By Chirag Mehta
Last Sunday, I was sitting next to my 82 year old grandfather as he read the Sunday edition of a newspaper. It has been his Sunday morning routine for the last 25 years since he retired from a public sector bank. He came across an article on the current pandemic soon morphing into a financial crisis, and how the central bankers are trying to combat the crisis.
After reading the news he asked me, “Do you know about these bailouts and stimulus packages coming out of the U.S.?”
I replied: Yes.
Grandfather: “Trillions of dollars, right?”
I: “That’s right.”
Grandfather: “They don’t really have the money, though, do they?”
I: “No, they don’t.”
Grandfather: “And so they are just going to print it, aren’t they?”
I: “Yes, the central bank would print the currency and allow the government to borrow money.”
Grandfather: “Out of nothing? Is there any real backing, like Gold in earlier days?”
Grandfather: “But that’s not right, is it?”
Chart: Less Gold underlying per unit of currency in circulation*
*Ratio of Gold (in tonnes) to currency (in bn dollars) in circulation
i.e. tonnes of gold per bn dollars in circulation
I was stunned and replied “But, do they have any choice?”
He replied that “central bankers are making a grave mistake of taking on an aggressive loose (lower) interest rate policy and flooding the economy with more and more paper money in order to revive the economic activity.”
He further added “But, that is not going to work as it would not lead to real economic growth. Let me explain this in more detail “. The trapped banker in him for years was urging him to come out.
He asked: Have you heard about “The Gold Standard?”
He continued: It’s not very long before paper receipts with gold in storage were used as currencies. This era was known as a “The Gold standard”. People exchanged these paper notes for goods or services they required as it was more convenient to carry them rather than carrying a lot of physical gold. So every paper receipt issued had an equal amount of gold backing it.
Over time, those who held the gold and issued the receipts noticed that physical gold was seldom claimed even though the receipts changed hands several times.
The temptation to issue more receipts than the gold in storage became too large to resist, and fractional banking was invented. This allowed the issuers to charge interest and increase the amount of currency or paper in circulation many times more than the underlying Gold.
The scheme would work as long as everyone did not claim his or her gold at the “same time” Those issuers who abused the system suffered from bank-runs, in which receipt holders came in to claim their gold in large sizes. Since there was not enough gold to cover all the outstanding receipts, only the first claimants that entered the door first, would get any gold.
The system was based on the faith the public had in the gold receipts, with all issuers not being equal. The Federal Reserve Bank (RBI of USA) was therefore created to regulate the system and stand ready to bail out any bank that could not meet its obligations. Fractional banking was allowed to continue subject to additional regulation and scrutiny, but the system is still based purely on the faith and confidence that people have in paper currencies.
A monetary system based on fiat money amounts to no more than a confidence game. The value of fiat money is determined solely by our confidence in the issuers of that money. The confidence is that the country’s currency is “valuable” because of the country’s economic and military strength. This is what we have been made to believe in. Actually speaking, fiat currency is simply the printing of a currency out of thin air with no intrinsic value. If too much money is created the public will lose confidence in its purchasing power and the perceived value of the money can collapse. Remember, fiat money has no intrinsic value; it only has perceived value. This is why most of the fiat currencies met with disaster if you look back in history.
The current regime
The Federal Reserve has been printing currencies at will over some time now causing devaluation of the U.S dollar. The current crisis is unprecedented and the Fed is committed to solving it by insertion of unlimited amounts of money whenever required. As a result, we regularly hear about bailouts, stimulus packages and similar measures amounting to trillions of dollars. In the process, the US Fed balance sheet is testing whether it can grow a tree to the sky. This will all lead to devaluation of the dollar. Just like stock in a company is diluted when more stock is issued.
Our Government calls this ‘inflation’, when in reality it’s devaluation. This devaluation will eventually lead to a loss of faith in the dollar and people will no more want to hold the fiat currency. As a result, people will want to convert their cash / wealth to something that they believe in, something that can protect their wealth with, something that has intrinsic value and that has proved its worth over decades.
Chart: Loss of Purchasing Power (Devaluation)
Source: World Gold Council
Gold certainly suits the requirements. The sheer fact that it cannot be created at will by the central bankers. It possesses an intrinsic value and is free from any counterparty risk. It has decade’s long history of being used as a form of currency.
However, Gold won’t be currency today – there isn’t a political will to support it and also there isn’t enough gold to support the return of the gold standard. Still, long-term trends in gold prices are driven by changes in the overall level of confidence in the monetary system and the economy. Therefore, to analyse gold over the long term, it needs to be seen as a monetary asset rather than a commodity. Given the current economic backdrop, where governments are struggling with problems like rising deficits and unsustainable debts, it is indeed logical for gold prices to increase in value. With policy makers continuously debasing currencies, gold will be viewed as “the real liquid store of value” investment, lending some calm to the chaos.
Fundamentally, gold is rightly increasing in nominal value being the only currency whose supply is highly constrained. In simple words, gold is simply adjusting to changes in global monetary conditions. When a central bank increases their money supply, the price of other currencies adjusts upwards. This is true for all currencies including gold. Therefore, the one thing against which global currencies are truly perishing is the ultimate form of real monetary asset i.e. Gold.
Make a strategic allocation to gold because it’s the counterweight to paper money which is continuing to lose credibility as a store of value.
(Chirag Mehta is the Senior Fund Manager-Alternative Investments at Quantum AMC)