May 5, 1997 – One of my favorite precious metal analysts is Andy Smith, who works in London for the Union Bank of Switzerland. His reports are always a treat for me to read. They are very well researched and loaded with numerous graphs that provide unique insights into the precious metals. As if that wasn’t enough, they are also witty and entertaining.
There’s something in Andy’s reports for everyone, except alas the bulls. In recent years he has been one of the steadfast London bears, and I might add, accurate in his price forecasts, even calling correctly the occasional rally. This exceptional record is one reason I pay attention to what he is writing and saying (we speak on the telephone and/or meet from time to time, and in between these occasional confabs, I can still keep on top of his thinking because he is frequently quoted in the major financial newspapers).
To my dismay but not I guess to my surprise Andy’s latest missive on Gold is bearish. In a nutshell, more central bank dishoarding in Europe will continue to weigh heavily on the market. In his view “central banks are metamorphosing from happy holders to prodigious producers” of Gold. He paints a generally bleak picture for the precious metal. I hope that he is wrong.
Only time will tell of course whether Gold will stay in the doldrums. And only time will tell whether central banks will remain the force they have been in the Gold market. These two non-controversial observations about the future are purposefully chosen by me they imply that Gold does have a future and that lower prices are not an inevitable outcome. There is in my view another side to the precious metal coin, and it is bullish. So in the recognition that it always takes a buyer and a seller to make a market, I am sending Andy the following open letter.
Your latest report, “Central Bank Gold: The Picture of Less Reserve”, got me thinking. It had to. Your report was at first a bit scary when I read it, so I needed to rethink some of my basic premises about Gold.
While doing so I realized that in all of our discussions about Gold over the years, we have rarely touched upon the ‘big picture’, and have focused instead upon a much shorter term orientation. I therefore decided to write this letter to provide you with some of my thinking in this regard.
I am happy to say that after some serious reflection and pondering, I do not think central banks are the force that you reckon them to be. Nor is the outcome for Gold so bearish.
Here’s why. It is true that central bank Gold reserves are a legacy of the past, and as a consequence, at first blush it may therefore appear that these reserves do not reflect “rational portfolio choice” on the part of central bankers. After all, as you observe, Gold no longer has a transactions role it no longer is used as currency or a medium of exchange.
However, Gold nevertheless still does have a monetary role. It is a useful unit of account for calculating the prices of goods and services, even though it can no longer be spent as a transaction medium in purchasing those same goods and services. This observation highlights the significance of the basic conclusions about the stability of Gold’s purchasing power by Roy Jastram in his book, “The Golden Constant”. Gold does retain its purchasing power over long periods of time.
As noted by Henry Thornton in 1802: “We assume that the currency which is in all our hands is fixed, and that the price of bullion moves; whereas in truth, it is the currency of each nation that moves, and it is bullion which is the more fixed.” Thornton’s observation remains true today.
First, units of Gold weight are not normally used for economic calculation. Government mandated curricula in schools teach us to think in terms of dollars, marks or francs, not grams or ounces of Gold. Consequently, it is not widely recognized that it generally takes about ten times the quantity of Dollars today compared to the 1960’s to purchase the same good or service. A barrel of crude oil is $20, not $1.80; a Ford Mustang convertible is $27,500, not $2,550; an ounce of Gold is $350, not $35; and on and on for countless marketable goods and services. When Gold is viewed by its purchasing power rather than its so-called price, it is clear why Thornton concluded that “bullion…is the more fixed.”
Second, Gold has this stability of purchasing power because the cumulative supply of Gold tends to grow by approximately the same rate as the world’s population and wealthcreation
Gold’s supply and demand therefore tend to remain in balance over the years. Consequently, goods and services today cost more or less the same in Gold terms as they did in times past. In short, Gold is money, even though we do not use it today as currency. I might add that this state of affairs is itself not a rational portfolio choice by the marketplace. The marketplace did not willingly abandon Gold currency governments forced the currency out of circulation. However, no government has the power to force the marketplace to abandon Gold as money.
The reason is of course that no government can force anyone to think and act contrary to that person’s own best interests. And for thousands of years people have intuitively understood Gold’s usefulness. They still do, which is why Gold still has value and a relatively stable purchasing power.
As experience in recent decades clearly indicates, try as they might using all of their considerable powers of propaganda and wishful thinking governments cannot demonetize Gold; after all, it still has the same purchasing power that it did when governments declared war on Gold in the 1960’s. Governments can only ‘de-currencyize’ Gold, a basic observation that unfortunately is lost in today’s environment in which complete and blind faith is placed by the general public in the currency issue of central government.
The central banks of course like it that way. A docile public makes it easier for central bankers to sustain the illusion that their fiat currency is well managed and has long-lasting utility. The aim of the central bankers is to keep the rate of currency debasement low enough so as not to evoke general alarm. To use Bismarck’s analogy on trying to find the right tax rate, it’s like trying to pull the right number of feathers from a goose without its squawking.
So what will be the outcome for Gold? I note that under each of the four potential scenarios that you identify Gold languishes under $400 per ounce.
I think the answer lies somewhere in a concept you mention in your report, which identifies the amount of “backing” that Gold provides to national currencies. I use this concept frequently, and call it the Fear Index. The Fear Index for the Dollar is presently 1.78%. It means that for every $100 circulating as M3, $1.78 of that currency is based on the Gold in the Federal Reserve. The other $98.22 is based on the value of IOU’s, non-tangible assets of the Fed and the banking system. In other words, these are the debts owed to the monetary agents.
The Fear Index hasn’t been this low since the early 1970’s, another moment in time when most everyone had complete faith in the government’s monetary management abilities and intentions. No one back then believed that the US government would renege on its commitment to redeem 35 Dollars for one ounce of Gold. But they did, much to the dismay of everyone stuck holding Dollars.
Today there is blind faith again. Most people think that national currencies will continue to circulate even if central banks have no Gold on their balance sheets. I doubt it. The savvy central bankers know that if they dishoard their Gold, they are diminishing their monetary power.
It is not a coincidence that the United States, Germany and France have not been dishoarding. The central bankers in these countries understand the importance of the Gold on their balance sheet.
Therefore, we are probably at or very near a low in the Gold price. The reason is that the unusual confidence held in the monetary and banking system today is just that unusual. In other words, from a central bankers perspective, things don’t get much better than they are now!
As for the inflation indicators, M3 growth is at 8% per annum. The Commodity Research Bureau Index just recently made a new 6-month high and looks poised to head higher. The Bank of Japan continues to try flooding the world with liquidity.
Interest rates are low and/or coming down in most countries. In short, there’s a lot of inflationary pressure in the pipeline. Given this and the irrational exuberance that people demonstrate when blissfully accepting central bank pronouncements at face value, it seems only a matter of time before Gold heads higher. But here’ the rub the timing of it all.
When US monetary policy began changing in the late-1950’s, anyone who began redeeming their Dollars for Goldhad a long wait. However, by March 1968 the wisdom of that Gold acquisition began paying off, and continued to reap big rewards for the next twelve years. Having waited for ten years for the all important break-out above $400 (comparable in significance to the March 1968 break above $35), it seems we are much closer to that point when Gold gives another bell-ringing buy signal. The market should be testing the resolve of the central banks before too long.
In any case, it will be interesting to watch developments from here, particularly since European Monetary Union is becoming an ever more distant prospect as the target date nears. In the meantime, buying Gold now means buying value, and that’s what prudent financial decision making is all about.
Best personal regards,