In gold we trust?

Throughout history, when societies and economies implode and currencies lose their value, people have taken refuge in the enduring power of gold.

In the Weimar Republic, when hyper-inflation took root, the exchange rate rose from 7.95 marks to the dollar in January 1919 to 130,000 000,000 in November 1923. Where ordinary Germans held their life-savings in marks they became worthless, and there was a rush to acquire gold, land and other 'real' assets. In the recent Global Financial Crisis, the price of gold started rising in the early 2000s, declined around the peak of the stock market boom in 2008, and shot ahead after the crisis took hold.

In the words of Julius Sumner Miller – why is it so?

Ron Hera of Hera Research LLC has suggested some answers in a paper (dated 26 March 2012) that has been widely posted on investment sites on the internet: 'Value subjectivism and monetary instability'. Hera is an advocate of a position that is common in certain circles in the investment community where there is nostalgic for the days of the 'gold standard'.

Up until the 1930s, when the USA and other countries abandoned the gold standard, countries tied their currencies to the price of gold, in the belief that this would stabilise them. After 1933 countries decoupled their currencies from gold, and were free to vary the price of their currencies as one of the various economic tools at their disposal to achieve their economic policy objectives.

The charge is that the price of currencies has become decoupled from any intrinsic objective standard, and that modern paper money only works at all because governments decree that people have to use them as the media of exchange – they have become 'fiat currencies'.

The advocates of gold are generally conservative in their political orientation, and adherents of the ideas of the American writer Ayn Rand. Ron Hera approvingly refers to Rand's theory of morality, which is based on individuals and groups pursuing their own interests without coercion, which he characterises as an 'objectivist' view, as opposed to the 'subjectivist idea' that reality is what we perceive it to be, and values are whatever we decide they should be.

The gold enthusiasts are also very much drawn to the school of economics known as the 'Austrian School', which included Friedrich Hayek who exerted much influence on Margaret Thatcher, and whose high priest was Ludwig von Mises.

Hera advances 15 specific arguments against the use of paper currencies that are not linked to the price of commodities such as gold:

1. Abstraction- money is an abstraction and fiat currencies have no value

2. Coercion– people would not use fiat currencies unless they were compelled to do so by their governments.

3. Rent seeking – 'fiat currencies extract economic rents by forcing commerce to take place in the fiat currency system.'

4. Immorality – 'fiat currency schemes are immoral because the primary thing that makes them acceptable is coercion.'

5. Central planning- fiat currencies are maintained and managed by central government authorities that cannot by their nature make correct decision about the quantity or price of money needed for a given economic situation.

6. Price instability – fiat currencies cannot achieve stable prices for the same reason.

7. Economic volatility – fiat currencies magnify economic volatility because they become increasingly decoupled from 'physical economic activity in the objective world'.

8. Currency debasement – governments inevitably keep increasing the supply of money, thus debasing its value.

9. Wealth redistribution – arbitrarily increasing the quantity of money in circulation redistributes purchasing power away from the majority of savers and workers.

10. Concentration of wealth – over time, fiat currency schemes cause wealth and property to accrue to those who control them ( a variation of argument 9)

11. Moral hazard – the small groups who enjoy a monopoly of economic power in fiat currency schemes inevitably abuse that power

12. Corruption and cronyism – these flourish for the same reason.

13. Confidence failure – fiat currencies depend on trust, not objective value, and confidence in them inevitably fails as they are debased

14. Counterparty risk – this is a variant of argument 13, based on the idea that the trust between governments, central banks and individuals is broken by currency debasement.

15. Transaction settlement – transactions based on fiat currency do not exchange value for value, and the party that receives currency in exchange for goods and services is at risk.

While there is merit in some of these arguments, they all rest on one broad and very questionable premise – that gold, unlike paper money, has an objective value.

But no serious economist would advocate this idea, and indeed it goes quite contrary to the principles even of Austrian economics itself. One of the first principles of the Austrian school is that value is in fact subjective.

Price emerges through the operation of a market which aggregates all the individual choices made by myriads of individuals who buy and sell in that market. The whole point indeed is that each individual makes his or her own choices, which are driven not only by their interests, but also by their values. Those values are not measurable, but the objective market price established through exchange is (see Robert P. Murphy's post on the U.S. Mises Institute site).

The price of commodities has risen and fallen over the ages influenced by both supply and demand and by fashion. Many of the sailors on Henry VIII's famous Mary Rose warship died with collections of peppercorns sown into their pockets. Why? Because peppercorns were new and exotic and rare, and were regarded as an ideal way to store value. Over the centuries, their novelty value wore off, and supply increased, to such an extent that they became commonplace and small amounts of peppercorns are worth only a few dollars now.

But through all this time gold has kept its value, and has never suffered these types of precipitate declines – why?

While the prices of other commodities have been through extreme variations through time, eventually falling out of favour, humans have valued gold in all known societies where it has been present, ranging from West Africa through to Spain, which sent expeditions to South American in search of El Dorado. It has been valued both for its relative scarcity, and for its aesthetics. Other elements are scarcer, but not as attractive and so not seen as effective stores of value.

For hundreds of years the gold price in England and the U.S.A. was set by governments. There have been steady increases in the amount of gold on the market over the long term since the price was deregulated in 1968, matched overall by steady advances in price, from $38.31 to $1,889 per ounce. The supply of gold has not shot ahead like the supply of peppercorns, and humans continue to love gold even more than they love peppercorns. This is partly because of its innate attractiveness and partly because of its reputation as a hedge against inflation. Mike Hewitt, another advocate of gold and Austrian economics, argues that the market price of gold in the long term is related to the growth in the global money supply (see various papers on goldnews.bullionvault.com). When the money supply rises, people buy gold because they anticipate that inflation will also rise.

On the same U.S. Mises Institute site, Robert Blumen (29 May 2010) explained that the price of gold is not determined simply by the increase in the supply of gold from mining in a particular year. The price of gold derives from the total demand at any point in time for the total amount of gold that exists.

The key reason why the Austrians saw gold as a source of price stability was that the supply of gold onto the markets cannot be manipulated by governments. When currency consists of digital artefacts, governments and central banks can increase the quantity of it almost at will. This has been the principle policy response of recent years to the lingering effects of the GFC, and so the four leading central banks have increased the money supply by $8 trillion in the last five years. Money is created and then lent to banks and to governments at very low interest rates. This is otherwise known 'quantitative easing' (QE) or 'printing money'.

Ben Bernanke, the President of the Federal Reserve is a long-standing student of the Great Depression and an adherent of the view that the deflationary effects of a contraction in credit of this magnitude need to be fought by expansion in the money supply.

On the other hand, adherents of the financial instability theory of Hyman Minsky and others (such as Australia's Steve Keen, who calls himself a 'post-Keynesian'), argue that economies move through cycles of boom followed by bust that are fuelled by excessive growth in credit during the good times. When the bubbles burst, a period of deflation inevitably follows that cannot be counteracted, in their view by monetary expansion.

Both the post-Keynesians and the Austrians place great stress on the excessive expansion in credit in the boom phase, as a key causative factor leading to a compensatory deflation afterwards, caused by severe falls in aggregate demand, in turn caused by unwinding levels of private debt.

The huge increase in the supply of money has made its way onto equity markets and resulted in rises in the prices of risk assets (shares) especially in the US. But the effects on economic growth have been much more modest, and the US has struggled to generate enough growth in jobs to decrease its unemployment rate.

The jury is still out on whether the QE strategy will work or not. While in the short term it has increased the price of the assets held by the financial elite, Ron Hera is probably right that in the long term QE will undermine value. Relative to gold, US equities have been in long-term decline since 2000, and this trend is likely to continue for some years before the next turn-around.

It is drawing a long bow to suppose that returning to the gold standard, however, would have prevented the GFC. The early examples of bubbles, such as the South Sea Bubble and the Mississippi Bubble, show us that capitalism is characterised by periodic booms and busts regardless of the type of currency that prevails. Markets can go haywire without the intervention of governments, although governments can contribute. There were severe economic crises in every decade of the 19^th century and up until the Great Depression, right throughout the period when most advanced countries were on the gold standard.

The GFC originated in just such a wild fluctuation in the markets. Of course the prolonged ultra-low interest rates of the Fed contributed to this, but the invention of opaque financial instruments and sheer greed played the largest part. In many countries, unprecedented government deficits were more of an effect of the GFC, as the vast liabilities built up in the private sector were transferred from banks to governments, than a primary cause.

Governments are making things worse, however, by following pro-cyclical instead of contra-cyclical policies. Instead of storing up surpluses in the good times that can then be spent in the bad times, evening out the business cycle, they have sent like drunken sailors in the good times, and then been forced to cut spending massively in the bad times, thus accentuating the effects of the crisis on 'we the people'.

The excesses of economic cycles have their origin in the famous irrational exuberance of investors. Towards the end of the upward phase of the cycle, positive feedback loops form in which investors pay higher and higher prices for assets, prices which are not justified by the real return on investment that the assets can produce. Ultimately stock markets regress towards the mean, and investors who have paid too much for assets that deflate are ruined.

Gold can offer a safe haven in difficult times like this, but is surely no panacea for regulating economies.