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June 29, 2008

Gold Bugs Bug Me

This essay is in response to a "gold bug" type post at The Motley Fool discussion boards.

The problem I see is how it got there, helped especially by $4 trillion in new money printed over the past three years or so. The dollar has lost approximately 95% of its purchasing power since the Fed was created in 1913, so I guess I just don't see that as a good way to get to the point where a lower dollar makes the U.S. more competitive on a global scale.

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People love to blame the Fed for devaluation and inflation but they are granting the Fed powers it does not have. Central banks are not all powerful and the proof is in the pudding. For good reason George Soros is known as the man who broke the Bank of England. Central banks can and do influence the economy in the short term but they are powerless to shape an economy in the long run because economies are so much larger than even the most powerful central banks. Sooner or later the piper has to be paid, there is no free lunch.

Murray N. Rothbard loves to bash the Fed. I wrote a very negative review on The Case Against the Fed for which I have been soundly thrashed but I stick to my opinion:

While I have no doubt that the Fed and other central banks can and do create inflation, Rothbard's introduction to money is so simplistic and so misleading that it stopped me cold in my tracks. If his conclusions are based on the foundation laid in the introduction, the whole argument is worthless. Rothbard's argument in the introduction is that only the Fed is permitted to print Federal Reserve Notes (correct) and that these notes are the only money in existence. This last statement is a grave error, Rothbard is confusing money with legal tender. The notes are the only form of legal tender in circulation but there are many other forms of money in circulation as well: bank deposits, mortgage loans and any other form of credit increases the money in circulation -- not the legal tender but money as perceived by markets. If we are to believe "Irrational Exuberance," even stock certificates act as money because they create the "wealth effect." All this is ignored by Rothbard in his introduction to money.

The purpose of Rothbard's introduction is to show that the ordinary citizen cannot create money and therefore cannot create inflation and the logical conclusion he arrives at is that only the Fed can create inflation. This is nonsense. Any society can create money. In jail they use cigarettes as money. Before the Fed was created money existed in many forms including sea shells and animal pelts.

Inflation is the setting to right of the unbalance between the supply of money (too abundant) and the supply of goods and services (too scarce). But the market does not care if that money is a piece of paper printed by the Fed, gold, the wealth effect of stocks or the bubbly prices of real estate.

I'm very happy to report that Louis Gave of GaveKal Research seems to agree with me. From John Mauldin's most recent email newsletter:

Louis Gave recently wrote a very interesting essay on inflation. He makes the point I have made often, that the Fed is not really increasing the money supply. If you look at the growth in adjusted monetary base, which is the only measure that the Fed actually can control, it has not been all that much over the past four years. But M2 and other measures of money supply have skyrocketed. What gives?

Two things. One is the extraordinary growth in credit offered by banks around the world. We saw a true inflation in financial assets of all types.

Secondly, and this is less intuitive, the US consumer has been a large supplier of money to the world by running a massive trade deficit. We have seen trillions of dollars flow into the world markets which has to find a home. Those dollars have been part of the growth in the supply of dollars around the world.

I'm in favor of closing down the Fed but not for the alleged sin of printing money. Their sin is to sustain reckless banks and high living financiers with tax money all in the name of protecting the system. This is nothing but grand theft of tax money by the banking system. The most recent example is the donation of $10 per share to the shareholders of failed bank Bear Stearns. Those bankers should have been made to eat their losses.

But let's go back to David's argument that "The dollar has lost approximately 95% of its purchasing power since the Fed was created in 1913..." What does that mean in reality? That 95% devaluation is a negative CAGR of 3.1%, in other words, if you put a $100 bill under your mattress in 1913 and you looked for it today, you would find a $5 bill in its place. Now suppose that you used your $100 to buy some machine back then, say a gramophone, and you put it under your mattress. First of all, people would look at you funny because instead of putting the machine to good use you are just warehousing it which costs money. If you were to pull it out from under your mattress today you would have in your hands a 100% useless machine. Maybe you could get something for it as a collectors item but so could you for a 1913 vintage Silver certificate or whatever was circulating back then.

Any machinery you buy will have a useful life, maybe two years for desktop computers, five for trucks and fifty for coal fired power plants. Money is just a kind of machine and you have to put it to work for it to be useful. Say you invested the $100 in the stock market in 1913. What would it be worth today? I don't have prices that far back but if you bought the Dow Industrial Index on October 1, 1928, it would have grown at a CAGR of 5% to $4,727.52. Remove the 3.1 deflation of the dollar and you are still ahead 1.9%.

More than likely you will tell me that had you bought $100 worth of gold, you would be even better off. Back in 1928 gold was $20.67 per ounce so you could have bought just under 5 ounces for the $100. It was not a risk free proposition. First of all, President Roosevelt would have stolen your gold as per Executive Order No. 6102 of April 5, 1933. But had you evaded this executive theft, you would still be at the mercy of lower level thieves which would force you to either put the gold in a bank safe deposit box, which costs money, or you could have made the gold into jewels in which case you would surely have bought insurance for them, again at the cost of money. Had your gold survived all these perils, your CAGR from October 1, 1928 at $20.67 per ounce to today at $912.30 per ounce, would have been 4.9% vs. a 5% CAGR for the Dow Industrial Index and the 0.1% difference does not include the extra cost of warehousing and safeguarding the gold.

The stock market beats gold hands down specially if you were to buy gold at today's inflated prices!

A word about the gold standard.

This is the biggest slight of hand perpetrated on humanity! Let's walk through the logic of it. Before we had paper money, people used gold (among other things) as money. If gold is money you don't need a gold standard, do you? You need the gold standard when you want to make something that is not gold the equivalent of gold, say warehouse receipts for gold. I take a couple of ounces of gold to the gold warehouse for safekeeping and they give me a receipt for two ounces of gold. This receipt is the equivalent of two ounces of gold. Suppose I had a debt for $41.34 (twice $20.67), I could pay that debt with the receipt for the gold without having to deliver the metal itself. That is 100% gold standard.

Once banks started to make partial reserve loans the gold standard became a myth because not all the dollars could be exchanged for gold, only some of it and only the first people in line got their gold. This is not strictly so because the gold standard is applied to governments, not to banks. The government is only responsible for the money they print, not for the money banks create by lending out deposits. So, if the US government has printed one trillion dollars in bills, it would have to have one trillion worth of gold in Fort Knox. The problem Richard Nixon ran into was that there was a disparity between the value of gold and the value of the US dollar so foreigners stared to withdraw gold instead of taking the receipts, i.e. US dollar bills. The US simply did not have enough gold to meet its obligations and it defaulted! Of course, in polite company we don't call it that. We say that the US went off the gold standard!

What in reality happened is that the gold standard did not exist and when the foreigners called the bluff, the game was up.

The reason why I could compare gold to stocks was because I used a very long time span, from 1928 to 2008, 80 years. A better comparison would have been from the date that gold was officially valued at a fixed $20.67 per ounce but, unfortunately, I don't have a Dow Index price for that far back. Since the economy's job is to remove excess profits from the system, I'm fairly convinced that the growth of the price of gold and the price of a stock index would be quite close if the time lapse is long enough. There are some long time comparisons of the price of wheat and other commodities that might be interesting to study.

Denny Schlesinger

The Motley Fool discussion board
Gold has biggest one-day move

Book review: The Case Against the Fed by Murray N. Rothbard
Stopped by the Introduction

Thoughts from the Frontline Weekly Newsletter by John Mauldin
The Slow Motion Recession Re-visited

Executive Order No. 6102 of April 5, 1933.
The Roosevelt Gold Confiscation Order Of April 5 1933.


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