Which would you rather own – $42,000 in a bank account, four bitcoins on your hard drive or a kilo of gold bullion under your bed?
Cash versus gold
Cash is useful stuff but you wouldn’t want to carry too much of it: it is bulky and can be easily lost or stolen. Money in the bank is much more convenient and normally yields a modest return. These days one can easily make payments from bank accounts – even in very small amounts – using our ubiquitous debit cards.
On the other hand – is the money you have on deposit with the bank really safe? Bank deposits rest on the delusion of crowds: in theory, you should always be able to take out all of your money deposited in cash as and when you want. But we have always known that if everybody did this at the same time, the bank would crash – since no bank ever holds more than a tiny fraction of its total assets in notes and coin. This is exactly what happened in the UK in the case of Northern Rock in September 2007. That was the first bank run in the UK since the 1860s when they were frequent. The novels of Dickens, such as Martin Chuzzlewit, are full of good old-fashioned runs on banks.
Again, if you have a tidy sum of money in the bank right now it is costing you to keep it there in real terms. Inflation in the UK (and elsewhere) is running well ahead of deposit rates. You’ll be lucky to get more than one half of one percent on your savings account while consumer price inflation is running at around three percent. So, doing nothing, you are losing about 1.5 percent of your savings every year. This is an injustice of Biblical proportions: the provident are being punished.
That is why we are advised to move unneeded cash into financial assets or property; in a word – to invest as much as we can afford. But, what if we think the equity markets look toppy and property is already in mild decline – as seems to be the case in the UK?
In Crypto we trust…
Satoshi Nakamoto, if he exists (and “he” is probably not even Japanese) must be feeling quite pleased with himself. On Tuesday (28 November) bitcoin hit the psychologically significant $10,000 mark. If you had bought a bitcoin two years ago you would have paid $300 – so you would have made a phenomenal return. On the other hand, on Wednesday (29 November), the cryptocurrency, having hit an all-time high of $11,434 plunged 20 percent back to $9,009 before rebounding.
How much further can it go? Your guess is just as good as mine… But it walks and talks like a bubble to me.
On the dollar bill – the greenback – the inscription reads In God we trust. But if Americans trust the Almighty to sustain the value of their currency then He has let them down. Thanks to inflation and the massive printing of money (which are of course intimately connected) the value of the greenback in purchasing power terms has plunged over the last century. In 1907 there was about $7 billion in circulation (notes and coin plus bank deposits); in 2017 the stock of dollars stands at something like 1,700 times that figure[i]. In 1907 one dollar could have purchased a pair of the finest leather shoes for which you would have to pay $200 today.
As I shall explain in my forthcoming piece in the December edition of Master Investor magazine – The Future of Money – an explosion in the money supply followed the Nixon Shock of 1971 when the US dollar was uncoupled from gold and all currencies were left “to float” on the international foreign exchange markets.
The advantage of cryptocurrencies (and gold) is that their supply can be fixed or restricted such that, when used as a medium of exchange, they will not generate inflation. In fact, one reason that central banks oppose the widespread adoption of cryptocurrencies is that they fear they will cause deflation. That said cryptocurrencies and gold could not be more different.
Bitcoin and its imitators are entirely intangible. I suppose that you could argue that they are physically manifest in your computer hard drive – at least one investor has lost big money when his hard drive died. Gold, in contrast, one of the heaviest and lustrous metals on Earth, is absolutely tangible. And yet the modern economy is one in which intangible assets are outpacing tangible ones. Apple (NASDAQ:AAPL) is the largest company in the world by market capitalisation – and yet it owns virtually no physical assets at all. The largest items on the assets side of its balance sheet are cash, near-cash, capitalised R&D and goodwill.
There are a gaggle of contenders in this space as well as the most well-known, bitcoin: Etherium, Litecoin, Monero, Dash, Stellar Lumens, Xem. I could not possibly tell you what is the comparative advantage of each – and I doubt that any other serious commentator could either.
But one reason “to trust” them is that they allow one to circumvent the banking system completely. Neither the greedy bankers nor the interfering central bankers can get their pesky hands on your money. Yet the only reason why bitcoin et al can be regarded as a store of value is that they can be converted back into “real” currencies, such as the US dollar, at bitcoin exchanges. If all countries outlawed bitcoin exchanges, as China has, its value would surely plummet.
I strongly suspect that what I call the priestly caste of central bankers will soon club together to ban bitcoin and other digital currencies outright – possibly as soon as next year. If there is a crash in the value of bitcoin they will use that as an excuse “to protect” the crypto nerds from their own folly. Thus they will drive its devotees into the bowels of the dark web where they shall rub shoulders with drug dealers, paedophiles, gun-runners and other ghastlies.
Gold is not really a medium of exchange any more but it is most certainly a store of value. Let’s agree for now that it is a commodity.
In my December magazine piece I ask whether gold might ever be reinstated as the standard against which currencies are valued – but I won’t give away my conclusion here. For now, the question is: in an era of floating exchange rates and “paper” or “fiat” money, what drives the price of gold?
In 1971 gold started out at $35 an ounce. As I write this, the price of gold is at around $1,297 – which is $41,702 per kilogram. If you can bench press your own weight in gold, you are not only buff but rich! So gold has appreciated 37-fold since fixed exchange rates were abandoned. Why?
There is obviously an ongoing demand for gold given its use in jewellery (especially wedding rings and chains) and as gold leaf in fine art and religious iconography and so forth. It is highly malleable and never tarnishes. In India and China, even relatively poor people treasure gold jewellery both for its intrinsic beauty and for the social status that it confers.
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Gold also has industrial applications. It is a highly efficient conductor of electricity, it does not corrode and it is bio-compatible – meaning that it can be used in contact with the human body without any ill effect – which is why it has been used for dental fillings for centuries. It is used in small quantities in mobile phones. Each mobile device contains about 50 milligrams of gold. That is tiny: but multiply that by one billion hand-held devices manufactured globally each year and that adds up to about $500 million worth of gold for that purpose.
But the demand for gold as a commodity used for jewellery and in modern electronics does not explain the 37-fold increase. Most of that increase is accounted for by the huge successive waves of inflation which the abandonment of the gold standard unleashed.
The main reason why gold is in demand is that it has come to be seen as a hedge against inflation and as a fail-safe asset that will keep its value in a recession or a depression. At the height of the fall-out from the financial crisis of 2008-09 – in October 2011 to be precise – gold hit a modern all-time high of around $1,900. From that level it declined to the $1,200 mark by mid-2013 since when it has been trading in the $1,000 to $1,300 range.
Remember that gold is an asset which offers no return in the form of income: the only return is the capital gain you may (or may not) have made when you come to sell it. In fact there is a cost-of-carry in the form of storage fees and transaction costs when you buy or sell. Even if you keep gold ingots under your bed you would be well advised to insure them against theft – which will not come cheap.
But as interest rates rise the opportunity cost of gold – that is the income forgone by not holding bonds and instead holding gold – increases. Now the interest rate prevailing has two components. One is the real interest rate (once inflation is taken out) and the other is the current rate of inflation. (There is an issue about whether you take the Retail Price Index (RPI) or the Consumer Price Index (CPI) – but let’s not muddy the water.) The conventional wisdom is that the gold price comes under pressure when the real interest rate rises faster than inflation.
One problem with this is that, after the Credit Crunch, the Federal Reserve and the Bank of England conducted expansionary monetary policy by means of quantitative easing (QE) for years. The European Central Bank (ECB) embarked on the same course later – in July 2012 – in a bid to do whatever it takes to save the Euro. This means they used invented money to buy financial assets such as bonds, thus increasing the supply of money in the economy. This on top of near-zero interest rates which persist: in the US the Fed Funds rate is currently 1-1.25 percent and the Bank of England Base Rate is 0.5 percent.
This programme of QE pushed up asset prices, including bond prices, and thus put downward pressure on bond yields – and therefore on the entire structure of interest rates. This was especially true of government bonds – Treasuries in the case of the USA. For much of 2012 and 2013 the yields on 10-year US Treasuries Inflation-Indexed Securities (TIPS) were negative over a range of maturities, even though the US economy had already started to recover. That was a great time to be a gold investor and indeed it was then that the price of gold spiked, trading in the $1,600-$1,800 band throughout those two years. Since real US interest rates turned positive again in roughly mid-2013, the gold price has more-or-less flat-lined.
Clearly rates in the USA and in the UK are heading up – though at a snail’s pace. On 14 June the Fed raised US rates by one quarter of one percent for the second time in 2017. And on 02 November the Bank of England raised the UK base rate by one quarter of one percent, reversing the post-Brexit referendum cut of August 2016. This was the first interest rate rise in the UK for over 10 years.
If this trend continues then we might expect interest rates at least to converge with the rate of economic expansion – GDP growth – which currently is at 3 percent in the US, though more like 2 percent in the UK (and heading south). Over the long-run, historically, prevailing interest rates have tended to be at least the growth rate plus the rate of inflation. The ten years after 2007 have been an aberration, historically speaking and, depending on your point of view, may turn out to have been temporary rather than the new normal. Such a return to “normal” levels of interest rates would, all things being equal, be bad news for gold investors.
On the other hand, there is a fair amount of inflationary pressure building up in the UK. This is largely of the cost-push variety arising because of the increased cost of importing goods thanks to the weaker pound sterling post-June 2016. At the same time, the recovery from the recession that followed the Credit Crunch, which began in 2011-12, is now more than five years old. While the UK was able to begin the recovery well ahead of the major EU economies, UK growth is now trailing below theirs, suggesting that the UK is on a different business cycle. If recession looms, it is unlikely that the Bank of England would raise rates further.
In short, if you believe that there may be a recession soon or that QE might make a come-back then you are more likely to be bullish on gold. As already mentioned, the real interest rate in the UK right now is something like minus two point five percent. Thus any cash you may have on deposit is losing money fast. Gold is a reliable hedge.
A future worry – exchange controls
Under the Bretton Woods system exchange rates were fixed domestically in terms of the US dollar, but capital could not flow freely between countries as this would have permitted speculators to exploit interest rate differentials between countries. Thus capital or exchange controls were imposed, limiting the export of both cash and bank account money. In fact these persisted long after Bretton Woods was abandoned in 1971.
It is incredible to reflect that until Mrs Thatcher came to power in 1979 British people could not take more than £25 out of the country in cash for their holidays. My parents drove their young son across France several times in their Ford Anglia in the late 1960s and early 1970s, living on a pittance. Fortunately for us, in those days, France was dirt cheap – though French food then was immeasurably better than it is today.
What is often overlooked is that ownership of gold was also tightly restricted. Indeed Americans were not allowed to own bullion until the 1970s as bullion was a government monopoly. If I am right that cryptocurrencies will soon be outlawed, there could be a displacement effect in so far as there will be more demand for gold. But if I am also right that states will launch their own sovereign monopoly digital currencies – starting with China, quite soon – they may find it necessary to restrict ownership of gold as well.
As I wrote here two weeks ago bitcoin is not even one thing. On 01 August this year bitcoin split into two derivative digital currencies, the classic bitcoin (BTC) and Bitcoin Cash (BCH). Then a third currency emerged in October – Bitcoin Gold (BTG). So we had digital currency and now we’ve got digital gold…
Bitcoin Gold is a Hard Fork of the cryptocurrency bitcoin, which is the nexus that “mints” new bitcoins in order to meet new demand. The fork took place on 23 October this year and was apparently created in order to facilitate a specific transaction and “to make the fork decentralised again”. This variant of bitcoin has received very negative publicity in its short life. A “data correction” on 25 November made Bitcoin Gold the fifth biggest cryptocurrency by market share on Coin Market Cap. Then the exchange released a critical warning on its blog revealing that its team discovered “two suspicious files of unknown origin” in its Windows Wallet installer[ii].
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Best of luck to you if you are invested in that one. The more I read about bitcoin, the more I get the sense that it is a cyber-game played between geeks for whom the prosperity of investors is the very last of their concerns.
But, suspending disbelief for a moment, if we can create a digital simulacrum of currency, why could we not create a digital version of gold? Well, once they have cracked their state monopoly digital currency – as I will argue in my magazine piece – that is exactly what the Chinese will do. Starting very soon, any oil exporter who sells oil in yuan/renminbi will be able to convert their surplus Chinese currency back into gold on the Shanghai International Energy Exchange. At the moment the contract is for the underlying physical gold…but that will change if the forthcoming Chinese digital currency becomes dominant…
As to my original question – the answer is personal, depending on one’s circumstances and one’s outlook. My own eccentric answer might be: None of those, thank you – I’ll go for six acres of prime agricultural land.
They can’t digitise land…Can they?