What to own when the monetary system collapses ?

If only history provided us with a clue..

“About one hundred years ago, John Ruskin told the story of a man who boarded a ship carrying his entire wealth in a large bag of gold coins. A terrible storm came up a few days into the voyage and the alarm went off to abandon ship. Strapping the bag around his waist, the man went up on deck, jumped overboard, and promptly sank to the bottom of the sea. Asks Ruskin: ‘Now, as he was sinking, had he the gold? Or had the gold him?’”

• Peter L. Bernstein, ‘The Power of Gold: The History of an Obsession’

“I am not a gold bug, but I am a hard working tax payer who is getting pretty fed up with having my savings earning no interest and possibly being devalued… and of not being able to find any sensible place to invest my hard earned due to central bank policies making it impossible to make any return anywhere without taking crazy risks.”

• A Financial Times reader responds to that newspaper’s continued hostility towards gold.

“When a social construct (gold as money) survives for 6,000 years I would expect curious people to inquire as to whether it is tied to some immutable underlying law, or otherwise investigate if there is something more here than meets the eye. Not so curiously inclined, our court economists prefer to write this off as a 6,000 year old delusion. That says a lot about the sorry state of the economics discipline today.”

• Another Financial Times reader responds to Citigroup economist Willem Buiter’s description of gold as “a 6,000 year-old bubble”.

“I don’t think the question really is what is gold worth but what are currencies not worth.”

• Shayne McGuire, Director of Global Research at the Teacher Retirement System of Texas.

Is there any asset more misunderstood than gold? It is widely regarded as redundant, what Keynes called “a barbarous relic”, in a world of electronic money.

Yet at a time when central banks have collectively gone mad in their zeal to reflate, gold becomes a must-own asset to help ensure the preservation of our purchasing power. It is the leaders of the world’s central banks that are the barbarous relics here.

Be under no illusion, we are talking about money here. As the banker J.P. Morgan put it, only gold is money – everything else is credit.

Money, of whatever form, has uses. Traditional economists assign money three characteristics. It is a unit of account – we can price things with it. It is a medium of exchange – we can use it as a helpful replacement to the barter system, exchanging one good for another. And it is a store of value – it retains its purchasing power over time.

Our modern electronic money still retains the first two characteristics. But as for the third.. Since the establishment of the Federal Reserve in 1913, the US dollar, for example, has lost roughly 98% of its purchasing power. The pound sterling has fared no better. Indeed every unbacked paper currency in history has ultimately failed. The dollar will be no different. It is only a question of time.

Gold and silver developed as money in a free market. Throughout human history we have used all kinds of things as money – cattle, shells, nails, tobacco, cotton, even giant stone slabs. But gold and silver always won out over the competition. People tended over time to favour the precious metals as money because of their scarcity, durability, malleability and beauty. Their use arose without coercion. Gold is the money of freedom.

Gold is also scarce. And it is horribly expensive, in both capital and human terms, to dig out of the earth and process. To produce one ounce of fine gold requires 38 man hours, 1400 gallons of water, enough electricity to run a large house for ten days, up to 565 cubic feet of air under straining pressure, and quantities of chemicals including cyanide, acids, lead, borax and lime.

Being chemically inert, gold lasts. Peter L. Bernstein (in his somewhat sceptical treatise ‘The Power of Gold: The History of an Obsession’) points out that you can find a tooth bridge made of gold for an Egyptian 4500 years ago. Its condition is good enough that you could pop it into your mouth today.

And it is wonderfully malleable. If you have just an ounce of gold, you can beat it into a sheet covering one hundred square feet. Or if you prefer, you could draw it into a wire 50 miles in length.

Clearly, gold is also a thing of beauty. “Oh, most excellent gold!” said Columbus on his first voyage to America. “Who has gold has a treasure [that] even helps souls to paradise.”

But gold is heavy, dense and impractical to carry around. So using paper certificates to represent gold held safely in reserve was a logical next step. The problem arose when greedy bankers realised that they could print more certificates than they had gold in reserve to back them.

The language associated with gold is invariably derogatory today. Those of us who see any role for gold in the modern world are dismissed as goldbugs. Our response is to label those sceptics paperbugs: they have to believe that unbacked fiat money will last. History, however, is on our side.

In recent monetary history 1971 amounts to Year Zero for gold, because that is when President Nixon finally took the US dollar off the gold standard. This has led to a 50-year-plus experiment in money that remains unprecedented. When Robert Mundell was made a Nobel Laureate in Economics in 1999, he pointed out that the “absence of gold as an intrinsic part of our monetary system today makes our century, the one that has just passed, unique in several thousand years.”

Robert Mundell could see the way the world was going. In March 1997, two years before receiving his Laureate, Mundell would remark, ominously, “Gold will be part of the international monetary system in the twenty-first century.” The author Nathan Lewis agrees. The title of his 2007 book on the subject? ‘Gold: The Once and Future Money’.

Russell Napier, formerly of the Asian brokerage firm CLSA, remains one of our favourite financial analysts. This is partly but crucially because he also happens to be a financial market historian. Here is his assessment of the situation, in light of a Chinese devaluation of the renminbi that brought global deflation in its wake, and of the dismal failure of central banks to reflate the system:

“If central bankers’ manipulation of prices fails to generate strong private demand and inflation, then the necessary debt to GDP reduction must come in highly destructive ways for the owners of capital. Society will have to choose between austerity, default, or the creation of a government demand-driven reflation. These are the only three options if central bankers fail to boost growth and also inflation. Austerity would bring depression; default would bring bankruptcy, and a government demand-driven reflation would bring some degree of suspension of the market economy. These are painful and difficult choices if central banks fail. [I] believe that society will most likely choose the apparently least painful route and thus we now face a massive structural shift away from a market-orientated economic system.”

In short, Napier predicts the reintroduction of capital controls, as governments simply elect to replace the central banks in the cause of stimulating inflation. The reintroduction of capital controls (last seen in the UK, for example, in 1979, after which the newly elected Prime Minister Margaret Thatcher wisely and boldly abandoned them), would be a terrible metastasis of the financial crisis.

Russell Napier again:

“There are many who see the above scenario as ‘the end of the world’ but of course it isn’t. For the man in the street it involves another economic shock but then a ‘democratic’ reflation without the assistance of the discredited [central] bankers. The cycle that results will be full of growth and mainly inflation. It would reduce the debt burdens of many and feel a lot better than the deflation wrought by market forces. The inevitable massive capital misallocation that results from any government-driven investment cycle would take many years to become evident and produce negative impacts. This will not seem like the end of the world for most people. However for the stewards of private sector capital there will be little to do in such a world of mandated prices and conscripted capital.”

If you’re unfamiliar with precisely what ‘capital controls’ might be, they could plausibly include taxes, tariffs, outright legislation and restrictions on trade. Capital controls could be imposed across equities, bonds and the foreign exchange markets. Let us consider for a moment the implications of Russell’s warning.

“A shift to the conscription of capital by government to force a government-led investment cycle would be very positive for gold. Gold, the form of capital that is easiest to move without trace, is the most difficult form of capital for governments to conscript. Those qualities will produce many buyers as the nature of the authorities’ response to our deflationary bust become ever more apparent. So how do we weigh up the negative impacts for gold of a rising US dollar and rising real interest rates with the positives associated with increased government intervention in markets? We wait for the gold price to rise even as the US dollar is rising. That should provide sufficient evidence that the threat of a government-instigated reflation is more than offsetting the negatives associated with the current deflation. Should that reflation succeed, then gold would likely be a major beneficiary as positive real rates of interest would turn into negative real rates that would be sustained by financial repression for perhaps a few decades.”

Central bank monetary policy has failed for over seven years, since the height of the Global Financial Crisis. The central banks’ reflation efforts have come to naught. If Russell Napier is right, governments will soon take over, and the money printing will then resume in earnest. In such an environment, gold, being a finite and precious commodity that is also no-one’s liability, is in prime position to enter a sustained bull market. We believe Napier is right.

Why own gold? Because it makes sense, within a properly diversified portfolio, to have portfolio insurance. If you own a home, it makes sense to have home insurance. Your investments are no different.

In a world of paper assets (like certificates of deposit or corporate or government bonds), some of gold’s attributes are unique. When it comes to credit and counterparty risk, gold comes with neither. Gold does not rely for its value on the solvency of some third party. It is not a claim against anything. Which is why gold is the perfect insurance against the failure of conventional money or the default of conventional debt. It is why gold is a more perfect form of money than any government-issued alternative.

How best to describe gold? The investment consultant Andreas Acavalos has provided the best definition we have so far heard: “Gold is not even an investment. It is a conscious decision to refrain from investing until an honest monetary regime makes rational calculation of relative asset prices possible.”

Our friend Charlie Morris offers a variation on this theme. He compares gold to a conventional bond. He describes gold as a zero coupon, perpetual, irredeemable bond. With no credit risk. With no counterparty risk. Issued by God.

Continuing this theme, one quotation from the world of economics fills us with more concern than any other. It comes from Ludwig von Mises. As someone with first-hand experience of the notorious Weimar-era hyperinflation, von Mises warned:

“The credit expansion boom is built on the sands of banknotes and deposits. It must collapse. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Our central bankers have made it abundantly clear that the credit expansion must and will continue. If von Mises is correct, then the ultimate resolution of the crisis is also clear: “a final and total catastrophe of the currency system.”

Got gold ?

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Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.

Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks.