Market Watch - April 4, 2014

Debt, not gold, backs the U.S. dollar

Problems with an indebted money supply can create losses in the stock and bond markets.

During the Bretton Woods discussions in 1944, the state of the world’s finances was disastrous. U.S. money was free of debt, which The Constitution requires. The strong position of the dollar in 1944 is why it became the world’s reserve currency. All outstanding 1944 dollars were covered by an equal amount of gold and silver in U.S. reserves. The dollar was known as hard money or honest money because it could be fully redeemed for gold and silver. Now, only 3% of our money is backed by gold. Ninety-seven percent is backed by debt, or what the Federal Reserve calls, “Promises to pay”.

To become a medium of exchange, money must be durable, transportable, recognizable, divisible and scarce. The U.S. dollar fails the test of durability and scarcity. The dollar is not scarce as it can be made with printing presses, unlike gold, which must be mined and is therefore, scarce by definition. If the money supply is composed of promises to pay and only 3% of the money supply is backed by gold, what does the promise to pay mean? Pay with what?

Constitutional Background

The Constitutional background of the dollar is interesting. The economic calamity of the colonies was the primary reason the Constitutional Convention was called. One of the first things delegates agreed upon was a clause in The Constitution requiring all debts to be settled in gold. The 18th century had suffered from three economic disasters that influenced the delegate’s attitude towards limiting government indebtedness and requiring gold backing of the money supply:

1. In the early 1700s, France had a monetary collapse known as the Mississippi Bubble. The collapse resulted from a French government money pyramiding scheme creating so much debt that the government could no longer raise enough money to pay interest on their debt;
2. England suffered a financial crisis from borrowing money to fight the French and Indian War. England’s solution to the problem was to lay taxes upon the Colonies in the form of the Tea Tax, the Stamp Act Tax, and a host of other taxes;
3. Debt was incurred to fight the Revolutionary War. When none of the debt could be repaid, the phrase “not worth a Continental" (meaning the Continental Dollar) was coined (pun intended).

Money supplies that were supported by debt instead of gold caused each crisis.

Aftermath of Inflating Money Supply

The deterioration in the gold backing of our money has resulted in a devaluation of the dollar’s purchasing power by 95% since 1944. It takes $20 to buy now what $1 would procure in 1944. Credit growth since 1980 is 8% annually while growth of the U.S. economy during that time averaged only 2.8% each year. Consequently, U.S. debt has grown to 350% of gross domestic product the highest ever. The result of this enormous build-up of debt is that the last ten years of our growth has averaged only 1.7% compared to GDP growth averaging 3.8% over our 220-year history. These numbers alone point out the downward spiral of the U.S. economy.

With the dollar leveraged like it is, we are exposed to potential monetary calamity. This is a perfect mathematical set-up for a catastrophic mass rejection of the dollar when it becomes widely known it’s really worth only 3-cents. Dollar based stocks and bonds could drop dramatically. How likely is our highly leveraged money supply to negatively affect those markets?

BONDS

The bond market is way over priced. The Federal Reserve System manipulates interest rates on the low side so the government can better afford to pay interest on outstanding debt. Upon maturity, the classic 30-year bond issued in 1984 for $1,000 would have a purchasing power that has deteriorated to $390. A dollar owned in 1984 can only purchase 39 cents worth of goods today. The 1984 $1,000 bond redeemed at today’s purchasing power would have to be redeemed for $2,560. Even after collecting interest payments all those years, the investor will be way behind because of the deterioration in the value of principal.

An investment in bonds in this economic climate, at these interest rates, is an investment whose principal is eroding in value. It is an investment from which one is unlikely to ever receive a return of capital. Government long-term bonds should be avoided. Only high-grade corporate bonds in growing and successful companies are an acceptable bond investment risk. Utilities, a former favorite for income investors, are way over-leveraged and should be considered high-risk investments.

STOCKS

Stocks have been one of the mainstays for investors the last two hundred years. Today the market is at an all-time high, and the yield on the Dow Jones Industrial Average is just over 2%, less than inflation. If stocks pay so little in dividends, then good returns must come from further increases in the value of stocks. That makes sense and has worked in the past; however, today’s stock market is as overvalued as the bond market. The average long-term yield on the Dow is 4.3%. If the Dow sold at a 4.3% yield, it would be 8,400 points, not 16, 400 points. The Dow could shed 8,000 points very quickly.

Investors are left with stock choices of only the highest-grade companies, which are not, themselves, over-leveraged. In the current market that represents a very small sampling of U.S. stocks, primarily because most stocks are already overpriced.

This is a dangerous market bearing a high degree of risk. Careful investors will stay away from long-term bonds and favor stocks in businesses that do not carry much debt. Good cash positions keep investors primed to take advantage of economic opportunities when they become available.

George Rauch
April 4, 2014