Life After Gold
John Mauldin's Outside the Box

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This week's letter is part two of a series by my good friend, Andy Kessler, author of Running Money about his days running a hedge fund in the 1990's, a book that I highly recommend, especially to anyone in the "running money" business. (

Last week we ran the first part of the two part series on Andy's view of gold. The first part laid the groundwork by looking at the role of gold, currency and inflation in 18th and 19th century England. Kessler argues that, as a side product of using a gold standard coupled with a banking system and a currency printing press, a country that received more gold would increase their currency; this led to inflation which would lead to bank runs and financial crises.

This essay will be a little controversial to many. As I noted last week, I take exception to a few points. But Andy does make me, and I hope you, think through the concept of what that thing we call money really is.

If you want to review last week's letter it is archived at, but now let's read part two.

Life After Gold

Bank runs and financial crises from too much gold became common: They occurred in 1825, 1847, 1857 and 1866. Think about it. In periods of inflation, money loses its value relative to the goods it is buying. This lack of faith in money causes people to move into real assets, including gold. Even though money was exchanged into gold at a fixed rate, the fear that the rate would change when the money lost value, caused depositors to ask for real gold from banks. Plus, if a local bank failed, their banknotes would be worthless. Better to convert to gold quickly. Lack of faith is disastrous.

Something had to be done. For answers, most economists looked back to something David Hume had written back in 1752:
"There seems to be a happy concurrence of causes in human affairs, which checks the growth of trade and riches, and hinders them from being confined entirely to one people; as might naturally at first be dreaded from the advantages of an established commerce. Where one nation has gotten the start of another in trade, it is very difficult for the latter to regain the ground it has lost; because of the superior industry and skill of the former, and the greater stocks, of which its merchants are possessed, and which enable them to trade on so much smaller profits. But these advantages are compensated, in some measure, by the low price of labour in every nation which has not an extensive commerce, and does not much abound in gold and silver. Manufactures, therefore gradually shift their places, leaving those countries and provinces which they have already enriched, and flying to others, whither they are allured by the cheapness of provisions and labour; till they have enriched these also, and are again banished by the same causes. And, in general, we may observe, that the dearness of every thing, from plenty of money, is a disadvantage, which attends an established commerce, and sets bounds to it in every country, by enabling the poorer states to undersell the richer in all foreign markets."
The best and brightest economists of the time met in Paris in 1867, to discuss a way to have both sound money and increased international trade. They came up with a system known as the "price specie flow." Sounds like a case of the runs, rather than a cure for bank runs. It messed up the financial digestive system for another century.

In 1870, even though England's economic power had already peaked (but who knew?), the bankers and government officials agreed to this system - better known as the classical gold standard - since the economists were promising them a system that would naturally balance trade and keep governments from screwing up by issuing too much or too little money. There were four "rules of the game."
  1. Gold exchange rates for each country's currency is fixed
  2. Gold is to move freely between countries
  3. Money supply in each country is tied to the movement of gold, it goes up when gold moves in and down when gold moves out
  4. Labor wages in each country are flexible
Hume continued:
"Suppose four-fifths of all the money in GREAT BRITAIN to be annihilated in one night, and the nation reduced to the same condition, with regard to specie, as in the reigns of the HARRYS and EDWARDS, what would be the consequence? Must not the price of all labour and commodities sink in proportion, and every thing be sold as cheap as they were in those ages? What nation could then dispute with us in any foreign market, or pretend to navigate or to sell manufactures at the same price, which to us would afford sufficient profit? In how little time, therefore, must this bring back the money which we had lost, and raise us to the level of all the neighbouring nations? Where, after we have arrived, we immediately lose the advantage of the cheapness of labour and commodities; and the farther flowing in of money is stopped by our fullness and repletion.

Again, suppose, that all the money of GREAT BRITAIN were multiplied fivefold in a night, must not the contrary effect follow? Must not all labour and commodities rise to such an exorbitant height, that no neighbouring nations could afford to buy from us; while their commodities, on the other hand, became comparatively so cheap, that, in spite of all the laws which could be formed, they would be run in upon us, and our money flow out; till we fall to a level with foreigners, and lose that great superiority of riches, which had laid us under such disadvantages?"
I think you get the concept. Each country would still use its own commodity money backed by gold, but at that fixed rate of exchange. The dollar was 1/20th of an ounce of gold. The British pound sterling was, thanks to Newton's precision, around but not quite 1/4 of an ounce.

The classical gold standard was basically a check on inflation, a way to make sure governments don't just print money willy-nilly. No wonder economists invented it - it gave them power.

The more gold and therefore the more money supply a country had, the lower interest rates would be, initially anyway - too much money chasing too few borrowers. This would stimulate domestic demand, entrepreneurs would borrow money and build factories, wages would go up, and consumers would borrow money against their future wages and spend it. Inflation coming?

So if a country had lots of gold and over stimulated the economy and its consumers had lots of money to spend, it would then import more than it exported. This country would then have to ship gold out to make up the difference. Inflation and gold leaving the country would drive up interest rates and slow down borrowing and spending, until gold stopped flowing out. Companies would then lower wages, making their products more competitive, so they could export more and have gold flow back into the country and then repeat the process all over again.

It's one of those brilliant concepts that works perfectly in a vacuum, but breaks down in real life. The problem with the classical gold standard is that the whole concept was based on the competitiveness of workers' wages. When some rich flaneurs (idlers, slackers) in France began buying too many British pots and suits, and the gold flowed out of France, all the lower class French workers had to take a pay cut or get laid off. That wasn't what they'd signed up for. No one puts up with a cut in wages without a fight. "But gold is flowing out" is a little tough to explain to the common worker. So they revolted and formed unions. Marxism, socialism and anti-productivity political regimes would soon flourish. All for some shiny metal.

The wrong thing was held constant. If wages had been held relatively constant and the exchange rate of money into gold allowed to float (like today), then workers would not have been as disaffected. In an uncompetitive country, instead of wages going down, the value of the currency would drop, import prices rise, and the blame laid on the foreigners for increasing prices. The flip side would have worked well for England. With a rising currency from a floating exchange rate, products like textiles would have gotten cheaper in both England and foreign markets, but not quite as cheap. So what? The market would still grow. National wealth would be created from a rising currency and money supply could grow at its natural Real Bills rate, rather than be affected by too much gold.

Rather than lowering wages and disenfranchising their customers, the British should have been working on ways to increase the wealth of all these other countries, because they were the end markets for the goods. And the more gold they collected, the smaller the markets became for their products. Pretty stupid.

* * *

The classical gold standard makes sense for a static world, one in which England trades lumber to France for wheat. It completely breaks down when industrial output is elastic. When the cost of iron goods and pottery and cloth and clothing is on a downward curve, making it more affordable for the masses and increasing the standard of living for everyone, it makes no sense to cut back production because you are TOO successful and gold flows into England. If England can offer a product cheaper than someone else can make it, then England ought to be able to sell as many as it possibly can.

The buyer will figure out a way to pay for it, almost by definition. If, because of volume production, England can sell a shirt for $5 that costs $15 for others to make, then buyers will line up around the block because they will save $10 for each and every shirt they buy. In fact, if you sold it for $14, you would do OK, but if you sold it for $5, you might sell a lot more shirts. That's what economists call elasticity.

They might even buy three shirts for every one that they used to buy. Either way, the buyer substitutes your cheaper shirt for the more expensive one, and has money to spend on something else. The old shirt maker will have to find something else to do, but so what, his shirts are uncompetitive. But not because wages are too high, but because of the huge gap between hand made and factory produced.

The classical gold standard fixed the wrong problem. Success from selling $15 shirts for $5 meant gold moved into England, increasing money supply, and causing inflation. The inevitable increased wages theorized by the classical gold standard would make England's goods less competitive, until gold flowed out and trade was balanced. But that would in no way close the gap between the $15 handmade shirt and the $5 power-loomed shirt. But why penalize progress? In the end, France and Germany industrialized and killed off their own cottage industry anyway. And closed the gap. Price gaps are to be exploited, not closed, but all the classical gold standard could do was level the field.

The reason to spend so much thought on the gold standard and its holding back of money supply is that elasticity renders a gold standard useless. In fact, a gold standard becomes dangerous as it distorts the real market for products and holds back increases in living standards in two ways: 1) It hurts shirt producers by decreasing the available market for the $5 shirt seller, and 2) It hurts buyers as they must pay more to the old $15 shirt maker, rather than buy the cheaper shirts and spend money on something else.

To be fair, England did have a problem. Bankers did lend out too much money in good times. It was profitable to do so and impossible to stop them. Regulation might have helped, but I doubt it. The Bank of England in 1870 and beyond needed a way to track money supply in the country, and make sure it didn't expand beyond a Real Bill-like pace. There were no computers to track such things, instead just those Dickensian men in visors and green eyeshades at the banks. It was trial and error. The information just wasn't available to determine an overheated inflationary economy until it was too late, so the classical gold standard was the less than ideal but workable solution.

Between 1865 and 1912, it is estimated that the capital markets in London raised 6 billion pounds. Of that total, 4 billion was invested outside of England, in "bond-based infrastructure ventures, such as Railways." Hmmm. By 1865, England no longer had any decent investments at home? Perhaps not - the industrial revolution had played out. Capital, backed of course by that accumulated gold, flowed out to lend money to American railroads. The echo from the South Sea still kept the Brits risk averse.

Trade in technology today is not much different than it was in British textiles. As long as microprocessors and digital electronics get cheaper, it is a win-win for the producers and the consumers, as the cheaper functionality replaces something else. But as we saw with the British, how you get paid can help or hurt the creation of wealth and increase in living standards. Today, money sloshes around, but back in the 18th century money was a fairly local instrument. Precious metals such as gold and silver were the de facto currency for trade. But monarchies and their governments created their own currency, backed by gold. First as a convenience since a titan of industry would need wheelbarrows filled with gold to do his business, and then as a tool to control the economy. Today, the world doesn't think about gold much, except around birthdays and anniversaries.

* * *

The British pound's convertibility to gold, predictably, was suspended during World War I. It took another seven years to get back on the gold standard. A guy named Churchill put England back on the gold in 1925, at the pre-War exchange rate. Heck, it was still Isaac Newton's rate. Big mistake. It overpriced the pound, which got dumped, and gold quickly flowed out of the country. Banks had restricted money supply and England went into a nasty recession, a loud advertisement for floating exchange rates.

By 1928, the rest of the world went back on the gold standard, but not for long. Following the 1929 stock market crash, 1930 saw the introduction of the protectionist Corn Law-esque "Smoot-Hawley" tariffs (some say the market predicted the tariffs, which were debated in 1929.) Trade dried up as most other countries put up protective trade tariffs and increased taxes to make up for lost duties. A recession began in the U.S. and elsewhere, and the Federal Reserve, formed in 1912 to act as the central bank for U.S. currency, in effect mimicked the Bank of England. The Fed forgot, or didn't know, that in a fractional reserve banking system, it was the lender of last resort, a concept that Brit Walter Bagehot had brought up years before.

In February 1930, it did cut the rate it would lend money from 6 to 4 percent. It also did expand money supply to a small extent. But the Fed chairman insisted that the situation would work itself out. That year saw the first wave of bank failures and each time a bank failed and deposits lost, the money supply was shrunk by that amount. By 1932, some 40 percent of all banks - roughly 10,000 of them, and $2 billion in deposits disappeared. The money supply dropped by over 30 percent. So did the gross national product, and just like that, 13 million people were out of work. If the Fed had just provided money as lender of last resort, most of the carnage might have been avoided. But no, the U.S. was back on the gold standard and not allowed to increase the money supply, lest gold leave the country.

Herbert Hoover vacuumed up whatever capital was left by increasing the top tax rate from 25 to 60 percent. In response, Franklin Roosevelt campaigned with "I pledge you, I pledge myself, to a new deal for the American people."

In March 1933, just after FDR's inauguration, unemployment hit 25 percent. After yet another bank run Roosevelt declared an 8-day banking holiday after which confidence in banks returned and deposits flowed back in. Later in 1933, the U.S. dropped the gold standard, following England, which dropped it in 1931. Unshackled, money supply could now increase and replenish banks. After a yearlong recession in 1938, New Deal spending kick-started the economy. A world war kept it going.

* * *

Meanwhile, the Germans were stuck paying WW I reparations. In 1921, the victors presented a bill for 132 billion gold marks. With a crippled industrial base and dependency on imports for raw materials, the Germans were forced to print money to pay back debts. The mark was devalued by a factor of 481 billion. By November of 1923, the exchange rate was 4.2 trillion marks to the dollar. While the resulting hyperinflation left Germany without debts (and debtors learned a lesson to carry debt in dollars!), it wiped out the country's savings and put the German economy into a severe depression, leaving the country susceptible to new political regimes.

On July 1, 1944, just 24 days after D-Day and well before World War II ended, a dollar standard was put in place, called the Bretton Woods agreement. It was considered a gold standard, but even economist John Maynard Keynes called it "the exact opposite of the gold standard." The U.S. dollar was pegged to gold at $35 per ounce, and became the only currency allowed to convert into gold. The rest of the world's currencies were pegged to the dollar at a "sort of" fixed rate. "Sort of" because the rate was fixed and stable until there was some trade problem, and then the currency would be quickly revalued to a new official/stable exchange rate. Stable and floating - quite the paradox. Banking continued as England or France would hold dollars, and lend against them as reserves.

The problem was the dollar itself. The Vietnam War and LBJ's Great Society welfare program helped create inflation in the U.S. Like the bank runs in England from having too much gold, and with inflation devaluing money, so too the U.S. had a run on the bank. In 1963, gold reserves in the U.S. were less than foreign liabilities - by 1971, they were barely 20% of the amount needed to cover liabilities. The run started as dollars were dumped, and despite efforts to kill inflation and shore up the dollar, Nixon halted convertibility on August 15, 1971. Finally, elasticity could run free of the restraints of gold. Mark this, then, as the birthday of the modern world.

With flexible exchange rates and relatively free trade in post-WWII (and to be fair, post the Bretton Woods gold standard), low margin tasks and low paying jobs moved out of the U.S. Displaced workers and union rhetoric screamed for something to be done about "lost jobs" but it probably was the best thing to happen to the U.S. since it allowed for high wages in the U.S. for high margin tasks. The stock market rewards high margin companies with high values, lowering their cost of capital. They can sell fewer and fewer shares to raise money instead of borrowing money from banks. High wages are taxed, to pay for social services, not the least of which is a military to protect the U.S. AND its trading partners.

Gold just gets in the way of the flow of funds.

You see, a new twist has been added to this system. Since the birth of the personal computer and the horizontalization of the industry, companies could focus on thin slices of intellectual property, which could have very, very high margins. Software, microprocessor architectures, semiconductors, network architectures, optical components, cell phone components, and databases are all pieces of intellectual property that could be licensed to others to build end products.

In fact, the U.S. is a huge exporter of these pieces of intellectual property, although these exports are hard to measure. Often, an entire architecture of a chip, valued at a billion dollars, can be emailed to a factory in Taiwan, without a cash register ringing or a commerce department employee around to measure the export. That chip and other intellectual property are then combined, using low cost labor with other low margin components, like a power supply and some plastic and turned into a laptop or DVD player. Oddly, this "margin surplus" run by the U.S. is the way to run an economy with declining price products. Gold won't help. Instead, it requires a stock market to balance out world trade. Fortunately, we've got one of those! The money that leaves the country to buy those laptops and BMWs and Sony TVs comes back and invests in our high margin companies.

So after all that, what I am trying to say about gold? The British had no choice. They and the rest of the world needed a "hard currency" - something rare like gold as a baseline to base their own paper currency on. The Brits were certainly not going to take French or German paper currency and trust them not to devalue it by just printing more of it. So gold was necessary.

Fine. But the classical gold standard was a huge mistake. They held the wrong thing constant. Wages were never going to go down without more than a few pissed off laborers. It was currency rates that should have floated instead of wages and domestic prices. But that would have required rooms filled with computers, human or electronic, neither of which really existed in great numbers.

But they do now!

Currency rates do float. And there are 100,000 or more computer screens on Wall Street and around the world armed by bond and currency traders that keep countries honest. Countries caught cheating see their currencies plummet, their interest rates pop and their economies slow. It is a tightly wound system.

But banks are still a problem. They profit from lending, but there is no decent mechanism to keep them from overlending. Banks are as dead as gold. Neither is any good anymore at allocating capital. Stock markets, on the other hand, are quite good at providing access to capital for great companies and starving those that have dim prospects. Banks still loan to son-in-laws!

Ask the Japanese still burdened by non-performing loans. Some argue that half of Chinese bank loans are non-performing. We don't have to ship gold around anymore, yet gold is still considered a currency in modern international commerce. Gold is no longer the reserve of central banks, it is dollars.

And these export economies have too much dollars. They have to give it back to us (investing in our high margin companies via the stock market) else they over lend. I know it sounds crazy, but it's the new classical "insert your species" standard. When things heat up at home, you've got to ship out your species, in this case dollars, and they are all going to naturally flow back into the U.S. The Japanese periodically intervene and ship dollars back here to keep the yen down. The Chinese have a peg, so excess dollars go to banks, with awful results. The Europeans are just figuring out that $1.30 to the yen doesn't do them any good, and they need to start intervening to get the euro down. This is the new economy, gold doesn't flow, but dollars need to, in order to keep them away from dumb bankers. On the margin, it will invest in high margin companies in the U.S., that is our margin surplus. And I'd like to get in the way of that flow!


A Few More Thoughts from John

Normally I do not comment on Outside the Box essays. But I think a little exception is due here. As I stated at the beginning of last week's letter, part one of Kessler's look at gold, I do not buy all of his arguments and I know many of my bullish gold friends will agree with him even less. I hope to have another essay which disagrees with his view at some point in the future

While Andy makes some points I still see gold as a neutral currency. It is the one currency that governments cannot create out of thin air. In essence, when you own gold you are creating your own gold standard. Gold does have a place as an investment in certain market conditions even if there is no "de facto" gold standard. As long as the dollar continues to weaken, which I believe it will, gold will do well. I should note that at some point in the future, I will be less enthusiastic about gold, because the dollar will find a bottom. But we are not close to that point yet.

Whether you agree with Andy or not, I hope that it has helped you think "Outside the Box."

Your watching gold go up analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 11-16-2004 4:05 AM by John Mauldin