By Paul Price and Ilene
Perhaps surprisingly, the buying power of the dollar had been increasing for three and a half decades before the Federal Reserves’ creation in 1914. Since the Fed’s been minding the store, however, the value of the dollar has been declining almost nonstop. It’s now worth only 5% of its original value. And that 5% is overstated.
A loss of the dollar’s value (buying power) causes inflation, i.e., higher prices. Conversely, a rising dollar value results in deflation, lower prices.
“Inflation is when a certain form of currency starts to have less value over time. Mainly two things cause it: people’s perception of value and the economic principle of supply and demand.” (What exactly is inflation?)
People’s perceptions of a currency’s value affect its value. When the U.S. dollar was on a gold standard, worry that the government or banks wouldn’t be able to redeem people’s cash for gold caused inflation. If one dollar that was worth an ounce of gold but people started worrying that the government only had half the gold needed to redeem their dollars, then dollars would start being traded at a value of half an ounce of gold. Similarly, if one dollar was worth five French francs, and the government announced it would allow the value of the dollar to drop to only three francs, the value of the dollar would drop immediately. People would believe their money would lose value, and so it would. Thus, a currency’s value depends largely on perception.
Supply has a more dramatic effect. Throughout history, governments have tried to solve financial problems by creating more money. As noted in What exactly is inflation?, “This can drive the value of money drastically downward, especially in modern markets where money is not backed by gold. Twice as many dollars in an economy makes those dollars worth half as much.”
Today, powerful central banks are “printing” money, decreasing the value of their own currencies. In the U.S., this program is known as Quantitative Easing (QE). The Federal Reserve wants to lower the purchasing power of the U.S. dollar. The Fed wants inflation, but won’t admit it, because inflation hurts significant segments of the population.
The Fed’s Zero Interest Rate Policy (ZIRP) and its push for higher prices (inflation) favor borrowers while punishing savers because the dollar’s buying power continuously shrinks. When a currency’s value is declining, and interest rates are nearly zero, there is no reason to save and every reason to spend. In this environment, bank CDs and fixed-income bonds are virtually guaranteed to lose buying power over time.
President Franklin Roosevelt stopped deflation when he abandoned the gold standard in 1933. Executive Order #6102, the Gold Confiscation Act, made it illegal for U.S. citizens to hold gold. (See Gold-Confiscation-Act-of-1933 for background.)
President Richard Nixon closed the door on asset-backed currency in 1971. Dollar bills stopped carrying the label ‘silver certificates’ and started bearing the term ‘Federal Reserve Notes.’ This allowed for unlimited money printing with no assets backing up the currency.
The dollar’s slide to 5% of the pre-Fed dollar
Due to the changes in how inflation is calculated, the 5% remaining value of the pre-Fed dollar is overstated. After double-digit inflation in the late 1970s and early 1980s, the Bureau of Labor Statistics (BLS) changed its rules in calculating the Consumer Price Index (CPI). It began understating the real inflation rate. Lower (reported) inflation saved the Federal government billions of dollars in its Cost of Living Adjustment (COLA). A higher COLA would have increased payments for workers and retirees.
The less than trustworthy CPI data understates real inflation. Inflation benefits debtors who repay borrowed money with lower-valued paper. The U.S. government is the largest debtor in history with over $16 trillion in debt. It also has trillions in unfunded promises for Social Security, Medicaid/Medicare and pension obligations–more debt, just not due to be paid yet. (See Death by Leverage)
Even though cash continues to lose value, there is no suitable substitute except for barter. Keeping one to two years of money liquid for day-to-day needs is prudent even though it will gradually lose buying power.
History shows that preserving wealth comes from owning real, income producing assets, including rental real estate and profitable businesses. These help pass along the effects of a weakening currency. Unless you own a company that meets this standard, stocks represent one of the best ways preserve wealth.
Stocks are liquid, often pay dividends, and the underlying company can adjust to future conditions. Shares of a profitable company represent partial ownership in an income-producing asset. While the stock market goes up and down, no matter what befalls the country, people will continue to eat, drink, need shelter, work and seek entertainment.
Japanese government officials set out to undermine their own currency. The government’s plan to devalue the Yen caused the Yen to drop by over 20% against the U.S. dollar over the past 12-months. Everything imported into Japan now costs much more.
Many Japanese savers transferred money from Yen to Japanese equities, which could be marked up as the fiat-based currency was marked down. While citizens couldn’t stop the politicians, they could protect their life savings. During this time, the Nikkei-225 index rose more than 70%. Those unwilling to ‘take stock market risk’ lost money. Owners of equities are still ahead.
The Stock Market
American equity markets have been hitting new highs as QE programs diminish the U.S. Dollar’s actual buying power. Holding appreciating assets, such as stock in profitable companies, rather than fiat-based cash has been beneficial in recent years.
Our strategy: Hold some emergency cash. Avoid any fixed income except for ultra-short term bonds or CDs. Buy stocks. Prepare for a wild ride.