Thursday, November 15, 2007

Changing Tides IV: Private Gold Currency

It's not exactly news that gold has been on a tear since 2000.
Frequent contributor Harun I. was kind enough to pass along this chart of gold for the period 1980 - 2007:

Please go to to view the chart.

At first glance, this sure looks like gold has been rising in reaction to a highly inflationary economy. Why else would a "safe haven" of value shoot up from under $300 to over $800 in a few short years?

This chart screams: somebody's lying or hallucinating. Either the U.S. Government is lying about the true rate of inflation, or gold buyers entered a 7-year state of hallucination. Which do you think is true? Gosh, that's a hard one. Of course the government is lying.

And yet there are certain technical features of this chart which suggest caution to those proclaiming $1,000/oz. gold, $2,200/oz. or $3,000/oz. gold. Maybe gold will shoot up to $3,000/oz.; this chart certainly depicts an unambiguous uptrend in gold.

Having noted that, let's also notice the divergences in DMI and volume, both of which are declining even as gold ran up in its recent parabolic rise. Could gold be setting up for a breather, or a serious retrace? Just as an opinion, not a prediction, I would say, hmm, why not? Nothing goes up in a straight line without occasional retraces.

But what if another trend is gathering force beneath the surface of gold's rise? That force is probably known to the majority of you, and it's called the devaluation of all "fiat" or paper currencies. What gold's rise might be telling us is the world's residents no longer trust any paper money as a reserve of purchasing power value.

Most of you also know that Republican Presidential candidate Ron Paul of Texas has proposed the radical idea (at least radical to the mainstream media) that the U.S. return to the gold standard, i.e. a currency backed not by promises but by gold. Most mainstream media sources dismiss this as a "lunatic fringe" notion. Yet not too long ago, the "lunatic fringe" idea was fiat money could be used to trade across borders for real goods.

Here is an extremely important essay from the pages of Foreign Affairs Magazine, (one of my regular reads), entitled The End of National Currency (May/June 2007, by Benn Steil, Director of International Economics at the Council on Foreign Relations and a co-author of Financial Statecraft.)

The author covers gold, international trade and fiat money succinctly, and then addresses a truly radical idea: a revival of gold money through private gold banks.

In other words: Forget government "fiat" currency, whether it's dollar, yuan, euro or yen--beneath the surface of the usual forex ups and downs, they're all trending down together. Forget trying to save essentially worthless paper money--store your wealth and transact your international business in private gold banks.

How would this work? The gold ETFs offer one pathway. Gold-backed exchange-traded funds (ETFs) have been accumulating physical piles of gold--hundreds of tons of the yellow metal. That is their promise: when you buy a share of a gold ETF, you're buying a sliver of actual gold, not a mining company or financial instrument like an option or derivative.

It doesn't take too much imagination to foresee an ETF accumulating, say, 500 tons of gold-- more or less the reserves of a small nation. Then the ETF launches the electronic equivalent of a currency--let's call them quatloos. (Hat tip to fellow Star Trek fans.)

So if I want to transaction some business internationally, in a currency with an assured value, I would deposit whatever fiat currency I had in hand into the ETF and then wire the gold-backed quatloos to my trading partner wherever the firm might be located geographically.

As all the globe's fiat currencies lose value, my quatloos would retain their purchasing power value everywhere in the world. Of course governments may well decide to confiscate their citizen's gold--as the U.S. government did in the mid-1930s--but if the bank is in Switzerland (for instance) and the transactions are all electronic transfers of quatloos, what exactly is there for our dear government to confiscate?

Of course I would use dollars in the U.S. and yuan in China for my daily living expenses, but my big holdings and business transactions would be made in quatloos, electronically.

Here are some excerpts from Mr. Steil's essay:

Capital flows were enormous, even by contemporary standards, during the last great period of "globalization," from the late nineteenth century to the outbreak of World War I. Currency crises occurred during this period, but they were generally shallow and short-lived. That is because money was then -- as it has been throughout most of the world and most of human history -- gold, or at least a credible claim on gold.

Funds flowed quickly back to crisis countries because of confidence that the gold link would be restored. At the time, monetary nationalism was considered a sign of backwardness, adherence to a universally acknowledged standard of value a mark of civilization. (emphasis added: CHS) Those nations that adhered most reliably (such as Australia, Canada, and the United States) were rewarded with the lowest international borrowing rates. Those that adhered the least (such as Argentina, Brazil, and Chile) were punished with the highest.

Yet what Polanyi considered nonsensical -- global trade in goods, services, and capital intermediated by intrinsically worthless national paper (or "fiat") monies -- is exactly how globalization is advancing, ever so fitfully, today.

Why has the problem of serial currency crises become so severe in recent decades? It is only since 1971, when President Richard Nixon formally untethered the dollar from gold, that monies flowing around the globe have ceased to be claims on anything real. All the world's currencies are now pure manifestations of sovereignty conjured by governments.

And the vast majority of such monies are unwanted: people are unwilling to hold them as wealth, something that will buy in the future at least what it did in the past. Governments can force their citizens to hold national money by requiring its use in transactions with the state, but foreigners, who are not thus compelled, will choose not to do so.

But the dollar's privileged status as today's global money is not heaven-bestowed. The dollar is ultimately just another money supported only by faith that others will willingly accept it in the future in return for the same sort of valuable things it bought in the past. This puts a great burden on the institutions of the U.S. government to validate that faith. And those institutions, unfortunately, are failing to shoulder that burden. Reckless U.S. fiscal policy is undermining the dollar's position even as the currency's role as a global money is expanding.

The precariousness of the dollar's position today is similar. The United States can run a chronic balance-of-payments deficit and never feel the effects. Dollars sent abroad immediately come home in the form of loans, as dollars are of no use abroad. "If I had an agreement with my tailor that whatever money I pay him he returns to me the very same day as a loan," Rueff explained by way of analogy, "I would have no objection at all to ordering more suits from him."

The question is how long such a well-managed fiat system can endure in the United States. The historical record of national monies, going back over 2,500 years, is by and large awful.

At the turn of the twentieth century -- the height of the gold standard -- Simmel commented, "Although money with no intrinsic value would be the best means of exchange in an ideal social order, until that point is reached the most satisfactory form of money may be that which is bound to a material substance."

Today, with money no longer bound to any material substance, it is worth asking whether the world even approximates the "ideal social order" that could sustain a fiat dollar as the foundation of the global financial system. There is no way effectively to insure against the unwinding of global imbalances should China, with over a trillion dollars of reserves, and other countries with dollar-rich central banks come to fear the unbearable lightness of their holdings.

So what about gold? A revived gold standard is out of the question. In the nineteenth century, governments spent less than ten percent of national income in a given year. Today, they routinely spend half or more, and so they would never subordinate spending to the stringent requirements of sustaining a commodity-based monetary system.

But private gold banks already exist, allowing account holders to make international payments in the form of shares in actual gold bars. Although clearly a niche business at present, gold banking has grown dramatically in recent years, in tandem with the dollar's decline. A new gold-based international monetary system surely sounds far-fetched. But so, in 1900, did a monetary system without gold. Modern technology makes a revival of gold money, through private gold banks, possible even without government support.

I recommend the entire essay; it is free online at the link above.

Thank you, S. B., ($40), for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

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