Is cash really king?

On October 17 Warren Buffett wrote in The New York Times that ôequities will almost certainly outperform cash over the next decade, probably to a substantial degreeö. Amid all the confusion, such a clear and bold prediction is jolting. Cash is king, right? How can Buffett be so sure that equities will mount a royal coup?

Buffett makes another prediction, but one that the worldÆs media did not pick up on. He said that ôthe policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accountsö.

What! Inflation? WasnÆt that yesterdayÆs story? Oil prices have halved, as have the prices of many other commodities. And anyway, commodity prices never stayed high enough to trigger wage spirals. All they did was cause demand to fall.

BuffettÆs point is that the printing presses have been turned on, following years of reckless monetary expansion, and that all the hundreds of billions of extra dollars recently created to prop up the banking system will ultimately feed through to rising prices (remember that inflation is really about money supply. Rising prices are the effect of inflation, not inflation itself).

Taking into account unfunded social security and Medicare obligations, the total US federal debt in 2006 was $49.4 trillion, equivalent to $160,000 for every American. Fast forward two years, during which there was an acceleration of government debt accumulation, and you get close to $300,000 for every working American. If Americans were to set aside, say, 3% of their average annual household income of around $48,000, it would take more than 200 years to pay off the debt.

The conjuring trick here required to create this debt mountain has been to convince people, Americans and foreigners alike, that the dollar, dollar deposits and federal debt are worth something. Spin is provided by implicit government guarantees, and continual reference to the dollar as the worldÆs de facto reserve currency. As long as there was confidence in the currency, debt (relative to economic activity) could rise forever.

We take for granted that bits of paper (bank notes) and electronic records in computer chips (bank deposits) have ôvalueö to such an extent that it is impossible to imagine it any other way or, worse, the entire system collapsing. Article one, section 10, of the United States Constitution states that ôno state shallàcoin money; emit bills of credit; make any Thing but gold and silver Coin a Tender in Payment of Debtsö.

Why were the founding fathers so against paper money (fiat currency)? Because they were aware that, throughout history, every single state-controlled fiat currency system had ultimately failed. The temptations to create money out of nothing could never be resisted, leading to the corruption of politicians and the elite and unsustainable wealth disparity between rich and poor.

George Washington had noted in 1787 that ôpaper money has had the effect to ruin commerce, oppress the honest, and open the door to every species of fraud and injusticeö. Later, in 1798, Thomas Jefferson wrote that the federal government has no power ôof making paper money or anything else a legal tenderö, and he advocated a constitutional amendment to enforce this principle by denying the federal government the power to borrow.

In days gone by money or, as it is also known, ôIOUsö, developed naturally in the market. The best medium for these IOUs was gold coins as they were difficult to fake (gold is heavy, sufficiently scarce, expensive to extract and impossible to synthesise below its market value). But governments soon took control, often by guaranteeing the quality and purity of the coins. As governments outspent their revenues, they found ways to counterfeit the currency by reducing the amount of gold in the coins, hoping their subjects would not discover the fraud. But the people always did, and they tended to react badly.

What is happening today is no different. For money to be considered legal tender it must have a maker (person that will make the payment), a payee (person that will receive the payment), an amount to be paid, and a due date. Dollar bills used to state that the bearer would be paid on demand. In 1963 these words were removed.

By the same token the creation of bank deposits involves even less work than notes and coins, which at least require machines with moving parts. To create bank deposits, a bank simply needs to find someone to lend to, then punches a number into a computer. Boosh! A bank deposit! Even if the borrower spends the money such that it ends up in another bank, itÆs still in the system.

When President Nixon closed the gold window in 1971, refusing, as promised under the Bretton Woods Agreement, to exchange dollars for one thirty fifth of an ounce of gold (there was not enough gold in the coffers), the stage was set for massive and unconstrained monetary expansion. Under Bretton Woods, credit as a percentage of GDP had been maintained at around 150%. From 1980 to 2007, it rose from 162% to 334%. The last 30 years have been one huge, credit-fuelled party. But the booze has now run out and the hangovers are just beginning.

BuffettÆs point is that the only way that the US û and other Anglo Saxon governments for that matter û is going to get itself out of its debt hole, is by inflating its way out. In a best case scenario, this only entails sharply rising interest rates and substantial dollar depreciation. In the worst case, a loss of confidence in banking systems and gold, assuming it is not outlawed, perhaps at $10,000 per ounce. In both cases, holding cash would be a very bad idea. In an inflationary environment, as Buffett says, it is best to hold stocks. Just make sure they are ones that will survive.

Hugh Young is the Singapore-based managing director of Aberdeen Asset Management Asia.