Yesterday's financial headline was an
eye-catcher:
Gold price ends at 24-1/2-year peak
That's all you need to know. Right? Well, no. If you kept reading you would have spotted an interesting quote buried deep in an obscure financial article.
"Obviously the next key level would be $515/oz and this looks quite possible. Although some commercial banks are trying to push the price lower I think it's not an issue for as long as it holds above $490/oz.
Huh? Why would commercial banks be trying to push a commodity price lower? Especially one that isn't oil. And why are people in the middle east
buying gold "at any price"? And why are market analysts calling gold a
fourth global currency?
To answer these questions you must first take a step back into economic history and understand how we got to where we are.
First of all, what is
Money?
Money is any marketable good or token used by a society as a store of value, a medium of exchange, and a unit of account. Since the needs arise naturally, societies organically create a money object when none exists. In other cases, a central authority creates a money object; this is more frequently the case in modern societies with paper money.
Anything can be used as money, but only certain things satisfy the three characteristics above: store of value, medium of exchange, and unit of account.
The first type of money in history that you didn't eat was
precious metals, namely gold and silver. This happened shortly after the first written language was developed.
China tried using Cowrie shells for a time. This didn't work because it failed to meet the third characteristic of money. Massachusettes settlers imitated native Americans and used Wampum shells as currency until it stopped being legal tender in 1661. In England they tried using
hazel sticks.
A piece of wood split down the middle will only match perfectly with its other half. So wooden sticks became a key component of English currency. The government's debt office took a nice looking hazel stick and notched across it various symbols which denoted monetary amounts borrowed and lent. The stick was then split down the middle, with each side showing one end of the notches. One side - which had a wooden handle known as a 'stock' - was held by the king's treasury, while the other was given to the goldsmith, who also got a piece of paper describing the date and circumstances of redemption.
It was used from the 12th Century until it was outlawed in 1826.
The first real coins were made in Lydia (western Asia Minor) circa 640 BC. They were an amalgam of gold and silver. A few decades later China began minting their own metal coins. Centuries later gold and silver had become accepted as money in Europe, Asia, Africa, and even in the Americas. Societies had decided it independently and without coercion.
But we have paper money now. It it worlwide and therefore superior, right? Well, not really.
The first thing to remember is that paper money has been tried before. Many times. And it has always failed.
China was the first to try it in the 10th Century but it ended early in the 11th Century because of hyperinflation.
It arose in China yet again in 1131 AD and the government outlawed all redemption rights into metal coins. The currency ended in hyperinflation in 1166. Mongol conquerers then issued their own fiat money, although like the previous attempts in China, it kept declining in value through multiple "re-issues". Gold, silver, and gems were forbidden from being sold except to the emperor.
But their fiat currency was over-issued. Credit was expanded too far and inflation went out of control. Eventually people lost faith in the currency. By 1350 the fiat currency ceased to exist and the empire crumbled into warfare and economic chaos.
After yet another try at paper money that ended in hyperinflation, China finally abandoned their 500 year experiment with fiat currencies in 1455 AD.
This pattern of inflating a paper currency until it was totally worthless was repeated over and over again throughout history. It was done during John Law's Royal Bank of France (circa 1720), during the American Revolutionary War by the Continental Congress (hence the term "Not worth a Continental"), and Germany's Weimar Republic (early 1920's).
It has been done over and over again - more times then I could list here and you would want to read.
"Uh, oh. Here comes Chicken Little," you might be saying to yourself.
Not true. China didn't cease to exist after repeated attempts at "perfecting" fiat currency. Nor did America's experience in the Revolutionary War ruin this country's chances. However, that doesn't mean that a lot of people didn't lose everything they had because they put their faith in fiat money.
Which brings me to my next point - fiat currency fails the first test of money: store of value.
If you go to this web site you can find out how much value a dollar has lost. For instance, a dollar's basket of goods bought in 1913 (the year the Federal Reserve was created) now costs $19.66 to buy. A dollar's basket of goods bought in 1971 (the year we defaulted on the international gold standard) now costs $4.80.
The goods didn't get more dear. It is the dollar that got more worthless. Put another way, the dollar has lost 96% of its value since 1913. And that is with using the heavily understated CPI.
Most people probably think that this is normal. You are supposed to have some inflation, right? No, that isn't normal when you have a real currency. Check out price inflation rates in the 1800's. From the end of the Civil War until the creation of the Federal Reserve price inflation was either zero or negative. In many years the deflation was rather extreme. That was normal because we were on the gold standard, and the economy grew consistently.
The reason the economy could stand boughts of deflation was because our currency wasn't debt-based, like the fiat we use today. We didn't have to create an IOU whenever we created a dollar like we do today.
This explains why commercials banks are "trying to push the price of gold lower". Central Banks (the Federal Reserve being one of them) are groups of commercial banks. Their product is paper money. They want to sell as much of it as they can. To do that they need to either make their product more attractive, or make a competitive product look worse. Since they are printing currency like it is going out of style, they are failing the first test. The competitor of their product is gold. Pushing down the price of it makes it look worse.
The next point, and perhaps the most important point, I need to make is what is legally money in America.
In the U.S. Constitution, Article 1, Section 10:
Clause 1: No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.
It's actually quite clear. Legal tender, according to the Constitution (aka the Law of the Land), is silver or gold. Not fiat paper.
So where does that leave us today?
First of all, with every nation in the world using fiat currency and buried in debt because of it, they are all madly inflating their currencies:
rates of money supply growth over the past year -
Australia + 9.8%
Britain + 11.2%
Canada + 9.8%
Denmark + 16.3%
US + 7.3%
Euro zone + 8.5%
And with the number of dollars growing by leaps and bounds (doubling in just nine years), it is very suspiciouos that the Federal Reserve has suddenly decided to
stop publishing the M3 monetary supply numbers, repurchase agreements (aka dollars printed out of thin air and forced into the system), and Eurodollars (something that reflects the exploding trade deficit).
It is no small coincidence that the price of gold has
increased nearly $50 an ounce since the Federal Reserve made this announcement.
Recently the central banks of Russia, South Africa, and Argentina have all announced that they intended to
buy gold in an effort to diversify their foreign exchange reserves away from dollars. China's central bank is now making similar noises.
Meanwhile, demand for gold worldwide has
increased 20% while mine production from South Africa, the world's largest gold exporter, has
dropped dramatically. It has also fallen in Australia and other gold exporters in the world. The fact is that gold mine production hasn't matched world demand in decades. Only the steady selling of gold from Central Banks has filled the gap between supply and demand. But now the gap is growing and several Central Banks, such as Canada's, are practically out of gold to sell.
So what should you do about this?
First of all, if you want to make some quick cash then don't buy gold. It is currently a little overbought and will suffer a correction in the near future.
But what if you want to make a killing in the distant future? Don't buy gold. Gold doesn't change in value over time. I read a study once where if you lived in London in 1899 you could buy a nice, men's suit for an ounce of gold. In 1999 London you could buy a nice, men's suit for the same ounce of gold.
The fact is that whatever number of grains of gold it took to buy a loaf of bread under Nebuchadnezzar's rule in Ancient Babylonia is pretty much the number of grains of gold it takes to buy a loaf of bread today. You see, gold is honest money. It take time, effort, hard work, and capital to get an ounce of gold out of the ground and into a coin. That's why it has intrisic value and paper money doesn't. It requires no effort to print out an electronic stack of hundred dollars bills. It only requires convincing someone that it is worth something. That's where government fiat comes in.
However, if you are more concerned about the return of investment rather than the return on investment, then buy gold with both hands. But it now. Buy it tomorrow, and keep buying it.
Perhaps some of you remember this Newsweek headline from last year. When it was discussed here lots of people recommended buying Euros. I recommended buying gold. Generally my suggestion was either ignored or ridiculed. If you took their advice and bought Euros you would have lost a lot of money. If you took my advice you would have made some money. That's why return of investment should concern you.
The fact is that when you see a Newsweek headline telling you that gold is The Next Big Thing and that you have to buy it right now, its because all the Wall Street 'smart money' will already be positioned in gold. It's too late to make money on it then. Right now 'dumb money' doesn't know anything about gold and is currently buying GOOG stock. That's why I am telling you about it now.