Gold, Wealth, Production and Immorality (Part 1)

I love to read different and interesting views to those of my own, particularly in the realm of economics and finance, as it keeps me grounded and constantly questioning my positions. The latest differing view comes from Twitter, which directed me to this post from Frances Coppola on the merits (or lack thereof) of ‘hoarding’ gold. Built on a general disdain for gold, the post touches on a wide variety of subjects, from savings, to production, to morality to financial Armageddon, so at the very least it is interesting. After reading it, I attempted to write a comment but thought it deserved a more thorough response (which has now become a two part post).

Coppola begins by recalling a Twitter battle she had with ‘people who appear to have an almost religious belief in the virtue of gold as a store of value,’ appealing to the tired, lazy argument that anyone who has ever said anything remotely positive about gold must be crazy, cemented by comparing those people to ‘religious cultists.’ Having been taken aback by their ferocity in debate, she went ahead and read some of the writings of their ‘guru’ FOFOA, from whom she picked up a deeper understanding of what their beliefs are. She lists them, and begins her objections to them. I will discuss two of her discoveries. She writes:

I’m going to summarise here what I have drawn from these writings.

  • In these people’s world, gold does not rise in price as people invest in it, unlike any other commodity. They invert the charts that show the rising gold price and use them to demonstrate instead that the dollar is collapsing.
  • They believe the reason for the dollar’s collapse is the unsustainable level of US public debt, which is driven at least in part by its trade deficit arising from the dollar’s status as international reserve currency. They call this status an “exorbitant privilege” and claim that it has been used to enable the US to borrow higher amounts, at lower interest rates, than any other country. Although there is currently a large and liquid market for USTs – and even a shortage of them – they believe that the world will eventually reject US debt as a safe asset, which will trigger unstoppable flight to hard assets (gold) and hyperinflation of the dollar against gold as noted above.

Before discussing the validity of those beliefs, I’d like to briefly step back and discuss what money is and the monetary system itself. Very quickly, the defining feature of money is its wide acceptance in trade as a medium of exchange. Other features, such as being a store of value, are implied by that wide acceptance because one who receives money anticipates using it in exchange at some future point. The key here is that there are many things that can store value, but not all of them can be considered as being money. The characteristics that make something quality money include durability, divisibility, portability, and scarcity. Throughout time, man has used many different goods as money, almost in trial and error fashion, finding that some things worked better than others. Goods such as salt, tobacco, seashells, beaver pelts and many others functioned as money in different times and different cultures. For various reasons, these goods all were replaced by other goods which better fit the characteristics of high quality money. Ultimately what ended up winning the competition among goods to be used as money was gold and silver, because its properties lent themselves better than any other good to fit the characteristics of quality money outlined above. As a result it became widely accepted for use in commerce.

From that, a system of assets could be organized, resting upon a basis of money. From the establishment of modern banking until 1971, that money, gold, was at the base of the system. From there, bank notes or other promissory notes could be drawn up, which gave the holder a claim on an amount of underlying gold. These notes could themselves be exchanged for goods and services, transferring the claim to gold from person to person. Over time, these bank notes became standardised by sovereigns to take the familiar form of currency that we know today as dollars, pounds, euros, yen, rupees and so forth. Debt instruments, such as sovereign debt and personal loans again give the holder a claim on a certain amount of currency at a certain time. Of course this asset, as described before, itself represented a claim – on gold. Securities that were based on sovereign debt or other forms of debt introduce yet another layer of assets. In short, we have a system in which money sits at the base of an inverted pyramid, on top of which currency, debt and other securities are stacked. Or, as J.P. Morgan succinctly put it in 1912: ‘Gold is money. Everything else is credit.’

What changed in 1971 when Nixon closed the gold window was simply the official removal of the bottom layer of the pyramid, or more accurately the replacing of gold at the base of the monetary system with paper money. If Morgan had spoken after 1971, his quote would have read ‘Federal Reserve Notes are money. Everything else is credit.’ What essentially happened was the victory of fiat paper money over gold as the new form of money, just as gold had triumphed over salts and furs as money long ago. This victory is still a condition of the current world we reside in, and ‘gold bugs’ must accept this.

What anti-gold people must accept, however, is the fact that the victory of fiat over gold as money came about through political decree, as opposed to a human-wide move towards seeking improvement in the quality of money. In other words, political expedience drove the move to fiat more than anything else. It says nothing about whether the move actually left us with money that is of higher quality than before, in terms of the characteristics of money listed above. If the new system is in fact worse, it will result on people seeking out the better one, regardless of the political stamp of approval placed on the new system. To further illustrate, imagine that Nixon had declared instead that all buildings going forward should be constructed from cardboard only. Assuming for some reason it was accepted, the new building standard would be eschewed once the quality of buildings was exposed as inferior. Nixons’ decree would not have changed the fact that lumber and concrete are superior building materials to cardboard.

With respect to the first bullet point above, the point made by FOFOA as Coppola understands it is that the increase in the price of gold is indicative of a decline in the value of the dollar, as opposed to being indicative of individual supply and demand factors specific to gold, like any other commodity. To reason this way requires divorcing the monetary aspect from gold completely. As I wrote in the preceding paragraphs, this is now justified from an ‘official’ standpoint, but it is equally justified from a ‘quality’ standpoint to continue to recognize the monetary aspect of gold as FOFOA has done. If doing so, it is correct to state that a rising gold price indicates a fall in the value of the dollar. Recall that the dollar represented a claim on a certain amount of gold. Not a claim on a certain amount of any other good. Its value was always expressed in terms of gold in an almost definitional manner. One could trade claims, expressed in dollars, for another good or service, but the net result was simply transferring the claim on gold to someone else. The value of the claim itself with respect to gold was always fixed. Now, if at a later date, a higher dollar total was then required to claim the same amount of gold, it is quite obvious that the value of each individual dollar has fallen. When FDR devalued the dollar, he did so by increasing the amount of dollars it took to procure the same weight of gold as before, specifically from $20.67 to $35 per ounce.

Presenting the second bullet point again:

  • They believe the reason for the dollar’s collapse is the unsustainable level of US public debt, which is driven at least in part by its trade deficit arising from the dollar’s status as international reserve currency. They call this status an “exorbitant privilege” and claim that it has been used to enable the US to borrow higher amounts, at lower interest rates, than any other country. Although there is currently a large and liquid market for USTs – and even a shortage of them – they believe that the world will eventually reject US debt as a safe asset, which will trigger unstoppable flight to hard assets (gold) and hyperinflation of the dollar against gold as noted above.

It was the French who initially coined the phrase ‘exorbitant privilege’ to describe the position the United States held post WWII, with a reserve currency deemed as ‘good as gold.’ President Charles De Gaulle stated in 1965 that:

The fact that many countries accept as a principle dollars as good as gold for the payment of the differences existing to their advantage in the American balance of trade, this very fact leads Americans to get into debt, and to get into it for free at the expense of other countries. Because what the US owes them, it is paid at least in part with dollars only they are allowed to emit. Considering the serious consequences a crisis would have in such a domain, we think that measures must be taken on time to avoid it. We consider it necessary that international trade be established, as it was the case, before the great misfortunes of the world on an indisputable monetary base, one that does not bear the mark of a particular country. Which base? In truth, how could one have any standard criterion other than gold?

De Gaulle was rightly critical of the existing system that enabled the dollar to be virtually equivalent to gold. However, as I’ve mentioned before, in that system, the dollar is a currency and thus a claim on money (gold), and not the money itself. The ability for the US to create unlimited dollars created a situation in which more dollars existed than it had gold, increasing the likelihood of a run on US gold reserves. In order to forestall this, Nixon closed the gold window, defaulting on the obligations to redeem dollar claims for gold, and ‘officially’ detaching gold from the monetary system as mentioned before.

The post 1971 system has given the US an even greater ‘privilege,’ with the dollar functioning as the primary reserve currency and the actual base of the system as opposed to merely a claim on the base. And accordingly it has borrowed in greater amounts than any other country. Should the US continue to pile on debt at the parabolic pace it has done, it will be in a position no different to where it was in the late 60s. Whereas then it had issued too much currency (claims) relative to its gold reserves (money), in the new system it will have issued too much debt (claims) relative to dollars (money). The joker here is the fact that the US has the ability to create dollars, which in the new system is money, such that it can avoid defaulting in nominal terms, the way it had to default in 1971 by declaring it would no longer redeem gold.

The creation of dollars in this manner is not a one-time thing. The United States has built an economic structure that relies on the ever increasing amount of debt to fund consumption. It faces two options: Curb the debt and allow that structure to collapse, or attempt to sustain the structure by increasing debt further still for the foreseeable future. The increased debt issuances in the second option have to be met by constant creation of dollars, for the purposes of keeping the rate of interest pressed to the floor to maintain an air of sustainability with respect to interest obligations. This is what the Federal Reserve has been doing for the last number of years in its various operations.

Crucially, the creation of dollars weakens its value, which has negative implications on the monetary system as a whole. Given the dollars’ position as the base of the system, a fundamental and continued weakening of the dollar automatically renders its derivatives weaker as well. For example bonds, which are simply claims on future dollars, would be rendered less valuable if the underlying asset is less valuable. The immediate argument against that statement would be the performance of US treasuries, having done nothing but go up throughout these ‘weakening’ exercises. The response is to point out that, while Treasuries have appreciated in price, they have become less valuable, returning less and less in real terms. The constant pressures driven by a hypothetical continued issuance of debt, and printing to service that debt, continually puts downward pressure on the value of the money itself and its derivatives. This is the hyperinflation end that is often talked about and stems from the consistent erosion of value in money followed by a psychological distrust and abandonment of it as money by the people.

This brings us back to the characteristics of good money and the system that forms on top of it. Above I listed some characteristics of good money, the relevant one here being scarcity. Good money has to have some degree of scarcity to retain value and to prevent the inevitability of transactions being done in impractically large amounts. The bases of the two monetary systems mentioned above – gold and fiat money – are both durable, divisible, portable, easily recognized, and so on. The major difference between the two is scarcity. The potential for fiat to be produced in unlimited quantities works against it in an assessment of its quality as money. Mind, it is much better than many other things that used to be money, but it falls short of gold due to the scarcity issue. This is something that humans have understood for a long time now. Humans have also understood the need for expedience in distressful moments, politically or in times of war. This is why on many occasions, including the Nixon decree, fiat money has come into existence. This propensity of man to opt for expedience, however, does not render fiat to be a superior alternative, just as in the example above the existence of cardboard buildings does not render them superior to ones made from concrete.

In part two, I will discuss the morality issues that Coppola raises involving the desire of some to opt for gold, in its current, ‘unofficial’ capacity.

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