Currency Risk

June 6, 2005 – Currency risk is a troublesome problem that everyone faces. It arises for a variety of different reasons, but more often than not, government management of the currency through its captive central bank is the source of the problem.

For example, inflation, i.e., the loss of a currency’s purchasing power because of rising prices, is a real risk, but it is not a natural phenomenon. It is man-made. It results from central bank policies that are designed more to fund government deficits than to protect the value of a currency.

The purchasing power of a currency need not be destroyed this way. From the time that Sir Isaac Newton invented – perhaps created is a better word – the classical gold standard in the early 1700’s until 1914, the British pound had essentially the same purchasing power. The Bank of England did not ‘manage’ the currency under the classical gold standard – it just simply followed the rules Newton established, using gold (i.e., money) to ‘back’ (i.e., provide value to) the currency (i.e., the British pound). Thus, we can see that the British pound and every other national currency is not money in the true sense of that word, but rather a money substitute, which is only used because it is forced into circulation by government imposed legal tender laws, which gets back to the essence of currency risk.

To understand currency risk, one must understand that despite the profusion of unrelenting propaganda to the contrary, governments and their captive central banks are not there to protect the currency and its purchasing power. They exist solely to protect the positions and the perquisites they now enjoy.

Given this objective, currency risk is a real threat, and more alarmingly, it is a growing threat. While government spending aspirations are becoming even greater, the hollowing-out of the various national currencies – and most notably, the US dollar – is becoming even more apparent. The value of the currency no longer rests upon gold as it once did; it now rests upon a mountain of promises by politicians, and these promises are becoming less reliable even as they continue to mount. Many of these promises are going to be broken. So how do we address currency risk?

The answer is fairly simple. We can no longer afford to be unidirectional in our thinking. We can no longer only calculate the price of goods and services just in terms of national currencies. We must also calculate prices in terms of gold. In this regard, I refer to the accompanying chart of the Dow Jones Industrial Average calculated in terms of gold.

We can clearly see that based on historical evidence, the DJIA is overvalued in terms of gold, or put another way, gold is undervalued in terms of the DJIA. Consequently, I have been recommending for a few years now a simple strategy to hold gold and avoid stocks (except special situations like select gold mining stocks, oil companies and other commodity producers). In other words, stay liquid until the DJIA once again gets cheap, say, it costs less than 50gg to purchase. Then use your gold to purchase the DJIA. It’s a winning strategy, and it’s that simple.

Currency risk is not going away anytime soon. But we can deal with it by calculating prices in terms of gold. We can also deal with it by maximizing one’s holding of gold, and minimizing the amount of national currency.