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 Investment Philosophies, Theories and Practices (continued…)


The History of Money: Fiat Currencies and Gold

By Bedlam Asset Management


Pre-history, when homo cave-potato decided he’d rather buy a club than make one, he needed a medium of exchange, and thus experimented with various forms of money including furs, shells, very large stones with holes in the middle, iron bars and blocks of salt. Each was unsuccessful; so early society soon settled on gold as the most practical medium of exchange, substituting it where supplies were limited, or when paying junior staff, with cheaper metals such as silver and copper. Although paper money has a long history, it was always explicitly understood that banknotes could be exchanged for something more tangible.


Since 1855 the Bank of England has been writing a now historically ironic promise “to pay the bearer on demand….. [in gold]”, even though any payment ceased in 1931. Almost all countries produce coins which look as if they are made from silver and copper to give them credibility. Early bankers soon worked out that not everyone would want to cash in these IOUs at the same time, so began issuing more notes than were actually backed by physical gold. Occasionally these ruses were found out, hence bank crashes; but as a global system it worked pretty well until 1913, when restrictions were imposed. Rather than cause a savings panic amongst the newly-monied middle classes, the system was replaced with a “let’s pretend” gold standard, which allowed for intra-government transfers of gold between debtor and creditor nations. This scheme limped along between major nations until July 1944 when, as a result of record wartime paper money printing, it too collapsed, to be replaced by the Bretton Woods Agreement.


Now all currencies would be fixed, forever, at an agreed exchange rate to the dollar, which in turn was initially backed by physical gold held in Fort Knox, Kentucky and valued at $35 an ounce. This scheme survived for an even shorter period, collapsing in 1971 when France’s Général de Gaulle, again in wartime (Vietnam) decided to cash in the excess dollars France had accumulated, in return for America’s gold. This did not run at all well in Washington. America decided to renege on the agreement (in practice a form of sovereign default).


The next permanent solution was ‘fiat money’, i.e. paper backed by nothing at all. At the core of this structure were the beliefs that (largely elected) politicians would be prudent economic stewards and if necessary could pay any financial obligations through taxing their local populations. The immutable fact about fiat money is that, over time, all paper currencies become worthless. Hence the mighty dollar today buys the same as 3.8 cents in 1900. Sterling is worse, the Swiss franc best, losing only four-fifths of its value in the same period.


Up until 1913, gold could be owned by anyone. Credit availability then was far more limited than now and inflation was self-correcting. So there were few reasons why its price should have varied much, and it didn’t, even when supply surged from new gold fields in the Americas, South Africa and Australia. It was a true store of value – a key purpose of money.


From 1913 onwards, private ownership became more and more difficult. The price was increasingly controlled by various arrangements fixed by a handful of central banks. The collapse of Bretton Woods removed the old $35 per oz. price cap which was then largely set by the free market. As a consequence, central bankers suffered a decade of near panic; for their populations immediately and very rudely showed an utter contempt for their politicians and financial authorities by increasingly preferring to own gold rather than the local funny money. Naked emperors do not like being figures of fun, so quietly agreed to regain control of the price. These various changes included taxing gold purchases, making its ownership illegal and, most important of all, prolonged and increasingly coordinated attempts to force the price down.


Thus, leaving aside ancient history, unlike all other commodities and currencies gold has only had one full cycle. Once freed in 1971, the price soared to a peak of $832 in 1980 and was then slowly brought back under central control at the turn of the century. A return to suppressing the price worked in part because of unprecedented international co-operation, and more because “new” forms of credit creation seemingly made gold’s monetary role as irrelevant. The collapse of this new credit paradigm in 2008 means it too has become history. Funny money has joined the shell and large rock with a hole in the middle as socially interesting but failed experiments.


Four decades on from a financial experiment with fiat money, the evidence suggests it is failing. Although governments will continue with the current system, relying on their ability to tax future generations, poor demographics alone in all advanced nations mean the odds that the current fiat money regime will survive unchanged for long are worsening. Change may be driven by this recession, followed by years of stop-go economic activity and a series of sovereign defaults – which are normal. The largest central banks have doubled or tripled their balance sheets in the last 15 months. This is an explosion in fiat money. Giant budget deficits and rising unemployment ensure that government money creation will remain explosive for the foreseeable future. These problems are exacerbated by a variety of new events, for instance Asia’s reserve diversification programmes and the marked reluctance of historic sellers to reduce their holdings further. It is simple school economics that a very finite supply of one form of money will respond to an almost fission-like increase in the supply of other forms of money, such as the amount of dollars, yen or euros in circulation.


It is very easy to make a case that the gold price could enjoy an explosive run. Given all economies (and businesses) are cyclical, then it is axiomatic that over time they will also revert to the mean. Therefore it can be expected that not just central banks, but also commercial banks and other financial institutions will revert to earlier policies of the 1970s and ‘80s – of holding a proportion of their ‘core’ capital in gold. Governments could try to prevent wider gold ownership as before, but new forms of ownership - such as gold ETFs - make it difficult to do so unless all leading nations agree simultaneously.


Quoted from an article by Bedlam Asset Management, June 2009