David R. Kotok
April 19, 2013
Central bankers prefer to have the public, the investor class, and the holders of institutional wealth believe in the credibility of their central banking skills and their ability to manage their respective currencies. But central bankers miss a critical point.
When it comes to gold, the gold bugs argue that gold is money. Simply put, that is not exactly correct. Gold was money 150-200 years, and even centuries, ago. In the US, if you wanted to buy something, you could pay for it with a gold coin.
Those days are long gone. I repeat, those days are long gone. But gold still maintains one important characteristic out of the three that we attribute to a functional currency.
So let us get to this question of whether or not gold is money. To be money, you have to have the ability to exchange easily in transactions. When you go to the store and pay for something in dollars, those dollars function as money. You can pay in paper currency, write a check, transfer it electronically, or pre-purchase the electronic entry on a piece of plastic that is carried and use it for payment. Money is a way in which payments are conducted. You cannot easily buy something with a bag or bar of gold, not even with a gold coin. There are not many people in the world who will take gold for payment. The payment mechanism of money is conducted in the currencies managed by the central banks, regardless of whether the currency is the dollar, pound, yen, euro, franc, krona, dinar, yuan, peso, or something else.
The second characteristic of money is to act as a unit of account, a method of measurement. Open up the income statement of your favorite company. It shows how much revenue, expenses, profits, assets, and liabilities they have in dollars as a unit of account or way of measurement. The same is true all over the world. We use these measurement tools constantly, so money has to provide easy, secure ways of measurement.
The problem with money substitutes that fail these two initial tests is that they become subject to volatilities that disrupt their use. Gold is such an item. Bitcoin is another one. Pay for something with bitcoin and how do you know how much you are paying in comparison to the rest of your daily transactions?
The third characteristic of money is that it is a “store of value.” It supplies an answer to the question, “Where can I safely place my accumulation of wealth, the result of my work effort, the gathering of my savings, –and have it hold its value?” Store of value is very important to gold.
Historically, gold, as well as silver and other precious items like diamonds to a lesser extent, has been seen as a place to store value. Gold worked in this regard: it was fungible, it was measurable by weight, and it was the same worldwide; and so it remained for many centuries the traditional place to store value.
In the beginning, central banks traded gold and used it as a reserve because it was such a successful store of value. The central banks still retain their attachment to gold, even when they do not want to admit it.
Now let us get to the wild volatilities of the gold market in the last few days and weeks. In Europe we have a crisis. The crisis involves Cyprus and its ability to pay. Cyprus is broke. It owes more than it has and more than it can earn. And it is beset by a banking collapse in the midst of all this. Cyprus uses the euro for money like the all other Eurozone members. With the euro, the monetary characteristics needed for transactions and pricing still apply, and so Cyprus now has to lock up part of its money because capital controls have been imposed. Furthermore, Cypriots have been restricted in their ability to take their euros and convert them to another currency such as dollars, yen, or pounds. Lastly, Cyprus has some gold, as do most other countries around the world.
The Eurozone colleagues of Cyprus are proposing that Cyprus sell some of its gold. They are very public about it. And the government of Cyprus may have to engage in some negotiation over that gold due to the pressure from its European colleagues. If it does not continue to receive Eurozone assistance, it will not be able to obtain money and make the payments it owes.
The Central Bank of Cyprus does not want to sell the gold. It knows it will not get it back. It also knows that if it holds the gold, it will maintain this mystical store of value that is associated with gold. But if it sells the gold, it will not have that store of value. The central bank resists the sale of gold for two reasons: (1) It has a historical basis on which to maintain the reserve of gold, and (2) It knows that it cannot replace its position if it sells.
In pressing Cyprus to sell, Europeans have announced to the world that there may be a large seller of gold. World traders in gold and other commodities will quickly jump on that trade. They know that if Cyprus breaks loose with the sale of its gold, countries like Greece, Portugal, and Slovenia may be next. They cannot see buying gold, thereby raising gold’s US-dollar-denominated price, in such a circumstance; but they can see selling it short, or otherwise trading it to the downside.
Result: gold plummets and there is massive selling. That terrifies the ETF holders and the retail buyers of gold. They pile on the trade, and gold gaps down to an unexpectedly low price.
What happens next?
First, the European drama around gold has to run its course. That is going to take a while.
Second, the terrified retail investors who panicked and sold have to become exhausted sellers. That is happening very quickly, though it is not over. The notion that gold can no longer be trusted as a store of value was clubbed into investors without any preparation. They saw the consistently upward movement of gold prices as confirmation that gold would continue to increase in value. They failed to see that volatilities could be very high in a market that is relatively thin worldwide. Now, disillusioned, they are reacting out of panic.
What happens after the retail investors are exhausted and the curtain is drawn on the European gold drama?
We believe there will emerge a new set of buyers of gold. They will be emerging-market institutions including central banks whose gold holdings are much lower as a proportion of total reserves than the Europeans have maintained. There will also be some larger purchasers of gold.
Here we are going to propose that the Japanese view gold as a new addition to their reserves. Japan has already said it is going to up its reserves. It has already said that it’s going to implement highly stimulative monetary policies. It has already launched that program in a very substantial way. Japan is printing yen and buying assets. Simply put, that raises the price of all assets.
Now Japan has a problem. It has to negotiate its policy change in a world in which colleagues in other major countries do not like this rapid weakening of the yen against their own currencies. And they do not want the Japanese to directly buy sovereign debt in other countries by converting newly printed yen into another currency and using that currency to buy the government debt of the country in which they have made the conversion.
But there is another option for Japan. Japan can print yen and buy gold. If it buys metal instead of a bond issued by a sovereign country, it will raise the price of the metal. It will exchange yen for currencies and diversify its exposure among all of the currencies. It will not be able to be accused of direct interference with the bond markets of other sovereign countries. Nor will Japan be able to be accused of interfering with the Federal Reserve’s present policy of buying US dollar-denominated, government-backed debt, or with the policies of the Eurozone’s central banks or those of the Bank of England. Furthermore, with central banks and other institutions in Germany, France, the US, India, Russia, and elsewhere continuing to buy gold, Japan is in a position to ask, “Why can’t we buy gold, too?”
Other emerging-market countries also have gold-buying programs. In our view, we are now likely to see more of them.
Our conclusion about gold is this. It is not money in the traditional sense of a currency in which transactions can be made. It does not facilitate payments. It is not a unit of account. We do not print financial statements in terms of ounces or tons of gold. Instead, we use currencies to measure our financial status.
Gold does have a historical store of value characteristic. It is held by central banks and institutions as a reserve. They do not want to sell it. On the contrary, many of them want to buy and accumulate it. Therefore, gold’s characteristic role with regard to sovereign reserves is still intact, even amid the fascinating evolution of central banking and institutional finance we witness today.
Our view about gold as an investment is slightly different from that of a trader. Gold is a long-term investment. We think it should constitute a small portion of a portfolio and be maintained on a continuing basis. It should be a relatively passive investment. Think of it as a type of insurance policy. So we would recommend gold acquisition, for those who are inclined to pursue it, on a very modest level, utilizing a dollar-cost averaging method. Buy a little gold and put it away. Forget the price. Come back again, buy a little more, add to your hoard, and forget the price. Look at gold as an insurance policy that you hope you never need to use. We do believe that abandoning gold completely and disparaging it as a barbarous relic is too extreme.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland
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