THE BLOG
06/21/2010 12:50 am ET Updated May 25, 2011

The Next Thing to Go Wrong

Gold prices just hit a new all time (nominal) high of $1,257 an ounce. The Dollar lost more than 70% of its gold value since the beginning of the decade (an ounce of gold was $273 in January 2001).

Because most people take note of the dollar in reference to foreign currencies, they overlook the significance of this. The European Union has bigger problems than America, and so their currency has been even weaker, making the dollar's decline easy to ignore. But since gold prices are quoted in dollars, the meaning of gold going up is that the dollar is falling.

A look at energy prices leads to a similar conclusion. For decades the prices of gold and oil closely paralleled one another. In 2003 an ounce of gold would have bought you 12 barrels of oil. Today that ounce will buy you about 16 barrels, even though the price of oil is now more than twice what it was in 2003. Thus the increase in oil prices is really a result of inflation, not energy markets' supply and demand. Energy prices are simply not keeping pace with the rising price of gold.

This erosion in the value of the dollar is effectively inflation, even if it does not yet show up in the CPI. And it is tantamount to a tax more devastating than anything Congress can come up with. Inflation consumes capital. If you receive 5% interest on your savings and pay 100% capital gains tax during a year of zero inflation, you are no worse off than a person who pays no income taxes at all during a year of 5% inflation. Either one is left with no real income.

People would riot in the streets if capital gain tax of 120% was enacted, but don't seem to mind collecting 5% interest rate on their municipal bonds with 6% inflation, even though that is exactly the same as 120% capital gains tax.

So far, both inflation and long term interest rates have remained surprisingly low, despite the flagitious promiscuity in which the U.S. has increased its federal debt, from $5.5 trillion to $8.6 trillion in just 18 months. But Gold has historically been a reliable harbinger of both inflation and rising interest rates.

Rising interest rates obviously reduce the value of all fixed income investments. And when the value of the dollar deteriorates, fixed income instruments with principal payments denominated in dollars are not going to do well. Thus, the erosion of the dollar is a threat to our economic stability.

Every empire in history has shirked its liabilities by debasing the currency. Aggressive spending plans, especially in a time of war, escalate these inherent tendencies. And the further the dollar declines, the more dire the consequences. Yet investors who should be looking for safe haven are, oddly, confident in our currency and convinced that Washington will honor its long term fiscal obligations.

That false sense of security is dangerous, because we are vulnerable to a crisis of confidence in the dollar. And the resulting sudden spike in interest rates will have such large impact on the economy that it will dwarf any other factor.

The second Murphy law says that what actually goes wrong is not that we anticipated going wrong. But this scenario is at the top of my worry list.


Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.