Why gold matters

12 mins. to read
Why gold matters

We face grave threats and growing uncertainties within the financial markets. Gold doesn’t solve all of the world’s problems – but it’s a start, writes Tim Price.

Few assets are more misunderstood than gold. Central bankers quietly amass it, even as they publicly denounce it. It is widely regarded as redundant, what Keynes called “a barbarous relic”, in a world of electronic money.

So why own gold at all? And more urgently, why own gold now?

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Just over a century ago, the British art critic John Ruskin told the story of a merchant who went on a long sea journey. With him he carried his life savings in the form of a large bag of gold coins. Suddenly a terrible storm came up. The alarm went out to abandon ship. The man strapped the bag around his waist, hurried out on deck, jumped overboard – and promptly sank without a trace. As the man disappeared beneath the waves, Ruskin posed a question:

“Now, as he was sinking, did he have the gold? Or did the gold have him?”

No other form of money carries the historical baggage of gold. But be under no illusion, money is precisely what we’re talking about. As the banker JP Morgan put it, gold is money – everything else is credit.

Traditional economists assign money three characteristics. It is a unit of account – we can price things with it. It is a medium of exchange – we can use it as a helpful replacement to the barter system. And it is a store of value – it retains its purchasing power over time.

Our modern electronic money still retains the first two characteristics. But as for the third… Since the establishment of the Federal Reserve in 1913, the US dollar has lost roughly 98% of its purchasing power. Sterling has done even worse. Indeed, every unbacked paper currency in history has ultimately failed. The dollar will be no different. It is only a question of time.

Gold as money

The likes of gold and silver developed as money in a free market. Throughout human history we have used all kinds of things as money – cattle, shells, nails, tobacco, cotton, even giant stone slabs. But gold and silver always won out over the competition. People tended over time to favour the precious metals as money because of their scarcity, durability, malleability, and beauty. Their use arose without coercion. Gold is the money of freedom.

Gold is also scarce. And it is horribly expensive, in both capital and human terms, to dig out of the earth and process. To produce one ounce of fine gold requires thirty-eight man hours, 1400 gallons of water, enough electricity to run a large house for ten days, up to 565 cubic feet of air under straining pressure, and quantities of chemicals including cyanide, acids, lead, borax and lime.

Being chemically inert, gold lasts. The US author Peter L Bernstein points out that you can find a tooth bridge made of gold for an Egyptian 4500 years ago. Its condition is good enough that you could pop it into your mouth today.

And it is wonderfully malleable. If you have just an ounce of gold, you can beat it into a sheet covering one hundred square feet. Or if you prefer, you could draw it into a wire fifty miles in length.

In recent monetary history 1971 amounts to ‘Year Zero’ for gold, because that is when President Nixon finally took the US dollar “off gold”. With the US economy straining under the twin demands of a “guns and butter” economic policy that began with its entry into the Vietnam War, foreign governments, led by the French, were queuing up to redeem their dollars and exchange them for gold.

But on August 15th 1971, Nixon went on national television and interrupted an episode of ‘Bonanza’ to announce that the dollar’s convertibility into gold was being “temporarily” suspended.

That led to a 40 year-plus experiment in money that remains unprecedented. When Robert Mundell was made a Nobel Laureate in Economics in 1999, he pointed out that,

“The absence of gold as an intrinsic part of our monetary system today makes our century, the one that has just passed, unique in several thousand years.”

Gold now accounts for less than 2% of global assets – it is hardly over-owned.

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The problem with this experiment in money is that an unbacked money allowed the world’s central banks – all of them – effectively unlimited powers of credit creation and money issuance. If your printing of money is no longer constrained by a finite amount of bullion, you can print, and borrow, as much as you like.

Mundell could see the way the world was going. In March 1997, two years before receiving his Laureate, Mundell would remark, ominously,

“Gold will be part of the international monetary system in the twenty-first century.”

The author Nathan Lewis agrees. The title of his 2007 book on the subject? Gold: the once and future money.

The world, straightforwardly, is carrying too much debt. If you accept my thesis that the accumulated government debt burden of ‘the West’ is now effectively unpayable, you must, in turn, accept the thesis that there are three and only three ways in which that debt burden can be resolved.

How to escape the debt trap

Option 1 is for western governments to ‘engineer’ sufficient economic growth to service that debt. I doubt if this is possible anywhere, but I have the biggest misgivings when it comes to the eurozone, which feels to me like it is already in a depression.

Option 2 is for western governments to default; to repudiate their debt. Since we also operate within a debt-based monetary system, in which money is lent into being by banks, a sovereign default by any major government would equate to something akin to Armageddon. Let’s park that option for a second.

By a process of elimination, logic, and thousands of years of history, we get to Option 3. Option 3 is an explicit policy of state-sanctioned inflationism. Governments will choose to inflate the debt away.

Which is precisely what QE – Quantitative Easing – is all about.

But QE has failed.

Despite ten years, trillions of dollars’ worth of collective money printing by western central banks, ZIRP, NIRP, and the most outrageous experimentation in monetary history, where’s the inflation?

There has clearly been inflation in the prices of financial assets. That, in turn, has led to increasing inequality between the wealthy and the poor, and the rising social tension that accompanies it. But as defined in CPI or RPI terms, inflation remains stubbornly invisible. Indeed, QE has been such a failure that it has actually brought us deflation instead.

And a world of deflation is a world that bankrupts heavily indebted governments.

Here is what Russell Napier, a financial market historian, has said about our predicament:

If central bankers’ manipulation of prices fails to generate strong private demand and inflation, then the necessary debt to GDP reduction must come in highly destructive ways for the owners of capital. Society will have to choose between austerity, default, or the creation of a government demand-driven reflation. These are the only three options if central bankers fail to boost growth and also inflation. Austerity would bring depression; default would bring bankruptcy, and a government demand-driven reflation would bring some degree of suspension of the market economy. These are painful and difficult choices if central banks fail. [I] believe that society will most likely choose the apparently least painful route and thus we now face a massive structural shift away from a market-orientated economic system.”

In short, Russell predicts the reintroduction of capital controls, as governments simply elect to replace the central banks in the cause of stimulating inflation.

Let us consider for a moment the implications of Russell’s warning.

“A shift to the conscription of capital by government to force a government-led investment cycle would be very positive for gold. Gold, the form of capital that is easiest to move without trace, is the most difficult form of capital for governments to conscript. Those qualities will produce many buyers as the nature of the authorities’ response to our deflationary bust become ever more apparent. So how do we weigh up the negative impacts for gold of a rising US dollar and rising real interest rates with the positives associated with increased government intervention in markets? We wait for the gold price to rise even as the US dollar is rising. That should provide sufficient evidence that the threat of a government-instigated reflation is more than offsetting the negatives associated with the current deflation. Should that reflation succeed, then gold would likely be a major beneficiary as positive real rates of interest would turn into negative real rates that would be sustained by financial repression for perhaps a few decades.”

Why own gold?

Why own gold? Because it makes sense, within a properly diversified portfolio, to have portfolio insurance. If you own a home, it makes sense to have fire insurance. Your investments are no different. And gold is now back, more relevant than ever. Since the start of the millennium gold, as expressed across a wide variety of currencies, has generated average annualised returns of over 9%.

Within my wealth management business, we allocate client capital across four main asset classes:

  • Cash and objectively high quality debt
  • ‘Value’ equities, internationally
  • Uncorrelated funds
  • Real assets, notably the monetary metals, gold and silver

Our objective is not to maximise returns per se. Our clients are already wealthy. Rather, our objective is to try and generate a meaningful return on their capital while simultaneously ensuring that these portfolios are not subject to the risk of a catastrophic permanent loss of capital. That means, in part, genuine asset diversification.

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Cash and debt are nominal assets. Equities and real assets, as the name implies, are real assets – claims on the real economy, and an inflation hedge of a sort. But in each case, the risks are different. Cash and bonds both come, inevitably, with credit and counterparty risk. A depositor in a bank is effectively an unsecured creditor to that bank. It comes as news to many depositors when they appreciate that they no longer have a legal claim to their money on deposit. Legally, it belongs to the bank. But the logic and natural fairness of this relationship clearly breaks down when depositors earn no money, or even incur negative interest rates, whilst taking the risk of being an unsecured creditor to the bank. Negative bank deposit rates are, logically, entirely consistent with a bank run.

But when it comes to credit and counterparty risk, gold comes with neither. Gold does not rely for its value on the solvency of some third party. It is not a claim against anything. Which is why gold is the perfect insurance against the failure of conventional money or the default of conventional debt. It is why gold is a more perfect form of money than any government-issued alternative.

One quotation from the world of economics fills me with more concern than any other. It comes from one of the founding fathers of the so-called Austrian school, namely Ludwig von Mises. As someone with first-hand experience of the notorious Weimar era hyperinflation, Mises warned:

“The credit expansion boom is built on the sands of banknotes and deposits. It must collapse… There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Our central bankers have made it abundantly clear that the credit expansion must and will continue.If Mises is correct, then the ultimate resolution of the crisis is also clear:

“…a final and total catastrophe of the currency system.”

Which is why you need to own gold now. You buy fire insurance beforeyour house is already ablaze. It is too expensive, if it is even possible, to buy it once the conflagration has begun.

The time to buy insurance is before the house is ablaze

Faith in paper currencies, and in the governments that issue and consistently degrade them, doesn’t follow a linear progression. Avalanches don’t happen in tidy stages. Snow continues to pile up until the system tips from being stable to unstable, whereupon one random snowflake will cause the entire snow mass to collapse. We just don’t know which snowflake it will be. Similarly, we don’t know which act of monetary insanity will cause the financial system to implode. We just have to recognize that the system is no longer stable – if it ever has been.

If you elect for convenience’s sake to own gold in the form of a fund, ensure that you own allocated gold – that is, gold owned outright by you and held in your name. You don’t want exposure to unallocated gold – which is the property of the custodian. That’s like being a depositor / unsecured creditor all over again. There are far too many paper claims on gold and simply not enough of the physical asset to support them. Paul Mylchreest, editor of ‘The Thunder Road Report’, a specialist gold publication, wrote several years ago warning of a potential short squeeze in the physical market:

“The next major leg up in the gold price will prove to be a religious experience for those people unfortunate enough to find themselves short.”

And if you hold gold in the form of a fund, also ensure that that gold can’t be lent out, or ‘rehypothecated’. Again, there are too many people playing too many games in the ‘fractional gold’ physical market – and there is insufficient supply of the physical asset to support all the contingent claims upon it. You don’t want to be caught short as and when the next ‘run to gold’ begins.

We face grave threats and growing uncertainties within the financial markets. Gold doesn’t solve all of the world’s problems and it would be silly to believe it does. But as an alternative to keeping flawed money in a flawed banking system, it’s a useful start. It’s a hedge against both inflation and systemic financial distress. And it’s the best performing ‘money’ in counterparty risk and purchasing power terms that you can own. So, here’s to gold – the once, and perhaps future, money.

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