Cash is Trash

By Howard Katz    Mar 30 2009 10:43AM www.thegoldbug.net

You have probably been taught that the responsible way to handle your economic affairs was to work hard, be thrifty and invest safely. This is what the old timers did, and it worked for them. When they reached 65, they were able to retire

However, the old timers lived in a country on the gold standard. They went to work at age 16, saved 15% of their income each year and put it in the local savings bank at 5% interest per year.  Let us do a little 8th grade math.

Assume an average wage of 30 oz. of gold per year. Saving 15% of that means saving 4½ oz. per year.  At the end of a 49-year working lifetime, you have saved 220½ oz. of gold.

Now listen closely because what happens next is so astonishing that it was called a miracle: the miracle of compound interest. When you lend money at interest, in the first year you get the agreed upon rate. If you lend $100 at 5%, you get $5.00.  It is in the second year, that the miracle starts. In the second year, you don’t merely get another $5.00.  In the second year, you are not lending $100; rather you are lending $105, and at 5% this produces an interest of $5.25.; so at the end of the 2nd year you have $110.25.  This is interesting.  Not only is your capital growing; it is growing at an increasing rate.

Now to calculate what 5% interest does to your capital over a 49-year working life span is a long, difficult problem in 8th grade math. But I was a bad boy one day and had to stay after school, and so I calculated what 5% interest does to capital over a 49-year period. The answer, to cut to the point, is that it multiplies it by 4.25.  So, the man who saves 220½ oz. of gold will, after 49 years at interest at 5%, have 220.5 x 4.25 = 937 oz. of gold.  That is, you saved 220½, but you have 937. This so impressed the people of the 19th century that they called it the miracle of compound interest.

So here you are at age 65 with 937 ounces of gold in the savings bank.  You can stop working, continue to draw interest on your capital, and you will receive 5% x 937 oz. = just shy of 48 oz. of gold per year.  In other words, you can stop working and receive 50% greater salary than you did when you worked.

This was a wonderful system.  It no longer exists, but it is very important if you want to know what to do with your wealth today and how to survive in the modern economic climate.

The fellow who set up the old system was Noah Webster, the same Webster who is famous for Webster’s dictionary. Noah knew his economics.  In 1785-86, he made a trip through the 13 newly independent states and convinced people (at least in the North) to legalize lending money at interest. This was the beginning of the modern banking system, and it also allowed people to retire at approximately the age of 65.  n the 19th century, thrifty Calvinists saved their pennies, got rich and were able to retire in comfort. In previous history and through most of the world, retirement was unknown. A person worked until he died.

It was the intention of John Maynard Keynes to return to the age before Noah Webster.  He wanted to go back to the Middle Ages when lending at interest was prohibited. At that time, people did not save.  No capital was accumulated.  Without capital, when a new machine was invented (which was rare), it sat in its inventor’s workshop because there was not enough capital in the world to build many copies of the machine and put it to work in factories producing wealth for people.  In a word, the legalization of interest caused the factory system, which vastly increased wealth in the (northern) U.S. and Britain (including Commonwealth countries). The bottom line of Keynesian economics was to do away with all of this and return to the Middle Ages. 

Keynes provided an economic rationalization for paper money. He stumbled across two Americans, William Trufant Foster and Waddill Catchings. These were crackpots who had written a defense of paper money called, The Road to Plenty, in which they argued that the road to plenty for a society was to print money.

Keynes was clever enough to perceive that Foster and Catchings were being rejected by the general public because they were conservatives. Keynes plagiarized their theory and dressed it up as liberal and progressive. This is why Keynesianism is called “the new economics” and why it is full of mathematical mumbo-jumbo (which appears absurd to any mathematician and has the sole purpose to intimidate people).

Under Keynes’ influence, the U.S. started printing money in 1933  Since that time the U.S. money supply has multiplied by a factor of 80 (from $20 billion to $1.6 trillion) while the population multiplied by 2.3.  (Per capita money supply multiplied by 35.).

But the point is that, if a person tried to save money in the U.S.A after 1933. in the manner that was done in the period 1788-1933, he found that, as his money accumulated from the interest, it lost its value from the depreciation of the currency. Using the official government CPI, the saver (in safe instruments) gained no real value between 1933 and 2009.  His buying power was just the same.  In effect, Keynes was successful.  He did not stop the payment of interest. But he did stop the payment of real interest.

What does this mean for you and your economic plans?  It is very simple.  In general, you cannot retire.  If you save your money and invest it safely, as was normal in the 19th and early 20th centuries, you do not accumulate real interest. The currency depreciates just as rapidly as your interest accumulates, and you are back in the Middle Ages when it was forbidden to pay interest and no one retired.

However, Keynes slipped up in two areas: stocks and real estate. If you own stocks, then the stock pays a dividend. This roughly corresponds to the interest on a savings account.  It is a return on capital. And the price of the stock goes up as the value of the currency goes down. This makes up for the depreciation of the currency.  It is the same with real estate. If you buy apartments or commercial property, in both of which the tenant pays rent, you are receiving a return on capital.  And the rise in the price of the real estate offsets the depreciation of the currency. (Speculative real estate, such as raw land, does not apply here.)

There is one serious problem with both of these investments.  They are very speculative.  The stock market rose by a factor of 18 times from 1982 to 2007.  But from 1966 to 1982, it fell by over 70%.  These swings are speculative and tricky.  But you cannot retire unless you play them because Keynes has taken away the traditional American (and British) method of safe investment.

What is more difficult and frustrating is that the vast majority of the people have an incredible talent for buying the stock market tops and selling the bottoms. The average mutual fund was 12% in cash back in 1982. As the market neared its 2007 top, this number dropped below 5%. So the mutual fund managers, the people the public regards as experts, were sitting in cash at the stock market bottom and were heavily invested in 2007.

One sees the same thing in individual funds. A new manager will emerge and burn up the racetrack. He hits the hot group for the period, and his fund shows a huge gain.  The public rushes to buy his fund. But just as the public turns bullish on him, suddenly he goes cold. For the next few years he can do nothing right.  He sticks with his group as it tanks.  It turns out that he was just an average manager who got lucky for a while, and his record over the full period is flat. But the public did not buy him until he hit his top, and they rode him all the way down.  In short, there is something about the stock market which works opposite to the thinking of the average person. And unless you are an exceptional person, it is going to take you to the cleaners.

At the One-handed Economist, we have two answers to this problem.  Austrian theory economics and the commodity pendulum.

Austrian theory is the work of 3 economists from Austria, who answered the question, what is interest. The most prominent of these was Ludwig von Mises, who immigrated to this country in 1940 and taught at New York University. Von Mises predicted (what is conventionally called) the Great Depression in the late 1920s and was the only economist to have done so. The rest of the economic community did not know it was coming and then compounded this error by predicting that it would return after WWII.

Austrian theory says that interest is the price we pay for time.  That is, everyone has a time preference in the sense that they prefer present goods to future goods.  A simple example to understand this might be: You are a young man, and someone says to you, “work for me over the summer, and I will give you a car.”  So you work for the summer, but at its end your employer says, “OK, I’ll give you the car, but I can’t actually deliver it to you until next year.”  You feel a sense of being let down and that your employer has been somewhat dishonest.  That is, you feel that a car now (which you expected) is better than a car next year.

All of us have this feeling. All a loan is is an arrangement so that you can get what you want sooner than you are able to earn it. To have car-now, you agree to pay interest whereas you can have car-next-year without paying interest. When you choose to pay interest, you are saying car-now is more valuable than car-next-year.

The Austrians developed their time theory of interest into a theory of the business cycle. It is widely recognized that such government interferences with the price mechanism as rent controls or farm price supports have disastrous effects on the economy. But these institutions are on the fringe of our society. However, interference with the free market rate of interest (the price of time) is mainstream.  An institution exists (in this country the Federal Reserve) whose sole function is to prevent the rate of interest from remaining at its free market level  What the Austrians discovered was that manipulation of the rate of interest by the Fed leads to the disruption we commonly call the business cycle.

As the interest rate is lowered below its free market level, one of these effects is to make the stock market go up. The stock market is competitive to the bond market, and prior to the creation of the Fed good quality bonds used to yield 5% while good quality stocks yielded 8%  (This 8% stock earnings yield gave us the traditional 12:1 P:E ratio.). This 8 to 5 ratio existed through the 19th century and up until 1914 (when the Fed was created). Then the Fed manipulated the interest rate market and cut rates in half. This caused a doubling in stock prices over the course of WWI. It repeated this policy in 1922 and caused the roaring ‘20s.

At the One-handed Economist, we use von Mises’ theory to predict the future course of the stock market. When the Fed eases, this turns us bullish, and when the Fed tightens, it turns us bearish. Right now we reject the conservative theory that Barrack Obama’s bad economic policies are going to put the stock market down.  Bad they are. But they are bad because they are robbing from the common people of the country and putting wealth into the hands of the (undeserving) rich.  Robbing is not good economic policy, but it does put the stock market up. This was well illustrated by F.D.R. He abolished the gold standard and printed money to lower real interest rates.  By the end of his first term, the DJI had more than tripled.

Barrack Obama’s policy may be immoral and amount to robbing from the poor to give to the rich, but it certainly tells you how to protect yourself in today’s economic chaos. You can’t save for retirement in the old fashioned way by putting your money in the savings bank and getting 5% real interest. The real interest rate since 1933 has been 0%. That is, CASH IS TRASH.  But if you can enter and leave the stock market in accord with Austrian theory economics, you are one big step ahead of the game.

To be a second step ahead of the game, you need to understand the commodity pendulum. This started to operate in this country in 1963 after the Kennedy tax cut of that year.  Kennedy ran a budget deficit and printed money to finance it. This caused a rise in consumer prices, but commodity prices remained stable until 1971. By that time, they were undervalued in real terms. So they exploded to the upside (tripling over the decade of the 1970s). This sharp rise in commodity prices fed through into consumer prices, and they rose more rapidly.  In effect, a part of the consumer price rise which Kennedy had caused and which should have occurred in the 1960s was postponed to the 1970s. To the people of the time, who could not remember 10-15 years before, it seemed to come out of nowhere. This price rise led the Fed to tighten and caused the stock market to decline.

By 1980, commodity prices had gotten over-valued, and they spent the ‘80s and ‘90s in a decline.  One would think that the Fed would have learned from its mistakes.  But Greenspan and Volcker had learned nothing from the bad policy of the 1960s. They printed money like crazy (17% in 1986, 15% in 1993). They lowered interest rates from 16% to 1%. This caused the greatest bull market in stock history.

But by 1999-2001, commodities were undervalued – very, very undervalued, worse than they had been in 1971. What will happen now? We will have a reenactment of the 1970s. Commodities will rise (are rising) until finally the Fed gets some sense and starts to tighten (as per Volcker in 1978). Then stocks will come down hard. (Of course, Bernanke is trying to set records for stupidity and is continuing to fight a non-existent “deflation,” but this plays right into my hands. He is in the process of tripling the nation’s money supply, which will cause an additional tripling of average prices and will just add to the commodity pendulum.

For those too young to remember the commodity pendulum of the 1970s, gold multiplied in price by A FACTOR OF 25 TIMES. From 1966 to 1982, STOCK PRICES FELL 70% IN REAL TERMS. Followers of von Mises, such as Harry Browne and myself, came to public attention and spoke at gold conferences across the nation.

If you think that we are in a “deflation,” then your problem is a short attention span. Commodity prices have been rising since the turn of the century. The decline of last summer-autumn was caused by the New York Times pushing the panic button. Already gold has recovered, and other commodities will recover over 2009. The CPI will move sharply to the upside.

At the One-handed Economist ($300/year),I use Austrian theory economics and the commodity pendulum to predict the markets of today. The idea is to defeat John Maynard Keynes and enable you to retire on your savings. You can get a subscription via my web site, www.thegoldbug.net (no charge), at which I blog on social and political issues (from an economist’s point of view).

Thank you for being interested.

How

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Howard S. Katz was one of the early gold bugs of the late ‘60s and ‘70s, turning bullish on gold in 1965.  His favorite gold stock, Lake Shore Mines, went from $3/share to $39/share over the course of the seventies (sold at $31).  Katz turned increasingly skeptical about gold as it mounted its final rise in 1979, and he called the top after the close on Jan. 21, 1980 (with gold at $825.50/oz.).  Katz traded gold in and out during the ‘80s and ‘90s and once again turned long term bullish in Dec. 2002.  His thoughts on commodities, stocks, bonds and real estate are available in a letter entitled The One-handed Economist and published every two weeks giving specific advice on trades in stocks and futures.  This letter is available (both electronic and paper copy) for $300/year with a 3-month trial for $100.  Send to: The One-handed Economist, 614 Nashua St. #122, Milford, N.H. 03055.  (Include both electronic and mailing address.)  Mr. Katz’s blog is available weekly (no charge) at www.thegoldbug.net.