Satyajit Das: L’Age d’Or, Part 2 – Golden Memories

By Satyajit Das, former banker and the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)

The Return of Gold…

Since the replacement of the gold standard with the dollar standard, the gold price has fluctuated widely. In January 1980, the gold price reached a high of $850/ ounce reflecting high rates of inflation and economic uncertainty. Subsequently, the recovery of the global economy saw the gold price fall for nearly 20 year, reaching a low of $253/oz ($8,131/kg) in June, 1999.

From 2001, the gold price began to rise due to a number of factors. One was increased demand, especially from emerging nations such as India and China. In 2007/ 2008, gold received an additional boost from the onset of the global financial crisis. Concern about a banking system collapse drove gold prices higher with gold prices finally passing the 1980 high reaching $865/ ounce in January 2008.

In late 2009, gold price renewed its upwards momentum upwards passing $1,200 in December 2009 on its way to over $1,913/ ounce in August 2011. The 500% increase in the gold price since April 2001 prompted gold bugs to speculate about a new age of gold.

In reality, the rise was driven by fear. The depth of the financial crisis, concern about the security of other assets including once risk-free governments bonds and a fragile banking system prompted a flight to gold as a safe haven. The monetary policies of governments and central banks, emphasising low interest rates and printing money to restart the global economy, also underpinned the gold price.

Germans wanted the return of their Deutschemark, now replaced by the Euro, pining for when “Mark gelich Mark – paper or gold, a mark is a mark”. The nightmare of Weimar, the erosion of the value of money, hovered in background. As governments borrowed ever larger sums, ordinary citizens feared that even gilt-edged government securities would become worthless. As a banker asks an old woman in 1918: “where is the State which guaranteed these securities to you? It is dead.”

A weak US dollar and the questionable prospects of other major currencies, such as the Euro and Yen, also drove demand for gold, as de facto currency.

David Einhorn of Greenlight Capital, a hedge fund, summarised the demand for gold: “Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. … When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.”

Like other investors, central banks, especially in emerging nations such as China and India, increased holdings of gold. With a large portion of their reserves invested in currencies of developed nations which were losing value, the central banks sought to switch to gold as well as other real assets. In 2009, China announced that over the preceding 7 years, it had acquired 454 tons of gold. It seemed that central banks had remembered J.P. Morgan’s words to Congress in 1912: “Gold is money. Everything else is credit.”

This fear of reduction in the value of paper money has haunted the system of fiat or paper money from inception. Keynes recognised the risk of governments and politicians determining the value of money: “By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

Former U.S. Federal Reserve Chairman Alan Greenspan once flirted with this problem: “under the gold standard, a free banking system stands as the protector of an economy’s stability and balanced growth… The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit… In the absence of the gold standard, there is no way to protect savings from confiscation through inflation.” Ironically, during his tenure in charge of the U.S. Federal Reserve system, Greenspan would use the banking system to expand credit in an unsustainable way that was to lay the foundation for the global financial crisis of 2007.

In his study of the human unconscious, Sigmund Freud noticed a striking association between money and excrement: “I read one day that the gold which the devil gave his victims regularly turned into excrement.” Many people now find the prospect of governments pursuing policies that would turn money into excrement a disturbing, real risk, forcing them to turn back to gold.

Means to a Golden End…

For investors, investing in gold is not without problems. Shares in gold mining companies may not provide the sought after exposure to gold prices.

The value of mining companies behaves more like shares than the gold price. This reflects the company’s operation which may include exploration. The mining company may have investments in other commodity operations which dilutes the exposure to gold. Decisions to hedge the gold price may affect the sensitivity of the company’s earnings to the gold price. There are problems of mergers and acquisitions, purchase and sale of operations, borrowing and sundry issues like mismanagement and fraud.

Most investors prefer direct investment to the precious, yellow metal. This takes the form of trading in instruments like gold futures contract or direct purchases of gold.

Gold futures and similar contracts require knowledge of derivatives trading. Physical gold is expensive and also difficult to store and insure. Popular forms of physical gold investment like coins reflect a premium to the actual gold content, adding to the cost.

To overcome the problems of physical investment in gold, some banks offer gold “passbook’ accounts especially for smaller investor. Operating like a normal bank account, the facility allows investors to buy and sell modest amounts of gold. The bank pools the investors money and buys and sells gold to match the amounts owed to investors.

Increasingly, investors use gold ETFs, which are an extension of the gold account. The ETF is structured as a mutual fund or unit trust which is listed and tradeable on a stock exchange. Investor purchase fractional shares in the ETF which then invested the money raised in gold. Some ETFs invest in the metal itself. Others synthesise the exposure to gold using instruments linked to the gold price, such as gold futures and derivatives. Some ETF allow leverage, borrowing funds to augment the investor’s contribution to increase sensitivity to fluctuations in the gold price.

Gold ETFs create new risks. Where the ETF uses derivatives and other financial instruments to obtain exposure to the gold, it is exposed to the risk of default by the financial institutions with which it contracts. Even where the funds are invested in physical gold, the metal is held via custodians, often financial institutions, exposing them to the failure of these entities.

This is ironic given the fact that the investment in gold is specifically motivated by fear of the failure of the financial system. In 2011, President Hugo Chavez ordered the Venezuelan central bank to repatriate 211 tons of its 365 tons of gold reserves (worth around $11 billion) from U.S., European, Canadian and Swiss banks, including the Bank of England. Part of the reason was concern about the developed economies and their banking systems. More recently, the Bundesbank, Germany’s central bank has requested an audit of its gold holdings.

Investors also worry about the risk of confiscation of gold holding. In reality, any government can confiscate anything – gold, savings, property – they want to in times of economic emergency.

In 1933 President Roosevelt issued Executive Order 6102, prohibiting the private holding of gold and requiring U.S. citizens to turn over their gold bullion or face a $10,000 fine (equivalent around $170,000 today) or 10 years imprisonment. In response, opportunistic coin dealers encourage investors to buy expensive “numismatic” or “collectible” coins, taking advantage of an exemption in the 1933 order which protected these assets from government seizure.

Seeking to reassure investors, some ETFs have installed fibre optic cable linked cameras in their gold vaults. Investors can monitor their holdings via the Internet. Of course, this clever marketing gimmick does not protect the investor from the failure of a custodian or financial counterparty as well as confiscation risk.

Golden Brown Bottoms…

The investment case for gold is mixed. Gold’s tactical value over specific periods is significant.

The period from 1999 to 2001 is referred to the “Brown Bottom” of a 20-year bear market during which gold prices declined. The reference is to the ill-fated decision by Gordon Brown, then UK Chancellor of the Exchequer and subsequent Prime Minister, to sell half of the UK’s gold reserves via auction over 1999 and 2002. At the time, the UK’s gold reserves were worth US$ 6.5 billion, constituting around half of the UK’s foreign currency reserves.

The decision to sell around 400 tonnes of gold at the low point in the price cycle cost the UK tax payer up to £10 billion or around £600 per UK family (depending on the gold price used). Commentators have compared to cost of £3.3 billion to UK taxpayers on Black Wednesday 1992 when the UK was forced to withdraw from the European Exchange Rate Mechanism after a failed attempt by the Treasury and Bank of England to defend the Pound.

Any investor who purchased the gold sold by the financial astute UK Chancellor would have made a substantial profit.

But gold is not itself a great store of value, at least over long time periods.

Gold bugs excitedly speculate about gold prices reaching $2,300. But even at that price gold would merely match its January 1980 peak price after adjusting for inflation; in other words, the holder had earned nothing on the investment over almost 30 years!

The gold price adjusted for inflation is the same as the price in the middle ages. Dylan Grice of Société Générale summed up the case for gold as a store of value in the following terms: “A 15th century gold bug who’d stored all his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90 per cent over the next 500 years.”

The gold price can also be very volatile. In late 2011, after reaching record levels, the gold price fell nearly 20% very quickly.

Warren Buffet observed that if stock investors are driven by optimism about prospects then “what motivates most gold purchasers is their belief that the ranks of the fearful will grow.” Harry “Rabbit” Angstrom, the central character in John Updike’s 1970s novels about American suburban life, spends $11,000 on the purchase of 30 gold Kruggerrands (a South African minted gold coin). Rabbit explains the purchase to his wife: “The beauty of gold is, it loves bad news”.

In economic chaos, war or collapse, gold reappears, reasserting it grip on humanity.

Back to the Future…

The revival of interest in gold is also underpinned by debate of a return to the gold standard. Advocates as varied as Libertarian US Presidential candidate Ron Paul and the Islamic Liberation Party (Hizb ut-Tahrir) have argued that the gold standard is a solution to the deep problems of the global economy.

The gold standard, it is argued, would foster economic stability and prosperity, primarily by creating price stability, fixed exchange rates and placing limits government deficit spending as well as trade imbalances. It will also limit credit driven boom bust cycles through constraints on the supply of money.

The gold standard, opponents argue, would limit the flexibility of governments and central banks in managing economies, restricting the ability to adjust money supply, government budgets and exchange rates. Opponents also point to the inflexibility of the gold standard which may have contributed to the severity and length of the Great Depression.

A return to the gold standard would also confer a natural financial advantage to countries that product gold, such as the US, China, Russia, Australia and South Africa. Geo-political considerations and global competition make this unlikely.

There are also limits to supply. In all human history, only about 140,000 to 170,000 metric tonnes of gold have ever being extracted. Annual production is around 2,400 tones of gold.

The world’s existing stock of gold is equivalent to about three Olympic standard swimming pools. The value of this amount of gold is over US$ 6 trillion, roughly 10% of everything that the world produces in a single year and a tiny fraction of global wealth and assets.

Limited central bank holdings of gold constrain a return to the gold standard. The US, German and French central banks have gold stockpiles valued at 250% to 300% of their reserves of foreign currencies. China, India, Russia, Brazil and South Korea hold between 0.5% and 10% of their foreign reserves held in gold.

If the central banks of China, India, Russia, Brazil and South Korea sought to increase their gold holdings to a mere 15% of foreign reserves, these countries would need to purchase more than 10,000 tons of gold. The US, the world’s largest gold holder, holds a little over 8,000 tons.

Max Weber, the father of social science, defined the state as the agency that successfully monopolises the legitimate use of force. The state, through its monopoly over the printing presses, has almost total control of money and the economy. Money is now a matter of pure trust. American dollars still bears the words: “In God We Trust”. But God is not directly responsible for control of money, it is governments and central banks. Politicians and policy makers are unlikely to willingly cede the power that a paper money system provides.

Golden Deaths…

As the metal’s price rose, a Tuscan spa offered wealthy clients a treatment which entails the entire body being covered in 24-carat gold. Costing Euro 420, the treatment, proponents claim, provides unverified benefits such as delaying the visible effects of age, skin hydration and skin elasticity.

Having switched from traditional financial investments to gold to preserve their wealth, investors will be hoping for the health benefits of the gold treatment rather than another possible ending. In the film Goldfinger, the character Jill Masterson, played by Jill Eaton, is murdered by being painted head-to-toe in gold paint —one of movie history’s iconic scenes.