Gold as a Store of Value, the Financial Foolishness of the West and the Wisdom of the East: the Winners and Losers of the Future
by Andrew Alexander
The views represented in this article are solely those of the author and may not be construed as in any way representative of the views or policies of Oxford Royale Summer Schools.
The gold market gives us an insight into all that is rotten in the modern economy.
The misallocation of risk, the failure to take a long-term view and the decision to chase short-term returns in high-risk assets with the belief that the government will always bail investors out: these are all hallmarks of the modern, Western financial system. As the West swaps its bullion for paper currency, and the East hoards the yellow metal, we are likely witnessing a transfer in wealth which will not be reversed for many generations.
Before discussing the modern gold market, it is imperative to talk about what gold represents. John Pierpont Morgan famously said that “gold is money, everything else is credit.” To an extent this is true – bank notes represent a promise on the part of a central bank, while savings and current account deposits are in reality loans from savers to banks. Gold alone represents both something which the owner can possess in fullness without other claims or obligations on it, and (crucially this separates it from, say, housing) something portable enough and liquid enough to be used as a medium of exchange.
Whatever the academic arguments one could make in support of this position, it is clearly one which bears little relationship to the real world. Gold is not money, people do not exchange ingots for their groceries, and we do not imagine a gold bar under the bed to be a more secure way of holding the family wealth than in a bank account.
The Role of Gold in Modern Economies
This is not to say that gold does not have an important function in the modern economy. In order to make this case it is firstly important to meet a criticism often levied by those who believe it to be a Dark Ages relic in the modern monetary system. These people claim that gold has no intrinsic value, and is therefore representative only of the slow pace at which human mental habits change, a metal relic in a fiat system.
In the sense that an intrinsic value is one which exists absent of subjective human judgement, then this is, of course, correct. No physical object holds an intrinsic value; the notion of worth and value is entirely subjective. However, if we were looking for an object whose subjective value was likely to endure into the future, then gold, which has been valued by human societies since the Ancient Egyptians in 3100 BC and which continues to grip the popular imagination as the, well, gold-standard for commodity investment seems a good bet. In contrast, fiat currency is a promise of payment based upon, amongst other things, the continuity of the nation state. Find me a 5,000 year-old nation state whose monetary writ still rules so many years hence.
The role gold plays in the system and, in my view, always has is as a hedge against the depreciating value of money. In other words, the fact that the gold price has moved from an average of $18.96 in 1900 to an average of $1571.92 in 2011 is not a reflection of an asset outperforming another asset (cash), it is a mark of the debasement of the dollar. In other words, thanks to inflation the amount of fiat currency you need to buy a basket of goods appreciates every year. Gold is the barometer against which we measure the declining value of money, and holding gold is not a way of making real terms gains in capital, it is a way of maintaining the level value of that capital base despite the falling value of fiat money.
The Declining Value of Money
The value of gold is measured in terms of currency. The value of gold in terms of paper money should be a function of the supply of both. In other words, the gold price should operate as a reflection of the degree to which gold is rare compared with money. When the increase in the gold in circulation rapidly exceeds the increase of money in circulation, you would expect the price of gold in money terms to fall, and vice-versa.
It is relatively easy to track the supply curves of both over the six years from 2007, when the financial crisis began to bite, and the present day in 2013. The supply of money has certainly gone up. Between them, the U.S.A., UK, Japan and Eurozone have purchased assets equivalent to 24% of their GDP, a total of $4.7 trillion in this period, using money which has been specifically created for this purpose by their respective central banks. Of these, the world’s largest economy, the U.S.A., has been growing its purchase programme by an annual compound rate of 28.1% per year. In the meantime, post-crisis annual gold production is up 12% (the figures only run to 2011). This would imply a steady rise in the gold price, and this broadly accords with what has happened until this year, when it has fallen back. The rationale for this fall has been the improving macro-economic picture in the West. Markets factor future expectations, as well as current supply, into their pricing, so this in itself is not illegitimate.
Even so, the price of gold is curiously low when placed in the context of the ‘innovations’ which the guardians of fiat money – the central banks – have discovered in recent years. In quantitative easing they have discovered a way of levying a tax on the poorer segments of society who rely on cash wages, rather than asset holdings, for income, without those segments noticing. The real value of cash wages falls, the assets held by banks rise in nominal value, allowing the banks to redeem what would otherwise be enormous losses. Quantitative easing is, therefore, a tax on holding money levied through the monetary policy-making system itself.
The reasons for which this very great change has gone largely unremarked upon are depressing. The median member of the general public in Great Britain and much of the West is almost certainly more ignorant of history, economics, literature, theology or the classics than at any time since the advent of mass literacy in the Georgian era. Any one of these disciplines would reward him or her with the intellectual tools to dissect statements on apparently complex social subjects with a degree of rigour, and would also teach him or her that there is immense value in the ability to evaluate how isolated individual events fit into general trends of epoch-defining importance. It would also allow them to place the tiresome, bitty news flow of modern times into its proper historical context.
In the early 1980s Western society has been defined by the same malaise which Gibbons discerned at the end of the Roman Empire and which the novelists, particularly Evelyn Waugh, among the Bright Young Things observed occurring as the foundations of the British Empire were laid waste in the 1920s.
It is not necessary to list all of these now. But most striking is an absolute refusal among senior figures in public life to tell the truth. Even relatively simple statements of fact must be couched in some nightmarish linguistic haze from which it is impossible for the casual observer to discern a meaning. This is especially the case with quantitative easing. A simple process – the creation of money ex nihilo not tied to production which is then used to inflate asset prices – is couched in dull technical language which prevents the public from rationally considering the consequences.
All of this is of relevance to gold. One of two things must happen eventually. Either quantitative easing must be withdrawn, with the government-held assets sold back into the market, causing a rapid fall in the value of all the assets whose values have been inflated by its operation, a result of a surge in supply, or quantitative easing becomes a permanent fixture in the Western economies currently practising it, meaning that the price of assets will continue to climb (and hence the value of money will continue to fall) permanently.
In both scenarios, it makes sense to hold gold. Continued quantitative easing penalises those who hold their savings in cash. On the other hand, holding savings in risk-loaded assets like equities raises the chances of suffering significant losses over the longer-term if the policy is reversed. Gold fills the gap as the only asset class at present which has a chance of storing value over the medium to long term with any degree of certainty.
China is a Long-Term Planner
This is not something which has been lost on the economies of the East. Both India and China continue to accrue holdings of gold at a rate of knots. This is driven by different internal markets – the Chinese government and Indian consumers – but in both cases, the urge appears to be to preserve existing stores of wealth, an urge which rests on the sentiment that fiat money is not to be trusted. The hunger for gold in these markets is so extreme that China is currently on course to import more than half of the entire world’s output of gold in 2013. Total demand from the East outstrips annual production, meaning a lot of the gold currently being traded is being sold by an existing holder. Obviously, that gold has to come from somewhere. It comes from the West.
Western governments have been anxious to divest themselves of gold for some time. Gordon Brown’s eccentric decision to sell around 60% of Britain’s gold reserves in a series of auctions from 1999 does not look particularly sensible in retrospect. The euros which he bought with the proceeds have offered little by the way of return, and are now being minted at an increasing rate by the European Central Bank. While there is a credible argument that Brown’s bullion sale was made for reasons beyond the direct scope of the national finances, it was not alone in being an example of technocratic European governments deciding to back the new, technocratic, central-banker-led fiat currencies in preference to gold, representing the wisdom and savings of the ages, early this century.
The result is that an ever-increasing share of the world’s wealth has now gone East. Britain’s gold reserves were amassed over four centuries of empire, world trade domination, military might and budget surpluses. They represented an inheritance from a glorious past capable of sustaining a country through a more austere future. Instead, this legacy was exchanged for some paper slips with European archways embossed on them representing a nominal sum of money which the ECB now happily summons into being on an average Monday. It is a legacy which will never be regained, and it is a tribute to both the Chinese and Indians that they have sought to benefit from the foolishness and vainglory of Europe’s monetary elite.
Western Economies are a House of Cards and Reality Cannot be Eluded Indefinitely
Modern, Western monetary systems are all based on promises. These promises are largely quite transparently untrue. For a long time, the Bank of England’s entire monetary framework was geared towards controlling inflation, a task it appeared to regard as boring and unworthy of its time while allowing month after month to slip by with targets missed. Bank notes too come with a form of promise, the idea that the issuer will make some attempt to maintain their value through scarcity. This scarcity has now been abandoned as a goal for central government in the rush to postpone the inevitable liquidation of profits which was bound to follow the shocks of 2007 – 2009.
When promises are suspended in favour of wishful thinking, the credibility of the entire system comes into sharp focus. It is not beyond the wit of man to restore order to his monetary affairs, although it may be beyond the wit of those men and women currently occupying the positions from which this might best be achieved. Should the worst happen, though, and confidence in the promises made by central bankers evaporate, I would be distinctly more comfortable were my government holding something of a more enduring value than some slips of paper decorated with pretty pictures. I would feel more comfortable if it held gold. In the final analysis, perhaps the most telling part of this whole sorry saga is that the one country that really does appear to understand how to hedge risk properly in the capitalist system is the world’s last Communist superpower. The West had better hope it is a hedge which is never called into use.