The US dollar is a sort of monetary brand. And like any other brand, it can fall out of favor. Even iconic brands can rapidly lose their “must-have” caché. Sometimes, a brand can disappear entirely, as did Pan American Airways or “Members Only” jackets. But there is always something else waiting to take its place. So it is with the US dollar, a brand making lows in the financial markets.
The dollar has been the “Coca-Cola of monetary brands,” says James Grant, editor of Grant’s Interest Rate Observer. But even the best of brands can be lousy investments. Grant uses the analogy of The New York Times. It was the greatest name in newspapers. In 2002, the stock sold for $53 per share – an all-time high, as it turned out. Today, the “Gray Lady” fetches only $8 per share.
“What happened?” Grant asked. The World Wide Web happened, he says. “The Times has hundreds of reporters, but this is a story they seem to have missed.” As if the lowly stock price was not evidence enough of its decline, the NY Times got another reminder when it borrowed $225 million against it headquarters building. The cost of such borrowing, Grant reports, was 14%. The august Times today borrows at rates no better than a working-class stiff at a pawnshop. The US Treasury should take note. The government seems as intent on creating dollars as prolifically as bunnies create other bunnies.
Here we get to John Paulson, a presenter at the Grant’s Fall Investment Conference and undoubtedly the richest man in the room. Portfolio magazine dubbed him “The Man Who Made Too Much” after he made $3.7 billion by betting against mortgage-backed securities (MBS). He is one of the greatest hedge fund managers ever.
Gold is his favorite today. As to why, Paulson presented a simple, but compelling case. First, the monetary base has exploded in a way we’ve never seen before. The monetary base is essentially the Federal Reserve Bank’s currency and reserves. The Fed, by buying up securities in this crisis, has pumped a lot of money into the economy.
You’ve probably seen this chart, or some variation of it. Still, there haven’t been noticeable signs of inflation as a result of that big spike – not yet.
As Paulson explained, that’s because this base money has not yet been lent out and multiplied throughout the economy. Yet the monetary base and money supply are highly correlated, “almost 1-to-1 between the two,” Paulson said.
That means that as the monetary base expands, the money supply surely follows, though there is a lag. (Money supply is a broader measure of money than just the monetary base, as it includes personal deposits and more. The monetary base is like a kind of monetary yeast. It makes money supply rise.)
If money supply grows faster than the economy, that will create inflation, says Paulson. As it is impossible for the economy to grow anywhere near that vertical spike in the monetary base, Paulson contends inflation is coming.
The US is not alone in its money-printing exercise. The supply of most currencies is expanding rapidly – even the normally tame Swiss franc. In the race of paper currencies, they are all dogs. Hence Paulson’s interest in gold, which no government can make on a whim.
Therefore, in the content of the exploding monetary base, gold seems relatively cheap. In other words, as the money supply rises, so does the price of gold, eventually. As a result, says Paulson, “gold has been a perfect hedge against inflation.”
There is some slippage over time. The gold price can change faster or slower than the money supply. But when the market gets worried about inflation, the gold price usually changes much faster – as happened in the 1970s. In 1973 – to pick a typical year – inflation was 9% and gold rose 67%. That was a pattern common in the 1970s.
The potential for inflation this time around is greater than it was in the 1970s, given that the growth in the monetary base is so much greater than it was in the 1970s. Gold could do much better this time around, reaching “$3,000 or $4,000 or $5,000 per ounce” as Paulson said.
I keep thinking how future historians will look back at the present day and see clearly how this unfolded. They will see the litany of news items that pointed to the dollar losing its top perch: China and Brazil settling up trade in their own currencies. The Russians and others openly calling for a new monetary standard. Even mainstream outlets are discussing alternatives to a dollar-based standard, a province once solely occupied by cranks and gold bugs. Not a week goes by without these kinds of stories.
As for a replacement waiting in the wings, Grant offers up gold. Indeed, a kind of “de facto gold standard” seems to be taking shape. The SPDR Gold Trust (GLD), the largest gold-backed security in the world, is now the sixth largest holder of the metal in the world. Anybody with a brokerage account can easily buy gold today through the trust.
It’s still early. Most people still own no or very little gold. As it becomes clearer what’s happening, they will buy more gold, especially as it is now easy to do so.
The gold supply, too, is limited against the vast pool of dollars. As Paulson points out, global money supply is 72 times the value of gold. I’m betting that gap will narrow. It only has to narrow a smidgen and the gold price flies.
As Grant eloquently put it: “Gold is a speculation. But it is a speculation on a certainty: the debasement of the currency.” Gold stocks, too, are a speculation. But they are a speculation on an inevitably higher gold price.
By Chris Mayer