The case for gold (part one)
Over the last 30 years, we have witnessed runaway inflation, a variety of speculative bubbles and a succession of currency crises. Is there no way to escape this mayhem, which spreads its misery from the day-labourers of Buenos Aires to the pensioners of New York? In fact, one solution offers itself; an idea so unpopular that only a handful of cranks nowadays even dare consider it. In order to rid the global economy of its chronic instability, we must return to our golden fetters.
In an introduction to a recently-published collection of historic writings on gold (The Case for Gold, three volumes, Pickering & Chatto), William Rees-Mogg lays out the case. Of all the currencies invented by man, according to Rees-Mogg, only gold is stable over the long run. Since Britain adopted a fiat currency in 1931, sterling has lost more than 98 per cent of its value. Gold, on the other hand, has retained its value: an acre of English agricultural land cost ten ounces of gold in 1800 and roughly the same amount 200 years later.
Rees-Mogg argues that a paper currency, prone to inflation and freely floating on the foreign exchanges, does not meet two of the classical requirements of money; that it should be both a standard and a store of value. Take away the stability of gold, he says, and long-term contracts become too risky. This argument overlooks the development of derivatives over the past quarter of a century, which can be used to hedge most financial risks and whose expansion is directly related to the collapse of the Bretton Woods currency system in the early 1970s. Yet contained in this collection is a more powerful critique of paper currencies. Economists of the Austrian school-such as Ludwig von Mises and Murray Rothbard-argue that the interest rate in a free market should be determined by the forces of supply and demand, rather than by the diktat of central bankers. A gold-backed currency, they claim, provides a self-equilibrating mechanism, balancing both the demand for investment with the supply of savings, and the demand for imports with the supply of exports.
According to the Austrian economists, paper currencies suffer from the inability of central bankers to determine the correct interest rate. In order to please their political masters, central bankers tend to set the rate of interest too low. This may produce several ill-effects, including excessive investment, insufficient savings, the over-extension of credit and the appearance of trade imbalances. All of these imbalances emerged in the US during the late 1990s, which explains why the Austrian economists feel a particular venom towards the chairman of the Federal Reserve, Alan Greenspan. The Austrians concede that booms and busts appeared under the gold standard, but argue that there was a natural tendency for the boom to be extinguished-through the medium of rising interest rates-before it did too much damage.
However strong the case for gold, there is no chance that it will be realised. First, central bankers will not concede the supreme power that is now vested in them; and, being economists, will find reasons to validate their activities. Second, most people in modern democracies have no desire to live under the rigorous regime of the gold standard, which would deny them pleasure of consumption before the pain of accumulation.
The case for gold (part two)
While hopes for a return to the gold standard appear forlorn, the investment prospects of the barbarous relic are positively glittering. Why? Gold tends to perform well when other asset classes are doing poorly. It provides a hedge against inflation when bonds are hammered. It also does well during equity bear markets, which tend by their nature to be backward-looking. In addition, of all the asset classes gold alone provides a kind of super-catastrophe insurance against war and other unpleasant occurrences.
All these conditions pertain, or at least may do, over the next few years. The US is on the verge of war with Iraq. There is a good chance that western stock markets will remain in the doldrums for some time. The boom of the late 1990s has left behind a huge pile of debt. It may occur to policy-makers, and compliant central bankers, that the best way to deal with this debt is to reduce its real value through inflation. If this happens, then bonds will plummet.
The particular situation of the gold market has also turned bullish. In the late 1990s, mining firms became so pessimistic about the downward trend in the price of gold-which declined over 20 years from around $850 an ounce to under $250-that they engaged in large forward sales, which only served to depress the price further. This situation is now changing. The gold producers are beginning to halt their forward sales. They are also consolidating, which will cause output to fall.
In recent years, the greatest enemies of the gold bugs have been the central banks, which have loaned their stocks of gold to short-sellers and sold off vast amounts of gold. These sales are coming to an end. Gold which was formerly lent out by the central banks is now in the hands of investors, who are less willing to undermine its value. In the end, the case for gold as an investment is little different from the case for a gold currency. If you believe in the over-arching competence of central bankers, avoid the precious metal. If you don’t, buy it.