Dear Thoughtful Investor,

a series of letters on real estate, finance, and economics

#11 The Alchemists (part 2)

Dear Thoughtful Investor,

The development of gold as money was one of the key developments that allows civilization to emerge from tribal cultures. People can begin to specialize and obtain their needs through money and trade. Gold facilitated the emergence of cultures and kingdoms from agrarian and hunter-gatherer cultures. But is gold still relevant as money today? Or is it just a ‘barbarous relic’? (a common misquote from Keynes) Gold is still quite relevant for today’s complex financial system and although central banks publicly disparage the importance of gold, they all privately acknowledge its critical function — at least implicitly through through their actions. The Fed maintains 8,000 tons of gold on their balance sheet (held by the US Treasury at Fort Knox & West Point). China has been obsessively and secretly buying and mining gold for several years with estimates that they have 3-4000 tons. Russia maintains a significant stock of gold. But again, why is it important to the modern titans of finance and trade to carry a large stock of gold?

In James Rickards, The New Case For Gold, he finds the answer with a quick trip through history and a look into the (not to distant) future. The global monetary system has collapsed three times in the last century: 1914, 1939, and 1971. It almost collapsed in 1998 (with the failure of hedge fund Long Term Capital Management) and 2008 (with the financial crisis ignited by the sub-prime mortgage bubble). The 1914 and 1939 collapses were aligned with world wars and the system was patched back together by the 1944 Bretton Woods agreement which made the US Dollar king by pegging it to gold and then pegging all other currencies to the US Dollar. On August 15th 1971, President Nixon removed the US Dollar / gold peg and initiated the modern monetary era where currencies are in free-float against one another and gold. We’re now 46 years into the free-float-fiat-currency experiment and with the unprecedented central bank activities of the last decade (artificially low rates, massive quantitative easing, forward guidance, et cetera) the experiment is winding down. Through massive interventions that have strained public trust in central banks the powers-that-be have saved the current monetary system twice in the last twenty years. But can they save it a third time? 

A fiat money system (a paper/digital currency system with zero hard asset backing) is based on trust. People around the world are willing to work for wages in dollars and receive payment for goods in dollars (or euros or yen) because they trust that those credits will store their value because the central banks and governments backing them will *do the right thing* to support their value (i.e. They won’t print too much and inflate the currency causing it to be a poor store of value). But when the next financial crisis hits and central banks need to do even more unprecedented activities (like more massive quantitative easing, bank bail-ins, cash freezes, negative nominal interest rates) the public may revolt and refuse to accept dollars/euros/yen. The lack of confidence, once sparked, metastasizes and spreads extremely fast. The only way to restore order to the global monetary system is for all the titans of global trade and GDP to get together with a big meeting and agree to a new set of monetary rules that will restore public confidence. Rickards describes this like a poker game between nations where the amount of chips each country has is based on the amount of gold that country has when the music stopped. This means the United States, Europe, China, and Russia will create the new monetary rules. China has been accumulating gold because it anticipates this collapse and reset and it wants to be ready with a bunch of poker chips so it can be a dominant player in the next century of global monetary power. 

The middle ages of Europe was marked by the alchemists — quasi-chemist/mystics that were trying to figure out how to create gold rather than have to dig it out of the ground. If one could turn plentiful and cheap lead or iron into gold one could become rich - as long as no one else figured out how to do it because then gold would not longer be scare, its real goods and services exchange value would inflate to becoming worthless. In a poetic twist of history, alchemy was actually accomplished through the emergence of fiat currencies in the 20th century and not the chemical re-arrangement of an element or middle ages ‘magic’. Just as the alchemist would need to keep his recipe for turning lead into gold a secret, so central banks and governments have needed to keep the ruse of fiat currency and credit away from public understanding. But after about 104 years its becoming obvious that the “gold” that’s been sold to the public is just a bar of lead with some gold paint on it. 

A new monetary system will emerge out of the next global financial crisis and thoughtful investors would be wise to position themselves to be the winners in the new monetary system just as nations (like China) are positioning themselves to be winners in the next monetary system. As investors, that positioning looks like shifting wealth domiciled in fiat currencies into wealth stored in hard assets - like gold, silver, and real estate and learning as much as possible about the technologies that will be backing the new monetary system (a la blockchain - we’re getting there, I promise).


A Thoughtful Investor

#12 Credibility - the real promise of cryptocurrencies

#10 The Alchemists (part 1)