"Gold is money and nothing else" ~ JP Morgan, testifying to the Pujo Committee, 1913.
Gold’s recent 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.
Silver was 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).
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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 tax.
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.)
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The overvalued 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.
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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.
Despite the 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.
Private debt 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.
Devaluation 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.
Governments 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 else.
September 16, 2009