Paper money is popular under democracies. Under the control of a central bank, paper money provides modern economies with the illusion of great flexibility and resilience. Without the rigidity of the gold standard, bad bank loans are easily swept under the rug. This prevents the possibility of setting a Depression-era bank failure into motion.
Contrary to popular opinion, paper money is not wealth. Paper money is a claim on wealth. It only has value to the extent that it can be exchanged for things — a bushel of corn, a gallon of gasoline, a dental cleaning, or an Intel microprocessor.
When the government prints more money, it gives a public fixated on asset prices the illusion that they are growing wealthier, when, in fact, they are growing poorer. As paper money becomes more and more plentiful, the producers of valuable products will eventually demand more units of money in exchange for their product or service.
Daily celebrations of new Dow records fail to recognize the inflation behind this index’s move upward. Dr. Marc Faber is on public record talking about a potential “Dow 100,000” scenario. This scenario is possible if current trends continue. But we must remember that under this scenario, the price of everything will be increasing dramatically, leading to lower living standards.
A stark example of consumer price inflation leading to declining living standards is the recent tripling of corn tortilla prices in Mexico. Protesters have marched on Mexico City, demanding that the government do something about it.
Mexico’s fairly socialist economy has produced a situation in which many citizens’ incomes rely heavily on the government’s entitlement spending. Mexican monetary policy must remain loose to keep the system afloat. The supply of pesos in circulation has been growing 15-20% over the past year.
Misjudging the root cause of tortilla price increases — an exploding money supply — populist politicians have blamed “monopolistic” tortilla companies like Grupo Gruma and have enacted price controls that will only worsen the future supply picture.
Once the stage for easy pesos was set, the final catalyst that sparked the Mexican tortilla price explosion was the U.S. government’s boneheaded policy of subsidizing corn-based ethanol. Demand from dozens of new ethanol plants has stretched the U.S. corn market to its limit. High corn prices have attracted all excess supply away from international markets, causing a shortage in Mexico’s regular imports from the U.S.
Paper money inflation is not confined to Mexico. Loose U.S. monetary policies and ethanol subsidies are combining to form a future perfect storm in the price of basic food ingredients. Those holding their breath for imminent Fed rate cuts will probably have to hold it beyond this year’s corn harvest.
The average Mexican citizen facing spiraling food costs doesn’t seem to care about housing prices or rallies in the Mexican stock exchange. Will Americans be facing this situation at some point in the future?
Over the past decade, a few billion new capitalists began their quest to achieve Western living standards. They will demand energy and industrial metals on an unprecedented scale, and the best way for investors to benefit from this trend is to own shares in the companies fulfilling this demand.
This capitalist revolution is well under way and nothing short of an economic meltdown will stop it. Just in case the economic machine that funds mortgage payments and all other manners of debt begins to sputter, central banks will slash interest rates yet again.
But unlike the 2001-2003 series of rate cuts, long-term rates are more likely to increase as CPI fears mount, causing demand for long-term bonds to dry up.
If that were to occur, the U.S. Federal Reserve would implement Chairman Bernanke’s well-outlined “unconventional monetary policies.” This would involve a new role for the Fed: buyer of last resort for bonds of any maturity. And lest you think the Fed could ever run out of money, check to see what institution guarantees the value of the “Federal Reserve notes” sitting in your wallet. If necessary, the Fed can use its ability to create an unlimited amount of this paper to keep the debt pyramid solvent.
If this scenario were to develop, the U.S. dollar would quickly be added to history’s long list of worthless paper currencies. Under the status quo, the U.S. dollar’s rate of decay will depend on public perception of inflation, and perceptions are likely to worsen after this year’s corn crop.
Thanks to corn-based ethanol subsidies, a huge portion of the country’s corn-derived food supply — everything from sweeteners in packaged foods to chicken and beef — will suffer from shortages and price increases. Much of this will be passed onto the consumers who can least afford it. So investors should expect the current momentum behind populist political movements to grow stronger. This will be bad for longer-maturity bonds and the overall stock market, but good for gold prices.
The global economy now floats on a sea of paper money. This grand monetary experiment has been in place for only a few decades — a mere tick in the clock of civilization. We know how this show ends, having seen previews in Weimar Germany and several banana republics.
Will the price of gold ultimately increase from its current $620 to $3,000 per ounce? I expect that it will. A better way to frame this large number is to flip the ratio from dollars per ounce to “ounce per dollars.”
for The Daily Reckoning Australia