London Bullion Market Association
November 18, 1999
Harry Bingham
There was a time around the last turn of the century when gold was the most contentious political subject in America. Three presidential campaigns were waged on this issue and three times the alleged crucifier of mankind triumphed. The press was gleeful. "You fight about it and we'll write about it", they said. Frank Baum even wrote a delightful classic about the gold controversy which was finally produced as a timeless movie, "The Wonderful Wizard of Oz" - Oz of course standing for ounces of gold and the wizard for our beloved President William McKinley, champion of the gold standard. Dorothy although enchanting, was on the wrong side of the issue.
A recent edition of the Wall Street Journal noted that Republican presidential candidates extol Ronald Reagan's administration as the Gold Standard of politics. Eighty-five years after the demise of the International Monetary Gold Standard the expression gold standard still retains the mark of excellence. Could that be because during the intervening eighty five years the best paper monies, untethered to gold, have lost more than 90% of their purchasing power value while others have been totally obliterated one or more times.
This year, gold, under severe attack and at its lowest ebb in more than twenty years, still retained more than 70% of its 1913 purchasing power. Today, having scored a victory, gold is very close to its pre-World War I parity with goods and 15 times its pre-War parity with the dollar.
In McKinley's time the enemy of gold was silver, a subsidiary form of money. Paper was a convenient receipt for money and was called a note. Credit itself was useful, but was disdained by most, and when speculatively used led to booms and panics even under the stringent limitations the gold standard imposed.
Last month in a letter to the editor of "The Alchemist" I wrote that the European central banks' September 27th statement to restrict additional gold supplies was a seminal event. This may have been a bit optimistic because in the words of Geoffrey Chaucer; "When you dine with the devil use a long spoon".
Three quarters of a century ago central banks began an attempt to eliminate gold as a discipline to the creation of paper money and credit. They finally succeeded temporarily in 1971, when the United States officially refused to redeem dollar denominated notes for gold. Subsequently, a fierce attempt has been made to remove from public consciousness gold's role as a measurement of the value of paper money.
This attempt failed abjectly during the 1970's, but supported by a great bull market in shares and gilts gained momentum during the 1980's and 1990's. This bull market is extraordinarily important because it sanctified the great credit inflation of these decades.
Credit Chart
1971-1981
1983-1993
1988-1998
On its face credit growth looks to have been slower during the 1990's than during the 1970's. In reality it has been faster when the leverage affect of derivatives is included - these having grown from virtually nothing in the 1970's to $85 trillion notional value today have contributed mightily to the unprecedented vitality and durability of the bull run in shares and have contributed just as mightily to gold's strategic retreat.
At the moment I am not attempting to judge the valuations in the securities markets. I am only suggesting that the shift in the use of credit from the pursuit of commodities to the pursuit of securities, for whatever legitimate or spurious reasons, was a great ally of central banks in their effort to "demonetize" gold.
There is good documentation that over long periods of time gold maintains its value. During periods of market euphoria and despair, however gold becomes the reciprocal of the values placed on shares, gilts and currencies. Even in a fixed exchange regimen gold lost half its purchasing power value during and after World War I and then regained all of it and then some in the 1930's.
There is a text book definition of money, but temporarily money may be whatever people think it is. People may even temporarily mistake credit for money. There is a saying on Wall Street "When the ducks are quacking feed them". After World War II there was some question about the value of currencies in terms of gold. World Central Banks then held 70% of all the worlds gold. They were able to suppress the ducks until multitudes began quacking in the 1970's. Then with all their might they could not stop a gold bull market. These weren't ducks after all, and people finally distinguished money from credit.
The small sales of gold by central banks during the 1980's and 1990's were de-minimus in terms of the gold market, as were the increases in gold production during the 1980's. Even then new mine supplies never added more than 2% a year to above ground stocks. The leasing of gold for new mine development and for modest price protection for the mines was also insufficient to account for the remarkable decline in gold's perceived value.
The analysis of the price of gold is more akin to bonds than to commodities. That is because virtually all of the gold mined and most of the bonds issued are still outstanding. Unlike commodities bonds and gold are issued and produced for accumulation rather than for consumption. There is a continuous bid and asked market for both bonds and gold. Their prices reflect the value that all the holders and potential holders place on all the gold and bonds outstanding. Isn't it remarkable that the great government bond bull market in the Untied States during the 1980's occurred despite the greatest issuance of new government bonds in history and that bond prices have fallen this year despite an absolute decline in the amount of US government bonds outstanding. Perception of value is the reason.
A demoralized market can be further demoralized until it reaches bottom. The final culprits in gold's case were the carry trade operators. These speculators had a vested interest in depressing the gold price. All that stood between themselves and a limitless sequence of profits was a sharp and sustained rise in gold's price. Speculators flooded the market with rumors of central bank sales and the disdain with which their bureaucrats held gold. Central bankers, I think finally sensed that they were being regarded as dupes by these speculators who thrived on the losses central banks were suffering. That is why the first point in the September 27th communiqu‚ was: "Gold will remain an important element of global monetary reserves". Deep down central bankers may detest this concession to gold, but for now and for some time to come they have no choice except to honor it. No choice now because a quick policy reversal so soon after sustaining dreadful losses of their own making on a public treasure so basic to central bank management as gold would risk the loss of public confidence in central banking itself.
Central banks likely have little choice in the longer term because the degree of confidence in monetary institutions changes with economic conditions. During the 1920's the Federal Reserve was revered as the institution that had saved the banks and conquered the business cycle. By 1932 the system was in disrepute and its structure was radically altered. Then less than a generation ago central banks were universally defined as "the engines of inflation". A seventeen-year bull market changed that perception. No bull market in this century, or the last, has survived for a full generation. Engines of economic activity and markets change. What does not change, but what a bull market may conceal, is the distinction between money, which is an owned asset, and credit, which is an owed liability. A bear market in shares and gilts clarifies that distinction.
Chart Debt vs. GDP
This is the evidence of a bubble in the markets. The multiple of debt to GDP including inflation in the United States was stable throughout the 1960's and 1970's but has since skyrocketed as excess credit has been absorbed by a seemingly endless bull market in shares rather than by what was once seen as endless inflation.
Alan Greenspan is concerned about the decline in the risk premium on common stocks. But the mother of all declines has been the decline in the risk premium on paper money. Share certificates at least represent real assets, albeit at excessive valuations. Shares also represent intrinsic value, which may rise or fall. Paper money today represents no intrinsic value and reflects only confidence in the virtue, wisdom and continuity of central banks. Once this confidence wanes the value of paper money will wane with it. This may take more time because as Charles Mackay, Author of Extraordinary Popular Delusions and the Madness of Crowds wrote: "Men think in herds. They go mad in herds but only recover their senses slowly and one by one".
On the other hand in an October 14th speech about risk management Chairman Greenspan said: "History tells us that sharp reversals in confidence occur abruptly with little advance notice". He went on to suggest that banks increase their reserves: He said: "These reserves will appear almost all the time to be a sub-optimal use of capital. So do fire insurance policies". What he didn't say is that cash protects cash but gold may protect the accumulated wealth of a generation.
Nevertheless, at the recent Jackson Hole monetary symposium there seemed little inclination to view the rapid rise in share prices as a harbinger of inflation or excessive speculation. Uninvited to the symposium was an official of the Bank of England, Charles Goodhart, who defines inflation as a decline in the value of money. He concludes that a rise in the price of a house or shares, which are claims on future services, should be counted as inflation just as much as a rise in the price of carrots or cars.
The greatest threats to financial market stability and confidence in paper as I see it are:
Inflation. This is obvious and requires no elaboration.
Trouble emanating from blistering credit growth which continues to far out pace economic growth. Ironically, on the very day that the Federal Reserve warned American banks about low credit standards, the Federal National Mortgage Association announced an easing of credit requirements on mortgage loans. There is nothing more damaging to confidence than vanishing credit availability.
The world may be locked into a continuing coordinated monetary expansion. The banking and credit systems of Mexico, Brazil, Argentina, Ecuador, South Korea, Thailand, Indonesia and even Japan are in varying states of disrepair, and some continue to deteriorate. Emerging market income statements have improved thanks to rising exports, official financial aid and the roll-over of billions of dollars of foreign bank loans, but their balance sheets remain in perilous condition. Imagine what would happen to the finances of these countries should the Federal Reserve actually tighten monetary policy and throw the United States into recession. Imagine what would happen to confidence in central banks in general if their policies were to be seen to have caused another round of emerging market economic turmoil.
The Federal Reserve would like to tighten credit to cool the economy but dares not because of the potentially disastrous affects on consumer finances and fragile emerging markets.
You know, Irving Fisher, the renowned economist of the 1920's is best remembered for his October 1929 remark that stocks had reached a permanently higher plateau. Less well remembered is his comment three months later: "Stock prices were rising three times more rapidly than earnings. There was no statistical precident by which to judge to what degree prices were entitled to out run earnings, but when stock quotations get to stepping thrice as high as the intrinsic values behind them, it should be time for careful people to stop look and listen". Professor Fisher had quickly seen the error of his earlier opinion. But even he could hardly sense that in less than three years the Dow Jones would collapse by 89% to a level not seen since the creation of the Dow Jones Averages in the 19th century. What Professor Fisher may have missed at the market's peak was that the excessive credit creation that funded the stock market boom inevitably had to lead to general price inflation or to a bubble bursting crash as it had throughout history - and also throughout history been the perfect prescription for a gold bull market.
The world is engaged in a coordinated monetary expansion in the midst of strong deflationary forces. But as was proved in the 1930's, deflationary forces are the wombs of devaluations which are fathers of the next inflation. The American consumer price index has never again been as low as on the day President Roosevelt, at the bottom of the depression, called in American gold coins and then devalued the dollar against gold. The truth is that to this day not every nation can devalue at once, except against gold.
In 1972, when gold was $59 an ounce an old friend, Douglas Johnston, suggested that his clients might make a killing in gold shares. He wrote: "Nothing has been less popular than the subject of gold. Congress is against it. The Federal Reserve is rabidly against it. The Treasury reads gold's funeral oration several times a year. Only a handful of mutual funds owns any gold shares. Virtually none of the banks, insurance companies or pension funds own any. The press and college professors lambaste gold without respite. It is precisely because they are so unanimous against gold that opportunity exists for an unprecedented killing today". Less than a year and a half later gold was almost $200 an ounce and a killing had indeed been made. A similar opportunity may exist today, because as a Wall Street sage once said; "Bull markets are born in pessimism, grow in skepticism, mature in optimism and die in euphoria". Or as a line from the communist Internationale goes "The volcano is thundering in its crater. The final eruption is at hand" - but not the one the communists had in mind.
I would like to end with quotes from a few Englishmen past and present.
John Stuart Mill 150 years ago said: "Money is like a machine for doing quickly and commodiously what would be done less quickly and commodiously without its and like other types of machinery it exerts an independent influence only when it gets out of order". As Christopher Wren said; "Look around". Then, Lord John Maynard Keynes - no friend of gold - said soon after Britain's departure from gold: "The metal gold might not possess all the theoretical advantages of an artificially regulated standard, but it could not be tampered with and had proved reliable in practice". I wonder how reliable Lord Keynes would think the artificial non-gold system is, now that the pound has lost 95% of its pre 1931 value. Perhaps that happened because since 1931 the pound has been tethered, not to gold but to government bonds, about which Benjamin Graham once wrote; "At bottom they are no asset at all".
More recently Robert Sleeper of the Bank for International Settlements at this year's Financial Times Gold Conference said in reference to gold: "This market is still the most sensitive to all the fears and uncertainties in the world and when a rebound occurs it will take few prisoners". He concluded: "Central banks themselves are most sensitive to the vulnerabilities of the world economy to the many exogenous forces that could potentially re-ignite inflation fears. It is for this reason that central banks will always hold gold. It is still their job to protect the financial system from crises of confidence in Fiat currencies". In his prepared text Mr. Sleeper capitalized each letter of the word FIAT; perhaps because throughout history all fiat currencies have eventually approached their intrinsic value.
Best of all was Sir Peter Tapsell's message in The House of Commons as he attacked the British government's decree to exchange gold for paper; "The Chancellor may think he has discovered a new alchemist's stone, but his dollars, yen and Euros will not always glitter in a storm, and they will never be mistaken for gold".
And now a final reading of Edward Lear's 19th century limerick:
The owl and the pussycat went to sea
In a beautiful pea green boat
They took some honey
And plenty of money
Wrapped up in a five pound note
25 November, 1999
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