All that Glitters Isn’t Gold

During this past quarter the price for 1 troy ounce of gold has precipitously fallen by 25%. Over the past two years the price of gold has tumbled 35% from the metal’s all time high of $1,900/oz reached in September, 2011 (see chart 1). Many investors are now questioning whether we see this recent plunge as a buying opportunity or perhaps the beginning of a longer-term slide for gold prices. Ultimately, we believe gold is still overvalued relative to our benchmarks and in consideration of other competing asset classes. However, let’s first review the fundamentals for gold production and then explore the history of this precious metal so we may expound on our resistance to invest at today’s market price.

Gold’s Marginal Cost of Production – Assaying the Price of Gold as a Commodity Only

When GHP Investment Advisors values gold strictly as a commodity, we apply our benchmarking discipline by quantifying gold’s Marginal Cost of Production (MCP). For a gold mining company, MCP is the change in total cost that results from producing one additional ounce of gold, and it allows the miner to determine when economies of scale are achieved at optimal mining productivity. Despite the recent plunge in gold prices, we continue to value the MCP of gold lower than its current market price of $1,226 (June 26^th, 2013), especially if productivity demands subside in the future. Therefore, we believe this price level carries too much risk for our portfolios.   But any analysis of gold must reach further than its value as a commodity alone, which leads us to explore gold’s checkered history as a monetary basis.

A Brief History of Gold – To the Victor Belong the Spoils

“Get gold, humanely if possible, but at all costs, get gold.”  King Ferdinand of Spain, circa 1500’s.

For as long as we can trace back civilizations, gold has been highly sought after as a symbol of wealth, beauty, holiness and power. Further, gold has always been in relatively scarce supply, greatly adding to its allure. The Egyptians used gold primarily for worship and adornment. The Greeks and Romans increased the demand for gold exponentially as they added coinage to its uses. With increased demand came territorial expansion as these empires strained to find new supplies of gold.

While gold has always been in demand for adornment, the broadening usage of gold as a unit of currency created a more infinite demand that has both wreaked havoc on money supply as well as inspired exploration and invention. Of course, the discovery of America was largely due to a European quest for gold, and we can thank that same unquenchable thirst for the settlement of Denver and so much of the Western U.S. Moreover, gold’s scarcity led to innovation as societies attempted new ways to keep pace with mounting currency demands. The Chinese are credited with inventing paper money around 800 A.D. as an alternative to precious metals while the Italians began using bank checks (bills of exchange) 400 years later to keep up with the growing volume of trade and transactions. With the simultaneous escalation of global trade and currency demands, an international monetary system was ultimately established in an attempt to ensure each country used a currency backed by something with a bona fide value agreed upon by the entire global community. You guessed it – that something was gold.

 The Gold Standard – A Functional Monetary System during Times of Peace and Prosperity

In 1844, England, as an imperial power and the world’s financial center, was the first to adopt the gold standard – a monetary system wherein paper money is convertible into a fixed amount of gold. By the 1870’s, England was joined by Germany, France and virtually all other economically powerful countries, thus creating the international gold standard. Because the U.S. enjoyed the resources of both gold and silver, we carried a bimetallic monetary standard, with great argument and political upheaval, until officially linking solely to the gold standard in 1900.

The international gold standard functioned somewhat smoothly from 1871 to 1914, serving as the catalyst for expanding global trade, settling international debts and safeguarding disciplined central banking. While each country maintained its own internal currency and banking system, their respective currencies found universal credibility if they were pegged to gold. Further, as this was a period of relative peace among gold standard countries, international cooperation served as a safety net if any individual country experienced short-term central banking difficulties. Unfortunately, this landscape would be forever altered in the aftermath of World War I.

 Deflation and Hoarding – The Struggles of the Gold Standard after World War I

“Anyone rash enough then to have advocated a different course (away from gold) might well have been locked up and certified as insane” Montagu Norman, Governor of the Bank of England in 1920.

WWI had a devastating effect on the functional operation of the gold standard. The costs of war overwhelmed government finances, which, in turn, severely damaged the financial credibility of each country’s currency. Many countries with currencies pegged to gold had to suspend gold convertibility during the war in an effort to protect their reserves. Once the war was over, international cooperation was torn asunder as virtually all major gold standard countries become embroiled in the settlement of reparations (war debts). These debts caused hyperinflation in some countries, most notably Germany, as their government printed more currency in order to maintain reparation payments once their gold reserves were depleted. Regardless of the global financial turmoil, however, the general thrust of the world economic powers in the 1920’s was to maintain the gold standard at all costs as they deemed this the successful framework for the monetary stability that had presided for almost 50 years prior to WWI. Thus, the perilous schemes of each gold standard country to protect their gold hoards typically played out like this:

1. Country A is waiting for reparation payments from Country B and is saddled by domestic debt burdens they are unable to satisfy until they receive reparations.
2. Speculators swoop in and affect a run on Country A’s gold reserves as it appears they might become insolvent.
3. To slow the outflow of its gold reserves, Country A raises interest rates in an attempt to placate domestic depositors and to attract foreign investment.
4. Rising rates deflate Country A’s domestic economy, unemployment increases, wage and price levels are suppressed.
5. With lower wages and prices, however, Country A’s exports might improve and gold possibly returns to its vaults.

This was often the precarious line many countries had to walk subsequent to WWI so their currencies could cling to the gold standard and remain competitive and credible in an increasingly uncooperative international community. Although the U.S. was not free from this worldwide struggle, our global financial strength and influence increased significantly at the conclusion of WWI, which is also why our own financial calamity of 1929 would render the knockout blow to the international gold standard.

Tidal Waves Don’t Beg Forgiveness – The Failure of the Gold Standard during the Great Depression

Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system.” U.S. Treasury Secretary Andrew Mellon in 1929.

The gold standard countries were already unstable when the U.S. stock market crashed in 1929. However, that crisis, and our leaders’ muted response in the months that followed, largely contributed to the global economy’s slide into outright depression. As credit was drained from the US economy and as our banking system collapsed, the conventional gold standard wisdom held that by purging liquidity and speculation from the economy with deflationary tactics, we could return to price stability and ultimately restore economic strength. Once again, the gold standard model (see #1-5 above) of raising interest rates and deflating the economy prevailed – at a time when expansion and liquidity was desperately needed. This expansionary alternative was denounced by most countries as inflationary. They argued that Germany’s experience in the 1920’s provided enough evidence to support this theory, regardless of the fundamentally different economic circumstances of the 1930’s. Further, international cooperation was nonexistent, which added to the Federal Reserve’s rationale to defend the gold standard despite the incredibly destructive effects this spawned for the domestic economy. Pounded by the tidal wave of depression and deflation, U.S. unemployment swelled to 25%, productivity fell over 30% and more than 6,000 banks failed during the 1930’s – and these banks did not carry deposit insurance, your money was simply gone.

Devaluation and Monetary Expansion – Sweet as Tupelo Honey

Obstinate devotion to the gold standard began to unravel in Europe in 1931.  England, the founding member, in failing to mitigate spiraling unemployment and fearing a possible revolution, finally suspended gold convertibility, a move which significantly devalued its currency.  Almost immediately, more than half of the world’s gold standard countries would follow suit, and by 1932 only 5 major economies, including the U.S., remained tied to gold.  With currency devaluation, expansion of the money supply generally followed and the deflated economies began to breathe again.

President Hoover, with his resolute adherence to deflationary methods, was defeated by Roosevelt in a landslide election that November. In January of 1934, the U.S., in witnessing the economic recovery of other countries that had severed their golden shackles, likewise devalued the dollar by over 40%. This devaluation, though not an official removal from the gold standard, had a positive effect. Unemployment was nearly halved, industrial production increased by 60% and the stock market recovered by more than 100% in 3 years. Also of great importance, while devaluation effectively expanded the money supply for countries formerly bound by the gold standard, inflation did not rear its ugly head as so many leaders had feared. Although the U.S. dollar alone remained formally linked to gold until 1971, the worldwide depression of the 1930’s brought a thundering conclusion to the international gold standard.

Debt, Deficits and Deadlock – Is Fiscal Rectitude Possible without the Gold Standard?

“We have gold because we cannot trust governments” Former President Herbert Hoover

While those currently calling for a return to the gold standard remain a minority faction, their argument deserves attention. They believe our current Federal Reserve System, by artificially adding to the money supply, will likely stoke inflation, which then becomes an insidious tax on the population. Further, it is argued that the Fed, by fueling inflation, enables reckless government deficit spending and, therefore, fails to operate independently of the U.S. government.

On the contrary, analysis of the Consumer Price Index (the economic measure of inflation) reveals that inflation has been rather mild since the Fed began boosting the money supply in response to the 2008 financial crisis (see Chart 2). 

Conversely, prices were far more volatile when we were tied to the gold standard of the 1920’s and Depression-era (see Chart 3).

And as a consequence of the capricious dictates of the international gold standard, the Fed had less independence from U.S. government policy when addressing domestic price stability than it does within our current monetary system.

Conclusion

Undoubtedly, widespread price instability, whether by inflation or equally harmful deflation, was the lay of the land under the failed international gold standard of the Depression-era. The era clearly revealed that during difficult economic times it is paramount for the money supply to float freely rather than anchor to a fixed asset in scarce supply. But of equal importance, a floating money supply, as we have in place now, necessitates prudent long-term deficit and debt management. Without this our Fed monetary policy is at risk of losing independence from government policy and might be forced to drift towards dangerous inflation levels. While those espousing a return to the gold standard argue our current course makes runaway inflation inevitable, we are more optimistic that Fed monetary policy will continue to navigate away from this dire scenario, albeit slowly.  It is also possible that the Fed and other global central banks will continue to loosen their demand for gold as a currency reserve, which will serve to boost market supply and exacerbate downward pressure on prices.  If global demand slackens because of gold’s fading value as a currency, production costs for miners will likewise decline, once again, pushing market prices down.  As a metal, gold’s malleability and luster will always maintain value for your sweetheart, but as a monetary basis, we believe gold’s inflexibility has dulled its value as an alternative to our current monetary policy and as an alternative asset for our portfolios.

Investment Insight is published as a service to our clients and other interested parties. This material is not intended to be relied upon as a forecast, research, investment, accounting, legal or tax advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only. Past performance is no guarantee of future results.