The ‘Weimar’ Dollar

December 3, 2007 – The outcome from the relentless inflation of a currency is all too predictable. Unfortunately, the inevitable future of currency debasement is generally ignored by most people, with the result that they end up unprepared when the inflation eventually destroys the currency they are using.

The dollar has been collapsing, albeit somewhat slowly as its downfall has been occurring over several years. Therefore, this decline has been imperceptible to many people. Nevertheless, in five years the dollar has lost one-half of its purchasing power compared to the euro. Crude oil during this period has risen almost five-times, while gold is up nearly threefold.

The dollar is losing purchasing power day after day because of inflation, which is undermining its usefulness as currency. Inflation is wearing away the basic attributes of the dollar.

It is a result that is no different from dozens of other fiat currencies that have had their purchasing power perennially eroded by inflation. All of them inevitably succumbed in the end to a total collapse where the ill-fated currency is abandoned for other alternatives. And just like occurred with these other doomed currencies, the demand for the dollar – as indicated by the willingness of people to hold dollars in preference to other currencies – is declining. Hardly a day goes by without some central bank or savvy money manager announcing that they have diversified their liquidity out of the dollar into other currencies.

When the demand for a currency declines, experience shows that the rot has progressed to a stage where it is unstoppable. In other words, the currency is usually close to being destroyed. After all, when a currency is on the road to the fiat currency graveyard, sooner or later it will get there. The dollar is not only on that road, it is picking up speed as the demand for the dollar continues to fall.

Here’s a good summary by Ludwig von Mises explaining the destruction of fiat currency from inflation.

“The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services … at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people … who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and … increase their cash holdings.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time … the things which were used as money are no longer used as media of exchange. They become scrap paper.”

Please read Mises’s observations carefully. The insights of this brilliant 20^th century economist are timeless.

In my view the first stage described by Mises is ending. For example, the massive dollar balances accumulated by central banks are now being used to purchase goods and services. China is leading the way, but we are now at the stage where others are starting to “wake-up”, as Mises describes it, because we see the dollar’s exchange rate to other currencies falling more rapidly than it has in the recent past. The collapse of a currency always starts outside the country, not in it.

Investors outside the country are more attuned to the loss of a currency’s purchasing power. They can easily compare it, for example, to the purchasing power of the currency in their own country, giving them a useful perspective. What’s more, they see how little the inflated currency buys in the global marketplace compared to other currencies, which is an invaluable point of view that most people unfortunately do not have the benefit of.

People within the country are the last to see that the currency is collapsing. The effects of inflation are often uneven and lagged as Mises explained, and because they are dealing in the troubled currency on a daily basis – receiving it, for example, as salary and using it in normal day-to-day ways – they are not sensitive to its changes in purchasing power compared to other currencies. Thus, they are the last people to dump it. When they do, Mises’ crack-up boom will have arrived. That’s exactly what happened in Weimar Germany, leading to the 1923 Reichsmark collapse.

I discuss this point in an interview by Dominic Frisby of Commodity Watch Radio. Also participating in the interview was Michael Hampton, aka Dr. Bubb, of Global Edge Investors.

Pleas to the Federal Reserve by US investors to lower interest rates are no different than those made to the Reichsbank to create more currency to make up what was being lost be inflation. The dollar is headed the same way as the doomed Reichsmark, and Fed chairman Bernanke is taking actions that are basically little different from those taken by the head of the Reichsbank.

The clear conclusion is that the dollar is headed the same way as the Reichsmark. Falling demand is eroding the purchasing power of the currency, and the central bank responds to it by creating more currency units – “printing paper” in the case of Reichsbank and “adding liquidity” in the case of the Fed. They are in fact exactly the same thing.

Some things in finance are counter-intuitive and managing a fiat currency is tricky. But the experience of Weimar Germany makes clear what the Fed should be doing – take steps to increase the demand for dollars.

Unfortunately, it is doing the exact opposite. The Fed is ignoring demand and increasing the supply of dollars, just like the Reichsbank increased the supply of Reichsmarks.

The Fed is good at propagandizing to get people to hold dollars, but doesn’t tell you its real mission, which is to fund federal government’s deficits. To do this the Fed will create dollars ‘by hook or by crook’, and there is nothing to stop it in the absence of some externally imposed discipline.

So the US dollar is on the road to the fiat currency graveyard. Worryingly, I think we are much closer than most people think. The flight from the dollar has begun outside the US. And Stage two – where the masses in the US finally start to “wake-up” – has already begun.