Miscellany June 6 Is Gold Money?

I've finished up my project with a data security firm in Germany.  We were working on DNS DoS (denial of service) and automatic filtering and re-routing during attacks.  My other German colleagues and I are still producing a financial newsletter for German and other EU subscribers.

I have several things to talk about in the financial world, and so I will publish them here. (Forgive me DHS for any words that offend, and the same for the Obama-nation.)

For three straight weeks (including this one), the USA stock market has moved down.  Don't get excited as there is still no indication the Western Central Banks are going to stop QE.  Yes, there is noise about slowing QE down in the USA, but there is very little noise about stopping it.  The Bernank has publicly stated he knows how to manage the end of QE, and any other central banker knows how to do this as well.

Good luck on that, Dr. Bernanke.  There is no historical precedence that suggests how the world's largest debtor nation repays this kind of debt, which debt therefore in the future puts huge pressures on the Federal Reserve to meet its mandates by providing more liquidity.  Common sense of the common man in the streets know that when the bills are too high, they are 1. going to jail or 2. they are going bankrupt (which does no good as Visa etc cannot be forgive according to new bankruptcy law) 3. or they are going into hiding.  Of course, you should go to jail if this goes south, but the bankers are never ever going to jail (or be ostracized from society) as the common man would.  What does history suggest will happen when the #1 economic power goes into debt like this? (Remember Rome? French? Brits? Germans?, or if you want to go back further, Spain, Portugal and back further than that? Greece?)

Having spent time in several countries in Europe (and Asia) recently, I began to consider "money" again.  What is money?  http://en.wikipedia.org/wiki/Money  "Money is any object that is generally accepted as payment for goods and services... in a given socio-economic context..."  That is not the classical definition as given by Adam Smith.

It is valuable intellectual and historical exercise to bring up Adam Smith, as he is considered the father of Western Economics and he was a philosopher on "political economy" -- "An Inquiry into the Nature and Causes of the Wealth of Nations".  But he was trained as a Social Philosopher at the University of Glasgow and graduate work at the University of Oxford.  "Labour was the first price, the original purchase - money that was paid for all things.  It was not by gold or by silver, but by labour, that all wealth was originally purchased."

Can we add to the definition and Adam Smith's insight.  (As my friends and colleagues that are quants in NY would tell you, "I don't know nuthen about nuthen, and so I must be a common man with little insight.)  However, my common senses tells me basically, money is the way I get things I need and want.  At the lowest level of that would be I labor to earn, and I would exchange that earning for the goods I need (or want).  That matches Smith.

OK, I can trade my computer skills for something (not for much where I live, but in NY or Stuttgart they pay lots).  The problem is if my friends in security need my skill we (they and I) need a medium of exchange that is convenient.  Since I don't drink beer, German Beer is not a good medium of exchange.  Exchange of labor (I don't need their skills; they need mine) does not provide the transfer-ability and divisibility that makes trading labor efficient.  That brings us back to the current socio-economic context of money - where money is generally accepted as payment for goods or services.  So money in the current context would allow the exchange of goods and services along with "divisibility" -- I can spend the German's money EU $$ in the EU, but it is not much good to me outside the EU.  Which then brings up the need for a money-exchange -- a reasonable and regulated place to exchange one currency for another.  For those who may not know currently the price is set in the FOREX market.

So Ron Paul would argue Gold is money, and Dr. Bernanke would argue it is not.  They are both correct in context, except, fiat currencies (based on confidence in the government only) do not last as a store of value, and Gold always lasts as a store of value.  And gold can always (100% of the time throughout history) be converted to the local currency.  The only exceptions is when the local government outlaws the ownership of gold (and then the common man just hides her/his gold).  There may come a time when no exchange will buy USA dollars, but there will always be a place to buy and sell gold -- at least historically (1,000s upon 1,000s of years of history).

Gold - Money or Not?

Well, no matter the definition of money, gold seems to fit the definition of money, but governments that produce fiat currency would prefer that not to be true, and therefore, make it as difficult as possible to use Gold as a medium of exchange.

Western Central bankers (and politicos) have made it clear: Gold is not money -- being relegated to a risk asset that can be manipulated by Central Bankers that stand outside the law.  Ludwig von Mises (an uber liberal http://en.wikipedia.org/wiki/Ludwig_von_Mises) stated that MONEY (true money he called it) must survive the regression test.  Regression theorem became a major part of Austrian Economics.  It is difficult to put regression theorem in English.   Generally the theorem states the economist must establish whether a "money" had value before it was used as money.  If the "before" cannot be established money is only a money-substitute which ultimately sets its value based on confidence -- not production.

Somewhat, it depends on how far back one wants to explore regression.   For 1,000s of years, Gold has a value, and can be used for barter.   Gold survives von Mises' regression theorem across times and cultures.  Paper money does not survive the Regression Theorem across times and cultures.

So ask yourself these two questions:  1. Did gold have value before it was used as money (remembering Western Civilization does not use - or condone the use of - gold as a base for value of their currency).  2. What value did modern currencies have before they were used as money?

Question 1: Yes, gold had value, and only in the most ancient of cultures was gold not used as a form of barter.  Modern currencies can only be evaluated for two hundred years at best, and there are many instances of modern paper currencies collapsing (along with the governments usually). 

Question 2: Paper currencies cannot survive the test of regression.  They start as money substitutes for gold (or silver or both) and over time (historically) have lost their value.  Even now, the US $$$ has lost almost all its value compared to 1950 (or any other date since then).  As a result the US dollar depends on its value based on confidence alone. 

Traders and Investors are unconcerned with this distinction.  Without thinking about it, they are basing their lives on the Sir Thomas Gresham Law.  "When a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation."  This is known as "bad money drives out good money".  Traders realize that bad money has driven out good money, and they invest to make a profit in CURRENCY (not a tangible asset).  Currency risk is then hedged by acquiring capital assets, and thereby manage investment risk without recourse to gold or silver.

An unintended consequence of this thinking is what happens when Western Civilization's central banks act in coordination where gold is no longer money?  We can observe that the four major central banks issuing more confidence-based currency in increasing quantities to finance their governments.  The most recent and outlandish example is the Bank of Japan supporting Abeonomics.  What happens when the central banks stop?  

The common man with common sense use to have a well known concept - Government prints money we reap inflation.  The Central Banks have turned a "known" concept upside down.  Many of us who came through the inflation period of President Jimmy Carter learned that monetary inflation was predictable.  Monetary easing raised asset prices first.  Then it raised prices of raw materials and manufactured goods. People spent money encouraged by jobs and low interest rates.  Ultimately, inflation occurred, and the sequence of credit-fueled economic cycles was all too familiar. That is true no longer (at least since the turn of the century which is a fairly long time in man's life-cycle).

The Federal Reserve has created huge sums of debt and lowered interest rates.   The "known" concept does not seem to be working at this point.  

What we can then observe is that fiat currency today is based on nothing except confidence in the Bankers.  If we return to Gresham's law (Bad Money drives out good money) and tweak it a bit we could conclude (I'm open to argument here gentle readers) that Gresham's  law indicates "Bad money drives out good if the money (currencies or metal) exchange for the same price".  If I think of it (common sense), if both currencies are legal tender and thus equally capable of paying a debt or making a purchase, the "bad" money will drive out the good money.  However, that then requires further insight into Gresham's law to have a sense of "good" or "bad". 

Then by reasoning from a general statement, an essential condition for Graham's Law to operate is that there must be two (or more) kinds of currency which are equivalent for some purpose and of different value for other purposes.  For example, suppose we have a USA silver dime (old days) and a new dimel made of fairly worthless metal.  Both coins are legal tender at face value, but they have different values if they are melted down for their commodity value. Now, you gentle reader, can buy junk silver coins, but common sense tells you, do not spend a silver coin for face value, and therefore, the "bad" (new worthless metal coin) drives out the "good" (silver based coin) coin.  You know this even further when you buy a 1 oz USA Gold Eagle at face value of $50.00, but you pay $1500 (or so) for it).  You are not going to observe USA Gold Eagles in circulation anytime soon, me thinks.

Is this a good example of "good money" having  equivalent value for some purposes and different value for others?  At the economic level of the two dimes, the fact they have different economic values does not mean that they cannot circulate in a state of equilibrium.  In fact, this occurred in the USA for 10's of years until the inflation times of the 1970s.  What happened to the silver dimes since then?  (If you get this, you get the concept of money pretty well.)  As the value of currency decreased (inflation), the supply of "bad" money increases.  Which dimes disappeared?  Not the worthless metal coins.  The silver coins became hoarded and sold as junk silver.  Ah ha, grasshopper, under ordinary circumstances the coins could circulate together as long as the balance of payments is in equilibrium.  

Once a circumstance arises where the USA develops a deficit, the "new-bad" nickle will only have value at home (try exchanging USA dimes in France for example).  The silver coins (albeit worn) will have value abroad (just not as a dime).  

If the markets were left alone (and this can be proven by economists) automatic forces would restore the equilibrium (meaning the USA would have had to produce more silver coins).  However, if the deficit is perpetuated by whatever means, the silver coins will disappear and the less-valuable coinage (or all USA currency) will lead to currency depreciation and inflation.

I won't prolong your agony reading this, but I've shown how this has taken place in asset values and currency depreciation since 2008 in this blog, and I will continue to show it in the future.

Has this example of coins every happened before (beside the USA)?  Of course it has.  Athens, Rome, and almost all current countries in the modern world.  The unintended consequence then happens. The "good" money in the form of valuable commodity is used in jewelry, collectible metal coins, and even in industry (as well as being stored in bulk in the form of bars).  

Gresham's law is neither trivial nor obvious in the execution of International Finance.  

But long before Gresham, Adam Smith (in collaboration with David Hume) went to great pains to demonstrate that the existence of paper credit would mean a correspondingly lower quantity of gold required, and an increase in paper credit would export an equal quantity of gold.  David Hume goes on to explain why some countries have more gold -- in proportion to population and wealth - than others.  In his words there is no exchange credit to displace gold.  

OK, here we go -- Dr. Bernanke would think I'm supporting his cause:

""It is not to be doubted, but the great plenty of bullion in France is in a great measure, owing to the want of paper credit. The French have no banks; merchant bills do not there circulate as with us; and usury, or lending on interest, is not directly permitted; so that many have large sums in their coffers: great quantities of plate are used in private houses; and all the churches are full of it. . .What a pity Lycurgus did not think of paper-credit, when he wanted to banish gold and silver from Sparta! It would have served his purpose better than the lumps of iron he made use of as money; and would also have prevented more effectually all commerce with strangers, as being of so much less real and intrinsic value"  Hume's essay "Of the Balance of Trade".

Adam Smith would develop this idea in The Wealth of Nations.  A few years ago, International Finance took Adam Smith's idea to a whole new level when the world had more debt than all the assets that existed then and being forecast to be produced for 100 years.  Mostly this was in the form of super-derivatives.

The Tipping Point Theory (or the breaking point if you prefer)

In history, our ancestors (Greeks, Romans, and so-on) recognized the advantage of replacing "intrinsic" money with currency, but they gave no indication they knew when to stop.  How far could precious metals be replaced without running the risk of in-convertibility and inflation?  They (nor modern financial students) could agree (or understand) the relationship and consequences of the money supply on Gross Domestic Product.

John Stuart Mill wondered about about the breaking point and gave the following answer:

"Suppose that, in a country of which the currency is wholly metallic, a paper currency is suddenly issued, to the amount of half the metallic circulation. . .[There] will be nothing changed except that a paper currency has been substituted for half the metallic currency which existed before. Suppose, now, a second emission of paper; the same series of effects will be renewed; and son on, until the whole of the metallic money has disappeared. . .

Up to this point, the effects of a paper currency are substantially the same, whether it is convertible into specie or not. It is when the metals have been completely superseded and driven from circulation, that the difference between convertible and inconvertible paper becomes operative. When the gold or silver has all gone from circulation, and an equal quantity of paper has taken its place, suppose that a still further issue is superadded. . .The issuers may add to it indefinitely, lowering its value and raising prices in proportion; they may, in other words, depreciate the currency without limit." (Mill 1848, 1909:544)

Mill concludes that substitution of paper money for metallic currency is a national gain until a country has issued more currency than they have golden (or silver) assets.  He then states an increase beyond that balance is a form of robbery.

Or in the context of Greshem's law the breaking point is when the "bad" paper money has driven out all the precious money. "M" is the money in two forms - "G" (gold or foreign exchange) and "D" domestic fiat currency.  Then arithmetically expresses as: M = G + D.

Imagine then the USA starts off with all metallic money where G = M and D = 0.  Imagine D is increased by .5 of M then D will be lowered by .5 (equal amount).  The process of substitution reaches a theoretical tipping point when G = 0 and D = M.  After this point, as Mill stated, we have robbery in the form in inflation according to the quantity theory of money (http://en.wikipedia.org/wiki/Quantity_theory_of_money) It does not exactly follow as Western Central Bankers continue to manipulate the amount of currency and foreign exchange.

In practice the limit is reached long before D = M as the public (ignorant as they are to what central bankers do) use common sense and start to anticipate the direction in which the government is proceeding and start to hoard golden-money.  Or in other words, they buy gold and silver and hoard it.

You and I can observe this right now as the common people are buying gold and silver coins faster than they can be minted on a world-wide basis.  In turn speculation sharply reduces the extent to which "good" money can be replaced.  In order for central bankers to maintain a mix, they can (and do) assume the money supply must be in equilibrium proportion to the GDP.  Whatever that desired ratio is (money to GDP) the banking system needs to be taken into account.  (Mundell, 1965)

However, Argentina is a good example where some counties cannot overvalue the currency and exploit the monetary system.  In a global economy there is a need to monopolize the coinage and MANDATE its use as legal tender, or uncontrollable inflation results.  This requires a strong central state, and Argentina only realized that after an inflationary and debt collapse.  One of the more interesting studies is Greece in the time of Plato.  This is Plato's thought to held in "The Laws" that domestic money should be non-exportable, restricted in supply, and exchangeable with "hellenic" money; which in effect is AN EXCHANGE AUTHORITY.  Greece under Dionysius issued tin coins and he compelled Greeks and all other nations to accept them under penalty of death.  Now that is global power.  This did not work, however, as the coins soon were devalued to their commodity value.  And if Mills had been around he could have shown mathematically where they would exceed the tipping point.

And in case we think only the ancients (and emerging countries) did not understand, The English in the 17th century started a period "The Great Recoinage" (http://en.wikipedia.org/wiki/Great_Recoinage_of_1696)  In the Fool of Fashion, the Hero declares "Virtue is as much debased as our money, and faith, Dei gratia, is as hard to find in a girl of sixteen as round the brim of an old shilling." 

Parliment passed in 1695 an Act which provided that anyone who bought, sold or knowingly possessed any coin clippings should forfeit them, be liable to a fine of £500, and be branded on the right cheek with a capital R. Actually, they enforced capital punishment and people (women and men) were executed.

Are you aware from your study of history that Alexander Hamilton created the metallic system in the Colonies by the Act of April 2, 1792?  The dollar (adopted by the Congress of Confederation) was defined as 24.75 grains of pure gold and 371.25 grains of pure silver.  (Ah, ha grasshopper, who defined the "price of gold" and who did Benjamin Franklin appeal to finance the revolution?)  France under Napoleon established the gold/silver ration as 15 1/2:1.  The USA's ratio was 15 making silver overvalued and gold undervalued.  In turn, there was then a dearth of gold coins in the US.  In July 31, 1834 the dollar was reduced to 23.2 grains and later to 23.22 grins.  Also the standard was changed from 11/12 fine to 9/10 fine.  The new ratio 16:1 making gold overvalued and silver under valued.  Silver fled the scenes and gold made the United States dollar a de facto on the gold standard.  That caused an emergency in "small change", which was taken care of by changing the amount of silver required to be in small coinage.  

Since Gold (and silver) are commodities, the currency's value could also be affected by a change in the supply of the commodities.  France in 1850 was mostly using silver, and there were huge gold discoveries made in Russia and California. This lowered the market price of gold but France's bimetallic standard of 15 1/2:1 was not changed.  According to Graham's law then, the new supply made gold overvalued in France, and France ended up exchanging silver for gold -- silver fled and gold took over.  Maybe that was not so bad for an individual, but for a major power, this was devastating.   

Ah, ha grasshopper, we are learning that currency based on metals is also subject to surprise new supplies of the metal, and there was little if anything a country could do about that.  They enforced the death penalty, but that does not keep the undervalued money from moving out (either traded outside the country or hoarded).  Britain experienced nearly the same thing in the 18th century as business could make a 5 % profit by importing gold and having them minted into guineas, and the newly-coined silver coins were exported.  

Sir Isaac Newton decided to lower the value of gold to silver.  The result was the guinea was henceforth to be rated 21 shillings, but it was not enough.  The ratios in Holland and France were 15:1 on bimetallic exchange, and since the British ration was 15.21:1, British silver was still exported.  Silver nearly disappeared in England.  

It turns out we don't need history to explain this (although it was a fascinating random walk through history).  Bimetallic ratio is determined by the interaction of demands and supplies of the two metals.  Of course Bimetallic ratio requires at least one very strong and large country to "command" the ratio.  Any country who deviates will end up on the sliver standard or the gold standard.

In the meantime the common people of the earth (except USA citizens) are buying and accumulating the physical metal.  From that standpoint, many common people seem to concur: Gold and Silver are a store of value and they are losing confidence in Fiat Currencies (or at least hedging their bets).

In the common man context then, Gold and Silver is "good" money, and it is being hoarded.  In the context of the Central Bankers, ultimately they will push for anyone hoarding gold and silver as terrorists.  Then they could get the governments to use the same tactics the Brits did - albeit it will likely be drones this time around instead of the hangman.  
I don't remember being taught any of this in school.  I wonder why students are not taught the relationship between country politics and currencies.  Since the Federal Reserve involvement under Greenspan and expanded exponentially under Bernanke are front and center in manipulating the currency, should we not be educated on how currency effects economics and politics?  Just wondering is all. 
Have any of us considered seriously why the USA Federal Reserve believes that injecting "money" into the International Financial system will increase employment? How does that work or how has it been working out?  On the surface, decreasing the taxes (at least temporarily) is a lot more effective in increasing consumer spending, which increases product demand, which requires investment to meet demand.  Investment requires liquidity, and therefore (it seems to the common man - me ) that dumping money from a Helicopter (remember Helicopter Ben) would be a lot more effective than giving the money to the bankers, who in turn drive the price of the stock market up, which the vast unwashed masses of the US and Europe are not participating in the wealth appreciation.  Just saying...  And the answer from the "gurus" at the central banks is in the Tipping Point of Greshman's law if we understand deeply enough.  

So observe as China accumulates more gold, and the gold leaves the Western World.  Who will be in the best position to control (not trade in the free market) all natural resources?  Germany knows this.  Russia knows this.  Certain emerging markets know what is happening.

Gold is down today -- 1385.20 as of this printing (that is down $30.30) from yesterday's close at COMEX.