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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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When Money Dies

Posted by Muthu on July 30, 2010

An obscure little book is capturing reader imagination like never before. ‘When Money Dies’ by Adam Fergusson was last heard retailing as high as Rs. 73,000 at an online retailer! In fact, as per reports, this book has caught even Warren Buffett’s fancy. The world’s greatest investor has termed it a must read. Now, what exactly is this book and why this new found interest in it? This book is perhaps an indicator of the dangerous times that lie ahead of us. It highlights how an unchecked growth in money printing can cause disastrous consequences if not controlled on time.

We all know that enormous amount of money has been printed in most parts of the world, particularly in the US. And this is certainly quite inflationary. The only thing that is keeping it in check is the fact that people are holding on to their money and not spending it as quickly as before. However, such a scenario may not last long. People’s willingness to spend money can change so suddenly that it can catch economists completely by surprise. And then all hell can break loose. Inflation can go completely out of control. So out of control that as per the book, during the German hyperinflation of 1920s, it took 1 trillion German marks to buy just one unit of English currency! Money lost its value so fast that it was not unusual to see people taking home their wages in suitcases or covering their wall with paper money because it was cheaper than wallpaper. Rest assured there are even more chilling accounts in the book of how the economy completely broke down in Germany.

We may certainly not have an inflation as bad as that happened in Germany. But we are definitely setting ourselves up for a huge disaster if we do not act on time. As the author of the book recently mentioned, “Politically, now is the only time tightening can be done. In a year or so it won’t be possible politically any more”. We hope Messrs. Bernanke and company are listening.

If any one of you is able to get the above book, please lend me the book for a week.

Can you tell us which is the safest asset in the world right now? Gold could be one of the options. However, there isn’t enough quantity of the yellow metal for it to absorb trillions of dollars of cash and still not move much in terms of prices. How about the US Government bond? It is the sovereign bond of the most powerful and wealthiest nation on Earth. Plus, it was the asset of choice the last time a crisis happened. Certainly, the US Government bond does qualify as the safest asset in the world based on historical track record.

However, is the famed US Government bond going to be equally safe in the future? Clearly not if the noted economist and investor Marc Faber is to be believed. In fact, as per Faber, the value of the US bond would be nothing more than worthless pieces of paper going forward. This is thanks to the enormous amount of debt the US has piled on. Faber believes that the US Government will have to run a giant Ponzi scheme just to be even on its interest payments. In other words, it will have to keep issuing new bonds so that the money raised could be used to pay its ever rising interest expenses.

The repayment of debt is just impossible as per Faber. And this scheme would come to end the day new bond issuances will not be able to match interest payments. Then, the US Government will be left with no other option but to print money thus significantly raising the risk of a hyperinflation like situation. While the reality may not turn out as grim as Faber has predicted, the US is indeed staring at a problem the magnitude of which is unheard of. The safest asset in the world may not be that safe after all.

What is hyperinflation and why it is considered risky?

Hyperinflation is inflation that is very high or “out of control”, a condition in which prices increase rapidly as a currency loses its value.

The main cause of hyperinflation is a massive and rapid increase in the amount of money that is not supported by a corresponding growth in the output of goods and services. This results in an imbalance between the  supply and demand for the money (including currency and bank deposits), accompanied by a complete loss of confidence in the money, similar to a bank run. Enactment of legal tender laws and price controls to prevent discounting the value of paper money relative to gold, silver, hard currency, or commodities, fails to force acceptance of a paper money which lacks intrinsic value. If the entity responsible for printing a currency promotes excessive money printing, with other factors contributing a reinforcing effect, hyperinflation usually continues. Often the body responsible for printing the currency cannot physically print paper currency faster than the rate at which it is devaluing, thus neutralizing their attempts to stimulate the economy.

Hyperinflation is generally associated with paper money because this can easily be used to increase the money supply: add more zeros to the plates and print, or even stamp old notes with new numbers. Historically there have been numerous episodes of hyperinflation in various countries, followed by a return to “hard money”. Older economies would revert to hard currency and barter when the circulating medium became excessively devalued, generally following a “run” on the store of value.

Hyperinflation effectively wipes out the purchasing power of private and public savings, distorts the economy in favor of extreme consumption and hoarding of real assets, causes the monetary base, whether specie or hard currency, to flee the country, and makes the afflicted area anathema to investment. Hyperinflation is met with drastic remedies, such as imposing the shock therapy of slashing government expenditures or altering the currency basis.

An example of the latter occurred in Bosnia-Herzegovina in 2005, when the central bank was only allowed to print as much money as it had in foreign currency reserves. Another example was the dollarization in Ecuador, initiated in September 2000 in response to a massive 75% loss of value of the Sucre currency in early January 2000. Dollarization is the use of a foreign currency (not necessarily the U.S. dollar) as a national unit of currency.

The aftermath of hyperinflation is equally complex. As hyperinflation has always been a traumatic experience for the area which suffers it, the next policy regime almost always enacts policies to prevent its recurrence. Often this means making the central bank very aggressive about maintaining price stability, as was the case with the German Bundesbank, or moving to some hard basis of currency such as a currency board. Many governments have enacted extremely stiff wage and price controls in the wake of hyperinflation but this does not prevent further inflating of the money supply by its central bank, and always leads to widespread shortages of consumer goods if the controls are rigidly enforced.

Do you want to know how high Hyperinflation can be? Take the case of Zimbabwe.

Hyperinflation in Zimbabwe began in the early 2000s, shortly after Zimbabwe’s confiscation of white-owned farmland and its repudiation of debts to the International Monetary Fund, and persisted through to 2009. Figures from November 2008 estimated Zimbabwe’s annual inflation rate at 89.7 sextillion (1021) percent.By December 2008, inflation was estimated at 6.5 quindecillion novemdecillion percent (6.5 x 10108%, or 65 followed by 107 zeros). In April 2009, Zimbabwe abandoned printing of the Zimbabwean dollar, and the South African rand and US dollar became the standard currencies for exchange

It is perceived that fiscal and monetary policies are the two levers with which growth in an economy can be regulated. But we believe that most of the developed economies have pushed the fiscal knob to its maximum permissible limit. Little wonder most of them are singing the austerity tune these days. So does this mean that the Governments have finally decided to go slow on spending and are looking to cut their fiscal deficits?

Certainly not believes Marc Faber, one of the top big picture guys in the world right now. “I am not a great believer in this austerity that they are proclaiming”, Faber said recently in an interview. He further adds that even if Governments cut deficits, it is most likely to be offset by a very expansionary monetary policy. In other words, the US Fed and other central banks will print so much money that nominal interest rates would continue to remain low. This in turn could force people to spend and invest and thus push up economic growth.

However, this is not going to solve any of the long term problems. Very likely, we could end up with an even bigger recession few years down the road. Thus it looks like there are no easy solutions in sight.

(with inputs from Equitymaster and Wikipedia)

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