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26 September 2013

Gold - An Inconvenient Truth

“Bad money drives out good” – Gresham’s Law was named after Sir Thomas Gresham, a sixteenth-century financial agent of the English Crown in the city of Antwerp, to explain to Queen Elizabeth I what was happening to the English shilling. Her father, Henry VIII, had replaced 40 percent of the silver in the coin with base metals, to increase the government's income without raising taxes. Astute English merchants and even ordinary subjects would save the good shillings from pure silver and circulate the bad ones; hence, the bad money would be used whenever possible, and the good coinage would be saved and disappear from circulation.


That sounds pretty simple, but have people in western societies forgotten what it means and its relevance today? Gresham knew how money worked and so did the populace because it was simple, unlike now. Because of the complex nature of modern finance, the mindset of the current population places too much trust in the financial elites even after all that has passed since 2007/8. The complacency that exists seems to suggest that people are prepared to accept the current monetary status quo even though they know that the seemingly mild inflation eats away at their savings and incomes. However, under the present formula being imposed, they may eventually be wiped out by an ever increasing inflation rate stealthily hidden by government manipulation of the headline statistics.

Loaded with Debt

From an early age we learn that money comes in coin and paper form and also in plastic in the shape of credit and debit cards. The disconnect  that occurs seems to be that people in general do not recognise that the role of cash has changed from being an asset broadly backed by gold prior to 1971 to being a liability backing debt after this date. They do not recognise that debt underpins the modern monetary system, and that when the system becomes overloaded with debt as occurred in 2008, it fails. The response to the failure has been a zero interest rate policy to reduce the repayment load, and bailouts of insolvent institutions (which adds more debt to the system) with the burden of all of this falling upon the innocent taxpayer. Problem one is that the debt must still be repaid, but problem two is that the debt is then so large that we have basically no way of paying it off. Put simply, the UK’s combined debt load, public, corporate and private is in the region of 500% of GDP and that does not include all of the unfunded liabilities - for example, public sector pensions, the NHS and a huge benefits system. Confidence in the system is now low and as the public cut back and de-lever the economy contracts, asset prices fall which then puts the insolvent banks back in trouble. Quantitative easing saves the day, hurrah! Money printing, buying bad assets from banks to re-capitalise them so that they can continue to lend to people who don’t want more debt, and money they can use to enhance markets in stocks and bonds to prop up their balance sheets. Problem solved then? Of course not, we have just delayed the day of reckoning. The bad assets still exist but are just on a different balance sheet and to some extent are conveniently forgotten until such time that they rear their ugly heads again. I suppose that if the powers that be delay long enough and create enough inflation then the debt will just go away along with everybody’s savings.

Gold Buying

So, back to Gresham. All of this newly printed money is “bad money.” So what should be done? People in the East, (China/ Russia/India) seem to have their answer. They buy gold. Gold is a misunderstood resource in the West but clearly has not been forgotten about by our Eastern counterparts. Gold is traditionally viewed as the best store of value for the long term and has been for at least the last 5000 years due to its many monetary qualities; currently its best quality is that you just can’t magic it out of thin air. The amount it grows by is a fairly consistent rate of 1.5% per annum so it is a constant against which other things can be valued. It’s pretty difficult to value anything accurately in a fiat currency world when governments and central banks are expanding the money supply (M1) continually through QE and devaluing currencies at will.

It Could Have Been Different

Maybe we could have avoided all of this current pain if we as humans did not have the greedy gene. The maintenance of the Glass-Steagall act in the US could have limited the leverage in the system but so could a gold standard. Of course, back in 1971 when the world was forced off gold as a trade settlement system (Bretton Woods) by the US (who then created the petro-dollar standard whereby Saudi Arabia would only accept dollars for oil) only broke with gold because they saw that their gold reserves were being depleted rapidly due to their deficit spending - living beyond their means!

Recent Moves

So back to the present. The gold story has been one of intrigue. It has risen pretty much continually for the last decade with the odd blip (2008 financial crisis) on the back of concerns over monetary expansion, potential high inflation and massive deficit spending by now insolvent governments/countries. And after the initial concerns we have had bailout after bailout and QE to infinity particularly in the US and Japan with probably more to come in the UK. So why has gold mysteriously dropped in fiat currency terms over the last 12 months? Western Governments, Western Central Banks and the Western Media hate it and are happy to tell the world that gold is a relic of the past. It is also in the interest of the authorities for the price to be lower so as to discourage buyers and to shake existing holders of the physical product out of the market in order to ease supply issues and undermine confidence in the metal.(The lower price has however had the opposite effect in the “physical market.” )  Why all the effort? Well, gold is a bell weather “currency” in a commodity guise and it is therefore sought after in times of financial stress. It is the futures market that prices it. As in any commodity market, if someone sells forward, either as a hedge of mine production or speculatively, the commodity must be either delivered against the forward short when it becomes prompt or borrowed or bought back. 

Listen to the Market

The gold market is potentially telling us a “truth” at the moment as a “physical metal” bottleneck is occurring as holders of the physical gold do not want to let it go due to concerns about the global financial system again. “Tail risk” as central bankers call it, a catastrophic collapse for anyone else! Thus we have a backwardation (The gold offered forward rate “GOFO” is below the paper spot price) which looks like it is not going away. This should just not happen in a properly functioning system because when GOFO is negative it means you will receive more interest when you lease your gold than your dollars, i.e. there is more interest to borrow gold and use dollars as collateral. Gold is perceived as having more value as something to hold than dollars. Could this be the first signs of people losing faith in “paper” currency? This situation looks set to continue with queues of people lining up in China and India to buy gold and many central banks adding to their reserves or trying to repatriate (with difficulty) gold held abroad. The West is seemingly being bled dry of the physical product as hoarding is taking place. The futures paper market could lose “control” of their ability to price the commodity/currency and thus default as lenders of last resort. Cash settlement would be the order of the day leaving the physical price to break free from the leveraged shackles of the paper based futures market.

QE to Buy Gold?

Imagine a world where gold increases in price so rapidly that countries decide that only gold will do in payment for international trade.  We would be heading back to a quasi gold standard. Fixed price gold based on money supply? Who knows, but the gold market is clearly telling us something at the moment that is seemingly being ignored by the financial elites and governments in the West. Let us hope that they start to take notice soon because a trade settlement style gold standard would make the UK a much poorer country due to our lack of gold reserves. Maybe we should be printing money to buy as much gold as possible before it’s too late.     

The author of this article is Richard Horswill. All views expressed are his own.


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