Let's Copy Napoleon

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Would you rather hold one thousand dollars…or two ounces of gold?

It is a little like asking if we would rather have one old woman dressed for Sunday services or two young ones stark naked. Ask us something harder.

What happened the other day? The price of gold jumped another $7. It is headed for $500. We may have to move up our buying target.

Why is the price of gold so important? Because gold is the ultimate competitor to the dollar. A vote for gold is a vote against the dollar, against paper money…and paper assets. It’s a way of saying, “Yes, we know Bernanke, Bush, Greenspan, Trichet and Goldman Sachs have everything under control, but we thought it might be a good idea to have some REAL money, just in case.”

Gold is a remarkable thing. It is found in the earth’s crust like lead or coal and sits on the periodic table. It can be mined, but it cannot be manufactured. It can be polished, but it cannot be enhanced. It can be wrought and worked, but it cannot be manipulated like paper money. It can be flattened into a sheet thinner than paper, but it yields to neither political pressure nor financial desperation.

For thousands of years, gold has been a measure of wealth and a way to keep it. Protecting your wealth was simple: you bought gold and hid it (Invading armies often routinely tortured their victims to get them to tell them where the gold was hidden.).

At last night’s dinner party, we sat next to a woman who is writing a book about Napoleon Bonaparte.

“Bonaparte hated debt,” she said. “And he hated paper money. He had seen what it had done to France during the Revolution. He insisted on an honest currency based on gold coins.”

Why gold coins? Because gold is nature’s money. Central bankers can’t create it at will. They have to buy it like everyone else. This naturally limits the “money supply,” generally keeping it in line with the economy itself.

Bonaparte’s financial system helped make France one of the world’s most prosperous countries. The evidence is all around us. Everywhere you go in France you see the buildings put in the 19th century — handsome edifices, solidly built. Most of Paris itself is a product of the same 19th century prosperity.

But the world turns. By the beginning of the 20th century, it had been a long time since people had suffered inflation. So, along came economists saying to no longer worry about it. They’d be better off if prices rose a little bit. It would “stimulate” the economy. It would help give people jobs. These same economists offered to “manage” their nations’ monies in order to produce the improvements they promised. Henceforth, no one needed to be crucified on a cross of gold, they explained.

Reluctantly, by fits and starts…the world’s money and gold were unhitched. On August 15, 1971, the last link was cut. Since then, we have been enjoying an experiment — a world of “managed” currencies. As far as anyone can tell, it is a success. The world’s most prolific currency — the dollar — is still accepted everywhere as though it were real money. Lenders have trillions of dollars worth of credits, and hold them as though they will be still be valuable next year…even 10 years into the future. Merchants do not laugh when you take a dollar out of your pocket. You can use the dollar to pay your bills. Dollars you left in your desk drawer last year are worth almost as much a year later.

Is this really a new era, dear reader? After all these thousands of years, has mankind really learned how to control paper money?

We will watch see. We will see. We will hold gold tight and enjoy the show.

u2022 Our book hits bookstores this week. Anecdotally, the Barnes & Noble in Towson, Maryland stocked 5 copies yesterday and sold 4 of them. That seems like a good trend.

u2022 It’s selling well on Amazon, too. We’ve been #1 on the business list, notably ahead of Friedman’s World Is Flat, for the last three days. But we’re getting beat out by two pop-up kid’s books and an Oprah book club recommendation for the number one slot on the general list. Perhaps, we should have gone with our original hunch and written the signature pop-up edition of Empire of Debt, complete with presidential seal.

u2022 At dinner last night, an American woman explained why there is so much activity in what is called “private capital.”

“It’s really very simple,” began the former investment banker, “the cost of money is lower than the earnings yield. If you can borrow money at 6% and use it to buy a company that is earning 8%, well…duh…”

Private capital firms aggregate money from big investors and use it either to buy private companies and take them public, or to buy public companies and take them private. With interest rates this low, and profits this high, there is apparently a lot of running around in the marketplace.

“Imagine you find a company that is worth $10 million in the marketplace. And the company is earning $1 million each year. You borrow $10 million at 6% and buy it. Your interest cost is only $600,000 per year. But the company you bought earns $1 million per year (and don’t forget…you bought the company’s assets…you might get non-performing properties that you can sell off too…reducing your basis in the company itself). So, you end up with $400,000 per year in profit. It isn’t usually that simple, but that’s the idea.”

This is why the “Fed model” and many investment analysts compare stock prices to interest rates. When rates are low, stocks are “worth” more, because you get more out of them than you could by simply lending out your money. They’re “worth” more too, because there are a lot of people who want to make the $400,000 described above by bidding up the prices of equities. It’s a kind of arbitrage, which reduces all assets to the same basic level, adjusted for risk. There’s no reason you should be able to make 5% from one investment and 10% from another — unless the one is more risky than the other. Generally, these differences disappear; investors buy the “cheap” sources of earnings until prices are no longer cheap.

Then, when the equities have been bid up to the point where they are no longer cheap, analysts explain why they are properly priced. Because interest rates are low, they say.

But here we pause to admire the elegant perversity of nature, and her markets. The same low rates that bring out the wheeler-dealers in the equity markets also bring the lumpenconsumers into Wal-Mart and the lumpenhomebuyers into the real estate agents’ offices. Pretty soon, a boom has been created — with cash registers ringing all over the country. Profit margins rise — especially for the companies that earn money by “financing” rather than making things. We note in passing, that Ford Motor Company wouldn’t make any money at all if it weren’t for financing — making companies more valuable still. But the boom, and the value of the assets, rests entirely on the low rates. If rates were to rise, sales would decline, profits would fall, and not only would a company’s earnings drag down its stock price, so would the higher interest-rate environment (the earnings themselves would be considered worth less when you could earn more from lending money out).

What would make rates rise? People could come to believe that a dollar next year, might not buy as much as a dollar this year, for example. Why would they think such a thing? Because so many dollars had been created in the boom brought about by low rates! Oh dear reader, it is a wicked world we live in.

Bill Bonner [send him mail] is the author, with Addison Wiggin, of Financial Reckoning Day: Surviving the Soft Depression of The 21st Century and Empire of Debt: The Rise Of An Epic Financial Crisis.

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