Gold and its Poorly Understood Historic Role in the Financial System

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My my my. Articles ridiculing gold are starting to pop up all over the Australia financial media now. What gives? It’s nice to see the media actually discussing gold. But what’s a little disturbing is how poorly understood gold’s historic role in the financial system is. What’s more, doesn’t anyone know what sound money is any longer?

The burden of today’s Daily Reckoning, then, is to remind these nattering nabobs of negativism that gold is not anyone else’s debt. It is not anyone else’s liability. It cannot be created with a few keystrokes. And for thousands of years, millions of people from all walks of life have been happy to use it as money because of its unique features (divisibility, durability, scarcity, difficulty in counterfeiting).

Gold is a commodity. But its price is not driven exclusively by the Indian jewellery market or investment demand. As a tangible commodity, gold has some of the aforementioned qualities that make it a fantastic medium of exchange.

And for people who trot out the canard that you can’t buy a Big Mac with gold coins, what do you think goldsmith’s notes were? They were receipts that indicated gold ownership and your ability to pay a debt. You could exchange goldsmith’s notes as payment for goods and services because the paper claim was backed by a real asset. Goldsmith’s notes were the precursor to bank notes. Same type of system, but with real money.

Is this all just some nostalgia for a financial system that no longer exists? Does gold have a real role to play in the future financial system? Of course it does! Gold is a threat to the fiat money peddlers from the warfare/welfare State because it exacts a heavy price for deficit spending and money creation. The expansion of credit or deficit spending is always possible in a fiat money system and thus placates voters with false prosperity borrowed from the future.

The rise in the gold price is telling us that markets are increasingly suspicious of the government-backed money and its ultimate affect on the real economy. Or, as guest essayist Greg Canavan says, ” Gold is saying that the crisis is not over, that it is in fact getting worse. We are seeing Gresham’s Law in action, as bad money pushes out the good. Gold is being swept off the market by millions of individuals who know that without fail governments always ruin the value of their paper money.”

The only real – albeit shallow – criticism of the gold story is that it’s primarily a U.S. dollar story. For Aussie investors, a collapsing greenback doesn’t equate to a higher Aussie-dollar gold price. We would say, though, that this is a short-sighted appreciation of what gold is saying about the modern money system.

The modern money system is built on credit, debt, and government money backed by nothing. To believe that does not mean you’d covert all your assets to bullion, or all your shares to gold stocks. But it IS to believe that the architects of this system are criminals who effectively steal your wealth through inflation and control of the money supply.

If you have confidence in that system, you’re a sucker. And if you don’t hedge against its collapse, you’re unprepared. After the last two years, is it so farfetched to believe that the foundations of financial capitalism – based on unsound money as they are – are weak by design and will fail in a world of increasing complexity and interconnectedness?

If you don’t think it could happen, you haven’t been living on Planet Earth. Either that or you’re in a business where you want everyone to go back to doing what they were doing pre-Lehman collapse because it’s good for your business. If that’s the case, it’s fine. But it’s foolish to ignore 5,000 years of monetary history.

Yesterday we wrote about what happens when a complex network of trade and commerce begins to shrink as credit is withdrawn from the global system. Another side effect of the Lehman collapse is a bear market in trust. Trade, once free flowing and robust, becomes politicised. Trading partners begin to bicker.

Take Barack Obama’s decision to slap a large import tariff on tyres made in China. It will probably just drive up the cost of cheap tires of middle-income Americans. But it makes America’s unions happy, and Obama needs them to push through his health care agenda. China has responded with warnings about possible tariffs on U.S. poultry and auto parts exports.

It’s probably not in neither country’s economic interests to get in a trade war. But it reflects the ambiguity and hypocrisy of trade practices by both countries. There is no such thing as free trade. China subsidises production with cheap labour and produces at below production cost for some goods and services. America is happy to lose those manufacturing jobs if American shoppers get lower prices and have access to credit to make up for falling real wages.

But that whole strange relationship that has driven global growth for the last ten years has reached its use-by date. We’re not sure what’s going to replace it. But both parties are guilty of being currency manipulators and subsidisers. Formerly, their interests were aligned. Now, it’s not so clear.

And finally a note from JL in Queensland about networks, nodes, and certain monetary commodities.

“Just my two cents worth. The difference between a node in a computer network vs. a node in the financial/economic system is that the node in the network can be self sustaining (provided that it’s plugged in to electricity), whereas, most of the nodes in the financial/economic system are NOT self sustaining.

“They rely on counterparty to deliver, so that they can also perform. This is the contagion effect. Computer network nodes also exhibit this attribute, but usually only when they suffer from a virus, Trojan or the like. If not, then they are self sustaining, unlike most mainstream financial/economic nodes.

“The ONLY financial/economic node that would be self-sustaining and immune from ALL shocks (i.e. Exhibit the financial equivalent of homeostasis) is one that is 100% backed by a financial asset which is no one’s liability. I’ll leave you to guess what THAT financial asset may be.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Michael Pascoe, that hack of a financial analyst suffers (incredibly) from the Central Bank Curse – that magic and genius of fiat currency taxation to which all mainsteam pundits are enthrawl to.

    The “gold has no intrinsic value” banality which Dan points to, is to me incredible. The imagination of these financial serfs seems so limited as not to, apparently, completely miss the concept of a medium of exchange. You cannot buy a hamburger with gold coin, just as much as you can’t buy a hamburger with an ATM machine or a bank teller or a gold dealer.

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  2. Does gold have a real role to play in the future financial system?

    It always has had and always will have a role in the financial system. This is where the likes of Alan Kohler & Michael Pascoe show their ignorance of the financial system.

    Gold is the most marketable commodity, to wit, it is money. Just because you can’t buy a hamburger with it (though I’d happily exchange a hamburger for gold), doesn’t mean gold is not used to settle liabilities on a daily basis on the London Bullion Market.

    If any of you don’t believe me, go spend some time on http://www.lbma.org.uk

    It’s not called a noble metal for nothing. Only one thing I’d disagree with Dan, gold is not valuable because it is scarce, it is in fact quite abundant. The best estimates are some 150-200 thousand tonnes exist in monetary form, whether that be bullion or jewellery. In fact virtually all the gold ever mined in human history.

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  3. Surely you agree that a properly working fiat money system is better than a gold standard. Obviously a gold standard puts controls on paper money – but has an additional economic cost in that gold has to be mined and stored for no reason other than to facilitate trade. Accordingly, it would be clearly best to avoid this additional cost if possible. Therefore, the key question is whether Gold is the best way to “control” paper money or whether there is a better way. If paper money could be controlled without gold (i.e. by entrenched laws / constitution) – surely this is a better outcome.(Please make no mistake that I am heavily against central banks printing money.)

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  4. Gold is real money, it always has been it dosen’t lose value through inflation. Gold has in the past, eventually always adjusted itself to its real value and most probably will sometime in the future. Whereas fiat currency’s value in itself, is just it’s paper worth and is devaluing it’s purchasing power on a regular basis through inflation. For the time being the world exchanges it’s trade through fiat currency but when the current monetary system collapes gold and silver will most probably soar in price to it’s true value, depending on how much fiat currency is in existance at the time. In history when economies collapsed those who held paper money lost nearly everything if not everything, but those who held gold and silver safeguarded their wealth. This is why so important in bad economic times to hold gold.

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  5. Pascoe’s anti gold article in the SMH contained more holes then a factory of swiss cheese. “Its foolish to ignore 5000 years of monetary history” – that statement alone tends to be ignored by many in the mainstream world.

    FACT since 2000 gold priced in aussie Dollares is up approx 130% – the asx 200 up 40% in the same time frame. Gold will always be misunderstood by the vast majority of so called economists – When the gold price has doubled in 2 years in all major currencies I can still see the Pascoe’s of the world trotting out “the well it pays no interest or dividends so it must be a dud investment” arguement – some folk will never get it.

    Thanks Dan Denning for a well written article – in my opinion this story needs to be reprinted in the SMH / AGE asap.

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  6. John Smith….All very well……but we have no precedent to assume any “entrenched laws/constitution” can hold out against governments seeking extra power only available from an “unchained” fiat currency.

    Government power is based on spending. The more debt/ money government creates and controls, the more power it exercises. It nurtures belief in a dichotomy between “our” money and “their” money, casting itself as an altruistic spender of “everybody’s money” in the community interest.

    Politicians lust too hungrily for power to be legislatively or morally constrained from their bastardization of currency.

    Until we elect governments that don’t seek power, gold remains “good value for the money”….

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  7. I take the points about the value of gold historically. but what if gold could be manufactured cheaply in the future (the alchemists dream)? .. much like diamonds can be artificially created now, but at vast expense.. the central banks can then “print” more gold… back to square one.
    in the long run I think it could all boil down to informational values (I am in Star Trek utopia here), where electronic credits are strictly limited and aligned with the real world. (actually i’ve read where Hitler did much the same thing, but that’s another story, and no utopia).
    and as for the good advice at this site re: gold purchases, what if everyone did that? (an answer in Catch22 is “then I’d be a fool to do otherwise”)

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  8. What I don’t get is that if the $USD Index is close to bottoming out and then rebounding as deflation takes hold (as increasing unemployment means people won’t have money to spend to drive up prices), won’t gold go down in value against the $USD?

    Richo (the Second)
    September 15, 2009
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  9. Comment to Justin: Scarcity is a sliding scale and a relative measure. Gold is succiciently scarce as to make it a reliable store of value over time, and sufficiently abundant as to make it usable on the street.

    Per capita (world), the amount of gold above ground is fascinatingly stable for thousands of years. You can stick it in the ground behind a tree, and likely it will not lose purchasing power, so history shows, if your grandson digs it up.

    So why not another metal? Sure why not, see silver historically. However there are a number of unique virtues which makes gold particularly on-the-mark as a money:

    * It is uniquely beautiful. Gold price drops due to oversupply, and people jump on it for romantic and auspicious reasons, bidding it up. Restoring stability.

    * Indistructible. Chemically inert, untarnishable.

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  10. John Smith, you have a point. If every central bank were run like the one in Australia or Germany the discussion would about how to optimize the financial system, rather than preventing catastrophe. The problem is that the U.S. has been running a scam on the world for 38 years in which they have solved their economic problems by creating money out of thin air at a faster and faster rate while the world pretends that it is actually worth something. America consumes goods and services for nothing.

    Daniel Newhouse
    September 15, 2009
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  11. comment to John Smith: If you consider the fundmantal virtue of an honest money system, your first line could be rephrased as follows:

    “Surely a corruptible system is better than an uncorruptible system?”.

    The point being is that humans have always and will for a long time trend toward hubris, greed, jealousy and war. If you will accept this basis, then you will agree that all systems that are placed in human hands will fail over time. T

    Thecharm and deity of gold is that it cannot be corrupted, cannot be produced cheaply, etc.

    For millenia the popular folly of alchemy has missed the point that scarcity is key to worth. Or more accurately, a short time after the successful alchemist begins plying his trade, the value of gold would drop to near zero since it can be produced en-mass and cheaply.

    If you could print hamburgers without cost, hamburger price would drop to zero. And so it is with anything.

    What we are whitnessing today is EXACTLY the philosophy and dream of the alchemist. The Central Banks hold the key to destroying that fiat promise. Their mates will benefit for a few years, just before the economy and currency collapse to zero.

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  12. Whilst I agree with most the comments and the article here regarding Golds ability as a store of wealth long term, whilst the price of gold is still pinned against a fiat currency, surely it becomes just another commodity/market which is dependant on the USD.

    With regards to the Gold standard, my understanding as to why the world moved away from this was because it was too fixed in value – during tough times liquidity couldn’t be introduced to stimulate a recovery and economies were stuck between a rock and a hard place. Of course now we have the situation where the Fiat currencies’ liquidity has been abused to the extent where is has been used to prop the lifestyle of one country in particular.

    So my question is this. If there was a gold standard again (or any other system for that matter), how could it be tied to something of fixed value and the liquidity be provided when necessary whilst also ensuring the extra liquidity is properly drained -instead of being increased to “make the good times even better”? Who would be in a position to make this sort of call?

    Jack

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  13. Jack, Do you work for the Reserve Bank?

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  14. No way. I have standards. All I’m trying to say is that there needs to be flexibility but the flexibility shouldn’t be abused, if this is at all possible.

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  15. We tie the dollar to greed, then all will be equal isn’t that what we want ?

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