Volume XII, No. V

Thanksgiving's just around the corner. Ordinarily, we're getting ready for that great day and our thoughts turn to everything in our lives that we can be thankful for - a virtually endless list.

But a few weeks ago, out of the blue, we all got sidetracked when Super-storm Sandy slammed into the east coast, devastating the New Jersey shore and, incredibly, so much of the New York metro area. For many, it was as improbable as the prospect of barbarians overrunning Rome might have been during the glory years of the Empire. But just as the improbable finally caught up with the Romans, so today's Rome - the mighty City of New York - succumbed to the howling wind and frightening storm surge of Sandy.

Even after three weeks, many still remain in the initial stages of recovery. And so we remind ourselves that the improbable is by no means impossible. Indeed, the high probability of a hurricane snaking its way up the east coast only to veer sharply left and hit New York City head-on, as well as the terrible consequences that would result, had been reported years ago. But no one paid much attention then, just as no one paid attention to a similar report regarding New Orleans years before Katrina's appearance in 2005.

Perhaps our recent confrontation with the ostensibly improbable will make us more receptive to something that may seem equally improbable: Money as a Weapon of Mass Destruction, a discussion we began last time when we saw how the 20th century began in relative peace and prosperity, only to suddenly collapse in 1914 into the hell hole of World War I. Today, we pick up our story at the end of the first World War to discover why, rather than returning to the stable monetary system that brought peace and prosperity to a previous generation, government leaders would instead find a way to use money as a weapon to pursue their nations' political objectives. We'll begin by exploring:

• When and How Did Our Modern Currency Wars Begin?
• Why the First Currency War Ended in Disaster - and the Second Didn't

and we'll end with an attempt to answer the critical question of our own time:

• Will Today's Third Currency War Follow the Disastrous Path of the First, or the Relatively Benign Path of the Second?

World War I - known at the time as the "Great War" and "the war to end all wars" - provides history's first example of modern states harnessing the raw power of industrial production in combination with modern technology to make a new kind of war - one that produced death and destruction seemingly without limit. In order to make war without limit, governments needed money without limit. As we pointed out last time,

The shooting ended with an "armistice" - technically a suspension of fighting, not a surrender of one side to the other. But the Paris Peace Conference of 1919 found the French and British demanding war reparations from the Germans. The terms of the treaty were so draconian that a member of the official British delegation, the economist John Maynard Keynes, wrote a book, The Economic Consequences of the Peace, in which he quoted and endorsed the German view that the treaty could signal "the death sentence of many millions of German men, women, and children."

Keynes's assessment may have been exaggerated. But so too was the exaggerated desire for revenge on the part of the French and British officials at the peace conference. While both sides had lost millions of their young men to trench warfare, the armistice left the wartime blockade of Germany in place, preventing trade with the outside world. Combined with a German war economy unable to produce enough food for its citizens, starvation descended on the country. The Germans were in no position to negotiate, and so they would sign the infamous Treaty of Versailles which sowed the seeds of Currency War #1.

By 1921, struggling to pay their war reparations and get their economy running, the German government made a fateful decision. They would not only continue to print money - something they never stopped doing after the war ended - but the printing would increase. Indeed, the German government had been the most aggressive in printing money of all the combatants during World War I. They had continued to print money after fighting stopped, increasing the price inflation that started during the war. Now, struggling to get their peacetime economy functioning, with war reparation payments due, they printed even more, thus assuring a rapid acceleration of increase in prices for food and other everyday goods and services.

Many think the government printed money to reduce the burden of war reparation payments. But as James Rickards notes in his recently published Currency Wars (emphasis added):

While other former combatants sought to restore some form of the monetary stability that marked the pre-war years, the German government had discovered the monetary weapon that today manifests itself under the names of "currency manipulation," and "competitive devaluation." (Just as the Germans seized the "opportunity to increase German exports by debasing its currency to make German goods more affordable abroad," so governments today debase their currencies to achieve similar advantage for their exported goods and services.)

As other governments made at least an attempt to restore a system similar to the gold standard that, as we saw last time, promoted peace and prosperity, the lesson learned by German officials in the early 1920s was that their currency, the mark, could be debased in pursuit of both economic and political goals. That lesson has since been learned by other governments. And as foreigners snapped up cheap German products, Germany's economy heated up. Not only were more German workers employed, but the government took the next step and guaranteed wage increases. For those industrial workers favored by the government, increasing price inflation was countered by higher wages. For owners of industry, profits increased with growing sales.

Now let's ask the obvious question: If printing money both helped the government pay their war reparations and also kept the economy growing, why stop printing? It all seemed to be working so well. Was it really possible that creating money out of thin air would continue to create prosperity? Did the German printing presses possess some magic that could create real wealth out of mere slips of paper and some colored ink? Had the improbable miraculously transformed itself into the possible?

Of course not. Simply put, people finally caught on. In his excellent book on the German hyperinflation, When Money Dies, Adam Ferguson explains:

And so the German currency manipulation would turn from higher and higher inflation to the infamous "hyperinflation" that found people filling wheelbarrows with debased German marks in order to buy a loaf of bread. The middle class was hit first, as they saw their life savings debased to worthlessness. Finally the industrial workers' wage increases could no longer keep up. Since the war ended, their wages had gone up 200 times vs. a cost of living that by 1922 had increased 1,500 times.

Ferguson continues:

Even the industrialists suffered as the acceleration in their cost of raw materials greatly exceeded any profit they could hope to get for their products. (Of course, a critical difference between the workers and the owners was that those owners who understood what was happening had taken some of their profits and parked them outside Germany in gold and foreign currencies backed by gold - gold being the only item that increased in value in lockstep with the hyperinflation.)

By the time the government finally faced the reality that their belief in a free lunch was not only improbable, but indeed impossible, the damage had been done to the German people: an impoverished middle class and working class. But even in the face of this national tragedy, Germany's improbable experiment inspired other countries to adopt devaluation of their currencies as economic policy; and so the first currency war gathered steam.

Meanwhile, all attempts to restore monetary stability ultimately failed. The gold standard never was revived. James Rickards describes the situation in Currency Wars:

Of course, government leaders had the choice of facing the full consequences of their wartime inflationary policies and taking responsibility for their actions. They could have tried to restore sound money by either shrinking the paper money supply or properly pricing the existing bloated supply relative to gold.

Rickards explains:

Either choice, deflation or devaluation - with devaluation better understood as inflation - would have resulted in a painful period of adjustment for just about everyone. (It reminds us of choices that our own politicians face in trying to grapple with a federal debt and budget that has spun out of control. To restore responsible government spending and reduce the debt, or even the growth of that debt, would result in pain to the citizens, the same citizens who vote. And there's a good chance that anyone proposing pain would get voted out of office. As you might imagine, the chances of politicians either then or now making decisions that might result in losing votes was and is highly improbable.)

Instead, from 1921 through 1936, governments developed policies that both devalued their currencies relative to the currencies of other countries and imposed tariffs on imports. This policy came to be known as "beggar thy neighbor" as each country sought an advantage at the expense of their neighbors. And just as in Germany's case, while an advantage could be gained for a time, in the end the world's economy would sink from initial economic boom to the depths of the Great Depression.

In the course of these events, two opposing systems of totalitarian government, communism and fascism, would square off against each first in one country, then another. Economic instability fed political instability, which spread around the world. In 1931, Japan would invade Manchuria, followed by Hitler's 1932 campaign to become German Chancellor. By 1933, Stalin had purged his last political enemies, even as he organized the genocide of 7 million Ukrainians. When Franklin Roosevelt took the oath of office as 32nd President of the United States on March 4, 1933, the major players who would eventually fight a new World War were firmly in place, with the totalitarian systems already building a military capability to fulfill their dreams of world conquest.

The virtuous circle of open trade between countries begun in the peace and prosperity of the late 19th century, interrupted by World War I, was finally irrevocably broken by 1936. Wasting no time, Japan would invade mainland China in 1937, the first major military engagement of a world in conflict, officially recognized as World War II with Germany's invasion of Poland in 1939.

And thus the First Currency War ended having lurched through economic boom and depression to the brink of yet another catastrophic world war.

Next time, in our last letter for 2012, we'll finish our series by looking at Currency War #2 that stretched from 1967-1987. While it didn't end in disaster, it did end with a kind of armistice that shares certain similarities with the Treaty of Versailles which treaty left many of the conflicts of World War I unsettled, thereby establishing the foundations for World War II. We'll see how Currency War #2 laid the foundation for our present currency war, begun in 2007, and attempt to discover when and how this currency war will eventually end.

But before leaving today's discussion, let's turn our attention for a moment back to Adam Ferguson's book When Money Dies, first with a recommendation that you consider reading it, You will gain valuable insight into what happens when a government prints too much money, while keeping in mind that governments around the world are printing money with a speed and in a quantity never before seen in history. The books value lies not only in its retelling of how the German hyperinflation unfolded, but also in its first-hand accounts from people who experienced the devastation of seeing their money simply go up in smoke. It will open your eyes to something that may seem improbable to some of us at the moment, but must surely not be discounted as impossible.

But whether you decide to read Ferguson's book or not, I would like you to carefully read his assessment of what actually happened when the value of their money eroded as a result of misguided government policies. He describes the effect on people over time as the purchasing power of their money quickly eroded, even before they reached the point of needing those wheelbarrows to buy a loaf of bread. As inflation drove up asset prices, a speculative fever took hold. While I don't believe we have arrived at the low point the Germans reached in the 1920s, see if you don't find striking similarities to some people's attitudes and behavior today:

We may not be there yet, but we do seem to be getting awfully close - too close, I'd say.

It Takes a Storm

Two hurricanes in two years in New York City? Definitely improbable. While last year's storm, Irene, did create tremendous havoc and hardship elsewhere, New York City was able to file it in the "nuisance" bin. Sandy's been a far different story. We'll be talking about this one for a long time.

While my own experience was more on the level of inconvenience, a couple we know - best friends of ours, in fact - won't be able to live in their home for at least the next 3 - 4 months. You won't hear about them or their neighborhood, since the really bad stuff hasn't been reported accurately. No surprise there. Politicians who joined in a staged media production featuring their supposed expert management of the crisis don't want to dwell on the utter devastation in my friends' neighborhood.

What's important to note here is not so much that my friends' experience would contradict the claims of government "being there" for the people (although it probably would); it's rather the way they've dealt with the almost total destruction of their home and loss of possessions. Imagine trying to find a place to live temporarily, while simultaneously searching for qualified professionals to begin the cleaning up and re-building and doing it all basically on your own, with occasional help from neighbors in the same situation and a trickle of good-hearted volunteers. The fact is, government was nowhere to be found in their neighborhood during or after the storm. (One exception: some FEMA people walking through the rubble and filth told them that if they smelled gas they should report it to their local utility company - the same company that still has not been able to restore power to some homes three weeks after the storm. Thanks a lot!)

Naturally our friends will apply for whatever government relief may be available to them. If it comes, in whatever form it comes, fine. Otherwise they'll keep plugging away until they're settled again, sometime after the holiday season, which, of course they'll have to spend away from home with the few possessions they've been able to salvage. In the midst of it all, they've focused on what needs to be done and faced the hardships in remarkably good spirits, even telling us how they're a lot better off than some others. Impressive people, these friends.

What about Thanksgiving? They'll be spending it with some other friends - the same friends who will provide them with space in their home to stay for a bit.

Sometimes it takes a storm to bring out the best in us. Fortunately there are still enough of "us" with enough of "the best" left in them out there, our friends being among the best of the best.

So a special thanks to our dear friends and all who put forth their best after facing the worst. We so need your example and inspiration, and you haven't failed us.

Happy Thanksgiving to all!

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com