Money, Gold, Capital Controls and Your Future

Eternal truths about the outlook for gold and mining stocks...

MONEY, in whatever form it is held, has uses, writes Tim Price at Price Value Partners.

Traditional economists assign money three characteristics.

• Money is a unit of account – we can price things with it;
• It is a medium of exchange – we can use it as a helpful replacement to the barter system, exchanging one good for another;
• And it is a store of value – it retains its purchasing power over time.

Our modern electronic money still retains the first two characteristics. But as for the third!

Since the establishment of the Federal Reserve in 1913, the US Dollar, for example, has lost roughly 98% of its purchasing power. The Pound Sterling has fared no better. Indeed every unbacked paper currency in history has ultimately failed. The Dollar will be no different. It is only a question of time.

Gold and silver developed as money in a free market. Throughout human history we have used all kinds of things as money – cattle, shells, nails, tobacco, cotton, even giant stone slabs. But gold and silver always won out over the competition.

People tended over time to favour the precious metals as money because of their scarcity, durability, malleability and beauty. Their use arose without coercion. Gold is the money of freedom. Gold is also scarce. And it is horribly expensive, in both capital and human terms, to dig out of the earth and process.

To produce one ounce of fine gold requires 38 man hours, 1,400 gallons of water, enough electricity to run a large house for ten days, up to 565 cubic feet of air under straining pressure, and quantities of chemicals including cyanide, acids, lead, borax and lime. But once produced, being chemically inert, gold lasts.

Peter L. Bernstein (in his somewhat sceptical treatise 'The Power of Gold: The History of an Obsession') points out that you can find a tooth bridge made of gold for an Egyptian 4,500 years ago. Its condition is good enough that you could pop it into your mouth today.

And it is wonderfully malleable. If you have just an ounce of gold, you can beat it into a sheet covering one hundred square feet. Or if you prefer, you could draw it into a wire 50 miles in length.

Clearly, gold is also a thing of beauty. "Oh, most excellent gold!" said Columbus on his first voyage to America. "Who has gold has a treasure [that] even helps souls to paradise."

But gold is heavy, dense and impractical to carry around. So using paper certificates to represent gold held safely in reserve was a logical next step. The problem arose when greedy bankers realised that they could print more certificates than they had gold in reserve to back them.

The language associated with gold is invariably derogatory today. Those of us who see any role for gold in the modern world are dismissed as gold bugs. Our response is to label those sceptics paper bugs: they have to believe that unbacked fiat money will last. History, however, is on our side.

In recent monetary history 1971 amounts to Year Zero for gold, because that is when President Nixon finally took the US Dollar off the gold standard. This has led to a 50-year-plus experiment in money that remains unprecedented. When Robert Mundell was made a Nobel Laureate in Economics in 1999, he pointed out that the "absence of gold as an intrinsic part of our monetary system today makes our century, the one that has just passed, unique in several thousand years."

Robert Mundell could see the way the world was going. In March 1997, two years before receiving his Laureate, Mundell would remark, ominously, "Gold will be part of the international monetary system in the twenty-first century." The author Nathan Lewis agrees. The title of his 2007 book on the subject? 'Gold: The Once and Future Money.'

Government debts throughout the world are simply too high – perhaps so high that it is now impossible to reconcile them. As gold investor Egon von Greyerz puts it:

"In 1971, Nixon, by closing the Gold window, started the most spectacular bonfire of the US government budget books. How wonderful, no more accountability, no more shackles and no more gold deliveries to de Gaulle in France who was clever to ask for gold instead of Dollars in debt settlement from the US. So from August 1971, the US embarked on a money printing and credit expansion bonanza never seen before in history. Total US debt went from $2 trillion in 1971 to $200 trillion today – up 100X! So we are getting very close to the end of the current monetary system which will die just like they all have throughout history. GOT GOLD?"

Strategist Russell Napier:

"If central bankers' manipulation of prices fails to generate strong private demand and inflation, then the necessary debt to GDP reduction must come in highly destructive ways for the owners of capital. Society will have to choose between austerity, default, or the creation of a government demand-driven reflation. These are the only three options if central bankers fail to boost growth and also inflation. Austerity would bring depression; default would bring bankruptcy, and a government demand-driven reflation would bring some degree of suspension of the market economy. These are painful and difficult choices if central banks fail. [I] believe that society will most likely choose the apparently least painful route and thus we now face a massive structural shift away from a market-orientated economic system."

In short, Napier predicts the reintroduction of capital controls, as governments simply elect to replace the central banks in the cause of stimulating inflation. The reintroduction of capital controls (last seen in the UK, for example, in 1979, after which the newly elected Prime Minister Margaret Thatcher wisely and boldly abandoned them) would be a terrible metastasis of the financial crisis.

Russell Napier again:

"There are many who see the above scenario as 'the end of the world' but of course it isn't. For the man in the street it involves another economic shock but then a 'democratic' reflation without the assistance of the discredited [central] bankers. The cycle that results will be full of growth and mainly inflation. It would reduce the debt burdens of many and feel a lot better than the deflation wrought by market forces. The inevitable massive capital misallocation that results from any government-driven investment cycle would take many years to become evident and produce negative impacts. This will not seem like the end of the world for most people. However for the stewards of private sector capital there will be little to do in such a world of mandated prices and conscripted capital."

If you're unfamiliar with precisely what 'capital controls' might be, they could plausibly include taxes, tariffs, outright legislation and restrictions on trade. Capital controls could be imposed across equities, bonds and the foreign exchange markets. Let us consider for a moment the implications of Russell's warning.

"A shift to the conscription of capital by government to force a government-led investment cycle would be very positive for gold. Gold, the form of capital that is easiest to move without trace, is the most difficult form of capital for governments to conscript. Those qualities will produce many buyers as the nature of the authorities' response to our deflationary bust become ever more apparent. So how do we weigh up the negative impacts for gold of a rising US Dollar and rising real interest rates with the positives associated with increased government intervention in markets? We wait for the gold price to rise even as the US Dollar is rising. That should provide sufficient evidence that the threat of a government-instigated reflation is more than offsetting the negatives associated with the current deflation. Should that reflation succeed, then gold would likely be a major beneficiary as positive real rates of interest would turn into negative real rates that would be sustained by financial repression for perhaps a few decades."

We note, in passing, that gold is now trading at new nominal highs even in US Dollar terms.

We would argue that central bank monetary policy in terms of the fight against inflation has failed ever since the height of the Global Financial Crisis. In terms of economic growth, the central banks' efforts at providing recovery have come to naught. If Russell Napier's analysis is right, governments will soon take over, and the money printing will then resume in earnest. In such an environment, gold, being a finite and precious commodity that is also no-one's liability, is in prime position to enter a sustained bull market. We believe Napier is right.

Why own gold? Because it makes sense, within a properly diversified portfolio, to have portfolio insurance. If you inhabit a home, it makes sense to have home insurance. Your investments are no different. In a world of paper assets (like certificates of deposit or corporate or government bonds), some of gold's attributes are unique. When it comes to credit and counterparty risk, gold comes with neither. Gold does not rely for its value on the solvency of some third party. It is not a claim against anything. Which is why gold is the perfect insurance against the failure of conventional money or the default of conventional debt. It is why gold is a more perfect form of money than any government-issued alternative.

How best to describe gold? The investment consultant Andreas Acavalos has provided the best definition we have so far heard:

"Gold is not even an investment. It is a conscious decision to refrain from investing until an honest monetary regime makes the rational calculation of relative asset prices possible."

Our friend Charlie Morris offers a variation on this theme. He compares gold to a conventional bond. He describes gold as a zero coupon, perpetual, irredeemable bond. With no credit risk. With no counterparty risk. Issued by God.

Continuing this theme, one quotation from the world of economics fills us with more concern than any other. It comes from Ludwig von Mises. As someone with first-hand experience of the notorious Weimar-era hyperinflation, von Mises warned:

"The credit expansion boom is built on the sands of banknotes and deposits. It must collapse. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

Our central bankers have made it abundantly dear that the credit expansion must and will continue. If von Mises is correct, then the ultimate resolution of the crisis is also clear: "a final and total catastrophe of the currency system."

Which is why you need to own gold now. You buy fire insurance before your house is already ablaze. It is too expensive, if it is even possible, to buy it once the fire has broken out.

Faith in paper currencies, and in the governments that issue and consistently degrade them, doesn't follow a linear progression. Avalanches don't happen in tidy stages. Snow continues to pile up until the system tips from being stable to unstable, whereupon one random snowflake will cause the entire snow mass to collapse. We just don't know which snowflake it will be. Similarly, we don't know which act of monetary insanity will cause the financial system to implode.

In summary, why gold? Because it's been a store of value for thousands of years. And it represents a form of money with no credit or counterparty risk. Why gold now? Because the risk of a global monetary fiasco rises by the day.

Depending on the extent of one's savings and one's risk appetite, there are three ways of getting exposure to the investment merits (and risks) of gold:

1. Physical metal. This is the purest form of gold ownership, but it involves counterparty risk if held with a third-party custodian.
2. The largest and best capitalised gold mining companies. This offers the potential of higher returns than from the gold price alone given the operational leverage of many gold miners, but it also involves equity market risk.
3. Depending on the size of your wallet and your attitude to risk, there are the junior miners too. In a gold bull market, the returns from owning smaller-cap miners are likely to be higher, but they'll come with additional risk of corporate failure.

Each of the above can also be held in the form of low-cost ETFs (exchange traded funds) or actively managed funds [albeit without any direct ownership, Ed.]. We favour some diversification into mining company stocks because of what has happened in the history of gold.

For example, Executive Order #6102, signed by President Franklin D.Roosevelt on 5 April 1933, made the private ownership of gold illegal in the United States, punishable by a fine of up to $10,000, or up to ten years in prison, or both. Clearly we no longer operate within a gold standard but we'd rather not take any chances – hence the merit of ownership of interests in gold mining concerns as well as the physical asset itself.

If you elect to own gold, you probably want to give some thought to where it's custodied. It makes no sense to own gold within the onshore banking or financial system – where national governments might ultimately start to display distinctly unconventional attitudes to the sanctity of private investors' property. It does make sense to hold gold in safe custody offshore.

Our preferred foreign jurisdictions (from the perspective of a UK-based investor), in no particular order, would include Switzerland, Singapore, Australia and Canada.

If you elect to own gold, ensure that you own allocated gold – that is, gold owned outright by you and held in your name. You don't want exposure to unallocated gold – which is the property of the custodian. That's like being a depositor/unsecured creditor all over again.

There are far too many paper claims on gold and simply not enough of the physical asset to support them. Paul Mylchreest, editor of The Thunder Road Report, a specialist gold publication, wrote some years ago warning of a potential short squeeze in the physical market:

"The next major leg up in the gold price will prove to be a religious experience for those people unfortunate enough to find themselves short."

Another thing to watch out for if you hold gold in the form of a fund is that that gold can't be lent out, or 'rehypothecated'. Again, there are too many people playing too many games in the fractional gold physical market – and there is insufficient supply of the physical asset to support all the contingent claims upon it. You don't want to be caught short as and when the next run to gold begins. (And it probably already has.)

To sum up the argument for gold, we'd like to share some words by an asset manager and friend, Tony Deden, who may have thought about the parlous state of our financial system and its implications more profoundly than anyone else we know:

"Substance is something that is real. It does not necessarily have to be tangible, but that would be preferable. Whether it is in gold – a form of money – or honest entrepreneurship, substance is rooted in economic reality. And so, understanding substance, whether it is in money or in entrepreneurial and wealth-creating activity, is the most important practical skill we must acquire.

"Indeed, the price of gold in money may increase. It may also decrease. When do you sell it? You ought to first decide why you own it. But even then, let me ask: 'What sort of substance will you acquire with the proceeds from the sale?'

"One of the greatest lessons in classical economics is that value is subjective. It is subjective to the aims and criteria and judgment of the person doing the valuing. And frankly, in our dishonest world, such subjective value is the cornerstone to what kind of capital you are likely to command in the future."

We face grave threats and growing uncertainties within the financial markets. Gold doesn't solve all of the world's problems and it would be silly to believe it does. But as an alternative to keeping flawed money in a flawed banking system, it's a useful start.

It's a hedge against both inflation and systemic financial distress. And it's the best performing money in counterparty risk and purchasing power terms that you can own.