The Death of Money

by James Rickards

  While money was gold for J. P. Morgan—and everybody else—for four thousand years, money suddenly ceased to be gold in 1974, at least according to the IMF. President Nixon ended U.S. dollar convertibility into gold by foreign central banks in 1971, but it was not until 1974 that an IMF special reform committee, at the insistence of the United States, officially recommended gold’s demonetization and the SDR’s elevation in the workings of the international monetary system. From 1975 to 1980, the United States worked strenuously to diminish gold’s monetary role, conducting massive gold auctions from official U.S. stocks. As late as 1979, the United States dumped 412 tonnes of gold on the market in an effort to suppress the price and deemphasize gold’s importance. These efforts ultimately failed. Gold’s market price briefly spiked to $800 per ounce in January 1980. There have been no significant official U.S. gold sales since then.

  The demotion of gold as a monetary asset by the United States and the IMF in the late 1970s means that the economics curricula of leading universities have not seriously studied gold for almost two generations. Gold might be taught in certain history classes, and there are many gold experts who are self-taught, but any economist born since 1952 almost certainly has no formal training in the monetary uses of gold. The result has been an accretion of myths about gold in place of serious analysis.

  The first myth is that gold cannot form the basis of a modern monetary system because there’s not enough gold to support the requirements of world trade and finance. This myth is transparently false, but it is cited so often that its falsity merits rebuttal.

  The total gold supply in the world today, exclusive of reserves in the ground, is approximately 163,000 tonnes. The portion of that gold held by official institutions, such as central banks, national treasuries, and the IMF, is 31,868.8 tonnes. Using a $1,500-per-ounce price, the official gold in the world has a $1.7 trillion market value. This value is far smaller than the total money supply of the major trading and financial powers in the world. For example, U.S. money supply alone, using the M1 measure provided by the U.S. Federal Reserve, was $2.5 trillion at the end of June 2013. The broader Fed M2 money supply was $10.6 trillion at the same period. Combining this with money supplies of the ECB, the Bank of Japan, and the People’s Bank of China pushes global money supply for the big four economic zones to $20 trillion for M1 and $48 trillion for M2. If global money supply were limited to $1.7 trillion of gold instead of $48 trillion of M2 paper money, the result would be disastrously deflationary and lead to a severe depression.

  The problem in this scenario is not the amount of gold but the price. There is ample gold at the right price. If gold were $17,500 per ounce, the official gold supply would roughly equal the M1 money supply of the Eurozone, Japan, China, and the United States combined. The point is not to predict the price of gold or to anticipate a gold standard but merely to illustrate that the quantity of gold is never an impediment to a gold standard as long as the price is appropriate to the targeted money supply.

  The second myth is that gold cannot be used in a monetary system because gold caused the Great Depression of the 1930s and contributed to its length and severity. This myth is half true, but in that half-truth lies much confusion. The Great Depression, conventionally dated from 1929 to 1940, was preceded by the adoption of the “gold exchange standard,” which emerged in stages from 1922 to 1925 and functioned with great difficulty until 1939. The gold exchange standard was agreed in principle at the Genoa Conference in 1922, but the precise steps toward implementation were left to the participating countries to work out in the years that followed.

  As the name implies, the gold exchange standard was not a pure gold standard of the type that had existed from 1870 to 1914. It was a hybrid in which both gold and foreign exchange—principally U.S. dollars, U.K. pounds sterling, and French francs—could serve as reserves and be used for settlement of any balance of payments. After the First World War, citizens in most major economies no longer carried gold coins, as had been common prior to 1914.

  In theory, a country’s foreign exchange reserves were redeemable into gold when a holder presented them to the issuing country. Citizens were also free to own gold. But international redemptions were meant to be infrequent, and physical gold possession by citizens was limited to large bars, which are generally unsuitable for day-to-day transactions. The idea was to create a gold standard but have as little gold in circulation as possible. The gold that was available was to remain principally in vaults at the Federal Reserve Bank of New York, the Bank of England, and the Banque de France, while citizens grew accustomed to using paper notes instead of gold coins, and central bankers learned to accept their trading partners’ notes instead of demanding bullion. The gold exchange standard was, at best, a pale imitation of a true gold standard and, at worst, a massive fraud.

  Most important, nations had to choose a conversion rate between their currencies and gold, then stick to that rate as the new system evolved. In view of the vast paper money supply increases that had occurred during the First World War, from 1914 to 1918, most participating nations chose a value for their currencies that was far below the prewar rates. In effect, they devalued their currencies against gold and returned to a gold standard at the new, lower exchange rate. France, Belgium, Italy, and other members of what later became known as the Gold Bloc pursued this policy. The United States had entered the war later than the European powers, and its economy was less affected by the war. The United States also received large gold inflows during the war, and as a result, it had no difficulty maintaining gold’s prewar $20.67-per-ounce exchange rate. After the Gold Bloc devaluations, and with the United States not in distress, the future success of the gold exchange standard now hinged on the determination of a conversion rate for U.K. pounds sterling.

  The U.K., under the guidance of chancellor of the exchequer Winston Churchill, chose to return sterling to gold at the prewar rate equivalent to £4.86 per ounce. He did this both because he felt duty bound to honor Bank of England notes at their original value, but also for pragmatic reasons having to do with maintaining London’s position as the reliable sound money center of world finance. Given the large amount of money printed by the Bank of England to finance the war, this exchange rate greatly overvalued the pound and forced a drastic decrease in the money supply in order to return to the old parity. An exchange rate equivalent to £7.50 per ounce would have been a more realistic peg and would have put the U.K. in a competitive trading position. Instead, the overvaluation of pounds sterling hurt U.K. trade and forced deflationary wage cuts on U.K. labor in order to adjust the terms of trade; the process was similar to the structural adjustments Greece and Spain are experiencing today. As a result, the U.K. economy was in a depression by 1926, years before the conventional starting date of 1929 associated with the Great Depression and the U.S. stock market crash.

  With an overvalued pound and disadvantageous terms of trade, the U.K.’s gold began flowing to the United States and France. The proper U.S. response should have been to ease monetary policy, controlled by the Federal Reserve, and allow higher inflation in the United States, which would have moved the terms of trade in the U.K.’s favor and given the U.K. economy a boost. Instead, the Fed ran a tight money policy, which contributed to the 1929 market crash and helped to precipitate the Great Depression. By 1931, pressure on the overvalued pound became so severe that the U.K. abandoned the 1925 parity and devalued sterling. This left the dollar as the most overvalued major currency in the world, a situation rectified in 1933, when the United States also devalued from $20.67 per ounce to $35.00 per ounce, cheapening the dollar to offset the effect of the sterling devaluation two years earlier.

  The sequence of events from 1922 to 1933 shows that the Great Depression was caused not by gold but rather by central bank discretionary policies. The gold exchange standard was fatally flawed because it did not take gold’s free-market price into account. The Bank of England overv
alued sterling in 1925. The Federal Reserve ran an unduly tight money policy in 1927. These problems have to do not with gold per se but with the price of gold as manipulated and distorted by central banks. The gold exchange standard did contribute to the Great Depression because it was not a true gold standard. It was a poorly designed hybrid, manipulated and mismanaged by discretionary monetary policy conducted by central banks, particularly in the U.K. and the United States. The Great Depression is not an argument against gold; it is a cautionary tale of central bank incompetence and the dangers of ignoring markets.

  The third myth is that gold caused market panics and that modern economies are more stable when gold is avoided and central banks use monetary tools to smooth out periodic panics. This myth is one of economist Paul Krugman’s favorites, and he recites it ad nauseam in his antigold, pro-inflationary writings.

  In fact, panics do happen on a gold standard, and panics also happen in the absence of a gold standard. Krugman likes to recite a list of panics that arose during the classical gold standard and the gold exchange standard; it includes market panics or crashes in 1873, 1884, 1890, 1893, 1907, and the Great Depression. Fair enough. But panics also occurred in the absence of a gold standard. Examples include the 1987 stock market crash, when the Dow Jones Industrial Index fell over 22 percent in a single day, the 1994 Mexican peso collapse, the 1997–98 Asia-Russia-Long-Term Capital market panic, the 2000 tech stock collapse, the 2007 housing market collapse, and the Lehman-AIG financial panic of 2008.

  Panics are neither prevented nor caused by gold. Panics are caused by credit overexpansion and overconfidence, followed by a sudden loss of confidence and a mad scramble for liquidity. Panics are characterized by rapid declines in asset values, margin calls by creditors, dumping of assets to obtain cash, and a positive feedback loop in which more asset sales cause further valuation declines, which are followed by more and more margin calls and asset sales. This process eventually exhausts itself through bankruptcy, a rescue by solvent parties, government intervention, or a convergence of all three. Panics are a product of human nature, and the pendulum swings between fear and greed and back to fear. Panics will not disappear. The point is that panics have little or nothing to do with gold.

  In practice, gold standards worked well in the past and remain entirely feasible today. Still, daunting design questions arise in the creation of any gold standard. Designing a gold standard is challenging in the same way that designing a digital processor can be challenging; there is good design and bad design. There are technical issues that deserve serious consideration, and spurious issues that do not. There is enough gold in the world—it is just a matter of price. Gold did not cause the Great Depression, but central bank policy blunders did. Panics are not the result of gold; they are the result of human nature and easy credit. Puncturing these myths is the way forward to an authentic debate of gold’s pros and cons.

  ■ The Scramble for Gold

  While academics and pundits debate gold’s virtues as a monetary standard, central banks are past the debate stage. For central banks, the debate is over—gold is money. Today central banks are acquiring gold as a reserve asset at a pace not seen since the early 1970s, and this scramble for gold has profound implications for the future role of every currency, especially the U.S. dollar.

  The facts speak for themselves and require little elaboration. Central banks and other official institutions such as the IMF were net sellers of gold every year from 2002 through 2009, although sales dropped sharply during that time from over 500 tonnes in 2002 to less than 50 tonnes in 2009. Beginning in 2010, central banks became net buyers, with purchases rising sharply from less than 100 tonnes in 2010 to over 500 tonnes in 2012. In the ten-year span from 2002 to 2012, the shift from net sales to net purchases was over 1,000 tonnes per year, an amount greater than one-third of annual global mining output. Increasingly, gold is moving directly from mines to central bank vaults.

  Table 1 shows increases in gold reserves for selected countries from the first quarter of 2004 to the first quarter of 2013, measured in tonnes:

  Table 1. Gold Reserves in Selected Countries

  All these large central bank acquirers are in Asia, Latin America, and eastern Europe. Over this same period, from 2004 to 2013, Western central banks were net sellers of gold, although such sales stopped abruptly in 2009. Since then emerging economies have had to acquire gold from mine production, scrap gold recycling, or open-market sales, including sales of over 400 tonnes by the IMF in late 2009 and early 2010. Taking into account all national central banks, exclusive of the IMF, official gold reserves increased 1,481 tonnes from the fourth quarter of 2009 through the first quarter of 2013—a 5.4 percent increase. Central banks have become significant gold buyers, and the movement of gold is from west to east.

  These statistics all need to be qualified by the curious case of China. China reported a gold reserve position of 395 tonnes for over twenty years from 1980 through the end of 2001. Then the reported position suddenly leaped to 500 tonnes, where it remained for a year; then it leaped again to 600 tonnes at the end of 2002, where it remained for over six years. Finally, the reported position was increased to 1,054 tonnes in April 2009, where it has remained for almost five years through early 2014.

  Officially, China has reported a series of sudden spikes in its gold holdings of 105 tonnes in 2001, 100 tonnes in 2002, and 454 tonnes in 2009. Increases of this size are extremely difficult to conduct in a single transaction except by prearrangement between two central banks or the IMF. No such prearranged central bank or IMF sales to China have been reported, and no reported central bank or IMF holdings show the necessary sudden drops at the appropriate times that would correspond to such increases by China. The conclusion is inescapable that China is actually accumulating gold in smaller quantities over long periods of time, and reporting the changes in a lump sum on an irregular basis.

  This covert, piecemeal gold-acquisition program makes perfect sense. Physical gold is marketable in the sense that it can be readily purchased or sold, but it is also thinly traded, and the price is volatile. Large buyers in any thinly traded market try to disguise their intentions to avoid market impact, in which bank dealers move the price adversely to the buyer in anticipation of large, inelastic buy orders.

  China minimizes the market impact of its buying program through the use of secret agents and direct purchases from mines. The agents are principally located in the HSBC headquarters building on Queen’s Road Central in Hong Kong and in the Shanghai branch of ANZ Bank, although the network of buying agents is worldwide. These agents place purchase orders for commercial-size gold lots of several tonnes each with brokers and London-based bullion banks. The buyer’s true identity is not disclosed. The gold is paid for by one of China’s sovereign wealth funds, the State Administration for Foreign Exchange, which is managed by former PIMCO bond trader Zhu Changhong. Once purchased, the gold is shipped by air transport to secure vaults in Shanghai. The agents are highly disciplined and patient in their buying activity and typically “buy the dips” in market price, as indicated on the New York–based COMEX exchange. In a masterpiece of market savvy, China bought 600 tonnes of gold directly from Australia’s Perth Mint and other sellers near the interim low price of $1,200 per ounce reached in the April to July 2013 price dip. Partly as a result of these large-scale covert operations, in addition to more customary commercial purchases, China is estimated to have imported approximately 1,000 tonnes of gold per year in 2012 and 2013.

  China’s direct gold ore purchases are principally from gold mines located in China, but they have expanded rapidly to include newly acquired mines in southern Africa and western Australia. As recently as 2001, China produced less than 200 tonnes per year from its own mines. Output increased steadily from 2001 to 2005 and then surged in 2006, so that by 2007 China surpassed South Africa as the world’s largest gold producer, a position it has maintained since. B
y 2013, China was producing over 400 tonnes per year—about 14 percent of worldwide mine production. Gold ore produced in Chinese-controlled mines, whether inside China or elsewhere, is sent to refineries in China, Australia, South Africa, and Switzerland, where it is refined to pure gold, cast into one-kilo gold bars, and shipped to vaults in Shanghai. Through these channels, Chinese gold bypasses the London market, minimizing the market impact and keeping the exact size of China’s gold hoard a state secret.

  The combination of internal gold mining output and imports from abroad means that China has increased its domestic gold holdings, both public and private, by approximately 4,500 tonnes since the last official update of its central bank gold reserves in 2009. It is impossible for observers outside the Chinese government to gauge exactly how much of that increase is waiting to be added to official reserves at the next announcement, and how much was devoted to Chinese domestic demand from consumers for jewelry, bars, and coins. It is well known that Chinese citizens are avid gold consumers, both for reasons of wealth preservation and as a convenient medium for flight capital. Gold is sold in various forms in thousands of bank branches and boutiques throughout China.

  In the absence of better data, a first approximation is that half the increase in China’s gold since 2009 went to domestic consumption and half, or 2,250 tonnes, has secretly been added to official reserves. If this approximation is correct, then China’s official gold reserves as of early 2014 are not the reported 1,054 tonnes but instead are closer to 3,300 tonnes. At the current pace of mine output and imports, and assuming half the available gold goes to official reserves, China will add another 700 tonnes to its reserves-in-waiting throughout 2014, which would put total Chinese gold reserves at 4,000 tonnes by early 2015. China waited over six years, from late 2002 to early 2009, before publicly announcing its last increase in official reserves. If China repeats that tempo, the next update to the gold reserve figures can be expected in 2015.