away and for the creditor who loses the wealth arising from having to write down the debt. Transfers of money and credit from those who have more than they need to those who have less than they need (e.g., raising taxes to redistribute wealth) is politically challenging but more tolerable than the first two ways and is typically part of the resolution. In comparison to the others, printing money is the most expedient, least well-understood, and most common big way of restructuring debts. In fact it seems good rather than bad to most people because it helps to relieve debt squeezes, it's tough to identify any harmed parties that the wealth was taken away from to provide this financial wealth (though they are the holders of money and debt assets), and in most cases it causes assets to go up in the depreciating currency that people use to measure their wealth in so that it appears that people are getting richer.
You are seeing these things happen now in response to the announcements of the sending out of large amounts of money and credit by central governments and central banks.
Note that you don't hear anyone complaining about the money and credit creation; in fact you hear cries for a lot more with accusations that the government would be cheap and cruel if it didn't provide more. There isn't any acknowledging that the government doesn't have this money that it is giving out, that the government is just us collectively rather than some rich entity, and that someone has to pay for this. Now imagine what it would have been like if government officials cut expenses to balance their budgets and asked people to do the same, allowing lots of defaults and debt restructurings, and/or they sought to redistribute wealth from those who have more of it to those who have less of it through taxing and redistributing the money. This money and credit producing path is much more acceptable. It's like playing Monopoly in a way where the banker can make more money and redistribute it to everyone when too many of the players are going broke and getting angry. You can understand why in the Old Testament they called the year that it's done "the year of Jubilee."
Most people don't pay enough attention to their currency risks. Most worry about whether their assets are going up or down in value; they rarely worry about whether their currency is going up or down. Think about it. Right now how worried are you about your currency declining relative to how worried you are about how your stocks or your other assets are doing? If you are like most people, you are not nearly as aware of your currency risk and you need to be.
So let's explore that currency risk.
All Currencies Have Been Devalued or Died
Think about holding currencies (which is the same as holding cash) in the same way as you would think about holding any other assets. How would you have done in these investments?
Of the roughly 750 currencies that have existed since 1700, only about 20% remain, and of those that remain all have been devalued. In 1850 the world's major currencies wouldn't look anything like the ones today. While the dollar, pound, and Swiss franc existed back then, most others were different and have since died. In 1850 in what is now Germany, you would have used the gulden or the thaler. There was no yen, so in Japan you might have used a koban or the ryo instead. In Italy you would have used one or more of the six possible currencies. You would have used different currencies in Spain, China, and most other countries. Some were completely wiped out (in most cases they were in countries that had hyperinflation and/or lost wars and had large war debts) and replaced by entirely new currencies. Some were merged into currencies that replaced them (e.g., the individual European currencies were merged into the euro). And some remain in existence but were devalued, like the British pound and the US dollar.
What Do They Devalue Against?
The most important thing for currencies to devalue against is debt. That is because the goal of printing money is to reduce debt burdens. Debt is a promise to deliver money, so giving more money to those who need it lessens the debt burden. How this newly created money and credit then flow determines what happens next. Increases in the supply of money and credit both reduce the value of money and credit (which hurts holders of it) and relieve debt burdens. In cases in which the debt relief facilitates the flows of this money and credit into productivity and profits for companies, rising real stock prices (i.e., the value of stocks after adjusting for inflation) happens. When it sufficiently hurts the actual and prospective returns of "cash" and debt assets so that it drives flows out of these assets and into inflation-hedge assets and other currencies, that leads to a self-reinforcing decline in the value of money. At times when the central bank is faced with the choice of a) allowing real interest rates (i.e., the rate of interest minus the rate of inflation) to rise to the detriment of the economy or b) preventing real interest rates from rising by printing money and buying those cash and debt assets, they will choose the second path, which reinforces the bad returns of holding "cash" and those debt assets. The later one is in the long-term debt cycle--i.e., a) when the amounts of debt and money are impossibly large for them to be turned into real value for the amounts of goods and services they are claims on, b) when the levels of real interest rates that are low enough to save debtors from bankruptcy are below the levels that are required for creditors to hold the debt as a viable storehold of wealth, and c) when the normal central bank levers of allocating capital via interest rate changes (MP1) and/or printing money and buying high-quality debt (MP2) don't work so that monetary policy becomes a facilitator of the political system that allocates resources in an uneconomic way--the greater the likelihood that there will be a breakdown in the currency and monetary system. So, there are a) systemically beneficial devaluations (though they are always costly to the holders of money and debt) and b) systemically destructive ones that damage the credit/capital allocation system but are required to wipe out the debt in order to create a new monetary order. It's important to be able to tell the difference. In this study we will explore both types.
To do that I will show you the value of currencies in relation to both gold and consumer price index weighted baskets of goods and services because gold has been the timeless and universal alternative currency and because money is meant to buy goods and services so its buying power is of paramount importance. I will also touch on their value in relation to other currencies/debt and in relation to stocks because they too can be storeholds of wealth. The pictures that all these measures convey are broadly similar in big currency devaluations because the currency moves are so significant that they change in relation to most things. Because many other things (real estate, art, etc.) are also alternative storeholds of wealth, we could go on and on describing how they perform in big currency devaluations but I chose not to because that would take this past the point of diminishing returns.
Continue reading here.
This article first appeared on GuruFocus.