Friday, November 16, 2007

Liberty Dollar and the inflation-proof currency

On November 15, the FBI has raided the offices of Liberty Dollar and seized all its assets. Up to that point, the Liberty Dollar was the best known alternative currency in the US, a currency that cold be used by those who didn't want to pay or receive payments in US dollars. The main reason for not using US dollars was stated as the fact that US dollars are not inflation-proof. Liberty Dollar has solved this issue by linking its currency with precious metals. Its coins contain an amount of precious metals, mainly silver and gold, valued at the coins' face value. Its notes (deposit certificated) were fully backed by precious metals, including two tons of gold, which were seized in the raid.

It is not my goal to explore the legalities of using Liberty Dollars or government theft; other blogs have covered it already. I was more interested in the claim that Liberty Dollars or other precious metals-backed currencies were inflation proof. The currency's Web site is prominently featuring a well-known chart showing the decline in the value of US dollar. I recreated the chart using government inflation data:

What the chart does not address, though, is the growth in prices and wages. Inflation causes harm primarily if the growth in personal income is lower than the rate of inflation. The following chart shows the level of disposable (after-tax) personal income. Note that to normalize this number and account for differences in industry-specific wages and number of household members, I averaged the total personal income by the number of people in the US. This chart shows income in current dollars, not adjusted for inflation.

The graph seems to grow faster than the decline in dollar value. This is not an illusion - translated into 1914 dollars, the average disposable personal income grew from $400 to $1600, a four-fold increase. This despite the fact that the average tax burden grew from 2% to 12%, a six-fold increase. In other words, if the US dollar didn't change its value, we'd earn four times as much today as nearly 90 years ago.

In fact, it seems that wages have almost always outpaced inflation in the US. The following chart shows the inflation-adjusted change in wages, as well as the price in two staples that haven't changed much for the past century: a gallin of milk and housing costs. As can be see, we not only earned more in real wages, but we spent less on housing and food. The reason we don't feel much richer is that we find new things to spend our money on.

In fact, we are not saving much at all. Gone are the Jimmy Carter days of nearly 10% saving rates; for the past two years we saved less than 1% of our disposable income. Given that all my savings (with the exception of a small sum in the bank I need for liquidity) go into gold, I was wondering how well gold would hold up against the dollar. The following chart shows two things: the number of gold the average American could purchase with his savings every year, and the total profit or loss generated by holding onto the gold, given the gold spot prices.

As can be seen, if a person started purchasing gold since the abandonment of the Breton Woods System (given that that's when the price of dollar began floating against gold), by 2001, 30 years later, that person would lose money. That despite the fact that at that time the person would accumulate over 25 pounds of gold. Only thanks to the most recent fall in the price of dollar the value of gold holdings would yield a profit. Thanks to this, the current return on investment averages 7.74% annually for the past 36 years. That is still less than putting all savings into a Dow Jones index fund, which would at this point yield around 8.67% annually and increase the total gain in savings from $140,400 for investing in gold to $177,300.

I believe that historical inflation data doesn't support the claims than precious metals based currency was safer than US dollars. That doesn't mean it will be true for the future, though. As the past few years show, the US dollar may be on the verge in a long-term slide, and with no clearly dominating currency in the next few decades, gold may be the safest investment. I'm betting on it.

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