Monetary Mess, the Dollar, Gold—and You, Part VIII (concl.)

(For other parts of this series, click on the 2010 October links in the righthand column.)

Gold has been known and valued since prehistoric times for its natural characteristics. People all over the world have found it appealing. The importance of gold in ancient Egypt thousands of years ago is well known from the tombs of the pharaohs. Thousands of years after the Egyptians began entombing their pharaohs with golden treasures, Cosmas Indicopleustes, a noted Egyptian traveler in the sixth century A.D., wrote: “It is with their gold piece [the bezant of Constantinople] that all nations do trade; it is received everywhere from one end of the earth to the other.”  

China was a poor country for a very long time, right up until it began to veer away from communism and introduce some capitalistic, free market reforms. In only a few short decades it has achieved tremendous economic growth, but the vast majority of its people still live in abject poverty. Yet today, the government admits that private citizens own more than 3,000 tons of gold—about three times the amount the central bank controls. Where did all this gold come from? Only a very small part was acquired in the recent years of economic growth. The rest was accumulated gradually and painstakingly over many centuries, under many different political regimes, by people who saw it not only as beautiful but as an enduring store of value.

The story is much the same in India, where people for many centuries accumulated not only immense quantities of gold jewelry but silver jewelry as well. Farmers traditionally stash their savings in precious metals. Rural buyers usually account for 30-40% of gold purchases every year. India's majority Hindu population regard the Hindu festival of lights (Diwali) as an auspicious time to buy gold. This year the festival will be celebrated on November 5, but the festival season runs from September to late November, or even early December in some states. “Most of the crops would have been harvested by then and they [farmers] would be buying. Typically their reserve money goes into gold,” says Mr. T. Gnansekhar, director of Commtrenz Research. He says this year's bumper crops mean farmers will likely account for around half of the gold purchases of 400-450 tons in India this year. India is the second largest consumer of gold. For many years it held the number one spot, but in the past year it was surpassed by China. Indians traditionally favored gold jewelry, but now they are buying coins, bars and ETFs too. In the second quarter of 2010, India's demand for gold rose 38%, reaching $1.6 billion.

On the other side of the planet, gold was valued by native Americans, especially in Central America, Peru and Columbia. The desire for gold was what prompted the Spanish crown to finance Columbus' voyage with instructions to “Get gold, humanely if possible, but at all costs, get gold.” Reports of profusion of gold ornaments among natives fueled the exploration and conquest of the Aztecs and the Incas by Cortes and Pizzaro.

In some cultures, private gold currencies served as the medium of exchange long before kings and governments got into the act of forcing the populace to accept fiat paper instead. The rulers never comprehended the damage created by their money illusion, which always impoverished the people and devastated the economy. It's happening again today.

In the past, after the damage was done, the people learned the hard lesson and would no longer accept unbacked paper money. Either their government would then turn to a gold-backed currency—as the U.S. did after the Revolutionary War—or some other country would, becoming the dominant monetary power and leading other nations back to gold. For example, in 1252 A.D., after a long period of monetary disarray, the city-state of Florence reintroduced gold coins, florins. Genoa quickly followed, perhaps in the same year. In 1254 Louis IX of France commenced gold coinage. Some thirty years later Venice joined in. In 1328 Germany began minting the Bavarian, which closely imitated the florin. One by one, these and other countries turned to gold when they realized the monetary stability it provided was beneficial to trade and prosperity. It will happen again. The only question is when and how.

The U.S. could return to gold now, while it still has the largest gold holding, with much less pain than after the smash-up occurs, but it won't. The politicians are not about to face up to the fact they have been wrong and have caused the problem. They like being well-paid “public servants” and playing god with the nation's economy and other people's lives and want to continue their (so-far) winning formula for staying in office: promise more benefits from more government spending, and pass more laws so “this will never happen again.” If 2,000-page laws don't work, they will pass 4,000, 8,000 or 20,000-page ones. It doesn't matter. Practically nobody in Congress reads them anyway. And certainly not the president. They couldn't even if they wanted to; the laws are simply too voluminous. Reading them wouldn't do any good anyway because they don't have the answers. All that matters to the politicians is that the laws can be held up to the public as proof the administration is “doing something” about the problems and keeping the benefits coming in return for the public keeping the votes coming.

Thus things will probably have to get much worse before the public wakes up, by which time the pain and cost will be much greater. No one knows when that will happen. But it could happen suddenly, like when a small leak develops in a dike, then erosion gradually increases the flow—and then suddenly the whole structure gives way and a flood ensues. Confidence in the U.S. dollar has been eroding, and the international monetary structure has been greatly weakened. No one knows when the end will come and the flood of dollars will flow into gold, but those with gold are far more likely to emerge better off than those without it. And more and more people are realizing this.

While Americans are preoccupied with paper (laws, regulations, fiat paper money), China has quietly become the world's largest producer of gold as well as the largest consumer. And as its people become more affluent, their appetite for buying gold is increasing. Their opportunities for doing so are also increasing through a new Chinese gold futures exchange, ETFs and even online gold sales. The government, which used to restrict how much gold citizens could own, now encourages gold buying. It runs ads on state television encouraging the rapidly growing middle class to own gold. In the second quarter of 2010, China's demand for gold jumped 187%, to $1.4 billion, second only to India's $1.6 billion.

China's goal to have its central bank accumulate 10,000 metric tons of gold in ten years may seem ambitious, but let's try to put this in perspective. The 2,000 tons owned by the ETFs are worth about $83 billion as of this month. So 10,000 tons should be worth five times that, or $415 billion. But China already has about 1,000 tons, meaning it needs 9,000 to reach its goal. So we subtract $41.5 (half of the $83 billion for 2,000 tons) from $415 billion, leaving $373.5 billion for the remaining 9,000. Of course, as we noted earlier in this series, China is well aware that if it started buying aggressively, it would drive up the price; it certainly could not buy 9,000 tons for $374 billion. But China has $2.45 trillion! If China paid $450 billion for 9,000 tons of gold, it would still have over $2 trillion dollars left, still by far the largest hoard of dollars on the planet. Realistically, it would have to pay far more than $450 billion—which it could well afford to do—if that amount of gold were available. But the world's annual production of gold is only about 2,400 tons. If the central banks are unwilling to sell, where is all the gold China would like to buy going to come from? The IMF does not have enough gold to alter the long-term scenario on more than a temporary basis, even if it decided to sell its entire stock. It is not going to do that since it is unlikely to take an action that would all but guarantee its future existence would be irrelevant. Besides, any sales would have to be approved by the member nations, which is not going to happen.

China could certainly afford to pay a much higher price for gold—certainly much higher than in our example—but no one can say what that might be or how high the price of future available supplies might be. At the same time, however, the value of her remaining dollars would decline drastically, and no one can say how low it might go. China is understandably leery of the outcome of such a trade-off. It would prefer to add to its gold holdings incrementally or off-market without stimulating a buying frenzy in the markets and hope that the dollar does not suffer a sharp fall from U.S. deficits and inflation in the meantime.

China would love to buy gold from the IMF because this is gold that would not be traded in the market, but there are other ways, too, of acquiring off-market gold. China has the world's sixth largest gold mine reserves and is rapidly developing new mines and expanding exploration. Domestic production provides a way for the government to buy gold directly that never reaches the world markets. This year China initiated another way to increase its gold holdings without going into the open market. The state-controlled China National Gold Group Corp., the nation's largest gold company, recently signed a long-term contract to buy gold concentrates from the large Kensington Mine in Alaska.

Even if China acts with restraint on purchasing gold in the open market, worldwide demand for gold is increasing from other sources, as we have pointed out. At some point the flow of money into gold may become a flood that leads China to join the crowd and buy before worldwide demand pushes the price even higher. Meanwhile, the value of China's dollar assets in U.S. treasuries will be declining from Obama's deficit budgets and the Federal Reserve's easy money policies. These will further increase the incentive for China to unload U.S. treasuries. The Chinese government has been extremely patient about giving Obama a chance to demonstrate that his spending policies will stimulate the economy and end the recession. But eventually it will be obvious to everyone that those policies are not working and, in fact, have made the problem worse.

Now, three years after the collapse of the housing/mortgage market, the prospects there are worse than ever. Last month 102,000 homes were foreclosed, the highest total ever. And the owners of 11 million homes owe more than their homes are worth. This problem is not going away and is going to put further strains on the economy and the dollar.

Allan Greenspan made two important points in two very recent interviews: 1) housing prices are right on the edge where a further price decline will create a new huge wave of foreclosures, and 2) interest rates are going to go up substantially as the U.S. need to borrow is bumping up against the limit at which buyers are willing to purchase U.S. treasury securities. As interest rates go up, the value of government bonds goes down. So China will see the value of its massive investment in U.S. treasuries decreasing at a time when the price of gold is increasing, giving further argument for unloading some of its treasuries and further reason not to buy more of them. Remember, too, that China's favorable trade balance, which accounts for its massive $2.45 trillion dollars, is almost certain to continue growing. That country is going to have even more dollars to invest as gold looks more attractive and U.S. treasuries look increasingly unattractive.

Yu Yongding is a member of the state-backed Chinese Academy of Social Sciences and a former advisor to the central bank. In August he wrote, “I do not think U.S. Treasuries are safe in the medium-and-long run.”

Looking ahead, Li-gang Liu, head of China economics at ANZ Bank, said “For the renminbi [also referred to as the yuan] to become a convertible currency, other than credible policies you also need credible gold backing.” 

In the end, gold will win over fiat paper. It always has.

Postscript:  When I began writing this series, China's held $2.4 trillion in foreign exchange reserves.  As I was writing, new figures showed it rose to $2.45 trillion, so I made the revision in my writing.  Now the People's Bank of China has made data available for the third quarter 2010.  The central bank's stash of dollars jumped by $194 billion in the third quarter, resulting in a total of $2.648 trillion as of September 30.  And there is every reason to believe this trend is going to continue.