Topics: What is money? Why is gold a smart investment?
I often get asked by non-economist friends and acquittances to explain the current economic crisis. I love those conversations because it helps me to keep my language free from the economic lingo with the complex acronyms that really helps nobody to understand what is going on around us. So, I thought I’d write articles that tries to encapsulate typical conversations I often get into in social settings. Almost always the conversation begins around the topic of how to invest in a smart way when the economy is as turbulent as it is. Since I’m a guy of the Austrian School of Economics, I think gold should be in everyones portfolio and this is often what makes people interested in what I have to say since it is not that common yet for people to advocate physical gold in your own possession. That is likely to change soon though since more and more people are moving into gold. So imagine a conversation something like this:
Q: Haha, you have gold bars? Why would you want to buy gold?
A: Because it is one of the only investments that is no one else’s liability. Gold is also money, which means that it is very liquid, which is another way of saying that you can turn your gold back into paper money very quickly. A house as an investment is not very liquid since it takes a long time to sell. But the key thing is that it is no one else’s liability. If you have your money in the bank, and that bank fails, you lose your money. Gold is also an insurance against inflation.
Q: Isn’t my money at the bank protected by the government?
A: Yes, but only up to a certain limit. It also depends on the type of account you have. Stocks and mutual funds etc are not protected. Also, should your bank fail, you better believe it will take a long time before the government pays you back the money your bank lost. So, I prefer to be independent of any institution, the government included, for the safe keeping of my hard earned money.
Q: Why not just keep money in the mattress at home?
A: To answer that we need to know what money is. This gets a bit complicated but let me explain. Paper money is debt. Nothing else. The Central Bank prints money out of thin air and that money is backed by nothing. This is called “fiat money”. Paper money used to be backed by silver and gold but that was a long time ago. For example, before President Franklin D Roosevelt decided to confiscate the gold held by US citizens in 1934 the US dollar was redeemable for gold at about 20 dollars per Troy ounce. The day after the “Gold Reserve Act” became law he devalued the currency to 35 USD/Oz over night. After the depression and towards the end of World War II in 1944 the ratio 35 USD/Oz was adopted in the new gold standard used between the central banks of the world. This system was called “Bretton Woods” and the US dollar became the world reserve currency. US citizens could no longer redeem their dollars into gold, but foreign central banks could, at the rate of 35 USD/Oz.
Time passed, The United States fought many wars in Asia and other places, while printing money to finance the military. They printed more and more and in 1971 on August 15th President Richard Nixon declared that the US could no longer pay back the other central banks in gold. So Nixon defaulted on the debt of the USA in the same way FDR did, but this time the central banks of the world drew the shortest straw. All of a sudden the central banks of the western world sat on huge piles of US dollars that they could redeem for nothing. All they could do were to buy American goods or convince other countries to accept US dollars as payment. You have to remember that in the 1970s the US was the largest producer and exporter of crude oil, so naturally there was still a demand for US dollars since everyone bought oil from the Americans. However, US oil production peaked in 1970-71 and started to decline. The new guy in town was Saudi Arabia. Nixon made a deal with the House of Saud, the royal family, and said that the US would protect their rule with military force as long as Saudi Arabia sold oil only in US dollars. Since then OPEC has sold oil in US dollars and all other countries have been forced to first buy US dollars before they could buy any oil. In this way the demand for US currency was sustained. Since then the US has kept their military war machine going printing all the money they need through the Federal Reserve System. In a way you could say that Nixon took the US dollar off of a gold standard and onto an oil standard.
Since 1913, when the Federal Reserve System got started, the US dollars has lost about 96% of its value. The same thing is true for most other currencies as well. The truth is that all paper currencies fail sooner or later since the central banks keep printing money to finance the expenditures of the government. When they print too much, and the national debt is too high, confidence in the currency is lost and the paper money is just worth what it is printed on.
Q: Okey, so you are saying that paper money isn’t worth anything? What makes gold so valuable then?
A: Well, paper money is only “worth something” as long as we, the marketplace, believe that the paper represents purchasing power. The more money there is in a given marketplace relative to the amount of products and services available, the higher the prices. This is known as “inflation”. Higher prices is not inflation, but the effect of it. Inflation means expansion in the supply of money. The neat thing about gold is that the quantity of gold around cannot be manipulated by any banker or politician. Gold is so scarce that if you divided up all the gold that has ever been dug up of the ground since the dawn of history, equally among the humans of the Earth, each person would get about 20 grams of the stuff. That’s about enough for a wedding ring. Gold has always been regarded as precious for that reason and will probably continue to be regarded as such until we learn to love each other and come up with a better idea than using money to facilitate trade. What I’m saying is that when central banks keep printing money faster than the economy grows you need to find a way to protect your purchasing power. The only way to do that, without winning on the stock market, is by investing in something which value is protected against inflation. Paper money is not protected, but gold is.
Q: So the stock market is OK then?
A: Well, that depends on how you look at it. What is a stock? It is a debt instrument. It’s a piece of paper representing shared ownership in a company and the shares outstanding is on the balance sheet of that company as debt to the owners. Again, it’s an investment class that is someone else’s liability. Sure, you could win on the stock market the same way a gambler wins on roulette, but is it worth the risk? Gold is risk free. The only risk you take is someone stealing it from you. Go back 10 years to 1999 and look how the S&P 500 has preformed and how gold has. S&P 500 is down 23% and gold is up 270% (August 2009). Sure, if you sold your dotcoms before the crash and invested the money in Google when they listed you’d beat my gold investment. You got to ask yourself if you can spot the next dotcom bubble at the same time identifying the next Google Inc? If you can, and if you are willing to take the risk, go for it. I don’t think I’m able to. Gold is a safe investment that has kept its purchasing power relatively stable for millennia. Paper money and stocks are the new experiments, not gold.
Q: So do you think the price of gold will go up? Didn’t gold hit an all time high recently? Wouldn’t that indicate it’s time to sell?
A: Sure, in nominal terms, yes. But not in real terms. When gold hit its latest all time high in 1980 the price of one ounce of gold was 850 US dollars. Today (September 2009) gold hovers around 1000 USD/Oz. However if you take inflation into consideration you have to talk about US dollars in terms of purchasing power. 850 US dollars in 1980 is about 2300 US dollars in todays money. That means that gold will have to hit above that until we can speak of a new high in real terms. This is one of the many evils of inflation: we lose the ability to track good investments over time and have to be smart about it and recalculate everything with the rate of inflation. So, I would say, this is just the beginning of a long up trend in the price of gold that really began this time around in 2001. It’s not so much that gold is rising but that the US dollar and other currencies are falling. Since the Lehman Brothers crash the Federal Reserve and other central banks have been printing money hand over fist. This will cause inflation on a massive scale and you need to protect your self from that.
Written by: Johnny Mellgren
