Sooner or later, if you’re writing about finance you end up writing about gold. Why? Because folks will not let the metal ride off into the monetary sunset.
Let me say right off the bat that I am not a gold bug. In fact, I have a great amount of skepticism about the virtue of the metal. This skepticism comes from at least two factors that I believe fans of gold fail to appreciate. The first factor pops up in my very first post here on the nature of bonds:
“Why buy a bond? Well, because you need cash to pay your bills. However, all your current bills have been paid and you are currently sitting on excess cash. Buying a bond consists of swapping excess cash today for theoretically risk-adjusted guaranteed cash in the future when you will need it for paying bills. You are paying for future liquidity. But what if your central bank will swap cash for bonds if you get into a pinch? Then the cashflows don’t really matter. Because you’re not holding onto the bond for the purposes of receiving cashflows from the issuer. You’re sitting on that piece of paper because it’s an insurance policy.”1
And then from an essay written on cryptocurrencies:
“Rather than the proverbial printing of money, or debasing of the currency, what’s really happened is that assets have become increasingly monetizable. In short, it is easier today for institutions to convert non-cash assets into cash via central bank mechanisms, than in previous decades. If you look at the M3 figure above you will notice that once the US got off the gold standard in the early 1970s, the line began to climb in earnest. The reason being that if the money supply was constrained by the size of the underlying gold reserve, then there would only be so much cash that could be produced via the purchasing of the precious metal. Once the US kicked gold to the curb though, it became possible for the Federal Reserve to accept assets other than gold in exchange for cash. If we think back to the Great Recession we see this in the way in which the Fed provided liquidity to financial institutions in exchange for certain financial instruments such as mortgage-backed securities. Thus, it is not the case that the Fed printed money out of thin air but that the central bank exchanged liquid assets (cash) for less liquid assets of the same worth.”2
In the first quote, I argued that bonds of reasonable grades act as liquidity mechanisms in contemporary markets. If you have a bond it is both a claim to future cash flows from the issuer, as well as a potential put option at the central bank.
The second quote speaks to the role that assets serve in our contemporary world. Whereas previously the currency supply was – at least in theory – constrained by the amount of gold held by the issuing country, today the money supply is, again, in theory, based on the holding of assets at the central bank. In the case of the United States, it is the Fed’s balance sheet and those of financial institutions, that back up much of the currency as opposed to the taxing powers of the United States. Now, we can have a discussion about whether or not the Fed is the market at this point, but that’s a different matter.
The point here is that most gold bugs have it in their heads that major currencies are more or less useless if they are not backed by gold. This is a categorical error. If it were the case that modern major economies were literally printing money based on nothing – indeed, the proverbial fiat – then they would have a point. However, as noted in the case of the Fed’s balance sheet, major currencies are backed by assets. The error that the gold bugs make is assuming that gold is the only asset that can back a currency.
If it were the case that major American financial institutions were sitting on hordes of proprietarily possessed gold, then I could imagine a world where the Fed would create a liquidity facility where Jamie Dimon could cart over J.P. Morgan’s bars for cash during a crisis. However, gold just ain’t that useful, or abundant, to cover the needs of contemporary finance.
What the current situation denotes is the overarching trend of securitization within society and finance. Securitization – at its most abstract – is the conversion of assets to cash. Sure, in ‘pure’ securitization circles there are the accompanying factors of cash generation and legal obligations, but the core gist of the matter is the creation of a financial device that is one step removed from the underlying asset. In this sense, major currencies are simply asset-backed securities in the current parlance.
Before getting into gold-backed currencies, it is perhaps helpful to comment on the relationship between currencies and banking. Normally, we tend to think of these two entities as separate: currencies are public goods while banks are private institutions. Except of course that the bulk of currency creation in a functioning economy comes from private banks who take deposits and then issue banknotes. Now, in the modern world, these banknotes consist of things like 5, 20, 50, and 100 dollar bills which we typically assume to be currency [I’m simplifying quite a bit here]. The situation is that governments have replaced private banknotes with public bills on a 1-to-1 basis via regulated banking systems. The key point here is that banks – not just ‘central’ banks – are crucial for the flow of currency in any economy.
With this relationship between banking and currency in mind, let’s take seriously the notions of either fully, or partially, gold-backed currencies – which demand gold-backed banking.
Decades ago, the likes of Murray Rothbard effectively died on the hill supporting 100% metal reserve banking. The idea is that any money not backed 100% by gold was fraudulent. The problem with this position is that its adoption would eliminate the existence of functional credit markets. Why? Because banks would cease to operate as centers of credit and lending. Instead, they would act as vaults. As Steven Horwitz notes in a brutal takedown of Rothbard’s thought:
“It is worth remarking that, to the extent that 100 percent reserve banks are warehouses, they cannot afford to attract deposits by paying interest. If banks are simply warehouses, their role as financial intermediaries disappears. It is not clear what supply of savings would be forthcoming if savers received no interest.”3
Now, while some folks might think to themselves ‘good, it’s my money and I simply need someone to watch it for me and keep it safe’ that is not at all how banks work and the banks are quite open about that. At no point does a bank take a crisp Benjamin out of your hand, and tuck it away for safekeeping until you want it again. Horwitz notes this by pointing out the obvious fact that,
“When people deposited gold and got banknotes in return, the notes did not guarantee that that very same gold, or an equivalent amount, would always be kept waiting in a drawer with the depositor’s name on it.”4
Fractional reserve banking cannot be fraudulent because there is no victim. The government legally allows banks to issue credit in terms of their currency based on the bank’s capital. The bank then does not hide the fact that its depositors’ cash is used as the capital upon which credit is generated. The irony of Rothbard’s critique of fractional reserve banking is that Rothbard was an extreme libertarian. By denouncing fractional reserve banking, Rothbard was rejecting the right of contract in monetary matters. Yes, you could argue that fractional lending ‘dilutes’ the currency held by others, but in that case, you can bugger off and make your own gold-backed currencies which then become government currency come tax time. This is effectively what the crypto-lads are trying to do – besides just shitpost and pay for kiddie porn. But we’ll come back to that later.
Turning to partially-backed systems, we find a similar level of issues. When a currency is backed by gold convertibility but the holdings of gold are less than the amount of banknotes outstanding, an issue arises whereby competing currencies can lead to successive runs. As Bytheway and Metzler note in their Central Banks and Gold, the existence of competing partially-gold-backed currencies means that the system can be gamed in order to ‘bleed’ gold from country to country via runs on central banks.5 This occurred in the 1920s and 1930s across Europe which eventually led to each of the continent’s currencies vacating the gold standard.
In effect, collusive efforts – or mob mentality amongst financiers – can easily lead to say, the Banque de France having its gold reserves carted off due to interest rate arbitrage. The mechanism by which this can happen is actually quite straightforward. If it is the case that gold seems undervalued relative to the amount of currency that you can redeem for it at a given central bank, then it is entirely feasible to gather up a relatively small amount of the local currency, and then demand instant gold conversion. As the gold stock declines, the currency appears weaker to the market: But governments have fixed prices of convertibility. This leads to the currency being artificially overvalued in terms of gold at official prices which means that you can gobble up more of it at its market value, convert it to gold, and then rack up ever-increasing rates of return. The end result is an eventual debasement by the government and, in effect, an exit from the gold standard.
The reason why the gold standard after World War II was effective until its ending by Nixon in the 1970s was that the gold supply was centered on the United States and the system of gold conversion was limited primarily to other central banks. Many folks forget that Americans were not allowed to own gold outside of decoration and jewelry from the Great Depression through to the end of the gold standard. It was this restriction of gold flows that made the system work for as long as, and as imperfectly as, it did.
With these two arguments against gold-backed currencies in hand, I think it’s fair to say that any argument in favor of the metal in terms of some future return to the gold standard is ridiculous from my point of view. But then again, that’s not going to stop the galaxy brains over at Real Vision from spewing such nonsense.
There is of course the argument for gold as a hedge against inflation. Recently, John Paulson – of The Greatest Trade Ever fame – has come out to say that he’s using the metal to offset predicted inflation.6 In a recent interview with David Rubenstein, Paulson puts forth a rather simple and compelling argument for inflation based on the circulation of an increased money supply outside of financial markets.7 Basically the notion is that the velocity of money in the system is higher alongside an increased supply thus driving the demand side of the monetarist exchange equation.
The strongest argument – in my mind – for Paulson’s position is the claim that if inflation hits, then fixed income securities, with their record low yields, will become a drag on portfolios in real terms. By comparison, gold in theory ought to be inflation-proof. The result is that portfolio managers and traders would ostensibly pile into gold meaning that those who already possess it will watch as the value of the commodity becomes the hottest date on the dance floor. Thus, in Paulson’s words, gold would go ‘parabolic.’ Pretty good argument, right? Or is it?
Although I could definitely see a ‘flight to gold’ occur, it is not at all apparent that that is what would happen. Sure, stocks would in theory decline due to the effect of an increased discount rate, and thus reduce their attractiveness, but why would someone jump into gold? In my mind, it would only be because they believe that it is indeed a hedge against inflation. In the same way that technical analysis is sometimes right because people believe in the system, a flight to gold relies on enough people believing the metal to be an actual hedge. In this day and age, the question is why anyone should believe that to be the case? Is it not just a modified version of Rothbard’s infatuation with the metal? As Peter Bernstein wrote in his (admittedly from a historiographical point of view horrendous) work The Power of Gold:
“At the dawn of the new millennium, gold is no longer at the center of the universe. The last vestiges of the golden fetters were discarded by Richard Nixon in 1971. When the golden Humpty-Dumpty fell off that wall, no one had much interest in wanting to put him back together again. Dispossessed from its power over the world of money, gold has been emasculated. Now greed and the lust for power run down different channels.”8
Gold was once the basis of currencies. While its literal role has been morphed – if not exaggerated – over the years, there is no denying that the metal once held a position and power in finance and economics that it no longer has. As noted above, the arguments for its position as a solid basis of currency are dubious, if not wildly outdated. In short, the world has moved on. You may complain that ‘the good old days’ were much better but nostalgia is neither here nor there. We have the world that we do, not that which some might wish.
Thus, Paulson’s thesis, although quite possible, is at risk of falling short due to expectations of another age. If inflation comes and is sustained, the flight may very well be “down different channels.” Even in the commodity space, there are clearly other metals and materials better suited for this day and age in terms of utility and future value than an emasculated yellow metal. However, if I were to take a guess, I would say that there is enough fairy dust left in the gold bug’s satchel to carry the metal through any near-term crisis.
As promised above, I said I would circle around to the crypto folks’ attempt to create a new system that more or less replicates what gold was. I’m only going to touch upon it shortly and then we can get out of here and pick up some pumpkin cream cold brews.
I have sympathy for the view of the crypto-crowd regarding the alleged attributes of their system. The presence of a fixed ‘money’ supply is akin in certain ways to gold in that gold mining is a laborious and slow process. However, the crypto claims suffer from the same damn flaws as mentioned above. In short, crypto – especially in its non-government-backed form – is never going anywhere long term. Yea, it’s hot right now, but dipshits are out here buying literal tulip NFTs so...9 Maybe we’re just in an age of decadence, in which case, knock yourself out boys. I’m just not won over by ahistorical and illogical arguments for the assets.
Photo by Sharon McCutcheon on Unsplash
Steven Horowitz, “Misreading the ‘Myth’: Rothbard on the theory and history of free banking,” in Peter Boettke & David Prychitko (eds.) The Market Process: Essays in Contemporary Austrian Economics, Mercatus Center ed., (Arlington: Mercatus Center at George Mason University, 2018 [1994]), 166-176, 173.
Ibid.
Simon Bytheway and Mark Metzler, Central Banks and Gold: How Tokyo, London, and New York Shaped the Modern World, (Ithaca: Cornell University Press, 2016).
https://www.cnbc.com/2021/08/30/john-paulson-says-inflation-will-shoot-much-higher-and-hes-positioning-with-energy-and-gold-bets.html
Peter Bernstein, The Power of Gold: The History of an Obsession, (Hoboken: Wiley, 2012 [2000]), 368.
https://opensea.io/collection/non-fungible-tulips