Dear Thoughtful Investor,
In my fifth letter, Good to Great(er) (fools), we discussed how the buy-and-hold real estate strategy protects against the erosion of purchasing power because real estate maintains a constant intrinsic value over time. For instance, the price of real estate goes up because of the value of the dollars used to buy the real estate goes down (more dollars to buy the same real estate).
But… 1) why does that erosion of purchasing power occur and 2) is this erosion in the form of ‘currency inflation’ a fundamental law of the universe?
In the broadest definition, HARD ASSETS are physical things that are obtained through work (i.e. extraction from the earth, assembling raw materials) or through purchasing of that physical thing from someone who did the work of extracting and/or assembling it. Primary hard assets include metals and raw land, secondary hard assets include timber, buildings, vehicles, equipment, textiles, plastics. The distinction between primary hard assets and secondary hard assets being that primary hard assets essentially do not decay, they can be used and molded and then reused and remolded over long periods of time without being ‘used up’. Consider how a piece of raw land can be farmed for a thousand years, then turned into condos, then the condos can be knocked down and it can be farmed for another thousand years. Compare this to a piece of wood or a vehicle, the piece of wood gets turned into a 2x4, it may last a long time and the 2x4 can be used for many things but over time it rots or breaks and cannot be used - vehicles are even less durable, but a piece of iron can be turned into a shovel for farming, then re-smelted into nails for building, then re-smelted into something else. The metal is not ‘used up’ (although iron will rust and in that sense it decays like a piece of wood or land can be permanently impaired by a nuclear fallout or toxic waste - more on these later).
In addition to hard assets, in our sophisticated financial world we have another (enormous) category of assets called FINANCIAL ASSETS. These are pieces of paper or digital 1s and 0s; financial assets are not physical and are HARDLY ASSETS when compared to HARD ASSETS. Stocks, bonds, mutual funds, ETFs, are all financial assets and they act like real assets as long as everything is functioning well - that is, governments enforce contracts (which is all financial assets ultimately are: legal contracts). Since hard assets can be re-molded and reused without losing value they can be said to maintain a constant value and therefore they have protection from inflation or a loss of purchasing power, they are pretty much always equally useful. Because financial assets are contracts, they are subject to the forces of government and regulation - they are only as valuable as the police force is willing and able to enforce them. In nations/regions/industries with weak contract enforcement corruption runs rampant. Just as contracts - and by extension financial assets - are subject to corruption in the lack of contract law enforcement, they are also highly subject to institutionalized corruption by those that enforce contract law (note the foreshadowing here).
The most important financial asset is cash. Cash is denominated by currency (that is, the unit of cash is dollars, euros, rand, et cetera, just as a unit of length is feet or meters). Cash is NOT money although the two are colloquially interchangeable. Cash is currency and currency is a contract. Consider what we call the ‘United States Dollar’. Printed on the Dollar are the words: Federal Reserve Note. It is a NOTE, a bank note, a LOAN issued by a private institution called the Federal Reserve.
Consider an example: let’s say its 1880 (prior to the Federal Reserve’s existence) and there are two banks: the Hypothetical Bank of Bend (BB) and the Hypothetical Deschutes River Bank (DRB). This is the wild west in the 1880’s so it isn’t safe to carry around lots of money. Two people each have one ounce of gold they extracted from the ground through mining. Person one deposits his ounce into BB and person two deposits his ounce into DRB. BB issues person one a “BB Note” worth $21 (the fixed price of gold in 1880) and DRB issues a DRB Note for $21 for person two. Both persons go out to buy some food and supplies. Person one goes to the general store to get 5 pounds of rice for $1. He gives the store owner $1 of his $21 of “BB Notes”, the store owner could say, “No, I want 1/21 of an ounce of gold for payment” but instead he thinks about the Bank of Bend and decides they are a trustworthy bank and he is likely to get money from them in exchange for the BB Notes and therefore he’ll accept the BB Notes.
The store owner has his money on deposit at DRB, the other bank. That afternoon he takes his $1 of BB Notes and deposits them at DRB (his bank). DRB also trusts BB so they accept the notes and credit the store owner’s account with an additional $1. Similarly person two goes and buys things at different stores his his DRB Notes which are deposited by various store owners at BB Bank. After a while, the Bank of Bend has $10 worth of Deschutes River Bank Notes and decides it wants to square up its bookkeeping with DRB and exchange its DRB Notes for real money. The Manager of BB meets with the Manager of DRB and finds out that DRB is holding $10 worth of BB notes. Wonderful - they decide since they each owe each other $10 that they will both just cancel the notes and they are square. The notes are cancelled and each bank still has the 1 ounce of gold that was deposited. In the Bank of Bend instead of person one having a $21 credit balance in their account, they have a $11 credit balance and the store owner that sold them the good has a $10 credit balance because $10 was spent.
You may notice that in this way “DRB Notes” and “BB Notes” work exactly like checks. The only difference between checks and bank notes is that checks are written for a specific dollar amount and from a specific person to a specific person. Bank Notes just carry a value (like cash!) and are denominated in (for instance) $1 increments - whoever holds the bank notes is entitled to that many dollars of the bank’s assets on deposit.
110 years ago, prior to the Federal Reserve Act of 1913, lots of banks issued their own notes that were traded like cash/checks. If a bank failed the bank notes went to zero value and that person lost all the purchasing power of that cash. Trust in the solvency of a bank was very important - your purchasing power depended on it - so when people lost trust in banks they all ran to take their money out or to turn their bank notes into a hard asset like gold. If the bank had in its vault an equal amount of gold for all the bank notes that were outstanding then there was not problem, it could give everyone their money back in hard assets. If the bank had practiced ‘fractional reserve banking’ - that is, created more dollars worth of bank notes than it actually held in hard assets because it was betting that not everyone would want to take their money out at once, if they did the bank would be in trouble and depositors and bank note holders would lose their money - a run on the bank that would make the bank fail. The functioning of the system was based on confidence that banks could make good on their bank notes.
In 1913 a Bank Note Monopoly was granted to one bank: The Federal Reserve. By law, and enforced by police force, the Fed would have exclusive right granted by the US Treasury department to issue dollars in the form of Federal Reserve Notes. The Fed became a ‘money cartel’ in the sense that just like a drug cartel seeks to be the exclusive supplier of drugs in a certain territory, the Fed would have exclusive rights to supply dollars in the United States. This makes Federal Reserve Notes “fiat” currency because it is decreed as money by government fiat and enforced by police force; but it is not ACTUAL MONEY - it is not a HARD ASSET that stores value, it is an asset declared by law to be value which makes it HARDLY AN ASSET. These Federal Reserve Notes are a contract with the words written “This note is legal tender for all debts public and private”. This legal tender clause means the proverbial store owner is no longer assessing the solvency of the issuing bank - the solvency of the Federal Reserve bank is guaranteed by it’s monopoly on supplying money and it’s discretion to supply as much or as little money as it wants.
This brings us all the way back to purchasing power. If dollars in the form of Federal Reserve Notes were of a fixed supply then prices would be stable… but the supply of money is not stable, it changes constantly and therefore prices of hard assets change. The hard assets are not changing in intrinsic value, the hard assets are stable but the number of dollars that can be exchanged for those hard assets changes all the time as the number of total dollars in the system changes all the time.
The Thoughtful Investor that is interested in maintaining the purchasing power of his wealth would be wise to not rely on ‘cash’ or ‘Federal Reserve Notes’ to preserve his wealth over time but should consider his investment in hard assets: real estate, precious metals, raw materials as his long-term stable store of value. This answers our two questions:
1) Erosion of purchasing power occurs from changes in the supply of currency
2)Currency inflation is NOT a natural law of money. It is the result of a currency cartel with a monopoly on providing currency the seeks to supply as much of its product (dollars) to the market without supplying so much that it collapses. Just as a drug cartel seeks to supply as much of its product to the market without supplying so much that it kills all it’s customers via overdose and collapses it’s own market.
A Thoughtful Investor