My Two Cents - "Fiats, the funny, and Real Money"

1/26/2007

A long time ago a wise man said that every dark cloud has a silver lining. For a variety of reasons, many people consider globalization and economic diversity to be the dark clouds in today's economic skies. For a pleasant change I am going to take a look at the silver lining. I am constantly getting emails and talking to folks who say 'Ok, I get what you're saying - now what can I DO about it?'

If you talk to a typical Wall Street broker and ask what their definition of diversity is, they will usually tell you that it means spreading your assets out among multiple types of investments. Some stocks, some bonds maybe, perhaps mutual funds, ETFs or even commodities. That is diversity. There is one chink in their armor though. These investments all have one rather large attribute in common: they are all denominated in US dollars. People generally don't think too much about their currency beyond how much of it they will need to make this month's bills and perhaps the new designs on George Washington's face. I ask people what they would say if the value of their currency was cut in half. They usually say 'That could never happen; the government would close the stock market.' Answer: It has already happened several times over. In fact, since the Fed was created in 1913, the dollar has lost nearly 95% of its value! Again, what to do?

To diversify, one must truly spread their assets out among as many investment vehicles as possible. For Americans, this means buying securities in foreign countries where the security is denominated not in US dollars, but in the local currency. One must also be willing to make purchases of REAL money as well meaning gold and silver. We'll get to that later.

Back in November, right before Thanksgiving, the dollar precipitously dropped very near a long-term support level. For a few days, the mainstream media actually paid attention. The primary beneficiaries of this sudden drop were the Euro and the British Pound. Purchasing power in those currencies increased commensurately with the dollar's decline. Any monies held in British pounds or Euros before the dollar's drop and summarily traded in afterwards would have preserved purchasing power.

Let me illustrate. Suppose I were to have a lump sum of $100,000. I stuff it under my mattress and wait. Let's assume that in 20 years, the dollar has 'lost' 50% of its value. My $100,000 is still under my mattress, but now only buys $50,000 worth of goods and services. In other words, its purchasing power has been diminished by 50%. Suppose on the other hand that I invested my $100,000 in a basket of foreign currencies and the dollar lost 50% against those currencies. By definition, the dollar's loss is the basket's gain. So the value of my basket of currencies would have increased by 100% (a doubling). When I converted my money back to dollars, I would get back $200,000. So I'd have twice as many dollars that would buy half as much. Meaning that my purchasing power would be unaffected. The British Pound - US Dollar exchange rate is a good example of this.

That said, investing in foreign currencies provides currency protection in the event of a dollar crash, or has been the case, a slow burn. A popular way of buying foreign stocks is by using ADR's (American Depository Receipts) that are traded on US exchanges. While this method buys you common stock in a foreign company, there are a couple of flaws in this methodology:

1) ADR's are denominated in US Dollars so there is no currency protection.
2) ADR's are often traded in wide spreads and this can result in the investor paying too much for the security.
3) Dividend streams thrown off are also denominated in US Dollars not the local currency.

Mutual funds that specialize in foreign companies tend to hedge away the currency differentials so generally speaking you aren't gaining currency diversification by owning them. If you own Emerging Market or other mutual funds that specialize in holding foreign companies, check with your broker or read the fund's Prospectus to find out how the fund is managed.

There are a couple of firms that deal specifically in buying securities on foreign exchanges. If anyone wants to know whom I recommend, drop me an email.

That said, all the major currencies at this point are fiat (not backed by REAL money or a tangible commodity to any real extent). History will teach us an important lesson about fiat currencies. They often come into existence much like bastard children; half improvised and half compromised. They often go out of this world in even worse shape than they entered. The ultimate protection of purchasing power is achieved by using currencies to buy real money. REAL money? Gold, silver, oil, base metals; anything that has REAL value. Gold and silver are the most notable forms of REAL money. History will teach us another lesson about real money if we allow it. Gold and silver have outlasted every single fiat currency ever created and will continue to do so. For this reason, gold is NOT an investment; rather gold is cash. Gold is real money. Currency is not money. I'll credit Irwin Schiff with inventing my favorite reference to currency: un-money. Too many people look at gold as an investment and therefore miss the whole point of why to own it in the first place. Market manipulations aside (and yes folks, they do occur), gold is a proxy for inflation. At the end of the day, the paper currencies will fade away and all that will be left is real money. Go get yourself some of it.

The Author holds an MBA in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics.

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