The dollar is on borrowed time -- Contrarian Chronicles

Expect a crisis of confidence when reality finally sinks in. It's the reason I think the place to be is in currencies that have lasted 5,000 years, can't be forged or rendered valueless by inflation: gold and silver.

I’d like to share a speech I gave April 26, called "Precious-Metallic Armor for the Coming Crisis of Confidence," at the Las Vegas Precious-Metals Conference. This crisis I see is incubating thanks to a constellation of factors now gathering force. We face a weakening dollar and, more importantly, a sea change in attitudes, as folks finally realize that our problems stem from the 1990s stock market mania and that there really is no magic Fed wand to get us out of them. When confidence shatters, stocks will sink -- and precious metals will soar.

I have been in the money management business since 1982. I decided to set up a short-only fund in 1996 because I thought that things were headed in a very bad direction, though my timing was a little on the early side. My goal was to distance myself from the "speculative performance derby" and greed that was building, so that one day I could return to the long side of the business with my credibility intact, which I still plan to do when I feel it's safe to be bullish on stocks. For those of you who care, I will start a mutual fund that will be open to everyone.

I thought I might state my prejudices at the outset. I believe that the mania for stocks and the revulsion against precious metals that we saw in the late 1990s were opposite manifestations of the same psychology. I believe that, while that psychology has been dented, later this year it will be shattered, and stocks will sink as precious metals soar.

I believe that the stock market averages are headed much lower. I believe a dollar crisis lies in our future. I believe that the move that we will see for silver will dramatically outpace gold to the upside, though I own both, and I am a director of and own a sizable position in Pan American Silver (PAAS, news, msgs) and one gold stock. However, I do not believe that a so-called plunge protection team actively manipulates the stock market (for the government) And I do not believe that gold is actively manipulated, as is suggested by many gold bulls.

Lastly, and most important, I believe that, in a social democracy with a fiat currency (like ours), all roads ultimately lead to inflation. And in fact, that is the story of all paper currency regimes. They all collapse.

The biggest bubble in the history of the world that we recently experienced was powered by the most incompetent and irresponsible Fed in history, along with the public's willingness to suspend disbelief. It was a state of mind as much as anything else. Folks believed in the existence of a "new era," in a Greenspan put, and in retiring early, and rich.

Folks believed that the wonders of technology automatically meant that tech stocks were great investments. They even thought that two small pieces of paper were more valuable than one larger piece of paper, as they believed that stock splits meant stocks should go up -- though I don't suppose they expected to pay more for a pizza that was cut into eight slices than just four. In short, it was all about confidence and, ultimately, near-arrogance on the part of those involved.

In a period when an Internet "incubator" (whatever the hell that is) like Internet Capital Group (ICGE) could be valued at over $40 billion -- more valuable at the time than, say, Boeing (BA) -- and sported a valuation of approximately 150% of all the world's gold companies combined, is it any wonder that no one thought they needed to own gold?

Paper reigned supreme, as people were bursting with confidence. At the peak, Cisco (CSCO) claimed a valuation of over $500 billion. I saved a description from February 2000 by an analyst who followed Cisco and thought that within 18 months, it would be valued at a trillion dollars, never mind that its revenues were on track to be about $25 billion or $30 billion. Here was a company doing, in essence, about one-quarter of 1% of GDP that was deemed soon to be worth 10% of GDP. Those are just a couple of examples of hundreds that I could pick to illuminate the overconfidence of the public at that time.

I believe that, as much as the mania for stocks was an expression of confidence in paper, the metals are just the opposite. They are an expression of a lack of confidence. I believe that given the pendulum's extreme swing to the side of confidence, it is now destined to travel back quite a ways in the other direction.

We all know that the government will cheat us over time, via inflation. We just don't know at what rate. While lots of intelligent people believe that deflation is right around the corner, this is not my belief (nor has it ever been). I believe that people have come to confuse declining asset markets with "deflation." Deflation, to me, means that the value of the dollar appreciates against a basket of goods and services.

A recession, coupled with a declining stock market and declining house prices, would be just typical consequences of what happens after a boom, much less the biggest speculative mania in history. I do not consider that to be deflation. So, I believe it's entirely consistent to expect a declining stock market and declining housing prices in the wake of a bubble, and higher inflation. That does not mean that inflation rates have to run at a high level initially. But over time, higher rates of inflation are what we should expect.

I believe we experienced deflation in the 1930s because we were still on the gold exchange standard, which was fairly rigorous, certainly compared to the confetti standard that we're on right now. As far as people asking, "What about Japan?", I don't believe Japan is a true social democracy. It may be moving in that direction, but when politicians there seek re-election, they don't tend to act in quite the same way as ours do.

And, I believe that the mindset existing in America is to never relive the Thirties again. I think that explains the statements we've seen from the central bank, in terms of Fed Governor Ben Bernanke talking about using the printing press to fight deflation, and FOMC secretary Vince Reinhart talking about buying Treasurys if asset markets don't respond in a way that the Fed likes. The Fed has basically said it will not accept "no inflation," and given its outstandingly consistent record of destroying the value of the currency over time, who wants to argue with it about that? However dangerous you may think the Fed has been historically, the Greenspan Fed takes that to an entirely different dimension.

Here, it might be useful to take a moment and review the history of the dollar. What I have prepared is a chart of the purchasing power of the dollar through something that we can all appreciate. I created it from data that the Hershey (HSY) company gave me, after I asked them what a Hershey bar has cost at retail since its introduction in 1908.

You have obviously noticed that, from time to time, the price goes up and the amount of chocolate per bar changes. So what I have done is to take the price and turned it into the price of chocolate per ounce of a Hershey bar. What you can see here is that, surprise, surprise, the price of chocolate per ounce of a Hershey bar has risen over that period, and in fact is up about twelve-fold. Measured thusly, the dollar has lost 92% of its purchasing power.

Interestingly enough, however, the value of Hershey stock, since it came public in 1927, is up about 295-fold, with one share purchased at $39.58 now worth 180 shares at roughly $65 each. Even after adjusting for inflation, as I have calculated it, that's still a gain of 14 to 15 times in after-inflation terms. Obviously, Hershey has been one of the rare, huge winners.

In the mania, all stocks were expected to eventually do as well "over time," as people were blinded by long-term returns of stocks like Hershey's -- though they were more interested in stocks like chocolate.com -- and completely oblivious to the risks. But folks were also completely oblivious to the No. 1 financial risk that we all face as investors/citizens, and that is inflation. In that regard, I consider the Fed to be Public Enemy No. 1.

Not only did guys like Greenspan, McDonough and McTeer help the Fed power the mania by making up new-era rationalizations for it, since the market peaked in March 2000, they have fomented another bubble, this one in housing prices. This has enabled consumers to continue to live beyond their means, thereby making the ultimate adjustment more protracted. Rather than taking the bubble as a warning sign and urging folks get their financial house in order, the Fed has given folks the shovel, via the housing bubble, to dig themselves deeper and deeper in the hole.

It's sort of like lending money to somebody who had a margin call, rather than making him meet the margin call, and then lowering margin requirements as well, so he can buy more. That is, in essence, what has occurred in the housing market, as many people have increased their mortgages as housing prices have gone up.

Further, we have put ourselves in a position of being completely at the mercy of foreigners. Thanks to our trade deficit, we are dependent on foreigners to be willing to accumulate an additional $1.5 billion every single day, just to keep the dollar where it is.

This period that we have experienced since the market peak has really been a period about denial, and it's gone on longer than I would have guessed possible. But it is what it is. Initially, folks were in denial about the fact that stocks had peaked and that we were in a bear market. Then, all of our economic and stock-market problems were blindly pinned on the attacks of Sept. 11, even though that wasn't the market or the economy's problem. And now, all the problems of the last six months have been pinned on Iraq.

Thus far, Greenspan and the Fed have basically been issued a pass after going 0-for-12 on the rate-cut front. Folks still have faith in the Fed, I believe, because the housing bubble has kept the consumer feeling more or less OK, even as people lose their jobs or know someone close to them who has lost his job.

However, I believe that later this year, people will finally be forced to realize that our problems are a result of the mania, and are long-lived. That psychological readjustment will come about when the economy and the stock market don't come back (excluding some minor postwar relief bounce).

Along with that realization, folks will start to contemplate what happened in the 1930s, even though things are different now, especially in terms of our currency regime. They will contemplate what's gone on in Tokyo for the last 12 years, where now 60% of the stocks on the Tokyo Stock Exchange sell below book value, contrasted to the three times book value that stocks sell for here.

I think that at some point, the exact moment being unknowable, folks will recognize that the Fed has ruined the financial system, the Fed is powerless to stop the bear market, and the Fed is powerless to fix an economic bust precipitated by the misallocation of capital that occurred in the mania.

That realization, I believe, will cause folks to lose confidence, and that loss of confidence will set off an avalanche in stock prices, forcing them to be valued as the fractional shares of businesses that they are, instead of the conceptual fantasy lottery tickets that they have become. I believe that this loss of confidence, both here and worldwide, will also cause the dollar to be reappraised as the piece of confetti that it has become.

Now, I don't say any of this because I want it to happen. I say this because to me, it was preordained by the policies that precipitated the bubble and the policies that have gone on since the bubble. I don't root for any of this to occur, but I fear it will occur. My choice is to be prepared, and to do the best I can in that environment.

Unfortunately, when it comes to looking at other currencies, the euro and the yen are not a whole lot better than the dollar. I sort of view each of them versus the dollar as a one-eyed man in the land of the blind. Not too interesting, just slightly better alternatives. However, all of this is very bullish for the only currency that has been in existence for 5,000 years, that cannot be printed, and is no one else's liability – i.e. gold. I would like to be clear that when I say gold, I also mean silver in the same breath, as I stated at the outset. Just as buying stocks until your hands bled was a state of mind of supreme confidence in the mania, owning precious metals is, to repeat, the expression of the lack of confidence in the monetary authorities, an oxymoron if there ever was one.

I believe that investor demand, the lack of which has been responsible for holding back the metals, will finally manifest itself as this year unfolds and the problems that I have articulated become clearer to people. Greenspan, in particular, has painted himself into a corner, at last, by blaming all of our current problems on "geopolitical uncertainties" surrounding the Iraq war. This is why I feel that we have a potential catalyst to cause people to re-evaluate their thinking. When the alleviation of those geopolitical concerns fails to ignite the economy and the stock market, the game will be up, and the race to protect oneself will be on.

I have no clue as to the precise timing of this scenario, since a lot depends on the length and potency of the relief rally in stocks and the economy. However, the relief rally in the dollar has been especially pitiful. Basically, the euro traded from $1.10 to $1.06 in three days, so we had a mild 5% correction, after a nearly 25% move in the euro. And of course, the euro is now back over $1.10.

This suggests to me that the dollar is on borrowed time, and trouble is coming, sooner rather than later. It also means to me that the price of gold has seen its lows. And, while the tsunami of investment demand that I envision may still be months away, I believe the surprises will now all be on the upside for gold.

I would just like to close by leaving you with one of my opening thoughts: In a social democracy with a fiat currency, all roads ultimately lead to inflation.

Bill Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At the time of publication, he owned shares of Newmont Mining and Pan American Silver. He’s also a director of Pan American Silver. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC on MSN Money.

(I wrote this a number of years ago when things were NOT going well with the economy. Trust me: They WILL get ugly once again as man -- or certain men -- cannot resist playing God. We continue to violate the universal, immutable laws of economics at our great peril.)

Despite the apparent economic strength of the American economy, history proves that EVERY house of cards eventually comes down. And the higher the card house, the harder the fall when it finally comes. And when it does, the more freedoms we will voluntarily surrender to "restore order." It was the Founders' concern about this historically valid problem which prompted their attempt -- now ignored -- to keep American "money" sound and honest.) Dick Bachert 1998

Oh yeah, almost forgot: File this under “Who Gives a Damn!”

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The Forgotten History of Money

This is the fascinating story of the efforts by certain of the Founding Fathers to prevent the economic distress we find all about us today. It is also a sad story on the basis that modern, "sophisticated" Americans have abandoned the corrective institutional mechanism that remains in place to this day. As you read it, think about a world with many fewer S&L, banking and political scandals and economic problems now considered the norm.

"Blood running in the streets. Mobs of rioters and demonstrators threatening banks and legislatures. Looting of shop and home. Strikes and unemployment. Trade and distribution paralyzed. Shortages of food. Bankruptcies everywhere. Court dockets overloaded. Kidnappings for heavy ransom. Sexual perversion, drunkenness, lawlessness rampant. The wheels of government are clogged, and we are descending into the vale of confusion and darkness. No day was ever more clouded than the present. We are fast verging on anarchy and confusion. (George Washington in a 1786 letter to James Madison, describing the effects of fiat paper money inflation then ravaging America in the pre-Constitutional period.)

"The annihilation (of the paper money) was so complete that barber-shops were papered in jest with the bills; and sailors, on returning from cruises, being paid off in bundles of this worthless money, had suits made of it, and with characteristic lightheartedness, turned their loss into frolic by parading through the streets in decayed finery which in its better days had passed for thousands of dollars." (Contemporary writer, Breck, 1786)

"Paper money polluted the equity of our laws, turned them into engines of oppression, corrupted the justice of our public administration, destroyed the fortunes of thousands who had confidence in it, enervated the trade and husbandry, and the manufactures of our country, and went far to destroy the morality of out people." (Peletiah Webster, 1786)

At the drafting of the U.S.Constitution, there were many "Friends of Paper Money" present. On August 16, 1787, when the discussion arose on Article 1, Section 8, the proposed wording was this: "The Legislature of the United States shall have the power to...coin money...and emit bills of credit of the United States."

A hot argument ensued on the power to emit bills of credit, which is another way of saying "printing paper money".

Here are the actual words James Madison wrote describing the debate in his diary: "Mr.G.Morris moved to strike out *and emit bills of credit.* If the United States had credit, such bills would be unnecessary; if they had not, unjust and useless.

MADISON: Will it not be sufficient to prohibit the making them a tender? This will remove the temptation to emit them with unjust views. And promissory notes in that shape may in some emergencies be best.

MORRIS: Striking out the words will leave room still for notes of a responsible minister which will do the good without the mischief. The monied interest will oppose the plan of the Government, if paper emissions be not prohibited.

COL.MASON: Though he had a mortal hatred to paper money, yet as he could not foresee all emergencies, we was unwilling to tie the hands of the Legislature [Legislature = Congress].

MR.MERCER:(A friend to paper money) It was impolitic...to excite the opposition of all those who were friends to paper money.

MR. ELSEWORTH thought this was a favorable moment to shut and bar the door against paper money. The mischiefs of the various experiments which had been made, were now fresh in the public mind and had excited the disgust of all the respectable part of America. By withholding the power from the new Government, more friends of influence would be gained to it than by almost anything else...Give the Government credit, and other will offer. The power may do harm, never good.

MR.WILSON: It will have a most salutary influence on the credit of the United States to remove the possibility of paper money. This expedient can never succeed whilst its mischiefs are remembered, and as long as it can be resorted to, it will be a bar to other resources. MR.READ thought the words, if not struck out, would be as alarming as the mark of the Beast in Revelation.

MR.LANGDON had rather reject the whole plan than retain the three words *and emit bills*".

The motion for striking out carried.

Historian George Bancroft later wrote: "James Madison left his testimony that *the pretext for a paper currency, and particularly for making the bills a tender, either for public or private debts, was cut off.* This is the interpretation of the clause, made at the time of its adoption by all the statesmen of that age, not open to dispute because too clear for argument, and never disputed so long as any one man who took part in framing the constitution remained alive."

ROGER SHERMAN(1721-1793)should be a name familiar to every American. As familiar as Washington, Madison, Jefferson and Adams. He is the only man to have signed all 4 documents surrounding the formation of the United States of America: The Continental Association of 1772, The Declaration of Independence, The Articles of Confederation and The United States Constitution. He was a Judge of the Superior Court in New Haven, Connecticut, serving that office with distinction from 1766 until 1788. He served as Treasurer of Yale University from 1765 to 1776. He was renouned for his high intelligence and unswerving honesty and was described by John Adams "as honest as an angel and as firm in the cause of American independence as Mount Atlas." He served in the U.S.Senate from 1791 until his death in 1793.

Why is Roger Sherman*s name unfamiliar? HE WAS AN ENEMY OF PAPER MONEY!! In 1751, Roger Sherman and his brother William sued James Battle for paying a debt to their shop in New Milford, Connecticut, in depreciating paper currency. Over a period of 15 months, Battle had charged "divers wares and merchandizes" amounting to 129 pounds of what Sherman assumed were pounds of Connecticut "Old Tenor", a stable currency whose value were well-preserved by taxation taking it out of circulation. But Battle assumed the debt was denominated in pounds of ever-depreciating Rhode Island currency, tendered in same, and the Shermans took a beating in the payment and sued for recovery of loss by depreciation. The Shermans lost when Battle argued that he was merely following the accepted custom of the day. In 1752, Sherman wrote his book "A Caveat Against Injustice or An Inquiry into the Evils of a Fluctuating Medium of Exchange" indicting UNBACKED PAPER MONEY.

It was this experience that Sherman brought to the Constitutional Convention and prompted him to rise on August 28,1787 and propose new, more restrictive wording to Article 1,Section 10. The standing version under consideration was worded this way: "No state shall coin money; nor grant letters of marque and reprisal; nor enter into any Treaty, alliance, or confederation; nor grant any title of Nobility." (From Madison’s Notes of the Convention) "Judge Sherman and Mr. Wilson moved to insert the words *coin money* the words *nor emit bills of credit, nor make any thing but gold and silver coin a tender in payment of debts* making these prohibitions absolute, instead of making the measures allowable with the consent of the Legislature of the U.S. Mr. Sherman thought this a FAVORABLE CRISIS FOR CRUSHING PAPER MONEY. If the consent of the Legislature could authorize emissions of it, the friends of paper money would make every exertion to get into the Legislature in order to license it." Mr. Sherman*s and Mr. Wilson*s motion was quickly agreed to and became the supreme law of the land.

Some additional quotations to ponder:

"All the perplexities, confusion and distress in America arise not from defects in the constitution or confederation, nor from a want of honor or virtue so much as from downright ignorance of the nature of coin, credit and circulation" (John Adams in a letter to Thomas Jefferson, 1787)

"I deny the power of the general government to making paper money, or anything else, a legal tender." (Thomas Jefferson)

"You have been doubtless been informed, from time to time, of the happy progress of our affairs. The principal difficulties seem in great measure to have been surmounted. Our revenues have been considerably more productive than it was imagined they would be. I mention this to show the spirit of enterprise that prevails." (George Washington in a letter to the Marquis de LaFayette, June 3, 1790 AFTER the United States Constitution prohibited unbacked paper money at Article 1, Section 10)

"Since the federal constitution has removed all danger of our having a paper tender, our trade is advanced fifty percent. Our monied people can trust their cash abroad, and have brought their coin into circulation." (December 16, 1789 edition of The Pennsylvania Gazette)

"Our country, my dear sir, is fast progressing in its political importance and social happiness." (George Washington in a letter to the Marquis de LaFayette, March 19, 1791)

"The United States enjoys a sense of prosperity and tranquility under the new government that could hardly have been hoped for." (George Washington in a letter to Catherine Macaulay Graham, July 19,1791)

"Tranquility reigns among the people with that disposition towards the general government which is likely to preserve it. Our public credit stands on that high ground which three years ago would have been considered as a species of madness to have foretold." (George Washington in a letter to David Humphreys, July 20, 1791)

"It is apparent from the whole context of the Constitution as well as the times which gave birth to it, that it was the purpose of the Convention to establish a currency consisting of the precious metals. These were adopted by a permanent rule excluding the use of a perishable medium of exchange, such as certain agricultural commodities recognized by the statutes of some States as tender for debts, or the still more pernicious expedient of PAPER CURRENCY." (Andrew Jackson, 8th Annual Message to Congress, December 5, 1836)

DESPITE WHAT YOU WERE TAUGHT IN SCHOOL, THE HISTORICAL RECORD IS CRYSTAL CLEAR: AMERICA WAS TO HAVE BEEN SPARED THE DESTRUCTIVE EFFECTS OF AN UNBACKED PAPER MONEY SYSTEM. MOST OF THE PROBLEMS WE FACE TODAY CAN BE TRACED TO WHAT ANDREW JACKSON CALLED "THE PERNICIOUS EXPEDIENT OF PAPER MONEY".

HISTORY TEACHES THAT AN "ARTIFICIAL" MONEY CREATES AN "ARTIFICIAL" WORLD WHERE THE PRICE FOR SOME ITEM...EVEN OUR MOST POPULAR WELFARE "PROGRAM"...CAN BE DEFERRED TO FUTURE GENERATIONS (OUR $11 TRILLION NATIONAL DEBT) OR PAID WITH A "MONEY" CREATED OUT OF THIN AIR WHICH ROBS THE VALUE FROM THE MONEY WE MIGHT BE UNFORTUNATE ENOUGH TO HAVE IN OUR POCKETS AT THAT MOMENT (INFLATION). AND ONE THING YOU MUST REMEMBER ABOUT INFLATION IS THAT IT IS NOT AN "EQUAL OPPORTUNITY" DESTROYER: THOSE FIRST IN LINE TO GET THEIR HANDS ON THE NEW MONEY ROLLING OFF THE PRESSES (THE MODERN FRIENDS OF PAPER MONEY) HAVE A CHANCE TO SPEND IT BEFORE IT LOSES ITS VALUE. THE LITTLE PEOPLE (THAT’S US, FOLKS!) FARTHEST DOWN THE LINE ARE THE ONES WHO FEEL THE FULLEST EFFECTS OF THIS DESTRUCTIVE PROCESS.

In early 1983, I wrote Senator Sam Nunn of Georgia to ask about the redeemability of Federal Reserve Notes. His reply arrived on March 11 and read (in part) as follows:

"Dear Richard:
Thank you for your letter requesting information on redeemability of Federal Reserve Notes for lawful money. I have enclosed information from the Congressional Research Service that I hope will be of assistance."
The enclosure was 4 pages from something called "The Gold Standard: Its history and record against inflation. A Study prepared for the use of the Subcommittee on Monetary and Fiscal Policy of the Joint Economic Committee, Congress of The United States." It was printed September 18, 1981. I was sent only the England and U.S. portions of the study. What they revealed was most interesting. From the England study: (Emphasis added)
"England has had 350 years of experience with various forms of the gold standard. She first went on the gold coin standard, de facto, in 1717. This was done by Sir Isaac Newton, then Master of the Mint. It was done by pricing gold at the mint more favorably, relative to silver, than in the marketplace. An Act of Parliament in 1816 gave formal recognition to this 'new' monetary standard that had been operational for a century in promoting England to a world power.
"Between 1797 and 1821, England temporarily suspended the gold standard because of the economic disruptions of the Napoleonic Wars. With no gold backing to the currency, the supply of money had no discipline except that imposed by the Board of Governors of the Bank of England (analogous to our Fed of today).
The result was that wholesale commodity prices shot up nearly 50% in 4 years-a momentous inflation.
The 'Bullion Committee' was formed by parliament to investigate. Their findings read in part as follows:
'The suspension of cash payments has had the effect of committing into the hands of the Directors of the Bank of England, to be exercised by their sole discretion the immediate charge of supplying the country with that quantity of circulating medium which exactly proportioned to the wants and occasions of the Public. In the judgment of the Committee, that is a trust which it is unreasonable to expect that the Directors of the Bank of England should ever be able to discharge The most detailed knowledge of the actual trade of the Country, combined with the profound Science in all principles of Money and circulation, would not allow any man or set of men to adjust, and keep always adjusted, the right proportion of circulating medium in a country to the wants of trade.'
"Gold convertibility of the currency was resumed in 1821. It is a matter of record that wholesale prices came back down immediately to the level preceding the hiatus in the gold standard.
"England was again off the gold standard between 1919 and 1925. When she resumed gold convertibility it was on a gold bullion standard where she remained until 1931, when she went off the gold standard altogether in the midst of the Great Depression."
Under the United States, we find the following:
"The long period of the gold standard in the United States was not an economic nirvana. The most severe inflationary period reaching completion under the gold standard was from 1897 to 1920. But from trough to peak, the average annual compound rate was 5.4%--mild by present experience. And most of this occurred from 1914 to 1920 when the European war and its aftermath bore so heavily on the domestic economy. If we look at the period between 1897 and 1914, the average annual rate of inflation was 2.6% -- enviable from the perspective of today."

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