Recently, representatives of China and Brazil have suggested that either the Renimbi, the Brazilian Real, or some new currency backed by the IMF be used to substitute the dollar.

US Treasury Secretary Tim Geithner said that this was an idea meriting consideration (but later recanted).

Columbia University economist Jeffrey D. Sachs wrote in the June 2009 “Scientific American” that the Chinese proposal had “much to commend it” and that “Geithner’s first reaction was right”.

Does this mean that the dollar’s role as the global reserve currency is doomed? Can the economists, central bankers, and IMF band together and decree some alternative “world currency”?

Probably not. Here is why.

What importers and exporters want

The main purpose of a global reserve currency is to serve as the means of payment in international trade. The key decisions regarding international trade are not made by central bankers, the IMF, or economists.

The real decision makers are importers and exporters.

Foreign trade is a two-way street: goods flow one way; money flows in the opposite direction.

Both importers and exporters must agree on the goods to be exported and the kind of money to be paid in exchange.

Furthermore, the importer must actually have available the kind of money that the exporter wants in exchange for his goods — this is a key point.

How many importers in the United States or Europe are holding fat balances of Chinese Renimbi or Brazilian Reais in their bank accounts? Not many. Fewer still have balances worth mentioning in Mongolian Togrog or Algerian Dinar.

If it were possible to change the means of international payment by decree to a currency (or basket of currencies) other than the dollar, the immediate result would be a sharp decline in world trade — a depressive effect similar to the tariff wars of the 1930s — simply because not enough importers hold enough of these alternative currencies to sustain world trade.

Governments would fall. It just ain’t goin’ happen!

The shortage of non-dollars

Now I know that some people think that if you need to get some Chinese Renimbi or Brazilian Reais you just go down to the local bank and buy some.

The only unlimited suppliers of Renimbi or Reais are the central banks of China and Brazil. Otherwise, you have to buy these currencies from off-shore residents that have accumulated them as a result of international trade, investment, or tourism.

The problem is that both China and Brazil — and almost every other country in the world except the United States — have a tacit or explicit policy to encourage exports and discourage imports (neo-mercantilism).

Brazil, for example, has an implicit tariff of about 100% on imports.

This means that, other than dollars, most currencies held in foreign hands are in relative short supply.

For the Brazilian Real to become a world trading currency, the government of Brazil would have to remove economic protection from local industries — so that foreign goods would become competitive on the local market.

At the same time, the Brazilian government would have to somehow find a way to convince foreign suppliers to receive payment in Brazilian currency. (if you know how this could be done, please leave a comment on this article.)

The Anti-Gresham’s Law of global currency

Sir Thomas Gresham stated in the time of Tudor England that “Bad money drives out the good”. But this is only true if both currencies are required to be accepted as legal tender at a fixed ratio.

There is no “legal tender” in international trade that binds exporters to accept a certain currency that importers may offer in payment.

Instead, there is a free market in which exporters prefer to be paid in what they perceive as the “best” currency, not the weakest.

Electing the “best” currency

Exporters elect the “best” currency based on their own practical experience, observance of the market, and commonsense:

• In how many other countries will exporters accept a certain currency?
• How safe are bank deposits in the country that issues this currency?

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• How well do the laws of the country that issues this currency protect the property rights of foreigners?
• For how many decades has this currency been widely accepted in international commerce?
• Over the last few decades, how well has the central bank of the issuing country protected the value of this currency, compared to other currencies?
• If the exporter (due to problems in his own country) were to move to the country of the other currency, how well would he be received? Would he and his family be comfortable living there? How well does the issuing country receive foreigners?
• How stable is the political and economic system of the issuing country relative to alternatives?

Try to answer each of these question, not in absolute terms, but in terms relative to other currencies — remembering that the currency selected must be issued by a country that is large enough to run a substantial trade deficit to supply enough currency to be relevant in the world economy — without putting the issuing country at risk.

So far, there are only two issuers of currency that even come close to meeting these requirements, the United States and Euroland — and Euroland doesn’t want to run a trade deficit.

How about the International Monetary Fund?

So far, there have been no serious suggestions that the IMF issue legal tender meant to be accepted by exporters throughout the world and that would be widely available in bank checking accounts or by credit card.

Instead, we have various suggestions that only are relevant to dealings between central banks.

An importer can’t pay an exporters in a check issued in SDRs, nor can the exporter uses this “currency” to pay for a trip to Disneyland.

Professor Jeffrey Sachs (in the above-mentioned article) seemed to like the Chinese proposal for “a more symetrical monetary system, in which nations peg their currencies to a representative basket of others rather than the dollar alone”.

However, this would require abandoning the free market, ignoring the “votes” of real-world importers and exporters, and surrendering national sovereignty to a small international body of over-paid, non-elected economists.

Not very likely to happen any time soon.

Too soon to give up on the dollar

The Crash of 2008 was undoubtedly a world-changing event that severely shook the position of the US dollar.

It also brought about the inauguration of one of the least inspiring (in economic terms) governments since Jimmy Carter.

With wild, irrational spending by the Pelosi-Reid Congress combined with quasi-nationalization of the US auto industry and proposals for massive tax increases to fund medical nirvana and a mystical green, “carbon-free” environment — it is not surprising that the Chinese, Brazilians, and other holders of dollar reserves are nervous — but so are a large and growing segment of the US population.

Moreover, US history suggests that the road forward may not be as dismal as it now seems.

1. The US holds Congressional elections every two years, and Presidential elections every four years. President Obama is spending his political capital almost as fast as he is spending taxpayer money. Opposition is growing faster than one would have expected. The genius of American Democracy is the ability to “turn the rascals out”. It seems likely that the Obama administration will become weaker with each passing day.
2. The US financial system will probably emerge from the debacle stronger than ever. Capitalism is all about “creative destruction” and the process is already well underway. Things will be different, but not necessarily worse.

Already there are signs that Americans are saving more, credit card use is being cut, lending to the non-credit-worthy is no longer in fashion, leverage is being reduced, stock buybacks are ending … the system is healing itself.

New leaders will come forward.

We’ll see.

The storm flags are now flying, warning of inflation that is likely to be the natural outcome of the Obama administration’s “spending is stimulus” programs.

Fed Chairman Bernanke, so far, has not presented a convincing plan on how the country will be able to pay for the multi-trillion dollar spending orgy that President Obama has ordered.

Now the question is how can investors protect financial assets from inflation? Gold? Real estate? Equities? Commodities?

For young people, with twenty or thirty years before they retire, there is time to recover from a bad decision. However for those entering into retirement, or already there, there is little or no room for error.

In this article I examine the inflation-resistant features of equities, specifically index funds. I’ve chosen index funds because this vehicle is now very popular with those seeking to reduce risk by diversification and low management fees.

Stock index funds also can represent equities as a generic investment, rather than results from a particularly good or bad individual stock selection.

Stocks in an inflationary environment: Brazil 1968-2004

The following graph shows the evolution of Brazilian stock prices over a 36 year period that takes in the “Brazilian Miracle”, the election of leftist governments in the early 1980s, the hyper-inflation of the late 1980s and early 1990s, and the return of centrist governments and economic recovery in the late 1990s and early 21st century.

The red and gray lines represent the stock price indices on the São Paulo (red) and Rio de Janeiro (gray) stock exchanges, deflated by the local cost of living index.

The green line represents the São Paulo stock index converted into US dollars.

Throughout this period, there were many well-established and highly successful companies traded on the Brazilian markets, representing a widely diversified selection of industries with worldwide clients, such as the Gerdau steel group and Vale do Rio Doce.

Throughout most of this period, inflation ran about 20-25% a year, except in the early 1990s, when there was hyperinflation of over 1000% a year.

The period encompassed governments on the right, center, and left, varying from good to terrible.

John Pierpont Morgan was right

Over 100 years ago, when J.P. Morgan was asked what stocks would do tomorrow, he replied, “They will fluctuate”. And this was at a time when the US dollar was convertible into gold.

The graph of Brazilian stocks against inflation illustrates the truth of Morgan’s statement in an extreme inflationary environment.

Inflation confounds estimates of intrinsic value of securities because of increased uncertainty about future interest rates and because accounting standards are not designed to adjust financial statements for the effects of inflation.

Therefore, in an inflationary environment, market volatility increases.

On the Brazilian stock index graph, we see that in this 36 year period, stock prices rose ten-fold and dropped 90%, twice — extreme volatility to match extreme inflation.

Furthermore, the graph shows that in US dollar terms, Brazilian stocks offered no protection at all against inflation.

This, in part, reflects government distortion of the consumer price index (all governments, including the US government, do this, especially in an inflationary environment).

In part, the weakness against the dollar reflects capital flight away from a weak currency to a stronger currency.

There is no “good government” with inflation

The Brazilian stock index graph shows two and one-half major cycles.

The first cycle, from 1968 to 1980 was during the period of the Brazilian Economic Miracle, with fast growth of GNP, rapid industrialization, and relatively high employment and good times.

However, at the beginning of the period, the government had a policy of encouraging public investment in shares, which was not calibrated with the supply of shares, resulting in the Boom of 1971, vastly over-priced equities, followed by a collapse in values over nine years.

The second cycle, from 1981 to 1990, was characterized by the end of the Brazilian Miracle and the advent of leftist governments, wild spending, and lack of fiscal discipline, typified by Guanabara Governor Leonel Brizola — similar in fiscal policies to the current Obama administration.

At first, because stock prices rose sharply, in part because prices had fallen to low levels from the peak in 1971 and partly because of the stimulus effect of undisciplined spending that generated optimism.

However, over-spending (even in an environment of endemic inflation), finally led to hyper-inflation of over 1000% by the end of the decade.

This led to a change in government and move back from the left to the center, with recovery in stock prices by the new century.

Lessons from history

The behavior of the Brazilian stock market in an inflationary environment from 1968 to 2004 suggests the following:

• Inflation increases stock price volatility.
• An equity market with an inflationary currency will under-perform a market with a less inflationary currency.
• A stock index fund does not insulate investors from the effects of inflation.

This suggests that American retirees who are relying upon the Common Stock Legend and index funds to survive the inflation which seems to be coming, will not be protected.

If you must invest in a stock index fund, it would seem prudent to at least chose a fund relative to a stock market in a country that has less chance of inflation than the United States.

Massive government spending appropriations with looming multi-trillion dollar fiscal deficits, combined with the Federal Reserve Bank’s determination to blow up the money supply by issuing a trillion dollars in the repurchase of government bonds and mortgages, presents a somber picture for those hoping for signs of economic prudence.

There are indications that the Obama administration is becoming much less popular — not entirely, not yet, but alarmingly so for a President who should be in his “honeymoon” phase. This casts doubt on the President’s ability to follow through for long on his New Deal policies of populist spending and taxes on capitalists and entrepreneurs — policies which, as with FDR in the Great Depression, are likely to be deflationary.

A poll in March 2009 indicated that for the first time in years, the majority of Americans said they would vote for a Republican for Congress. Congress has turned into a populist mob, fearing the elections of 2010, forgetting the spirit of the Constitution and voting what was almost a Bill of Attainder to mask their complicity in the AIG bonus scandal.

Time magazine, for the first time, put out an issue distinctly critical of President Obama’s competence.

More and more Americans are having “buyers remorse”, now realizing that the charismatic figure they had put in the White House has no executive experience. It seems increasingly unlikely that Obama will to be able to charm the masses for much longer — there are too many educated people in the country and almost half the population voted against him just last November.

The President seems anxious to get far away from the toils of executive duty and decision making, preferring what he knows best — inciting chanting crowds in carefully chosen “town hall” settings and appearing on late night comedy shows.

Meanwhile, President Obama, having joined the outcry in calling for action against “Wall Street Greed”, has compared his Secretary of Treasury to Alexander Hamilton — perhaps confident that many of those who voted for him don’t know anything about Alexander Hamilton, much less Secretary Geithner (whose betting odds of staying in office are rapidly deteriorating).

So, as Obama’s popularity wanes, so does the outlook for his deflationary measures over the longer term, leaving the country exposed to the now seemingly inevitable inflationary results of extraordinary wasteful government spending and a trillion dollar pumping up of the money supply.

Time to buy real estate and get a mortgage

The worse effects of inflation fall on those who don’t understand how it works or on those who, even if they see what is coming, can’t get out of the way.

In the long span of history, the Brazilians have lived through inflation for many, many years — usually never less than 20%, including the fifteen years of the “Brazilian Miracle” — an outstanding period of rapid industrialization and economic good times. The Brazilians survived inflation of 1000% during the populist governments of the 1980s and 1990s. The lesson is that people can put up with a lot, if they know what to expect and have time to be prepared.

Prolonged, high rates of inflation usually produce predictable effects:

• long-term life insurance becomes worthless.
• long-term bonds, without the protection of monetary correction or a link to gold, disappear from circulation.
• fixed annuities or pension plans fail to provide economic support for the elderly
• debtors gain a huge windfall by being able to pay off debts in devalued currency
• the price of real estate (like everything else) goes up
• wage earners whose salaries are not adjusted frequently, suffer a decline in living standards
• the self-employed (who are able to raise prices daily and who factor inflation into their business plans) can do well
• short-term interest rates rise to match or exceed inflation, so that creditors who roll over short-term obligations can survive.
• governments that depend upon current sales taxes, rather than backward-looking real estate and income taxes, can survive, while government employees without monthly salary adjustments, have a hard time.
• governments lie more the usual about the rate of inflation and cost of living.
• price-earning ratios, reflecting high short-term interest rates, fall sharply. However, stocks, once adjusted downwards for inflation, and once business learns to live with the new reality, can be a reasonable investment, although not a safe as real estate.

Most Americans today work for a salary or fixed wage or depend upon social security that is adjusted for inflation only yearly. American society is not set up to withstand inflation at rates of 20% a year or more. Brazilians during the decades of high inflation, were able to get by because defenses against inflation had been built into the system, based on long experience.

The first casualty of high inflation in the United States will be the political party and the politicians who are in office at the time. This looks like it will be the Democrats. This is what brought down Jimmy Carter.

Inflationary economies still have business cycles

The business cycle doesn’t go away with inflation. Sales and production still rise and fall. There are good years and bad years. Monetary values are just adjusted daily and, if this goes on long enough, people get used to it.

The main reason that inflation is difficult to stop once it gets started is that it is based upon government spending that is endemic — baked into the political cake. There are just too many government employees, too many entitlements, too many special programs and no politician has the guts or ability to do anything about it. It is easier to adjust to inflation, that to stop it.

I lived in Brazil during the sixties and seventies, years of high inflation, never less than 20%. I was able to successfully run various businesses and raise a family, without ever feeling that inflation was really that much of a problem. Certain things didn’t exist, like life insurance, but you adjusted to it and soon forget about it. Almost everyone had government employees in their family. Some of my staff also had government “jobs” on the side, alhough they never had to show up other than to collect a paycheck.

The Obama administration is laying the groundwork for a rate of inflation that the American public is not prepared to accept. Some future administration will have to clean up the mess.

Meanwhile, if you can get a thirty-year fixed mortgage at 4.5%, even if your home is “under water” today, the odds seem very favorable that, in the long run, you’ll be a winner.

If inflation is indeed coming, its time to be prepared. Run your own business, hold real estate, borrow long-term at low fixed rates of interest in amounts you can afford to pay. Once inflation hits, sources of attractive long term loans will dry up.