European Insights


The alchemy of money

01 July, 2020

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Gold has many powers attributed to it in terms of its ability to act as money and to offer a real return. We have decided to unpack these topics because this has become a very contemporary concern. There is a long-held belief that money was originally commodity based, then it progressed to coinage, and finally into fiat money. This evolution took a further step with the rise of electronic money, a step that has been heavily entrenched as a result of the current viral pandemic. This view of the history of money betrays a key misunderstanding of its nature which is at its heart entirely abstract.

Coins, being made almost exclusively of metal, are long lasting, and whilst the language and ideas under-pinning their use might have disappeared, many ancient coins still exist. What they show us is the prestige and power required to establish widespread acceptance of a particular currency. The quality of the metal, often precious for the higher denominations, and the words and images embossed on the coins give remarkable clues as to the nature of the projects they represented. It is understandable, therefore, that a modern mind might be distracted from the fact that money is not currency, it is a system.

That system is one of agreed credits and debits supported by a method of clearing. Understood in this way, currency is just a token that helps to record the tally. We can't look back to a prelapsarian time when money was tangible, real and absolute and this is because money as an idea has changed very little since its invention. What we use as a token or representation of it has changed, but this matters less than most people think.

It is interesting that the history of gold used as money is full of conflict, with as many violently opposed to its use as those who would accept nothing but the metal. This opposition of views is more revealing than most conventional analysis and it appears to arise from the fact that different parts of society are affected in different ways by the logic of the economic policy applied at any one time. If gold is at the centre of policy it will also be at the centre of conflict.

It is easy to imagine a time when relative stability glossed over any shortcomings that gold might have had as money but as economic growth began to take off in the 18th Century, problems arose. This was primarily because the supply of gold has often been limited (or at best variable) and at times this tended to impose a deflationary pressure on prices. As we have seen in our own period of austerity, some people gain and others suffer and this polarisation ultimately becomes highly political. A fall in prices will favour the creditor over the debtor and if one part of the population is structurally indebted and the other is composed of a sort of rentier or creditor class, then the benefits will flow ceaselessly to the latter and away from the former. The resettlement of this state of affairs by governments is one of the major reasons why, over time, currencies fall.

This back and forth is best illustrated by the U.S. presidential election in 1896. The Republican nominee, William McKinley, narrowed an initially wide manifesto to focus purely on the superiority of the gold standard whilst his opponent, William Jennings Bryan, campaigned for bimetallism with a fixed ratio between gold and silver. What Jennings wanted was looser policy and this was the basis for his famous words, “you shall not crucify mankind upon a cross of gold”. McKinley won the campaign by a wide margin because, to quote the economic historian Peter Bernstein about a similar event “his arguments had the attraction of being cloaked in virtue, prudence, stability and tradition.”[1] As luck would have it wheat prices rose after the election of 1896, despite gold, helping the embattled farmers that Bryan was attempting to protect. Milton Friedman later ascribed this inflation primarily to the Macarthur-Forrest invention of the cyanide gold-refining process which lead to a huge increase in gold production, thereby loosening policy.

But this loosening and tightening of policy as a consequence of variations in the supply of gold continued to bedevil the gold money system. In his great essay Auri Sacra Fames John Maynard Keynes talked both about the failure of gold to impose stability on national currencies (as the Gold Standard) and also its failure to be stable in terms of purchasing power domestically (as money).[2] Perhaps the British Prime Minister Benjamin Disraeli got closest to the truth in 1895 when he stated that “Our gold standard is not the cause, but the consequence of our commercial prosperity.”[3] Neither this insight nor Keynes's subsequent attack on the ‹barbarous relic' stopped the return to gold in the 1920s following its abandonment because of the outbreak of the First World War in 1914. The subsequent austerity imposed by the gold standard in the 1930s is thought by many to be one of the key contributors to the economic problems of the era.

But if gold is not the essence of money is it perhaps an instrument that allows protection from inflation? We have seen a return to this discussion as people worry about future price levels as a consequence of the current substantial economic stimulus. As Keynes noted in the above-mentioned essay, “gold as a store of value has always had devoted patrons.” As investors in productive assets, the type where a surplus can be earned and then ploughed back into a business to drive up its economic value, we struggle to see how gold can do the same thing, given that it doesn't create an income stream. What is clear, however, is that money is a work of human imagination that merely requires a collective belief in its ability to work for it to do so for a time. If enough people think gold will protect them from inflation then, assuming supply remains restricted, they will bid up its price and, magically, it will do pretty much what they have expected of it.

In our view however, equities are much better at protecting against inflation over any period other than the very short term. The CFA Financial Market History study from 1900 to 2015 allows us to test this assumption. This period of time saw deflation, inflation, war, huge technological change and every type of policy. The mean geometric return per annum for gold over that period was 0.7% and for U.S. equities it was 6.5%. US$1,000 invested in gold in 1900 would have been worth US$2,230 by 2015 whereas US$1,000 invested into U.S. equities would have been worth US$1,397,000.  Past returns cannot, as they say, be extrapolated into the future but this seems very clear cut.[4]

The Victorian critic John Ruskin told the story of a man who boarded a ship with all of his wealth in gold. Some days later a violent storm led to the order to abandon ship. The man tied his gold around his waist, jumped overboard, and was lost to the depths. Ruskin asked: “Now, as he was sinking, had he the gold? Or had the gold him?”[5] Perhaps the true power of gold is how revealing it is of human nature.

[1] The Power of Gold, Peter Bernstein
[2] Essays in Persuasion, John Maynard Keynes
[3] The Power of Gold, Peter Bernstein
[4] RBC GAM, The CFA Institute Research Foundation, Financial Market History: Reflections on the Past for Investors Today, David Chambers, Elroy Dimson, 2016
Unto This Last, John Ruskin

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