The Power of Gold: The History of an Obsession

by Peter L. Bernstein

  January 1980 in the gold market turned out to be one of the wildest months in the history of any market, anywhere, any time. The price of gold jumped by $110 an ounce to $634 in just the first two business days of the month, while the value of the dollar in terms of German marks fell to a record low. A London branch bank reported that its inventory of one thousand gold sovereigns had sold out in the course of the two days. A precious metals trader for one of the Swiss banks, in a master understatement, told a reporter from the New York Times that "The market shows that people don't trust the governments and they don't trust paper money either."'s

  All of a sudden the central banks began to make noises about restoring gold to its traditional role in the monetary system, a complete reversal of recent policies of selling gold out of their reserves. The U.S. Undersecretary of the Treasury declared before Congress that "Gold remains a significant part of the reserves of the central banks available in time of need. This is unlikely to change in the foreseeable future."16 No wonder: the stunning increase in the price of gold since 1978 had swollen the market value of the gold reserves to more than three times their total holdings of foreign currencies.

  Then Treasury Secretary G. William Miller held a news conference at which he announced that the Treasury would hold no further gold auctions. "At the moment," he told the press, "it doesn't seem an appropriate time to sell our gold." With 220 million ounces (about seven thousand tons) of gold stored away at Fort Knox, gold hoarding was regaining some traditional respectability. This was a curious observation in light of the auctions of gold that the Treasury had conducted at much lower prices since they had begun the practice five years earlier. Most investors aim to buy low and sell high, but the U.S. Treasury apparently was more attracted to selling low than high: the last auction before these events, just two months earlier, had produced an average price of only $372.30."

  Within thirty minutes of Miller's remarks, the gold price shot up $30 an ounce to $715. The next day it was up to $760. The day after, gold hit $820. The manager of the precious metals department of a New York bank specializing in the gold trade was ecstatic: "Certificates, bullion, coins, bars, you name it, our business has been very brisk. Americans are catching the gold fever. As for the international bullion market, which represents the bulk of our business, it's become a zoo."'s

  Not everyone was caught up in the panic. Unlike Secretary Miller, many common citizens thought selling high was kind of a good idea. The New York Times for January 12 carried an article that began with these words: "They came clutching all manner of objects precious to them, from heirloom silver to gold coins and jewelry, hoping to turn their old gold and silver into new, fresh [dollar] bills." One prominent dealer's waiting room was described as resembling an airport lounge at peak holiday season rather than a company in the business of purchasing old metal objects. Five days later, when the price in the gold market was at $760 an ounce, a similar article reported, "On 47th Street the dealers were predicting the price would hit $1,000 an ounce by July, but no one seemed to be waiting."

  The price touched its record high of $850 on January 21. James Sinclair, a commodities broker, summed it up when he commented that "We're in World War Eight, if you believe the market." 9 Late that afternoon, President Carter announced that the United States would have to "pay whatever price is required to remain the strongest nation in the world." His comment seemed to cool tempers in the gold and foreign exchange markets-the price of gold was down $50 by the close of trading.

  Indeed, the temper of the marketplace did a 180-degree turn with extraordinary abruptness. On January 22, the price plunged by $145. The high in 1981 was $599 an ounce. By 1985, gold was down to around $300. The subsequent high, touched only briefly, was $486, in the wake of the stock market crash of 1987. At the end of 1997, gold broke below $300. It had fallen by more than 60 percent in the course of less than eight years.

  That fantastic bull market in gold from $35 in 1868 to $850 in the climax of January 1980 is an extraordinary episode in financial history. It represented a gain of 30 percent a year over twelve years, far in excess of the inflation rate of 7.5 percent from 1968 to 1980. Even the greatest bull markets in stock market history pale by comparison. The highest total annual return (including income) in the stock market over a twelveyear period was 19 percent, from the middle of 1949 to the middle of 1961. In 1959, the amount invested in gold was about one-fifth of the market value of all U.S. common stocks; in 1980, the $1.6 trillion invested in gold exceeded the market value of $1.4 trillion in U.S. stocks."' If only Croesus, Charlemagne, and Pizarro had lived to see such a triumphant march in the value of their precious gold!

  Nevertheless, the raw data exaggerate the happiness that these zooming prices brought to the gold bugs. Few people who bought at $35, or even under $100, held on to sell at $850. Most of the early buyers undoubtedly took their profits and bailed out long before the peak, for the path to $850 was volatile all the way. The likelihood is that many more people were sucked into the gold market as it approached $850-and shortly afterward-than those who were farsighted enough to go in when the price was fussing around $40.

  The rush into the gold markets in the early 1980s produced much the same kinds of results as the gold rush to the Klondike eighty years earlier, where only about four hundred people out of one hundred thousand prospectors hit it rich. Indeed, it is ironic that the State of Alaska Retirement System bought a ton of gold bullion in 1980 at $651 an ounce, and then a second ton at the end of 1980 for which they paid $575. In March 1983, the state sold out at $414.21 Thus, the real winners at the end were the sellers-an opportunity that the U.S. Treasury chose to pass up.

  In 1981, the U.S. monetary gold stock amounted to approximately eight thousand tons, a little more than a third of the 1949 peak, only 50 percent more than in 1933, and equal to about a quarter of world monetary gold stocks. At the official price of $42.22, the stock was carried at a mere $11 billion, although the stock was worth $120 billion at the 1981 average market price of $460 an ounce. Liabilities to foreigners, however, were now over $300 billion, an astonishing increase of nearly tenfold over the level that had so agitated General de Gaulle thirteen years earlier.22

  Donald Regan, the Secretary of the Treasury, decided that the situation required a thorough examination. As David Ricardo in 1810 had called for the creation of a "SELECT COMMITTEE to enquire into the Cause of the High Price of GOLD BULLION, and to take into consideration the State of the CIRCULATING MEDIUM, and of the EXCHANGES between Great Britain and Foreign Parts," Regan appointed a Gold Commission in June 1981 to "conduct a study to assess and make recommendations ... concerning the role of gold in domestic and international monetary systems." The Conur fission included members of Congress, representatives from the Federal Reserve Board, leading economists, one well-known academic, and two individuals active in the gold markets.

  After nine meetings and 23 witnesses, the Commission issued a report that features an extraordinary number of footnotes drafted by individual members, indicating the depth of the disagreements over their understanding of what had happened to gold in the recent past and the appropriate course of action that the Commission should recommend for the immediate future. The report contains an admirable history of gold in monetary systems and a cornucopia of useful historical statistics, but its recommendations hold little interest because they fell so far short of unanimity in support among the members. The Regan Commission of 1981 has passed into anonymity, while the Bullion Committee Report of 1810 continues to be an important element in the study of money and banking. Just about the only vestige of the Regan Commission's recommendations that remains is the small number of gold coins minted after they were authorized by President Reagan in December 1985. Most of these handsome coins now reside in the hands of collectors.21

  Quite aside from the failure of the Gold Commission to speak loudly and clearly with one voice, fundamental economic trends in the early 1980s were finally shoving gold away from center stage.
Bond yields were in double digits and common stocks were providing a flow of dividend income as high as 6 percent. As gold pays no income and incurs storage costs, owning gold was expensive indeed compared to alternative investment opportunities.

  Gold would still have made sense in spite of these hurdles if people had expected inflation to remain out of control. The whole story of the 1980s, however, was the growing recognition, around the world, that the virulent inflation of the 1970s had been beaten back at long last and that the prices of goods and services for the foreseeable future would rise at a more moderate and manageable pace. It is indeed remarkable that U.S. inflation fell from such precipitous heights at the end of the 1970s to as low as 3 percent by 1985, but similar trends were at work in most countries, even in such areas as Italy, Latin America, and the Middle East, where inflation had been a chronic problem. Holding gold can make little sense if inflation is dead or dying, because then there is little hope of recouping the storage costs and offsetting the lost income.

  During the two decades after 1980, the ups and downs in the price of gold followed the ups and downs-mostly downs-in the rate of inflation. The price of gold fell absolutely, however, while the prices of goods and services continued to rise, albeit at a slower pace. The cost of living doubled from 1980 to 1999-an annual inflation rate of about 3.5 percent-but the price of gold fell by some 60 percent. In January 1980, one ounce of gold could buy a basket of goods and services worth $850. In 1999, the same basket would cost five ounces of gold.

  The stock market offers an even more striking comparison. By some remarkable coincidence, the Dow Jones Industrial Average of stock prices was at just about 850 when gold touched its $850 peak.* Thus, an ounce of gold would have bought one share of the Average at that moment. When gold was down to the $300 area in the autumn of 1999, however, the Dow Jones was around 10,000. Now more than thirty ounces of gold would be needed to buy one share of the Average.

  One little-noted recommendation of the Regan Commission of 1981 involved the appropriate size of the government's stock of gold. Although an initial majority vote concluded that "Under circumstances as those that presently exist, the stock should be maintained at its present value," the final report recommends that "While no precise level for the gold stock is necessarily `right,' the Treasury [should] retain the right to conduct sales of gold at its discretion, provided adequate levels are maintained for contingencies."24 Despite the double-talk in the final phrase, this recommendation set the tone for the environment for gold for the rest of the 1980s and throughout the 1990s.

  The lower the price of gold fell, the greater became the prospects of official sales, not just from the United States but from other countries and the International Monetary Fund itself. As the gold price rose from $375 in 1982 to nearly $500 after the stock-market crash of 1987, few central bank sales were executed. As the price then drifted downward toward $350 in 1992, about five hundred tons were disposed of. From 1992 to 1999, however, as the price sank below $300, the central bankers sold off three thousand tons, or about four hundred tons a year.25 One does not have to be an amateur investor to sell low.

  As the central banks were liquidating their gold, over two thousand tons a year of additional gold came into the markets from new mine production, about double the level of production before the price of gold broke free from the old $35 price. Sales of four hundred tons from the central banks sound small relative to the two thousand tons of supply forthcoming from the mines. Nevertheless, the volume of total central bank and official holdings was still so large-over thirty thousand tonsthat the overhang loomed like a black cloud over the markets. Who could say how much of that hoarded treasure might come to market?

  A loud thunderclap along these lines hit the markets in October 1997, when a team of Swiss experts issued a report recommending an amendment to the Swiss constitution that would result in a radical restructuring of the Swiss currency system. "Gold has lost its monetary function," the experts declared. "The gold parity is strictly an accounting tool.... A return to gold standards today is impossible.... The proposed draft of the new constitutional article does not contain any connection of the [Swiss] franc to gold. Paragraph 5 of article E-BV, which mandates the Swiss National Bank to hold adequate currency reserves, should replace the confidence inspiring gold coverage and ensure that the public's trust in the state currency remains. 1116

  The experts were not quite ready to go all the way in abandoning gold, however. "Many depositors," they point out, "conceive of gold as the only asset that held its value over the millennia." They therefore recommended that the central bank continue to hold nearly half of its total gold stock and that "the separated portion of gold is to be sold in small steps."27 Despite this bow to potential popular anxieties, the entire spirit of the report rests in its unquestioning confidence that the forecasting and managerial skills of the directors and staff of the central bank would perform a better job than obeisance to the gold stock in "the priority of maintaining price stability."

  This view was by no means revolutionary doctrine in 1997-on the contrary, it represented mainstream thinking. Nevertheless, this was the Swiss, not the British or the Americans or some minor-league country. The Swiss were legendary in their attachment to gold and in their aversion to holding currencies of countries whose devotion to the constant struggle to keep inflation in check was less passionate than theirs. The "gnomes of Zurich" had been famous for their speculative attacks on the dollar and sterling during the crises of the 1970s. Now all that was forgotten.

  Two years later, the British took a similar step with their gold stock, once upon a time the pride of British power. In May 1999, the British Treasury announced its intention of selling 415 tons out of its 715-ton stockpile. The price of gold promptly lost 4 percent of its value.

  The central banks would soon catch on: their enemy was themselves. The overhang of gold held by central banks meant that every time an official sale hit the headlines, the gold price would fall and the proceeds of the sale would be diminished.

  The authorities had already made some effort to talk up the price of gold. Six weeks after the report of the Swiss experts had been published, the vice chairman of the Swiss National Bank asserted that "We are convinced that gold will continue to play a role as a currency reserve, especially in times of crisis." In April 1998, the annual report of the Bank of France of 1997 sounded like old times: "Gold remains an element of long-term confidence in the currency.... Above all, holding gold is, from the political point of view, a sign of monetary sovereignty [and] an insurance policy against a major breakdown in the international monetary system." About the same time, a former managing director of the International Monetary Fund affirmed that "Gold remains at the heart of a collective belief in the credibility of an international economy ... a sort of `war chest,' indispensable for a tomorrow whose needs we can only guess :."28 When the new European Central Bank opened in 1998 to manage Europe's new currency, the euro, 15 percent of the bank's reserves were held in gold.

  But all of this was mostly talk or just symbolic. Few people were taken in by it.

  How times had changed! In the 1960s, the major central banks had organized the gold pool to sell whatever amount of gold was necessary to keep the speculators from driving the price upward. In September 1999, owning nearly half of all gold held by central banks and other official institutions, they were in a position identical to Ruskin's man who strapped his golden wealth to himself as his ship was sinking and promptly sank to the bottom of the ocean. If the central banks all moved at the same time to sell off their hoards of gold, the price would run away from them on the downside and their sales would be a disaster.

  They therefore agreed to limit their annual sales to four hundred tons of gold over the next five years-about the same as the annual average liquidated over the previous eight years. The IMF announced that it would "abide" by the spirit of the agreement. Australia and South Africa joined in an informal affiliation, bringing the amount o
f official gold covered up to 85 percent of the total. The central banks also resolved to limit their lending transactions with the mining companies. The agreement covered the thirteen hundred tons in the pipeline for the Swiss to sell and 365 tons for Britain, leaving only 335 tons for any other country that wants to liquidate gold over the fiveyear period covered by the arrangements.

  William Duisberg, the President of the European Central Bank, was honest enough to refrain from describing these decisions as a move back toward restoring gold to its former glory. He was blunt about the matter: the objective was to protect the value of central bank reserves by "[keeping] the value of gold where it is.... The purpose of this action is to give certainty to the gold market."2y

  The central banks were not the only important sellers in the market, but they had been eager cooperators with the other major group: the mining companies. We would expect the mining companies to be sellers, because that is what they are in business for. During the 1990s, concerned like so many others about the future outlook for gold, the mining companies began to sell more than their current production. In effect, they mortgaged their future output at the prevailing price in order to avoid having to sell at a lower price later on. Buyers, however, want delivery when they contract to buy. The mining companies enlisted the central banks for this purpose: the miners borrowed gold from the central banks at a nominal rate of interest, secured by the promise to pay off the loan from future production, and then delivered that gold to the buyers. The central banks were delighted to earn anything at all on what was once the glory of their economic power but that they now considered a barren asset. This arrangement worked well-as long as the price of gold was falling. On the occasions when the price of gold went up, however, the central banks became more reluctant lenders and the mining companies got squeezed. As their current production was smaller than the amounts they had borrowed, they had to go into the market and join the other buyers there in order to make their promised deliveries to people who had bought gold from them. The result was an added impetus to the upward movement in the gold price.