is money and nothing else" ~ JP Morgan, testifying to the
Pujo Committee, 1913.
breach of the symbolic US$1,000 level has elicited a predictable
amount of commentary from mainstream analysts. The problem is, much
of it is ill-informed. Due to the general amnesia of most market
analysts, of all asset classes gold remains the most misunderstood.
In order to comprehend why gold is rising and why it will continue
to rise in the years ahead, we need to review some history.
As JP Morgan
pointed out early last century, gold is money, and nothing else.
Grasp this simple fact and you understand gold. More to the point,
gold is international money. It always has been. Over thousands
of years of human economic interaction, gold (and silver) evolved
as the chosen medium of exchange. These two precious metals contained
all the qualities necessary to facilitate growing trade and economic
interaction. The most important quality of course was man’s inability
to create the metals out of nothing. Alchemists tried, but to no
avail. This inability to manipulate supply made the metals perfect
for the role of money.
de-monetized by the major developed nations at the end of the 19th
century, leaving gold as the pre-eminent monetary metal. (Silver,
however, continued to circulate as money in the peripheral economies,
such as Latin America and Asia, including China).
Under the classical
gold standard prior to World War I, gold coins circulated as money
alongside banknotes, although for ease of use banknotes were preferred…as
long as people had confidence that they were backed by gold. So
the system acted as a natural restraint on banks issuing too much
credit. If they did, gold reserves would flow from the offending
bank, forcing it to curb it easy lending ways.
In the same
way the system was also a natural check on government spending.
But the outbreak of World War I made such restraints impractical.
Governments needed to print large quantities of paper money to finance
the war effort. Instead of paying for the war through increased
taxes, citizens paid via inflation, a far more subtle and insidious
While war spending
led to massive and widespread currency depreciation against the
international monetary standard – gold – Britain stupidly
tried to return the pound to gold at the pre-war parity, which grossly
overvalued its depreciated currency. It didn’t do so straight away,
as the economy would have collapsed. It was not until 1925 when
Chancellor Winston Churchill announced the pound’s return to gold.
(The new gold standard was a deliberately poor imitation of the
classical standard, but that’s another story.)
pound decimated British exports, especially the traditional industries
of coal, iron and steel and shipbuilding. With these workforces
heavily unionised, wage rates were too high and unemployment rose.
This placed more pressure on the government to print their way out
of trouble. Headed by Bank of England Governor Montagu Norman, Britain
hoped and persuaded the US (through Norman’s good friend Benjamin
Strong, the boss of the New York Federal Reserve) to inflate their
currency to "catch-up" to the weakened pound.
The US’ willingness
to help Britain return to a half-baked gold standard by keeping
interest rates lower than they should have been led directly to
the stock market boom of the late 1920’s, and the subsequent depression.
The downturn in world trade hit the rigid and uncompetitive British
economy hard, and in 1931 Britain finally faced the reality of its
disastrous monetary policy and abandoned the gold standard. The
pound plummeted against gold and those countries holding pound sterling
as reserves, believing it was "as good as gold," suffered
massive losses. In this way the pound relinquished its role as the
world’s reserve currency.
The US dollar
remained fixed to gold at $20.67 per ounce for some time longer,
but with competitive devaluations occurring around the world, US
citizens began to realise that gold was undervalued in terms of
US dollars. So like any rational person, they exchanged their paper
money for gold. This "run on the banks" forced the government’s
hand and within days of taking office in March 1933, President Roosevelt
closed the banks for nearly a week and upon reopening, forbade them
from paying out any more gold.
A few weeks
later, Roosevelt demanded that all bank and private ownership of
gold be handed over to the government at the official price of $20.67.
This process continued for the remainder of 1933 and in January
1934, the government re-valued gold at $35 per ounce, robbing their
citizens of some $3 billion in the process.
efforts of governments and central banks around the world, gold
has not gone away. It is still money. The US dollar remained officially
fixed to gold at a ratio of 35:1 until 1971, when more money printing
led to the breakdown of the dollar exchange standard. Gold is now
hovering around the $1,000 an ounce mark, which says something about
the Federal Reserve’s management of their currency since the 1970’s.
Gold is rising
because the international monetary system, with the US dollar at
its core, is in the process of breaking down. Decades of unfettered
credit creation by the global banking system, led by the US, is
now beginning to implode. This is deflationary, as the private sector
begins to reduce its huge debt burden.
A huge expansion
of government debt around the world is mitigating some of the deflationary
force of contracting private sector credit. So while deflation risk
is the pre-eminent threat and will be for some time to come, as
more and more government paper flows through the credit system inflation
will surge. It is worth examining an important difference between
private and public debt to explain why.
can and does go "bad." It essentially represents money
that was created and spent, but ultimately proved unproductive.
The money disappeared. This is deflationary. Government debt –
at least government debt with a AAA rating – does not go bad.
The US or UK government for example will not default on its debt.
As the debt comes due, the government will simply issue more debt
to pay for it. The end game is a massive devaluation of the currency.
against what? All other nations are trying to inflate their economies
equally by issuing huge quantities of government debt. China is
no exception. With the yuan linked to the US dollar, the Peoples
Bank of China must print money to maintain the link. This is causing
asset bubbles to surface again in China. All fiat currencies are
equally as bad.
The gold market
knows this. Gold is saying that the crisis is not over, that it
is in fact getting worse. We are seeing Gresham’s Law in action,
as bad money pushes out the good. Gold is being swept off the market
by millions of individuals who know that without fail governments
always ruin the value of their paper money.
have always resented gold because when freely traded, its price
tells the story of bureaucratic ineptitude. So don’t expect gold
to breeze through the psychologically important $1,000 mark. In
fact, despite gold’s recent rise and the weight of history on its
side, a record net "short" position has been building
to the tune of nearly 28 million ounces. Someone is betting very
heavily on a price fall.
In the past,
large net short positions have presaged big, albeit brief, price
declines. Will it happen again? It might, but who really cares?
The damage to gold will be short lived and after this crisis fully
plays out – and it will – gold will have soared against its paper
rivals. More importantly, gold will still be money, and nothing
Greg Canavan [send
him mail] is editor of Sound Money. Sound Investments,
a soon to be launched financial letter providing wealth generation
and protection opportunities in a post credit bubble-bust world.