The political value of gold

Unless Western governments and central banks change their policies,  people may start shifting their trust from fiat money back to gold (Source: dpa).
Unless Western governments and central banks change their policies, people may start shifting their trust from fiat money back to gold (Source: dpa).

People and economies have always needed means of exchange that represent value and set prices, even in a barter economy, writes GIS guest expert Gisela von Liechtenstein.

These means of exchange had to have a trusted value and as economies evolved, precious metals, silver and gold served this purpose. As international trading developed, nations relied on paper money supplied by their governments and central banks that was still backed by silver and gold. This gave value and trust to the currency and forced discipline on the emitting institution.

In the course of the 20th century, the gold standard was abandoned and trust in the resulting fiat money depended on assessments of the underlying economy, political stability and belief that the central bank would protect the value of the currency with responsible monetary policies. This worked in some instances. Germany and its Bundesbank set with the deutsche mark an outstanding example of prudent monetary policy, impervious to pressure from politicians.

Unfortunately, government overspending led to large budget deficits and a fiscal crisis. Allowing economic cycles to run their course is rejected for political reasons, meaning that unsustainable cheap money is often used to ease cyclical lows in the economy. On the whole, the European Central Bank (ECB) has followed the politically expedient approach of southern European countries rather than the discipline that was the bedrock of the old German Bundesbank.

All means of exchange should be constrained in supply in order to retain value. For fiat currencies, the supply limit is no longer restrained. The euro area’s monetary base has increased from approximately 700 billion euros in 2006 to about 1.8 trillion euros in 2016, according to the ECB. This additional money creation, not covered by an economic basis, is worrying.

Gold-backed currencies used to provide a measure of control on monetary aggregates that is lacking today. Without controls on the money supply, confidence in its rarity is being sacrificed along with value. While gold may no longer be a realistic form of currency, it is still a valid medium of exchange with the advantage of holding intrinsic value and being limited in supply.

With individuals being discouraged from acquiring gold, central banks are buying again – especially Russia and China. Increasing gold reserves relative to foreign currency reserves has the advantage of reducing exposure to foreign monetary policies. There are large uncertainties around the quantity of gold the Chinese are acquiring, as the Peoples Bank of China may not be the sole purchaser. The authorities in Beijing can use other entities to buy gold on global markets, while China is also the world leader in gold mining output.

Both China and Russia are seeking to reduce their dependence on the U.S. dollar, especially China, which is striving to establish the renminbi as a global reserve currency. The gold in the vaults of the Russian and Chinese central banks is insufficient to back their currencies. So why are these countries buying? They are probably trying to use gold as a lever to increase confidence in their currencies and make them more independent from U.S. monetary policies and the dollar.

Meanwhile, there is growing awareness that central banks have misused their money creating capacity for political ends. This realization, combined with low interest rates, plunging confidence in traditional currencies and government institutions, and increased gold demand by Eastern central banks, may be contributing to the present rally in gold prices.

Unless Western governments and central banks change their policies, people may start shifting their trust from fiat money back to gold. Precious metals have the advantage of being easily storable, holding intrinsic value, and not being subject to negative interest rates, as is the case with bank deposits. Gold will only become more attractive if governments make progress in their current push to physically abolish cash.

A key concern is that today’s policymakers could abuse their legislative powers to outlaw physical ownership of gold, especially in Europe and the U.S., as a way of extending the control and reach of monetary policy. There are precedents for this, including President Franklin Roosevelt’s executive order in 1933 to outlaw gold currency ownership by individuals. The step would be a logical, if totalitarian, outcome of current monetary policies.

It is just one small step from abolishing cash to outlawing gold ownership.

If the current economic policy direction is maintained, the strength of the U.S. dollar and the euro will wane, people’s trust in gold relative to their own currencies will increase, and certain members of the “dollar bloc” will prepare themselves to stop following the lead of the Federal Reserve and the U.S. currency.

Related statements:

ECB policy has unintended consequences


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