Donald Trump’s arrival in the White House has confirmed a new period of political and economic volatility. While volatility can be something to defend oneself from, it also opens up new opportunities. Investing in gold – specifically, gold money – could protect you if the traditional banking system hits trouble. Which it easily could.
There’s every chance Trump will last for the full four years of his first presidential term. What this means is that the volatility we see today is likely to be just the beginning.
Even if we exclude the political controversies, Trump’s economic policies – such as his proposed infrastructure spend and his protectionist leanings – seem set to transform the economic world.
And, then, we don’t even have to look to the US for potential causes of instability. We have plenty to entertain us here in Britain, with Brexit and other ongoing pressures affecting the EU, our main trading partner, among them a potentially testing set of elections.
Essentially, with volatility comes risk and there are risks associated with wherever you leave your money. The pounds or dollars in your pocket or bank account might seem familiar and safe, but the factors at play may suggest otherwise.
In fact, there are many respected commentators, such as David Stockman, who strongly recommend protecting themselves against a banking collapse. And their favourite alternative is gold.
Historically, gold has a good track record as a store of value compared with fiat currencies. But to understand why, one must look at these different types of money and their likely reactions to the volatility we now face.
This is the first of three articles. This looks at gold, how it compares to notes and coins – ‘traditional’ money. The next looks at how to save and spend gold money. And the final piece looks at the economic case for using gold money compared with fiat currency.
So here goes.
From fiat currency…
The notes and coins in your pocket are examples of fiat currency – fiat is Latin for ‘let it become’. It is so named because the money in your pocket is created out of thin air by a central bank, such as the Fed or Bank of England.
Our currencies are not backed by anything of intrinsic value. Instead, they are backed by habit and the trust of those who use them. If they do have an underlying value, it’s framed by a generalised sense that the economy is doing okay.
This hasn’t always been the case. Until 1971, US dollars were convertible into gold under the Bretton Woods system agreed after the Second World War. The dollar was the foundation of this fixed-exchange system, effectively tying all the participating currencies to a gold standard.
However, by 1971, the war in Vietnam had virtually exhausted US gold reserves. Richard Nixon responded by temporarily suspending the dollar’s gold convertibility, ostensibly until Bretton Woods was reformed. As it turned out, Bretton Woods was abandoned, leaving the various international currencies to ‘float’ on the foreign exchanges. And, thus, a new age of fiat currency was born.
…to debt dependency
But when a currency has no intrinsic value, central bankers and governments are all too often tempted to manipulate it in some way – typically by printing more of it.
There are often good reasons to print more money; the question is when to stop because banks cannot simply ‘print’ value. Printing too much paper money can stoke inflation and debase the currency. And that’s exactly what happened during the late 1960s and 1970s.
However, it’s not merely governments that create money out of nothing. Your high street bank routinely performs this magic trick when it lends to its customers.
Margaret Thatcher and Ronald Reagan deregulated the financial system, effectively sub-contracting money-creation to commercial banks. Consequently, ‘debt-money’ flooded the money supply.
Deregulation. At the end of the Second World War, Bank of England notes and coins accounted for around 40% of the total UK money supply.
Today, that figure has fallen to around 2.6%. The remainder is debt-money created by the banking system – which keeps only a small proportion of its liabilities as real money. This is the bank’s fractional reserve and the system is called fractional-reserve banking.
Fractional-reserve banking only works if customers don’t all want to withdraw their money at the same time. If we did, the 2.6% reserve would be quickly depleted and there’d be a run on the bank. Cue scenes of fury and panic a la Northern Rock.
The Thatcher-Reagan revolution
In other words, the period since Thatcher and Reagan can be characterised by a truly staggering debt-money explosion, facilitated by a 30-year trend of falling interest rates.
As a result, households, companies and banks across the West are close to debt saturation. And, at these levels, debt is deflationary because the onerous repayments significantly reduce spending power.
What’s more, debt servicing transfers wealth from the productive economy – where people make things of value – to the financial system, which doesn’t make anything. So, at this level of indebtedness, the banks are issuing debt but simultaneously undermining the economy’s ability to service it. Debt saturation compounds our other economic problems.
While you might think indebtedness is a question of personal responsibility, it is actually a structural issue. Because even if you’re not paying interest on your bank balance, under the current system, someone else is. And, in any case, our business and personal debts pale when compared with the derivatives created by the banks themselves.
Ultimately, fiat currencies tend to become the plaything of their ruling elites. They simply cannot resist printing more money of no intrinsic value to sustain their lifestyles and pay for their pet projects. It’s the primary reason that fiat currencies ultimately collapse.
Physical gold has been used as a currency at various points in history, but its relatively fixed supply means it functions differently from debt-based, fiat money.
The stock of physical gold cannot simply be expanded like paper money. New gold production is not great enough to significantly change the overall supply vis a vis demand. Physical gold is also a global commodity, which means it’s harder for governments, corporations or elites to control its price and supply. The same is true, by the way, for silver and bitcoin.
However, although elites cannot simply print more physical gold, this doesn’t mean they don’t try. And it’s at this point where we need to make a very clear distinction between physical and ‘paper’ gold.
‘Physical gold’ is what it says on the tin. It’s actual physical stock of the precious metal, which could be in the form of gold bars or coins, such as Krugerrands.
However, in the same way as commercial banks ‘sell’ more money then they actually have, so do bullion banks. And they do this by selling ‘paper gold’, or GLD, which are contractual claims on physical gold. In this way, gold is leveraged in exactly the same way as fiat currency using exactly the same fractional-reserve system.
Because nothing quite lights up a banker’s eyes than creating demand for a product that doesn’t exist and trading paper claims to said non-existent product for shedloads of money. What’s not to like about that?
The problem is it would appear the bullion banks have been even keener than their currency brethren to sell multiple claims on every ounce of gold. The fractional gold reserve is smaller – though exactly how much smaller isn’t clear.
However, the margins are so tight that the fractional gold reserve may be insufficient to service GLD redemptions. In which case, the bullion banks may have to default and liquidate their GLD contracts in a fiat currency, which rather rather defeats the object. Receiving your gold in fiat is like redeeming a sterling-denominated bond in Zimbabwean dollars.
Three years ago, there appeared to be a concerted attempt by bullion market players to flood the market with GLD contracts to force the gold price down.
Numerous institutions and governments might have an interest in artificially-lowering gold prices. A sudden fall could encourage small investors to cut their losses and sell their gold at bargain-basement prices. Institutions and governments could then increase their gold reserves and simultaneously reduce gold’s attractiveness compared with fiat currency.
If this was behind the GLD rush three years ago, then the ruse didn’t work. Instead of ‘flushing out’ small investors, millions across China and India saw the lower price as a buying opportunity. Long queues formed outside jewellers, pawn brokers and bullion exchanges as the demand for gold rocketed. So, rather than replenishing institutions’ stocks, spare gold went east, reducing the fractional reserve even further. Doh!
There is a lesson here for anyone interested in bullion: be aware of the difference between GLD and physical gold. Though both are based on the same price per ounce, the two products are very different. And, critically, GLD probably carries a greater long-term investment risk than fiat currency.
GLD contracts come with a risk that they cannot be fulfilled, which is why holding physical gold is more secure. Indeed, some commentators claim that paper gold could become detached from the physical gold market. If that happens, the value of GLD will almost certainly collapse while, freed from the weight of worthless paper, physical gold will soar.
So, anyone looking to buy gold should ideally restrict themselves to the physical stuff. But that doesn’t mean you have to lug around loads of gold money when you go shopping in Waitrose.
Thanks to full-reserve gold banking and digital technology, you can save and spend your gold money like the cash in a normal bank account. Gold money accounts can even come with MasterCard or Visa payment cards.
Next time, I’ll look at how the new gold money offerings make saving and spending physical gold a synch.