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This Move in Gold is Different – And That’s Not Good
(March 1, 2003) Today, in the third year of a bull market in gold, the commonly accepted wisdom is that this is just one of those unstable times in which that old barbarous relic, gold, pops up, this time aided by rumors of war in Iraq. It is expected that gold will eventually slink back into the swamp where it belongs, a boring, growth-less commodity that brings no benefits whatsoever. We disagree:
The backhand dismissal of gold is almost second nature in this modern world. It was daring and probably shocking in 1923 when Keynes wrote of the gold standard as a "barbarous relic," but in fact his home country of Great Britain had already abandoned gold as currency. The monetary discipline required under a gold standard was increasingly starting to chafe and constrict governments back in the early part of the 20th century. Ten years later the US would accomplish its first devaluation of the dollar since its inception in 1794 by raising the official price of gold from $20.67 per ounce to $35 per ounce.

More significantly in 1933, money changed in the US. Not only was the dollar devalued, but US citizens, formerly able to enjoy the freedom to convert paper dollars to gold at any time, were now denied the right to convert their paper dollars to gold coins. This was the end of an era of nearly 140 years under a freely convertible gold standard, in which the US dollar had been defined simply as 23.22 grains of pure gold.

The US dollar derived its value from its free convertibility to gold. As explained in 1919:

"To maintain the established parity between the money unit and gold bullion the principle of free exchange is relied upon. This principle is to the effect that any value relation can be maintained between two commodities which can be exchanged without limit at such relation. If I can always take 23.22 grains of gold to the mint and get a dollar for it, and if I can always get 23.22 grains of gold from the government for a dollar, a dollar will always equal in value 23.22 grains of gold. In other words, the gold is the standard to whose value the value of the dollar is necessarily adjusted." - from "Foreign Exchange and Central Banking," a primer on money and banking published by the National City Bank in 1919.

The fully convertible gold standard that this country enjoyed for so long was a simple, efficient, and stable monetary system. But in 1933 FDR devalued the dollar and took gold out of the hands of Americans.

Upon hearing of the impending abandonment of the dollar gold standard, banker Paul Warburg lamented that “We are entering upon waters for which I have no charts and in which I therefore feel myself an utterly incompetent pilot."

Mr. Warburg was a bit premature, as Roosevelt did not entirely sever the dollar from gold, but instead simply devalued the dollar from $20.67 per ounce of gold to $35 per ounce of gold. And this new shrunken dollar prevailed for some 35 years. It was in 1968 that President Nixon, staving off a run on US gold reserves led by the French, began a series of baby-step devaluations of the dollar, culminating in 1972 in a complete severance of any connection between paper US dollars and the hard, shiny stuff that had been money for thousands of years.

It's at this point in time that the dollar, once 23.22 grains of gold, became an abstraction. The dollar, which had been a constant amount of gold for 140 years, and a shrinking amount of gold from 1933-1972, became, all of a sudden, no amount of gold at all. It was a mere 31 years ago that we in the US entered the brave new world of money-which-is-not-gold, that is to say, the monetary belief system that we have today - the faith-based dollar.

In sum, think of today’s ‘dollar’ as an experiment. As John Hathaway of Tocqueville Asset Management puts it in his latest essay, “Beyond Iraq,”

“In today’s regime of floating exchange rates, the slightest pretext of a gold anchor is gone. The currency’s intrinsic value is defined by market faith in the ability of central bankers and national governments to get it right. The advancing gold price signifies shakiness in the foundations of the floating rate/ central planning monetary regime. Without an unimpeachable link to a unit of value beyond reproach, the dollar is no different than an overpriced stock, capable of successful illusion until investors no longer choose to believe...”

“...Iraq related hype notwithstanding, a significantly higher price target for gold seems appropriate. A re-allocation of 1/10th of 1% of world financial assets, or $50 billion, would swamp the physical market, especially if it coincided with recognition by the central bank community that the dollar, rather than gold, is their least attractive asset. A mere $50 billion equates to more than two years of annual gold production, a quantity that could not clear the market within several hundred dollars of today’s price.”

In short, think of today’s ‘dollar,’ post-1972, as an experimental creation. How this modern dollar will hold up, no one can say, but the harsh economic reality is that history is not usually kind to such experiments in fiat currency. And considering our enormous current and future trade and budget deficits, this artificial construct that we call the dollar is at the mercy of the world’s perceptions of us.

Monetarily, we really are in Warburg’s ‘chartless waters.’

Gold, a solid and permanent store of value, will protect you when our ersatz dollar faces its next significant devaluation in the world. Unfortunately, it won’t save you from having to witness some ugly economic times.


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