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Inflation is caused by a decline in currency value. When the value of
a currency falls, then, over time, it tends to take more currency to buy
things. This process is very obvious in the case of Mexico, for example, which
went from about 3.5 pesos/dollar in 1994 to about 9.5 pesos/dollar in 1999.
If a Sony Playstation cost US$200 or 200*3.5 = 700
pesos in 1994, it might have cost US$200 or 200*9.5 =1,900 pesos in 1999.
Pretty simple.
The process is not so obvious when the US dollar declines in value.
Due to the dollar's importance worldwide, when the dollar declines in value,
other currencies tend to decline alongside. Otherwise, they would be subject
to terrible trade pressures from "beggar thy neighbor" devaluation.
If the euro was trading for $1.25, and both the dollar and euro's value fell
in half, then afterwards the euro would still be trading for $1.25. However,
we might expect the cost of a Sony Playstation to
slowly rise to $400, as the market for Playstations
gradually accommodates the fact of the decline in dollar value.
This sort of dollar decline is not obvious in the foreign exchange
market, since major currencies tend to stay in line with each other. It may
slowly appear in the price of Playstations, cars,
crude oil, food, medical expenses or in the government's CPI statistics, if
they are being honest. In my experience, the best way of measuring this sort
of decline in currency value is by looking at a different currency market. I
prefer the market between dollars and gold, the world's great monetary
standard. If gold's value remains roughly stable, then when the dollar
declines in value, it will take more dollars to buy gold -- just as when the
Mexican peso declines in value, it takes more pesos to buy dollars. Thus, a
"rising dollar price of gold" is really a decline in dollar value,
with all the attendant consequences.
The last great inflationary period in US history was the 1970s. In
1970, it took only $35 to buy an ounce of gold. At that time, $2,500 (71
ounces of gold) bought a decent car, and a house might run $25,000 (710
ounces of gold). After the smoke cleared in the 1980s and 1990s, the dollar
was worth about 1/350th ounce of gold, one-tenth of its 1970
value. A decent car cost about $25,000 (71 ounces of gold) and a house,
before the recent mania, was about $250,000 (710 ounces of gold).
The Dow Jones Industrial Average peaked around 1,000 in 1965, or 28.6
ounces of gold. Today, the DJIA at 13,000 is worth about 19 ounces of gold.
If the dollar was worth about 1/350th of an ounce of gold
in the 1980s and 1990s, and today it is worth close to 1/700th of
an ounce of gold, then the dollar's value has fallen roughly in half. This
does not cause an immediate doubling in prices for everything. That process
takes a long time, on the order of twenty years -- or about 3.5% per year on
average. However, this change in currency value distorts all manner of
economic relationships. One of the first effects can be to make financial
markets quite giddy. This was the case in 1972, for example. The dollar had
moved from $35/ounce to around $65/ounce, kicking off the inflation of the
1970s, but for a little while the "Go Go Years" were still going
full tilt. It seems to be the case today, when the dollar has moved from a
long-term average around $350/ounce to around $650/ounce. As the dollar went
to $100/ounce and beyond in 1973-74, the inflation really took hold and
financial markets everywhere were pulverized.
The US and world economies have already received a good stiff dose of
inflation. It could be remedied by appropriate action by the Fed and other
central banks. In practice, this would likely mean rate hikes, although there
are other, more effective methods. In 1969, to counter incipient inflation,
Fed chairman William McChesney Martin took action
that drove short-term rates to 10%. In 1974, Fed chairman Arthur Burns'
anti-inflation policies took rates to 13%. In 1980, Fed chairman Paul
Volcker's anti-inflation policies took rates to 14% or higher. In 1989, Fed
chairman Alan Greenspan's anti-inflation policies took rates to 9.5%. The
political support for such policies today is virtually nil, especially
considering the wave of adjustable-rate mortgages coming due over the next
three years.
Indeed, many Fed-watchers have expected the Fed's next move to be a
reduction in policy rates. Whether this turns out to be correct or not, this
expectation alone suggests that the trend toward further decline in dollar
value will continue. It may not show up in the dollar/euro or dollar/yen rate
-- the dollar didn't fall much against foreign currencies in the 1970s either
-- but it would show up in the dollar/gold rate. Following our worn but
useful 1970s roadmap, a move to $1000/oz. or beyond would probably be
accompanied by a blooming of full-on 1970s-style inflation. It could happen
by the end of this year.
Gold never really "goes up." It simply holds its value while
the values of other things are collapsing due to inflation and currency
devaluation. Many times, in the 1960s or 1990s for example, it is the most
useless of assets, sitting inert and generating no income. In inflationary
periods, this inertness of value is gold's most admirable quality.
It seems these days like a lot of people can't help blurting out the
H-word -- hyperinflation. I am one of them, and I notice that the normally
level-headed Marc Faber has his episodes as well. We are far from such a
scenario at this time, and by any reasonable standard the likelihood of such
an outcome remains extremely remote. I take this premature anxiety as a sort
of premonition, the way some people feel an earthquake in their knee before
it happens. There is something going on that we haven't seen before. The US
dollar is apparently being rejected worldwide, partially as a result of the
unpopularity of US foreign policy. How this all plays out remains to be seen,
but a certain amount of preparation might be worthwhile if that tingling-knee
thing turns out to be right.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset management.
Lewis has written for the Financial Times, the Wall Street Journal Asia, the
Japan Times, Pravda, and other publications. He has appeared on financial
television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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