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Sunday, 8 March 2009

Gold!

Inflation, Insurance and Warren Buffett's Dad

From King Midas to Gordon Brown gold has always attracted legendary behaviour - although the latter’s sale of the UK’s gold reserves at a cyclically low price looks with hindsight to have been, well, less than optimal. All right, it was completely rubbish. Still, the nature of the stuff fascinates people. It’s bright and shiny, heavy and it doesn’t tarnish. And people are willing to pay good money for it. What’s not to like?

However, gold really isn’t the stuff of basic investment. It has no intrinsic value, creates no cashflows and pays no dividends. It can go radically out of fashion, sometime for decades and it doesn’t have much commercial use beyond adorning rap artistes and gilding lilies.

As an asset class it’s a very odd thing to invest in.


Timeless Value

Yet it holds its monetary value over very long time periods. In thirteenth century England an ounce of gold was defined as enough to garb yourself in a manner fit to meet the king. Fast forward the best part of a millennium and an ounce of gold will still buy you a suit nice enough to greet Queen Liz. For although gold’s price has fluctuated, often quite dramatically, over a long-enough time period it provides a decent hedge against inflation and the collapse of governments. In a real sense gold offers insurance against economic and political calamity in a way that no fiat currency can ever do.

For a long time currencies were underpinned by gold. In fact for a long time currency was made of gold – starting as far back as King Croesus in 500 BC and lasting in some form into the last century. Unfortunately wandering around Europe carrying large bags of gold was apt to attract the wrong sort of company and merchants generally found that they needed to hire large bands of mercenaries in order to protect themselves. This, of course, was detrimental to returns. Even more detrimental was that the mercenaries were quite likely to decide that the best way of protecting this gold was to take personal and permanent possession of it.

Negotiable Instruments

The invention in the Middle Ages of negotiable instruments like promissory notes and bills of exchange was a key financial innovation both reducing the need to transport physical money and simultaneously increasing the volume of trade across Europe by making money transfer easier. Essentially these documents are promises in which the issuer promises to pay the bearer the amount of money on the note.

To support this system the great commercial banking houses of Europe grew up to manage the gold behind these notes. So you could get your bills of exchange in London from a bank, backed by your own gold and hand it to a merchant in Amsterdam. At the counterpart bank in Amsterdam the merchant would get their gold and the two banks would adjust their accounts to reflect the transaction, minus their cut of the take. Hence, for a fee, merchants could avoid the perilous carting of money across the lawless wastes of Europe and reduce the need to hire expensive and frequently treacherous guards. The mercenaries were forced to find new ways of extorting money. Presumably most of them went into banking and politics.

This money transfer mechanism was quite beautifully exploited by the British government in times of war. Bills of exchange were acquired in London then exchanged on the Continent for hard cash which the British used to buy supplies and weapons to carry on fighting. The bills were then used by European importers to purchase British made consumer goods. This in effect meant that the British were conducting a war funded by the same people they were fighting. Which was pretty darned clever, and had the added benefit of really annoying the French.

Upsetting Warren Buffett’s Dad

Eventually, as trade increased, the need for money began to outrun the supply of gold and governments, as the monopoly issuers of currency, decided to cut the link between the promissory notes (more commonly called “dollar bills” or “pound notes” or whatever) and the underlying precious metal. The story of the world’s nations going “off the Gold Standard” is a complex one and requires a more detailed retelling but many commentators immediately prophesied doom.

The United States was forced to cut the link between gold and the dollar due to the need to fund government spending during the 1930’s depression. This provoked Warren Buffett’s dad greatly:

But when you recall that one of the first moves by Lenin, Mussolini and Hitler was to outlaw individual ownership of gold, you begin to sense that there may be some connection between money, redeemable in gold, and the rare prize known as human liberty.


Printing Money

Unconstrained by the need to back their currencies with physical gold governments suddenly found themselves with the ability to, quite literally, print money. Which many of them proceeded to do happily and liberally, until they found inflation running footloose with the real wealth of nations. Essentially, in the absence of a gold standard or equivalent, a country’s money supply is really constrained by the businesses of that country being able to make profits and its government’s ability to tax that cashflow.

The battle against inflation was brutal and bruising. In the 1980’s both Britain and the United States racked up their interest rates and saw unemployment soar in consequence. Eventually, though, most developed countries managed to bring inflation under control and set the scene for the long economic boom that we’re only now seeing the end of.

So, fast forwarding to the beginning of the twenty first century, we see central banks printing money as fast as they can in order to try and stimulate the collapsing economy. Given the fall in company revenues that’s driving this there’s clearly a point at which the rate of new money production will not be underpinned by current business revenues and that means either economic collapse or, more likely, rampant inflation. One is irresistibly reminded of Woody Allen’s words:

More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.
Still, no doubt we’ll muddle through. That’s official Fed policy as far as I can tell.

The True Value of Gold

So where, in all this, lies the value of gold? Well, when people lose their faith in the underpinning of fiat currencies gold is likely to do well as an asset class. If you need to buy a suit to meet the Queen you’ll likely find an ounce of gold will meet your needs, but who knows how many pounds sterling it’ll cost in a few years time?

High inflation, of course, destroys the real value of bonds and cash but tends to favour equities and gold. Given a choice between investing in companies with inflation proof business models and investing in gold I’d take the former every time. Proper earnings, re-invested to drive future growth, are the best hedge you can have against the worst that the economy can throw at you. But, as many people found throughout the twentieth century, having some gold set aside can be a very useful insurance plan, especially in times of political upheaval.

Countries can default on their debt or see their currencies overcome with hyperinflation. Regimes may arbitrarily nationalise companies or whole industries or decide to abrogate the property rights of individuals. Think of Peron’s Argentina, Weimar Germany, Cuba under Castro or Russia in the wake of Lenin’s victory. Virtually all assets carry some kind of risk that isn’t apparent from the standpoint of survivors. Gold, however, is timeless. It holds its value, is transportable, easily exchanged for other assets and it’s carried these attributes for thousands of years.

So gold may not be a great investment but as insurance, it’s hard to beat.

This article appears in the Investing in Gold carnival at Gold Spot Price Today - here.

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