Market Watch

A currency collapse occurs when the value of a nation’s money drops radically. It is a state of hyperinflation in which the price of goods and services increases quickly. People scramble to turn currency into hard assets such as land and buildings, gold and silver, and commodities that have “real” value other than paper value.

At times in American history when there were bank panics, people lost confidence in paper currency and rushed to banks to turn currency into “hard money.” Depositors could go to banks any time before 1932 and exchange dollars for gold and silver (“specie” in the Constitution). There was enough specie in our banks’ vaults that most government obligations could be redeemed in full until just 50 years ago.

Gold has been the backbone of monetary systems throughout written history. Our Constitution stipulates that all public debts be settled in gold. In 1949, 100% of U.S. monetary obligations were backed by gold and silver. Today, less than 3% of our obligations are backed by specie.

History of modern reserve currencies
Portugal held the world’s reserve currency from 1450 to 1530, followed by Spain until 1650; the Netherlands until 1720; France from 1720 to 1850; and Britain until 1920. The U.S. dollar is the world’s latest reserve currency. The above countries were able to have a reserve currency because they dominated ownership of specie, such as gold and silver. Remember the discovery of the New World and the great galleons that sailed the oceans during that age? It was gold and silver they sought, and they plundered the Mayan and the Aztec civilizations, thereby greatly enhancing the value of their own country’s currency.

The U.S. began accumulating gold in the middle of the 19th century, beginning with the gold rush to California. In the 1930s, we held more than 50% of the world’s monetary gold, coining the expression “the dollar is as good as gold.”

What causes a crash?
Inflation, bond market collapses, bank runs and currency collapses are all a result of one thing: excessive government debt. Politicians prefer to inflate away debt through a gradual collapse in our currency of 2% to 3% a year. They never plan for hyperinflation, in which prices increase daily. The result is a currency crash.

These economic displacements occur during such a crisis:

• Depositors try to extract large amounts of cash from the banking system because gold and silver are no longer available. Withdrawal of cash reduces bank assets by the amount of deposits withdrawn. Draining cash from banks increases the demand for cash. The actual cost of cash (interest rates) goes way up.

Interest on federal debt cannot be paid because no cash exists. New bonds cannot be issued unless the interest rate is substantially higher than before the crash. Increased interest rates drive up the government’s cost of servicing debt. Many investors want to dump government bonds, causing a rapid decline in bond prices.

• Mortgage and credit card rates soar, making it impossible to meet current obligations or move forward with projects such as housing. The government’s response has usually been to continue printing money, which exacerbates the problem. Over-expansion of the money supply is what caused the problem in the first place.

• The value of savings and government bond investments are decimated. Presently, there exists the slow destruction of the value of savings accounts through inflation the last 40 years (20 cents would buy in 1974 what it takes $1 to buy in 2014).

Is this likely to happen to our economy?
It’s unlikely; however, we should be aware of the enormous risk to which we are exposed. The risk is as great as any other time in modern economic history.

If we are as exposed as any other time in history, why isn’t a currency crash imminent?
Since 1500, the Dutch, Portuguese, Spanish, French, English and Americans have been at war with each other frequently. Their economies were not interdependent. Today’s world is dependent on the ability of Americans to purchase goods and services. Countries most dependent on U.S. consumption also own the largest amounts of U.S. government bonds. To avoid a currency crash, which results in a crash in the price of those bonds, no stops will be spared. With continued cooperative effort among our trading partners, the dollar is likely to remain propped up at least as much as it benefits dependent governments to do so.

Leading economists such as John Williams disagree. He believes a crash is imminent. There is nothing of value, such as gold, underlying support of the U.S. money supply. It’s built upon paper assets that are only IOUs.

The U.S. is China and Japan’s largest customer. How would a dollar crash affect them?
A drastic decrease in the value of the dollar would make goods produced in China and Japan too expensive for Americans to purchase. China and Japan would be hurting themselves by selling U.S. bonds rather than holding bonds in hopes that price levels remain such that Americans could continue to buy products. But that is all supposition and based upon the judgment of politicians. The reality is that it would be politically and economically unpalatable for them to do anything but support U. S. currency and bond markets. Further, should they decide to liquidate U. S. bond portfolios, to whom could they sell them? Who has the cash?

Conclusion
The old Wall Street adage of “the trend’s your friend” means we should be in this bull market with both feet. The judicious investor, however, should try to sit back and hedge his bets by positioning himself in only the highest grade of securities available.
Caveat Emptor.

George Rauch, Longboat Key, is chief executive officer of Bradenton-based General Propeller and a former Wall Street investment banker.