Rising asset prices

Dr Marc Faber - Thu 21 Jul, 2005

...People are not concerned about paper money losing its purchasing power as a result of consumer prices rising, but as a result of paper money losing its value because of rising asset prices...

"Everything in the world may be endured except continued prosperity."
- Goethe

In the late 1970s, investors became increasingly concerned about accelerating consumer price inflation. Since consumer prices were rising at more than 10% per annum, the prevailing view was that cash was depreciating by approximately 10% per annum.

People rushed into precious metals and drove the price of gold and silver to $850 and $50 respectively in January 1980. At the same time, investors were dumping bonds, which became known as "certificates of confiscation". US long-term government bond yields soared to more than 15% in September 1981. I would argue that there was at the time a real panic about the role of paper money as a store of value.

Today, we have a similar situation. However, people are not concerned about paper money losing its purchasing power as a result of consumer prices rising, but as a result of paper money losing its value because of rising asset prices.

Rising asset prices: Real estate

If real estate prices rise for an extended period of time at a faster rate than incomes and interest rates on cash deposits, it is only natural that people become concerned that they won't be able to afford to purchase their own home in future. Their concern about future affordability, which is nothing else than the fear of their income and savings losing their purchasing power, then induces them to purchase their homes now rather than later.

This incremental demand drives prices even higher and attracts speculators who want to capitalise on the rise in prices, which is driven first by the genuine buyers and later by themselves as well.

As a result, prices then overshoot and lead to even deeper apprehension about the loss of purchasing power of paper money on the side of the household sector. A general rush from liquid assets to "illiquid assets" inevitably follows and creates a bubble.

Rising asset prices: John Law

This is nothing new. The first well-documented instance of such a loss in the purchasing power of paper money was John Law's Mississippi Scheme. In 1716, John Law had opened, under the patronage of the French regent, a bank (Banque Generale), which issued paper money backed by gold. With the help of the regent, the bank became an immediate success. Its banknotes were very convenient, since the government accepted them for tax payments.

Based on this first success, in 1717 Law managed to convince the regent to grant his new venture, the Mississippi Company, a monopoly on all commerce between France and its French territories in North America, which included the present states of Louisiana, Mississippi, Arkansas, Missouri, Illinois, Iowa, Wisconsin and Minnesota, in return for accepting outstanding notes of the French government in payment for the Mississippi shares.

This arrangement basically amounted to nothing other than a partial conversion of France's government debt into shares of the Mississippi Company.

The operations of the company didn't prove to be profitable, partly because when it issued shares it hadn't received cash, but debts of the French government, which had been converted into shares of the Mississippi Company, and partly because very few French wanted to emigrate to the territories in America.

Still, the shares of the Mississippi Company performed well after the regent took over Law's bank and began to run its money printing press around the clock. (Presumably, Law gave him the bank in exchange for having obtained so many privileges.)

But, whereas John Law had always maintained a small balance of gold reserves to back up the paper money the bank issued, he now advised the regent that the public had gained sufficient confidence in paper money and, therefore, gold reserves in the bank's vault were no longer necessary.

As a result, in 1719, the government increased the money supply dramatically and lowered interest rates by lending money for as little as 1-2%. The vast increase in the supply of paper money, combined with the ability to purchase shares in the Mississippi Company on margin, led not only to the shares rocketing towards the end of 1719 to over 20,000 livres (from 300 at the beginning of the year), but also to rapid price increases across France.

Rising asset prices: Inflation

The cost of bread, milk, and meat had risen six-fold, while cloth was up by 300%. The horrendous inflation made the holders of Mississippi Company shares and of paper money nervous.

In January 1720, just two weeks after John Law had been appointed as comptroller general of finance (minister of finance), a number of large speculators decided to cash out and switch their funds into "real assets" such as property, commodities, and gold. This drove down the price of the Mississippi Company shares since the speculators could only pay for real assets with banknotes.

As confidence in paper money was waning, the price of land and gold soared. This forced Law, who still enjoyed the backing of the regent, to take extraordinary measures. He prevented people from turning back to gold by proclaiming that henceforth only banknotes were legal tender. By then the Banque Generale had practically no gold left.

Thus, payments in gold and silver above 100 francs were prohibited; in addition, the ownership of gold exceeding 500 livres in value was declared illegal. Severe penalties were imposed on people who hoarded gold. To enforce this most blatant expropriation, Law encouraged the public to turn informer by handing out large rewards to those who assisted in the discovery of gold, which was then confiscated.

At the same time, he stabilised the price of the shares of the Mississippi Company by merging the Bank Generale and the Mississippi Company, and by fixing the price of the Mississippi stock at 9,000 livres. With this measure, Law hoped that speculators would hold on to their shares and that in future the development of the American continent would prove to be so profitable as to make a large profit for the company's shareholders.

However, by then, the speculators had completely lost faith in the company's shares and selling pressure continued. In fact, instead of putting a stop to the selling, the fixed price acted as an inducement to sell, which led the bank once again to increase the money supply by an enormous quantity.

Rising asset prices: 'Sharply escalation prices'

The result was another round of sharply escalating prices. In four years, the supply of circulating medium had been trebled. John Law suddenly realised that his main problem was no longer his battle against gold, which he had sought to debase, but inflation. He issued an edict by which banknotes and the shares of the Mississippi Company stock would gradually be devalued by 50%.

The public reacted to this edict with fury, and shortly after Law was asked to leave the country. In the meantime, gold was again accepted as the basis of the currency, and individuals could own as much of it as they desired.

Alas, as a contemporary of Law's noted, the permission came at a time when no one had any gold left. The Mississippi Scheme, which took place at about the same time as the South Sea Bubble, led to a wave of speculation in the period from 1717 to 1720 and spread across the entire European continent. When both bubbles burst, the subsequent economic crisis was international in scope.

Today, I am a firm believer that Mr Greenspan, Mr Bernanke, and their colleagues in other central banks around the world are modern-day John Laws. They, like him, will not only manipulate and intervene in markets but, over time, will also totally destroy the value of paper money. In fact, I believe that, given the very high levels of debt we have in the US and other industrialised countries compared to the size of their economies, the central banks have no other option now but to print an ever-increasing quantity of money.

Whereas John Law tried to fix the price of the Mississippi Company by printing money, the Fed chairman has tried - and managed, at least so far - to inflate asset prices through an extraordinary money and credit expansion. But in the same way that asset price inflation replaced consumer price inflation in the early 1980s - unexpectedly, I might add - in the near future CPI inflation and rising commodity prices could begin to exceed asset inflation rates, and in particular home price inflation.

This would likely depress long-term bond prices and lead to a very unappealing global economic and financial environment. It would eventually discredit central bankers and bring about the end of central banking as we know it today.


Regards,

Marc Faber
for The Daily Reckoning

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