I’m willing to bet that nearly every parent has heard these words at one time or another, especially as the kids head back to school. Unfortunately for my girls, when they recently asked this question, I was admiring my newest acquisition, a freshly minted One Hundred Trillion Dollar note from Zimbabwe (The largest denomination note ever printed with the zero’s on it, all 14 of them). I had just paid $8 dollars for it on Amazon.
I asked the girls what they thought this “money” was worth? My youngest eyes got a little wider as she asked, “Is that like real?” I said, “it is very real, what do you think it is worth?” My oldest daughter, having played these games a few too many times, rolled her eyes and said, “whatever I can get for it.” Correct, money is only worth what you can purchase with it. You see the poor people of Zimbabwe lived in a war torn country, with a very corrupt government, that just kept on printing more and more money to pay for things. Eventually they printed so much money that it wasn’t worth anything.
Prices for basic goods, like milk and bread, were doubling every day. Soon the sellers of these goods wouldn’t put them out on the shelves, and instead of accept the government’s paper money, people would just trade goods with each other. My $100 trillion dollar note was introduced in January 2009, and just two weeks later Zimbabwe abandoned their currency and converted their economy to US dollars.
So what’s my $100 trillion dollar note worth; eight dollars to a currency collector, or zero to someone trying to spend it.
“That’s pretty cool Dad, but we still need some “real” money.”
“Real money” I said, “you mean like this?” Pulling out a fresh One Hundred Dollar bill.
“Yeah, that will do,” they said, while reaching for it. “Woo not so fast, is this “real” money?” “Yeah” they said in unison. “How do you know”, I asked? “Because, if we take it to the store we can buy $100 worth of stuff,” Rachel answered. “True enough,” I said, “but why is it worth that?” “Because that’s what the government says it’s worth”, says Lauren.
“Well done, but why is the US note worth $100, and the Zimbabwe note worthless?”
I could tell that they were tiring of my questioning so I answered this one, “because we trust the US government, and no one trusts the Zimbabwe government, at least for now.” “You see all money today is based on faith, faith in others to accept it, and faith that the issuing government won’t devalue it.”
“Wow that’s like scary, you mean its like all just based on trust and nothing real?” “That’s right, but it wasn’t always that way, money used to be backed by stuff like gold or silver, this faith based money is a rather new phenomenon.”
“Well, we still need some money Dad.”
“OK, OK, but first let me tell you a little story about money.”
A long, long time ago (when I was your age), currencies were backed by gold. In other words, you could exchange your paper for an equal amount of the metal. This was the way the world worked, in varying degrees, for thousands of years. Paper money, or promissory notes, could be exchanged for gold or silver. And in many cases coins were actually made out of precious metals. This gold backed currency system worked well during most of history. When governments usually got into trouble it was because they were printing more currency than they had gold to back it. This was generally done to support their military endeavors.
Our US system started to unravel in earnest during the 1960's when an excessive amount of money was printed to help finance the Vietnam war and our struggling economy. At the time the price of gold was fixed at $35 per ounce, and any government could go to the gold window and exchange their dollars for gold. During this period foreign governments accumulated large quantities of dollars, far exceeding our governments stock of gold. The proverbial (you know what) hit the fan in August 1971, when the British ambassador turned up at the Treasury Department to request that $3 billion US dollars be converted into gold. The very next week President Nixon announced to the world that the gold window was now closed and the United States was no longer on the gold standard. Obviously the dollar weakened versus other currencies, and inflation shot skyward. This was a momentous step in the history of international economics. From that day forward the US dollar would be backed by faith and faith alone.
The beauty of this faith based system was that governments could print and spend as long as they were able to find other governments to buy their debt. They were no longer constrained by the amount of gold mined annually. This unconstrained money supply is very appealing to politicians trying to spend enough to make good on their promises to voters. It didn't take long for all the worlds governments to quickly follow the US's lead in abandoning their gold standards. Today we live in a fiat based world where our leaders have decreed that currency is worth what they say it is, as long as everyone continues to believe in what they are saying. Occasionally it doesn't work and a country will need to default on their debts and devalue their currency. Zimbabwe was an extreme example, but Argentina, Brazil, Russia, and Mexico are all recent examples (Greece and others soon to follow.)
We've also seen periods where certain currencies appreciate versus others, and periods where currencies weaken. Since 1973 the Fed's Major Currencies Dollar Index (the US dollar versus the worlds major currencies) has declined by 27%, and the dollar is down 45% from its 1985 peak. And just this week the US dollar set a new 15 year low versus the Japanese Yen. Fortunately for the United States, many of our major trading partners have been as prolific as the US in promising and printing (also known as competitive devaluations), and therefore the dollar hasn't declined even more. But hows that fiat dollar doing versus it's old protector gold? Since 1973 gold has risen from $35 an ounce to $1,200 an ounce for a gain of 3,328%. Measured in gold the value of one dollar has declined by 97%! They didn't call President Nixon "Tricky Dick" for nothing!
Now most people think of gold as an inflation hedge, and prior to 1973 that was generally the case. But since 1973, gold has generally moved in the opposite direction of the US dollar. In fact, gold has a correlation to inflation of just 0.08. A perfectly positive correlation would be 1.00, while a minus-1.00 means that two assets move in perfect opposition. A near zero reading means that gold and inflation mostly ignore each other.
The correlation between gold and the dollar is another matter. Since that infamous day in 1973, the correlation between gold and the dollar is a high negative correlation of minus-0.65. This means that when the dollar weakens gold strengthens, and when the dollar rallies gold retreats. Many wrongly believe that since the US is on the verge of deflation, and there is no inflation in sight, then gold should be trading lower. That's simply not the fact, gold will move in the opposite direction of the dollar.
As a portfolio manager, or more appropriately a risk manager, my job is to protect my clients wealth. Since I and my clients all live in the US, own houses denominated in dollars, get paid in dollars, and have most of our investments denominated in dollars, our biggest risk is the continued devaluation of the dollar. And a real scary risk is the potential that the world no longer believes in the value of the US dollar and we see hyperinflation and a currency collapse. Now don't freak, no one knows if this will happen, but it is a risk (see Zimbabwe dollar at the top). So in order to hedge this risk we own gold.
Gold is the ultimate fiat currency hedge. It's an insurance policy against government mismanagement.
Be careful out there,
Chris Wiles
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This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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