The end of money?

It is a commonplace among hard money advocates that the U. S. dollar and all other fiat currencies are doomed to become worthless. History seems to be on their side. There is a long list of currencies based on nothing other than the say-so of a government that have indeed become worthless or near worthless. Perhaps the most often cited example is that of the mark during the great German hyperinflation. From the beginning of 1922 until the currency was replaced in November 1923 inflation was nearly 2 trillion percent.

Many Latin American currencies suffered similar fates during the latter half of 20th century. Bolivia's inflation rate peaked at 11,750 percent in 1985. Peru's topped out in 1990 at almost 7,500 percent. Brazil's hyperinflation reached nearly 3,000 percent in the same year.

Today's poster child for hyperinflation is Zimbabwe where the inflation rate is a moving target last calculated by independent analysts to be running at 1 million percent annually. Oddly, Zimbabwe's stock market was the best performing stock market in the world in 2007 on a percentage basis. And, therein lies an important story, one that tells us what people do when they begin to lose faith in the currency of their country.

In this case, one of the few options beyond bank deposits available to Zimbabweans with savings is the stock market. Controls on exchanging the local currency for foreign currency have made it exceedingly difficult for most people to move much of their savings or current paychecks into more stable currencies. With the stock market practically the only outlet for those with savings, Zimbabweans pushed up stocks by more than 300,000 percent in 2007, handily beating inflation of 24,000 percent. The point is that it didn't pay to keep cash in the bank or anywhere else for that matter. The stock market at least offered the opportunity to invest in businesses with tangible assets that appreciate with inflation.

On the North American continent another currency is thought by some to be threatened by a similar kind of spiral. The woes of the U. S. dollar are well-known: persistent high trade deficits, high government deficits, and expansive monetary policy amidst a crash in housing prices. Add to this the possibility of a derivatives-driven financial crisis that might engulf the entire world economy. One economist believes the situation is so bad that a hyperinflation could visit the United States as early as 2010.

The first signs of worry at the political level have come in an indirect way. Congressional leaders have been pointing the finger at speculators for rising commodity prices, especially oil. Sen. Joe Lieberman has proposed legislation that would limit what large institutional investors can put into the commodities markets.

Before we go any further, it is worth examining why those investors are moving so heavily into the commodities markets. First, there is the ongoing robust demand for commodities of all types, but especially metals, grain and oil and the apparent strain on supply. Fundamental factors are driving up prices, and rising prices attract speculation. Second, there is the pleasant fact that there is no president of copper or wheat or pork bellies. This stands in stark contrast to publicly traded companies whose top managers have all too often in recent years deceived and defrauded their investors. Those holding commodity investments are in most cases only taking the risk that the price of those commodities will go down (or up, if they invest on the short side). Outright fraud in the heavily regulated commodities futures markets is exceedingly rare and difficult to bring off. Third--and this is the most salient point for this discussion--most commodities are denominated in U. S. dollars. When the dollar declines in value against other currencies, commodities generally move up.

At the margin, institutional investors are voting with their money against the U. S. dollar and perhaps against currencies in general. Here it is worth noting the presumed purposes of a currency. First, as everyone knows, currency is a medium of exchange. It's easier and more convenient to use currency for exchange purposes than to try to barter for everything. Second, currency often serves as a store of value. While we wait to decide what to buy with our money, we usually put it in the bank where it earns interest. Sometimes we put it in for a long time in the form of a retirement account or a college savings plan. It is this second function of currency which is being called into question, not just in the United States, but worldwide, for the so-called speculation in commodities is now a worldwide phenomenon.

Governments naturally fear any loss of faith in their currencies. But rather than address the reasons behind that loss of faith, they typically focus on making it more difficult to move money out of one's home currency. That's because it is the easier of the two tasks. Hence, Mr. Lieberman's proposal. The proposal would make it more difficult for large institutional investors to move out of their home currency, in this case, the U. S. dollar, and into commodities.

While the U. S. imposes few restrictions now on the movement of money in and out of the country, the restrictions that are in place are usually defended as necessary for tracing money related to illegal drug and money laundering schemes or to terrorism. That's how Canadian officials are portraying their investigation into websites that allow individuals and companies to turn cash into "electronic" gold that can be used to pay those accepting payments in gold. There are legitimate reasons why governments want to know who transfers money where. But it seems all too likely that those legitimate reasons will be used as cover to extend restrictions on financial transfers out of one's home currency as more and more people attempt to protect their savings.

All of this would be of little import were the world about to return to an environment of low commodity prices, fiscal probity by governments and households, and noninflationary economic growth. Under such circumstances people would have little reason to flee their own currencies. But the trajectory of the world seems decidedly in the opposite direction. And, the focus on oil as a store of value by investment managers may only be the beginning.

The tremendous demand for basic materials needed by growing Asian countries continues to levitate prices of metals such as copper and zinc; foodstuffs such as soybeans and corn; and oil, of course. Oil prices may subside from their recent highs, but it seems unlikely that they will fall to levels even remotely close to those experienced at the beginning of this decade. Moreover, governments and their central banks seem determined to keep their economies growing with expansionist monetary and fiscal policies. More debt-funded spending and more money printing are the order of the day.

What frightens policymakers more than institutional investment managers moving money into commodities is the possibility that average citizens may attempt to flee their own currency. The avenues open to them, however, are considerably more narrow. Certainly, those who have brokerage accounts can call their brokers and ask that their money be shifted into commodity investments. But that is a small subset of the world. The rest of the population is left with turning their ready cash or small savings accounts into real things: jewelry, coins, precious metals, even sides of beef for storage in the deep freezer. But this part of the population usually doesn't realize what is happening to them until the cost-of-living has been rising for some time, and so they are the most vulnerable segment of society. When they do realize what is happening, their collective rush to the exits is so large that it can create a very high rate of inflation and even hyperinflation as real things are bid up and money is spent as quickly as it is earned.

By themselves high prices for energy, food and other essentials do not wreck a currency. But they do lower the standard of living for everyone except those whose incomes are directly tied to profits in the relevant sectors of the economy. What could wreck the world's currencies is a desire to offset the effects of the ever-tightening noose of resource scarcity caused by the approach of peak oil, the march of climate change, and the rapid industrialization of the Far East. The desire to offset these effects is already expressing itself through easy money policies and the financing of government expenditures through borrowing rather than taxation. As scarcities build, the temptation will be ever greater for governments to go down the path of high inflation. None of them will intend, of course, to cause hyperinflation. But it will be an ever-present danger.

Some say that if the U. S. dollar crashes and brings with it a hyperinflation, this will be the end of money as we know it. A few predict that the phenomenon will eventually be worldwide and result from the economic effects of peak oil and climate change. Even if these scenarios do occur, I doubt that it will be the end of money as we know it. The convenience of electronic payments and paper money are too great for people to give up. Even the poor Germans of the 1920s didn't want to give up that convenience. When the German government announced the introduction of a new currency to replace the worthless mark, people accepted it and used it right away.

Perhaps what will be different this time is that while most people will want the convenience that paper money and electronic payments provide, fewer of them will trust money as a store of value. What that means for individual commodities is anybody's guess. But, unless 1) we are miraculously delivered into a time of plenty by huge, unexpected discoveries of the basic building blocks of civilization or 2) people suddenly en masse embrace an abstemious lifestyle (or are forced to embrace it by a depression), it seems possible that one time-honored role of money, that is, as a store of value, will disappear for an extended period as the world comes to grips with resource limits that are only now beginning to convulse our societies.