A Brief Treatise on Gold and Other Currencies
Asset prices were volatile in 2011, especially to the downside. As the sovereign debt and banking crisis in Europe continued, signs of a global economic slowdown mounted, and a variety of other negative factors weighed on securities markets. One of the best performing assets in 2011 was gold, up 10%, although also with plenty of volatility. The S&P by comparison was flat while touching both 1,100 and 1,350 in the course of the year. Balestra has held varying amounts of physical gold and gold derivatives since 2002, during which time it has been our single largest asset and in most years the most volatile. This report will present some background information for gold and explain our case for gold as an important investment asset.
History is replete with politicians and central bankers hijacking sound currency systems. That process is once again well under way on a global basis. Ever more debt and fiat currencies are flooding global markets. We believe the bull market in gold has further to run despite the second half 2011 setback. The post World War II global monetary stability underpinned by the U.S. dollar (and gold until 1971) has come undone.
Conventional wisdom has it that gold is an anachronism, which John Maynard Keynes famously called a “barbarous relic.” For over 60 years since WW II, individual countries and the global economy have functioned quite well as gold’s role as a currency and store of wealth has diminished. Indeed, the final break in 1971 of the technical connection between the U.S. dollar (as the world’s reserve currency) and gold heralded a magnificent period of global growth and prosperity. History shows, however, that eventually any given monetary paradigm breaks down. We believe that this kind of change is now underway.
The long-term case for gold is supported by other strong factors. While gold does not pay interest or a dividend, unlike fiat currencies, it cannot be created in infinite amounts. It is also not subject to ratings downgrades and deteriorating sovereign balance sheets. It is not a liability of a company or a country. The skepticism about gold in the developed world is not shared in the developing world. Gold deposits have become harder to find and far more expensive to mine and process. Central banks have recently been building their gold reserves, instead of selling them. Gold is not substantially held across the worldwide spectrum of investors. Conventionally trained investors are not believers. Nevertheless, if for no other reason than that the global store of gold is limited while paper money is rapidly proliferating, gold’s role as a store of value is expanding, and its investment profit potential is rising.
The Evolution of Money
Over the course of centuries, metals became the currency of choice because they are divisible, portable, and easily stored. Metals can be standardized and made into coins. Eventually, governments entered into the business of money creation by standardizing coins unique to their jurisdictions. The first coins were valued based on the actual weight of the metal in the coin. Many different metals were used, but by the middle ages, silver and gold rose to the top.
Individuals looking to safeguard their gold deposited it with goldsmiths. The goldsmiths issued receipts to be used to redeem the gold at a later time. Eventually, these receipts began to circulate as a medium of exchange. As gold receipts gained widespread acceptance as currency, the goldsmiths/bankers discovered that their gold holdings were quite stable, with few depositors seeking to redeem at any given time. Gradually, the goldsmiths/bankers removed the warehousing fees and started paying interest in return for the right to loan out the gold they held. The nascent bankers further discovered that they could loan out a multiple of the gold on deposit to increase profits. Rather than loan out the physical gold, the goldsmiths simply created new gold receipts. Thus, we had the beginnings of the framework of the modern day system of fractional reserve banking, where a bank depositor and a borrower from the same bank effectively had title to the same ounce of gold (i.e. one ounce of gold but two ounces of gold money). The additional money created through this process is referred to as bank credit, and is the primary means by which new money now enters the global economy.
The final progression in the evolution of money was the complete removal of any commodity backing. Fiat money, as it is called, derives its value from the legal tender status bestowed on it by the issuing government. Critics of fiat money rightly point out the prior failures of fiat money standards. That is, all known fiat money regimes prior to the one operating at the present have ended with debilitating inflation.
The History of Currency Debasement and Fiat Money
Currency debasement is used to describe present date central bank actions such as quantitative easing. However, the classic meaning of the term currency debasement refers to when ruling regimes would systematically lower the metal content in order to increase the amount of coins in circulation. The government could easily introduce the debased currency into circulation by paying its bills with devalued coin. As the previously higher valued coins were used to pay taxes, the government would melt them down to make the new coins. The earliest known example may be the Roman Denarius, which was first issued in 211 B.C. as a relatively pure silver coin. Over centuries, the silver content was gradually reduced by various emperors. By the 4th century A.D., the silver content was less than 1%. Rampant inflation had become evident, and is now considered to be a major precipitating factor in the fall of the Roman Empire.
It is quite easy to see that early currency debasement was simply a precursor to fiat money. In many cases, a commodity standard was merely a pretense that governments adhered to when it was not a hindrance to rulers’ objectives. Historically, when governments found they could not finance themselves under a commodity money standard, they have either debased the currency, or moved to fiat currency.
The first known paper currency, which was dubbed “flying money”, originated in China under the Tang Dynasty around the 9th century A.D. Due to a copper shortage, it was intended to be used as representative currency for the copper coins that normally circulated. The succeeding Song Dynasty began issuing paper money in greater amounts in the 10th century A. D. Although the notes were valued at a fixed rate to gold, silver and silk, redemption was never actually allowed. Over the ensuing centuries, inflation became a problem, and the notes fell out of favor. Succeeding ruling regimes expanded the use of paper currency with virtually no commodity backing. In 1455, amid hyperinflation, the Ming Dynasty suspended the use of paper currency and returned to a copper standard.
Colonial America had several early disasters with fiat money. A shortage of specie (coins used as money) with which to finance trade led to the issuance of fiat currency in the mid 1600’s. Massachusetts is believed to be the first