By Alex Stanczyk, Chief Market Strategist and Founder, The Precious Metals Fund – LFP Prime SICAV SIF
A speech delivered at the 5th Annual Conference on Analysis of International Financial Markets, Beijing China Jan. 7th, 2012
Ni hao, it is an honor for me to speak to you today.
Briefly about myself, I am not a formally trained economist, rather as a young man I spent some years in the US Military serving in both the US Navy as well as the US Army, with several years of combat experience in the deserts of the Middle East. Because of this, I tend to view things plainly, and I will speak plainly to you today.
I am going to talk to you today about gold’s potential role in the future economy, more precisely the monetary system. I realize this is a topic that has been hotly debated for decades by people who are probably much smarter than me. I am not going to try and make an argument that we should be on a gold standard nor a paper standard. I would like to simply point out that gold may matter as we move forward, and for an entirely different reason than use as daily money.
I intend to share with you a series of observations and encourage you to form your own conclusions on this matter.
Three thousand years ago the Chinese were weaving silk, carving jade, casting bronze, and producing other alloys; creating sophisticated pottery, growing wheat, millet, and rice, and recording events in a written language of thousands of characters.
The crossbow, used in Europe in the Middle Ages, was invented in China some fifteen centuries earlier. A thousand years before the English Industrial Revolution, China had advanced coke ovens and steel blast furnaces. The Chinese also invented paper, ink, the printing press, the clock, and suspension bridges. I could go on with other Chinese achievements.
Chinese science, which was passed on to Europe in waves, has laid the foundation for much of the innovation of the modern world. The Chinese were also ahead of the west in the use of paper currency. Some of the first recorded examples of paper money date back to the Song Dynasty in China in the 7th century AD, almost a thousand years before the west figured this out.
Whether your view is for a gold standard or for paper, I think it is fair to say that we all agree a key criterion to the acceptance of anything as currency is a matter of confidence. It is confidence in currency, or rather in the government if you are dealing in paper currency, that I would like to address with you today.
As many of you are well aware, the US Dollar is the reserve currency of the world. To understand why the dollar fills this role, we have to go back in history a bit.
After World War II, the United States held over 20,000 tons of gold in its reserves much of it having come from Europe to pay for war supplies and arms. The world was in desperate need of rebuilding, and there was a general agreement that what was needed was a stable reserve currency.
This was the environment that gave birth to the Bretton Woods Agreement of 1944. Under this agreement, the United States guaranteed that the US Dollar, which would be used to settle international trade, would be redeemable for gold at the fixed price of $35 per ounce.
This was acceptable to the nations of the world, because at the time the US held over 80% of above-ground officially-held gold reserves. In effect, the dollar was as “Good as Gold.” It is important to note that gold was one of the primary factors in the psychological foundation behind the confidence of the dollar playing this role, not just because of confidence in the US Government, or the US Economy.
It was assumed that a currency which is redeemable to physical gold would act as a means of discipline to prevent governments from irresponsible printing of paper currency.
The failure of the Bretton Woods system may not have been so much that the USD was exchangeable for gold, but rather that there was no limit under Bretton Woods as to how much paper dollars the US could create. This clearly offered no such monetary discipline or restraint.
Over time, this had the important effect of eroding confidence in the dollar and led to a slow bleeding of the US Gold reserves as countries continually exchanged their devaluing US dollars for gold. This culminated in 1971 when US President Nixon “closed the gold window” and ended convertibility of dollars into gold.
There are two important points to take away from this. The primary reason that the US Dollar was acceptable to the world as the reserve currency is because:
1) the US held more gold than any other nation and
2) that gave the world confidence and the US dollar credibility
Ever since 1971 the entire world has been functioning on a monetary system that is derived solely upon the “Full Faith and Credit” of the United States. This last part is what may be of concern, as it is clear that by any reasonable standards, the US creditworthiness is in a horrible position due to the current debt structure and lack of GDP growth. This is before we consider possible additional bailouts and quantitative easing moving forward.
It has been pointed out that the US has been in a worse Debt-to-GDP situation before and was able to simply raise taxes in order to pay this debt. I would remind you that the environment then versus now was very different. The American baby boomer generation, often accredited as being the “greatest American generation” in terms of productiveness, provided a substantial number of workers to pay off the debt.
The amount of debt held by the baby boomers was much smaller than consumers today. Many of these boomers today are retiring, or attempting to retire, today with fewer workers to replace them while at the same time pay for social programs that are many times the size they were at the end of the war.
Add to this a current environment of declining cheap oil production, the pressures of inflation on food prices and other necessary goods required for basic survival, a declining standard of living in the west, and you have an environment where the newer generation that is inheriting this mess may not be so willing to sacrifice everything for a fiscally irresponsible government that no longer holds their unwavering loyalty.
These factors of demographics, energy trends, and inflation of basic goods are not just affecting the United States but also many nations globally. When you view the ability to repay the debt of not only the USA but also the Euro nations with these factors in mind, the likelihood of sovereign default or a change of the global monetary system seems much more likely.
We have seen five consecutive generations of Federal Reserve Chairmen with a specific policy of making it appear that gold’s role in the global monetary system has come to an end. I have with me a declassified letter written on June 3rd of 1975 by Federal Reserve Chairman Arthur F. Burns addressed to US President Gerald Ford.
In this letter Mr. Burns quotes an IMF communiqué that states, “Freedom for national monetary authorities to enter into gold transactions should ensure that the role of gold in the international monetary system would be gradually reduced.”
I think these gentlemen may have gotten their wish since gold is no longer taught in American universities. Anyone who really knows anything about gold is either very old or self taught. They have been so successful in erasing gold from public consciousness that out of every single exam one could take in the United States for any form of financial license, you will not find a single question about gold. It is my understanding that Chinese economics students often attend the very same universities.
The letter from Mr. Burns to President Ford goes on to say in clear terms that the US Federal Reserve views gold as a critical component of controlling the global monetary system and that losing control of it, and I quote, “…may well determine the shape of the world’s monetary arrangements…over the next generation.”
The view of the Federal Reserve at the time was that countries must be limited to how much gold they can own, and that the US should not agree to anything regarding gold that did not include these limitations.
From another section of the letter: “Freedom for governments to trade in gold at a market-related price may easily frustrate efforts to control world liquidity.” This letter was copied to Secretary Kissinger and future Federal Reserve Chairman Alan Greenspan who is the mentor of the current Federal Reserve Chairman, Mr. Ben Bernanke.
Regardless of what Western Central Banks might say, however, I think it might be wise to consider the old saying, “Actions speak louder than words.”
I ask the simple question, if it were true that gold is in fact not important to the monetary system, why then has the USA not sold any serious amount of gold in close to 40 years? For our proof we need look no further than the Central Banks themselves, as they do not hold copper, cotton, or coffee. They hold gold.
At the recent 6th Annual China Gold and Precious Metals Summit here in China, it was mentioned that at one point in recent history there was a US Presidential campaign in which a gold standard had become a platform issue. The gentleman who came up with the idea said that all he needed to do was restore confidence in the dollar. There is that confidence word again. It is interesting to me that the gentleman chose to use gold as the tool to do it.
When the IMF was originally formed, it required both credibility and the ability to provide temporary credit to handle balance of payments for nations that found themselves unable to do so. Interestingly, the IMF was formed by voting member nations all contributing quantities of gold. Once again, gold was used as a tool to provide credibility and confidence.
Tom Kendall, who is Head of Precious Metals Research for Credit Suisse recently stated it well when he said, “We have a bear market in trust, and a bull market in gold.” It seems that when confidence is lost in government, confidence naturally grows in gold. Recently, hedge fund managers in Europe have suggested that gold be used to back a Eurobond as a potential solution for the Euro debt crisis. Again, we see gold being suggested as a solution to a problem of confidence.
In a recent interview, however, when asked about mobilizing some of Germany’s gold reserves as part of a European Debt Crisis solution, German Economic Minister Philipp Roesler said that Germany’s gold reserves with the central bank cannot be touched. It is becoming more clear from day to day how important gold may truly be as the new monetary order is determined.
I would suggest that perhaps the reason Western Central Banks hold gold is because they know that if there is a critical loss of confidence in government, gold can always be used as a backstop to restore confidence in a nation’s currency.
That said, if we look at gold as a percentage of reserves, western nations tend to hold substantially higher amounts of gold than Asian countries, especially China. For example, according to the IMF’s July data, the US holds 74.7% of its foreign reserves in gold, Germany holds 71.7%, Italy holds 71.4%, France 66.1%. Taiwan holds only 5% of its reserves in gold, and China, assuming that the IMF figures are correct, holds only 1.6% of its foreign reserves in gold.
According to Mr. David Gornall, Chairman of the London Bullion Market Association, there are talks underway in consideration of a new super currency that may include gold in some way.
If we look at this particularly from a strategic perspective, should a new monetary system have a gold component as a means of providing confidence, the US holds over 8,100 tons of gold, the Euro Zone owns another 10,000 tons, and the IMF owns another 2800 tons. This is over 20,000 tons of gold when combined, a number close to what was held by the USA when the US Dollar was made the world reserve currency by international agreement.
This also does not take into consideration the over 1000 tons of gold held by the popular gold ETF GLD, which, according to its prospectus could be annulled by a simple statement from the US CFTC or other US government body, whose shareholders could then be paid off in dollars printed by the US Government.
If the old saying of "He who owns the gold makes the rules" is true, then this may go a ways to explain why the west is in control of the global monetary system.
To use an analogy from Wei Qi, it may appear that the west has indeed encircled China when it comes to control of gold reserves.
This may in fact be the Achilles heel of the Chinese financial strategic situation, as despite China’s incredible success in many areas, it still has 19,000 tons less gold than the west.
If gold is so unimportant, why then does the US hold over 8000 tons of it as well as thousands of tons more of other countries’ gold AND have its own gold guarded at the two military installations of West Point and Fort Knox? Six thousand tons of central bank gold from the world's nations is held in New York with the NY Federal Reserve as its custodian, and yet the US gold's custodian is arguably the most powerful military force in the world - the US Army. If actions speak louder than words, what do you think this is saying?
Back in 2008 I wrote an article in which I said that any country that chose to back its currency with gold may find its currency in high demand as a safe haven. I am sure that at the time there were a few laughs to be had by financial academics at my expense. However, shortly thereafter, the market crashed.
On March 17th and 18th of 2009, the Secretary of Defense and the APL Warfare Analysis Laboratory hosted the first ever Financial War Games in the United States designed to determine how financial instruments might be used in a non-kinetic war. During these war games the specific scenario of a gold-backed currency was introduced as a potential method of financial warfare versus the United States.
Again I suggest that perhaps we should “watch what they do, not what they say.” If a gold-backed currency is considered by US Defense Department Advisors as a legitimate scenario in today’s economic environment, perhaps gold isn’t just another commodity after all.
If China had a gold reserve that was a larger portion of its foreign exchange reserve, it might provide additional credibility for China to play a larger role in the next global currency system.
Should China choose to significantly increase its gold reserves, this could have an important impact on both the price as well as the significance of gold in the future monetary system. To give you an example of what that might look like, if we use a rough number of approximately $2 Trillion USD of foreign reserves, if China wanted to achieve a 50% of reserves level in gold, then at today’s prices, China would have to buy 19,230 tons of gold. For a 25% of reserves level, China would have to buy 9,615 tons.
There are many who are quick to point out that the gold markets are not particularly “deep” when it comes to absorbing a trillion USD. While I agree with this point, I also think this could still happen under the right conditions. For example, if gold were $5000 per ounce, China would only have to add another 5000 tons or so to reach a roughly 50% reserve of gold. If you add together China’s annual mine production of approximately 350 tons per year, ongoing buying of gold by SAFE of another 100 or so tons per year, then just add a bit more (perhaps gold that is repatriated to China from its many mineral properties around the world), then China could reasonably achieve these goals within a 7 to 10 year time frame.
In closing, I would briefly speak on our views in regards to the future price of gold. Over the short term I will leave to the technicians, however over the long term several things appear clear.
I will use a story from the last gold conference here in china to elaborate. At this conference there was a panel discussion tasked with the purpose of determining whether it was likely we would see continued quantitative easing in the USA. The panel consisted of what was considered the most qualified experts present on the matter, mostly hailing from well recognized western banks.
The panel started out by asking the audience if there were any questions. After a pregnant silence in which no one seemed willing to breach the subject, I of course put my hand up. I asked the panel in quite simple and non complicated language "do you gentleman see any resolution to the structural debt problems of the USA and Europe that does not involve printing a whole lot more money?" the immediate response was a few nervous laughs, and what then ensued was an almost 40 minute discussion of how complicated the situation was, with each panelist ultimately saying in a very round about and educated sounding fashion that yes, there would probably be more quantitative easing.
In short, at the end of the 40 minute illuminated panel of fancy words and economic theory, that yes, there would be a whole lot more printing. This in one of the fundamental points our team has looked at when it comes to the likelihood of long term increases in the price of gold.
Gold price is little more than a measurement of confidence in government and the rate of devaluation of paper currencies. While confidence may be high in the Chinese government among its people right now, the same may not be said for governments of the west. Should confidence in western governments continue to deteriorate, and as long as the money printing continues, indeed accelerates, it is our view that the gold price as well as the price of basic goods globally will likely continue to rise.
I thank you for the great honor of speaking to you today.
©2011 Alex Stanczyk
