What if pounds (the measure of weight) were similar in nature to dollars? Let's say you have been monitoring your weight for the last 27 years. The first time you weighed yourself was in January 1972 when the reading on the scale said 170 lb. You were in pretty good shape and this was a reasonable weight for someone of your height. However, despite the fact that you were watching what you were eating and getting regular exercise, each month you weighed yourself you were, according to the scales, slightly heavier than the month before. By January 1976 you were weighing in at a very chunky 260 lb, even though you still felt the same as you did in 1972. In fact, there was also no noticeable change in your appearance despite the extra 90 lbs. Depressed by this weight gain and the election of Jimmy Carter, you decided to stop weighing yourself. The depression remained until 1983 when, after 3 years of Reaganomics and with an economy obviously on the way up, you decided to weigh yourself again. After all, you were feeling great! You couldn't find your old scales so you purchased a new set. You hopped on to the new scales with confidence, expecting to see your reward for what you believed to be a healthy life style. At first you didn't believe what you saw. There must be some mistake - you could not possibly weigh 540 lbs! You returned the scales to the local store and extracted a full cash refund from the bewildered shopkeeper. You knew the scales must have been faulty and anyway the alternative was far too terrifying to even consider. More years pass. You have survived a stock market crash and 6 years of Bill Clinton's presidency complete with the inevitable impeachment trial, and you now feel strong enough to be able to cope with any manner of adversity. It is January 1999, and you do what you had sworn never to do again - you purchase a new set of scales and weigh yourself. Later that day the doctor tells you not to worry - he assures you that you are in pretty good shape and that 1250 lbs is a reasonable weight for someone of your height.

Money is supposed to serve three purposes – a unit of account (or unit of measurement), a store of value, and a medium of exchange. The above analogy illustrates what would happen if a unit of weight measurement behaved in the same manner as the most commonly used unit of economic measurement and demonstrates that, as a unit of account, the Dollar is sadly lacking. How can you measure something in terms of units that are, themselves, constantly varying? For similar reasons the Dollar has also failed miserably as a store of value for not only does its purchasing power vary over time, it moves inexorably lower. As a medium of exchange, however, the Dollar has been (at least in recent decades) an unqualified success, with a large section of the world's population readily accepting it in exchange for goods and services.

The purchasing power of all fiat currency reduces over time, although some currencies fall much faster than others. This happens because, with no link to the physical world, the supply of money will tend to increase at a greater rate than real economic output (since it is almost always in the short-term interest of the government and the banking system for it to do so). In the US today the seemingly excessive prices that investors are willing to pay for company shares, relative to the earnings of the associated companies, is a form of currency depreciation.

On almost a daily basis we hear market commentators make the argument that there is no need for the US Federal Reserve to raise official interest rates or for market rates to increase further because real rates are already at historically high levels. This is a classic case of beginning with a false premise and then applying flawless logic, thus guaranteeing an erroneous conclusion. The false premise is that the CPI represents inflation. During a period of high real interest rates you do not get a huge expansion of credit. Large increases in credit only occur when money is cheap. However, the fact that most of this 'cheap money' is channeled into the stock and real estate markets leads many 'experts' to proclaim that inflation is minimal and, therefore, that real interest rates are high. In actual fact we are seeing the depreciation of the currency reflected in asset prices rather than the prices of the goods and services which make up the CPI.

The US CPI figure released on 14th May shocked the market because it momentarily destroyed the illusion of low inflation. However, the only real surprise is that the CPI is beginning to reflect the rapid increase in inflation that has occurred during the past 2 years. After all, as well as gaining an enormous benefit from cheap imports and the lowest commodity prices in two decades, the CPI is also 'adjusted' for changes in product characteristics. For example, if the average price of a refrigerator has increased by 5% over the past year, but today's refrigerator is deemed to be better than last year's model, then refrigerator prices are adjusted downwards in the CPI calculation to account for the quality improvement (because you are getting more for your money).

The strength of the US Dollar on the foreign exchange markets demonstrates the resolve of the monetary authorities outside the US to depreciate their currencies. The Bank of England has provided the most extraordinary recent examples of this worldwide drive to de-value by not only announcing their intention to sell 60% of the country's gold reserves, but making the statement: "If Sterling does not decline then further easing may be needed to prevent under-shooting of the inflation target".

The challenge for the US Federal Reserve is to maintain a strong US Dollar to ensure the continued flow of investment capital into the US whilst, at the same time, maintaining loose monetary policy to ensure the continued health of the US stock market. In other words, the Dollar must be weak but the Yen, the Euro, the Pound, the Franc, etc., must be even weaker. The first of these objectives (a relatively strong Dollar) can be achieved through the determined efforts of every other major central bank to weaken their respective currencies by setting their interest rates far below US levels. Achievement of the second objective (loose monetary policy) effectively prohibits an increase in official US interest rates, regardless of how uncooperative the CPI becomes. The challenge for the other major CBs is to pursue monetary policies that promote the price competitiveness of their exports and prevent the under-shooting of their inflation targets - hardly a challenge at all.

The game will be up if the Dollar begins to weaken with respect to other major fiat currencies or, more importantly and more likely, with respect to gold. Gold is the one form of money the central banks cannot create, therefore their ability to control its relative worth is extremely limited. A sustained rise in the US Dollar gold price would highlight the inherent weakness in the world's reserve currency.

There is nothing new to this currency depreciation game - governments have been playing it with fiat money throughout the ages. To date they have a 100% success rate. The only difference this time around is that the US cannot be seen to be participating.

Milhouse
Hong Kong
18 May 1999

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