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Good as Gold?

Thursday, December 15, 2011

Both very rare and useless for anything else, gold is uniquely useful as a store of value. While a gold standard will never return, here’s a way to make money once again as good as gold.

Gold is funny stuff.

It’s incredibly heavy. With a specific gravity of 19.3, almost three times that of iron, a lump of gold the size of a quart container of milk would weigh nearly 40 pounds.

It’s incredibly rare. If you wanted to build an exact replica of the Washington Monument out of gold, all the gold ever mined would not allow you to build more than the bottom third.

It’s incredibly malleable. A lump of gold a fifth of an inch across can be hammered into a sheet 18 inches per side.

It’s incredibly desirable. Gold was one of the seven metals known to the ancients (the others were copper, tin, silver, iron, lead, and mercury). Its beauty, unique color, and the fact that it is easily worked made it much in demand for jewelry and objets d’arts. Its rarity and cost quickly made it the ultimate status symbol for the nobility and kings.

Most of all, it’s incredibly useless. Because its outer electron shell is filled, gold does not combine with other elements. Thus, it has almost no industrial or chemical uses. Its chemical inertness is why, unlike most metals, gold doesn’t tarnish and is usually found in the pure state, from nuggets that can weigh up to 160 pounds (worth about $4 million at today’s prices) to microscopic flakes embedded in quartz. And because it is inert, virtually all the gold ever mined is still around.

It’s incredibly rare. If you wanted to build an exact replica of the Washington Monument out of gold, all the gold ever mined would not allow you to build more than the bottom third.

And because it is both very rare and useless for anything else, gold is uniquely useful as a store of value, one of the vital functions of money. Gold coins have been minted since the mid-first millennium B.C. but rarely circulated because of their high value. Treasuries have held wealth in the form of gold for even longer.

It was only when goldsmiths invented banknotes in the 17th century that gold entered into its heyday as a vital part of the money supply. Because goldsmiths were, necessarily, experts at storing gold safely, people would often use the goldsmiths’ vaults as places to store their own gold. The smiths would issue receipts for the gold they had on deposit. It wasn’t long before the receipts began to circulate in payment for goods and services rather than the gold itself.

It also wasn’t long before goldsmiths—in the process of becoming bankers—figured out that they could lend gold at interest by issuing receipts instead of lending the actual metal. And they could lend more gold than they had on deposit. As long as people had faith in the solvency of the goldsmith there was no problem, as not everyone would try to redeem their receipts at the same time. If they did lose faith, of course, there would be a run on the bank as people tried to get their gold out while the getting was good.

Once banknotes became legally negotiable—that is, the holder who receives one honestly then legally owns it, regardless of how illegally the previous holder obtained it—banknotes were money, universally accepted in exchange for every other commodity.

In today’s economy, barring a highly unlikely massive gold strike, there simply wouldn’t be enough gold to back the needed money supply.

The English government had relied on far more abundant silver as the basic metal for coinage for centuries. A pound of silver, 92.5 percent pure, was the basic monetary unit, divided into 20 shillings, and each shilling into 12 pence. But what was silver worth in relationship to gold? In the early 18th century, by which time the Bank of England had largely taken over the business of issuing banknotes in Britain, the ratio was set by Sir Isaac Newton, of all people, who enjoyed a well-remunerated sinecure as Master of the King’s Mint. Newton decided that one ounce of gold (troy ounces, which come 14 to the pound, not 16 like ordinary ounces) was worth 3 pounds, 17 shillings, and 10½ pence.

The gold standard was born.

Suspended during the Napoleonic Wars, in 1819 the Bank of England announced that it once again stood ready to buy or sell unlimited quantities of gold for pounds sterling at the fixed price. This made the British pound literally “as good as gold.” Over the course of the 19th century, all other major countries adopted the gold standard.

The U.S. Congress set the dollar at $20.66 an ounce. It did not mint gold coins, however, until the 1850s, when California gold began to flood into the American economy. The United States was forced off the gold standard by the Civil War and did not return until 1879.

The great virtue of the gold standard is that it makes inflation impossible. If a country creates too much money relative to goods and services, people will begin to convert that money into gold. The country is then forced to increase interest rates in order to slow down the economy and prevent an outflow of gold from the treasury.

Gold is now around $1,700 an ounce, almost six times what it was a little over a decade ago.

The gold standard was extremely controversial during its heyday, roughly 1870 to 1914. Bankers and the rest of the property-owning classes liked it, of course, for it guaranteed sound money. Debtors, however, such as farmers, regarded the gold standard as a form of class warfare. William Jennings Bryan won the 1896 Democratic nomination with his electrifying “Cross of Gold” speech, in which he demanded the free coinage of silver at a ratio to gold that would, inevitably, have produced inflation. Debtors like inflation as it allows them to pay their debts in cheaper money.

Bryan was a much better speaker, but it was the sound-money William McKinley who won the election.

All major countries went off the gold standard with the outbreak of World War I, although the United States did so only briefly. It too went off the standard when it entered the war in 1917. Some countries reestablished the gold standard after the war, usually only in a modified form in which foreign central banks could buy gold for currency, but not individuals. Britain was financially devastated by the war, but it nonetheless returned to the gold standard in 1926. It was forced to abandon it again in 1931 as the Great Depression deepened.

The United States stuck with the gold standard. But this forced the Federal Reserve to increase interest rates despite the contracting economy. The result was a devastating deflation that greatly exacerbated the Great Depression. In 1933, a new president, Franklin Roosevelt, took the country off the gold standard and revalued the dollar at $35 an ounce. The United States also ceased to mint gold coins and outlawed the holding of bullion by private citizens, a prohibition that lasted until the early 1970s.

Because its outer electron shell is filled, gold does not combine with other elements.

But countries still valued their currency in gold even if they no longer guaranteed to redeem it in the precious metal. In 1945, with the Bretton Woods agreement, the United States promised to maintain the $35-an-ounce value of the dollar, redeeming dollars for gold on the demand of foreign central banks. Thus the dollar became the world’s primary reserve currency, taking over from the British pound. Much of the world’s monetary gold by this time was stored in Fort Knox and in vaults 85 feet beneath the Federal Reserve Bank of New York on Liberty Street.

But as the world economy expanded after the war and the United States began running large trade deficits, the United States became unable to maintain the dollar-gold link, and in 1971 President Richard Nixon severed it.

The gold standard was dead. Increasingly, however, so were banknotes and coins. In fact, coins ceased to be coins in the 1960s, when their precious metal content was removed. That made them, technically, tokens.

Paper money in the last 40 years has become a much less important part of the money supply. The vast majority of the money supply is now in bank balances and lines of credit, which in turn are nothing more than the zeroes and ones flitting around the bowels of giant, interlocked computer systems. Whenever you buy something with a credit card, you are, quite literally, creating money.

Debtors, however, such as farmers, regarded the gold standard as a form of class warfare.

But if gold, paper money, and coins were becoming unimportant, inflation—the fall in the value of money relative to other commodities—most certainly was not. As inflation swept the world in the 1970s after the link between gold and money was ended, the price of gold soared to over $1000 an ounce in 1980. As inflation subsided in the 1980s, so did the price of gold. In 2000 it fell below $300 an ounce.

As more and more countries spent in deficit (an act that, of course, creates money just as charging on a credit card does) and took on huge future obligations that they made no provision to pay for, the price of gold began, once more, to increase. It is now around $1,700 an ounce, almost six times what it was a little over a decade ago. There are endless ads on television pitching gold as something that should be a part of every investment portfolio.

This is a strong indication that gold and money are still powerfully linked psychologically, just as gold and banknotes once were. It is argued that a return to the traditional gold standard would prevent future monetary and financial turmoil such as we have seen in the last few years.

Is that possible? Almost certainly not.

In the late 19th century, when all the world’s important countries were on the gold standard and the world economy and global trade were increasing rapidly, so was the supply of gold. Major gold strikes were found in California, Australia, Nevada, Yukon, Russia, Alaska, and South Africa in that period and much of that new gold ended up in central banks. This allowed for a steady increase in the money supply as the world economy expanded. In 1867 there was about $2.5 billion in monetary gold. By 1893, the figure was $3.75 billion. By 1918, there was over $9 billion.

All major countries went off the gold standard with the outbreak of World War I, although the United States did so only briefly.

But in recent years, humans have been pulling only about 50 million ounces a year out of the earth, worth at current prices about $87.5 billion. Even in the current period of sluggish growth, the world economy is expanding by about 2 percent a year. That’s roughly $1.5 trillion in increased global gross product, compounding every year. Barring a highly unlikely massive gold strike, there simply wouldn’t be enough gold to back the needed money supply. The traditional gold standard thus would act as a tremendous drag on the world economy.

There is an alternative, however. Gold, as we have seen, is both useless and very rare. That means that its price is, to a very large extent, a reflection of expected inflation. If the world’s major central banks were all required by law to act to keep the price of gold steady within certain limits, the only way they would have to do so is by adjusting interest rates to keep inflation under control. It would be an effective gold standard, but one tied to the collective wisdom of the marketplace rather than literally to gold.

That would be a very difficult thing to do politically, of course, as it would greatly limit the ability of politicians to buy votes. William Jennings Bryan is dead; his political philosophy is anything but.

But such a move is the only way to make money, once again, as “good as gold.”

John Steele Gordon has written several books on business and financial history, the latest of which is the revised edition of Hamilton's Blessing: The Extraordinary Life and Times of Our National Debt.

FURTHER READING: Gordon also writes “Occupy Wall Street Faces a Winter of Discontent,” “The Henry Ford of Our Time,” and “English: The Inescapable Language.” Alex J. Pollock says “We've Broken Bond Promises Before” and “Goodbye, Gold Redemption of the Dollar.” John H. Makin describes “Three dangerous myths about monetary policy.”

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