Hold Gold or Fold

It is the job of the American central bank, known as the US Federal Reserve, to set interest rates for the biggest economy in the world. Although its committee members are very intelligent we must also remember that they are only human. Just as our musical tastes and fashion sense are heavily influenced by what was prevalent in our youth, central bankers are likewise shaped by the economics they grew up with. Many were brought up with stories and direct experience of the Great Depression. They were taught that adherence to the Gold Standard brought on two devastating periods of deflation in the 1890’s and 1930’s.

The idea of the Founding Fathers in the USA was that their currency should have real value behind it in the form of precious metals. The rationale stemmed from events in their own era on another Continent. The build up of massive debts in France had been caused by a mixture of overseas wars and a failing tax system that fell most heavily on the poorest members of society. The end result is well known; abject poverty leading to a Revolution and thereafter a complete debasement of the French currency. The Church and aristocracy were not subject to these taxes so it was not surprising that the ensuing revolutionary wrath fell directly on their heads (literally).

The first deflationary problem from the Gold Standard (otherwise known as a real money policy), came in the 1890’s but this was later offset by the Klondike gold strikes. In effect, the extra supply of metal allowed an increase in the supply of money, which in turn reflated the economy. The next deflationary shock came in the 1930’s but this time there was no discovery of gold to offset the collapse of the stock market bubble and subsequent crunch. The first death knell for the Standard came in 1933 with FD Roosevelt’s devaluation of the Dollar versus Gold. However, it was not until the 1960’s that we saw its total abandonment as the US government sought to print money and burn off old debts through inflation, in part to help finance the Vietnam War.

Central banks are now free to control the money supply, and hence the economy, uninhibited by any restraints of holding real assets to back paper money. Central bankers are therefore somewhat dismissive of gold as this is seen as a vote of no confidence for paper money and hence a bad reflection of their abilities. However, the notes in your pocket are just an IOU and if central banks turn on the printing presses to reflate the economy, they are likely to create inflation and devalue their currency internationally. It then becomes an IOU that does not inspire confidence. Interestingly, since the Federal Reserve was created in 1913, the Dollar has depreciated by some 90%, with the bulk of this occurring since leaving the Gold Standard.

For those who think that a bit of inflation through devaluation does you good, they should think again. Inflation has a habit of snowballing in a self-feeding spiral. For example, in the face of punitive reparations after WW1, the German Weimar Republic deliberately set about devaluing their currency in order to pay off the unrealistic debts imposed by the Allies. The spectre of workers taking delivery of pay in wheelbarrows of cash and burning it as a cheaper source of fuel compared to coal are a stark reminder of what can happen. The later consequences of this economic instability are scarred across the world’s history books. Apart from pushing up short term interest rates, inflation also damages the value and future purchasing power of government bonds (alternatively known as fixed income securities). Rising inflation pushes up government bond yields which in turn increases mortgage rates for Americans and diminishes their disposable income.

Even the faintest whiff of inflation can have drastic consequences. We have recently witnessed an unfortunate development where the Federal Reserve Chairman Alan Greenspan changed his rhetoric from fears of deflation to expectations of a return to economic growth. These mixed messages in such close proximity brought about the biggest and quickest bond market sell-off in decades. The surge in bond yields will have a direct effect on mortgage rates, US disposable income and property values and hence consumer confidence will suffer. It also comes at a time of rising unemployment with manufacturing jobs shifted to China and service jobs outsourced to India. So, in a world where share valuations are expensive, a bond bubble is bursting and property may follow, where do we turn? There is one market that is slowly gathering pace and is generally going unseen by the public and that is gold. Many investors have not noticed the fact that its price has appreciated with a weaker Dollar and in turn some of the mining stocks have been hitting new highs.

To consider the logic of such a strategy, just think for a moment about how much one can trust the international IOU (US$). If you were to go into space for ten years and had a choice of leaving $100,000 cash or $100,000 worth of gold in a safe for your return, which would you choose? For me it would always be gold because it has stood the test of time as a keeper of value for over 4,000 years. If you cannot hold the metal at a bank then buy some mining shares. In the flat, churning stock markets that we are witnessing today, a buy and hold strategy for mainstream equities is no longer appropriate. However, there is a bull market brewing in gold so a long-term strategy makes sense. If nothing else, gold is a great hedge against future risks and is a key ingredient that we have added to client portfolios.

Toby Birch
January 2004