Gold vs. Fiat Currency: Opportunities and Challenges

Debating the Relevance of Gold in Modern Finance

Economist John Maynard Keynes is often quoted as calling it the “barbarous relic.”

Soviet revolutionary Vladimir Lenin said he would build toilets out of it, as the ultimate symbol of capitalist waste.

More recently, economists have claimed it was “irrelevant,” was “no longer a currency,” and it gave investors “a false sense of security.”

I’m referring, of course, to gold – element #79 on the periodic table (symbol: Au).

For at least 50 centuries, Homo sapiens have used gold as a medium of exchange. It’s easily divisible, transportable, and durable.

Gold is also scarce. If Goldfinger were to come to life and somehow seize all the world’s gold, it would fit into a cube with sides of less than 70 feet each.

Gold’s Rarity and Properties

Scarcity makes gold difficult for governments to debase.

Many have tried, of course, primarily by alloying it with much less valuable metals.

Royal dynasties in Rome, China, France, and England all followed this practice.

The Transition Away from the Gold Standard

Governments achieved the same goal by increasing the quantity of supposedly gold-backed currency in circulation, without increasing gold reserves.

But this policy led to price inflation in the countries that practiced it and eventually forced the US – and effectively, the rest of the world – to gradually abandon the gold standard. Its last vestige was swept away in 1971.

The Rise of Fiat Currency

Since 1971, global central banks have created hundreds of trillions of dollars, yen, euros, and other fiat currencies out of thin air – monetary units backed only by the “good faith” of the issuing government.

Central banks pump these fiat currencies into their respective economies to maintain growth.

Most of this new money has been created since 2008, when the world entered the worst economic downturn since the Great Depression of the 1930s.

Negative Interest Rates and Economic Policies

This hasn’t led to economic growth. So in a sign of increasing desperation, central banks have also imposed negative interest rates.

Negative rates mean lenders literally pay businesses and consumers to borrow money. They also penalize savers for hoarding it.

In theory, that policy should force consumers and businesses to spend their money, rather than save it. That hasn’t happened, so central banks keep pushing rates lower. In Switzerland and Denmark, for instance, the rate the central bank pays on deposits now stands at –1.25%.

The Disconnect Between Gold Prices and Fiat Money Creation

In a world with a gold standard, gold prices would have skyrocketed with all the newly created fiat currency sloshing around in the financial system, not to mention negative interest rates. But while gold prices rose sixfold from 2001 to 2011, over the next four years, they fell more than 40%.

Gold’s price decline wasn’t matched by a decline in central bank money creation. Some experts account for this disconnect by observing that bullion banks – banks that lease bullion from central banks – made massive leveraged bets against gold in futures markets. One development that facilitated this strategy is the appearance of securities whose value is tied to the price of gold, such as SPDR Gold Trust (symbol: GLD).

The Emergence of Paper Gold

GLD and similar securities give investors a convenient way to purchase gold without needing to store it securely. But these securities also give speculators the ability to bet on gold prices without taking physical possession. This led to a massive growth in “paper gold” transactions – metal that effectively exists only in cyberspace.

In September 2015, the Chicago Mercantile Exchange (CME) revealed that the ratio of paper gold to gold that could actually be delivered had spiked to 200:1.

This strategy also served the interests of central banks and governments. With gold prices stagnating or worse, investors who might have wanted to purchase gold as a hedge against a currency collapse or negative interest rates would instead purchase government bonds, stocks, or other paper assets.

That strategy stopped working in 2016. In the US, the stock market is off to its worst start in its history. Markets in other countries aren’t doing much better: in Japan, stocks are down 15.35% for the year; in Germany, 10.63%.

The barbarous relic, though, has prospered. Gold prices have increased 13.88% since the beginning of the year, including a stunning one-day gain of nearly $50 per ounce (more than 4%).

Demand for Physical Gold

One reason for this recovery in gold prices is that a growing number of investors are demanding physical delivery of gold. This makes it harder for central banks to slam down gold prices via massive shorting of paper gold.

Leading the pack in this regard is the Bank of China, which in January alone added 580,000 ounces of gold to its reserves. That’s especially notable because China’s foreign currency reserves have fallen sharply in recent months, as it tries to prop up its domestic currency and collapsing stock market.

But the most important reason gold is rebounding, I believe, is the financial alternatives to it have become increasingly less attractive. That’s the only plausible reason China, with its bleeding foreign exchange reserves, is buying so much of it.

Challenges to Traditional Banking

Then there’s the “bail-in” issue. Following the 2013 model pioneered by Cyprus, governments worldwide have quietly adopted the bank bail-in model.

For Americans, that means your accounts in domestic banks – possibly earning negative interest rates if former Fed Chairman Ben Bernanke has his way – could be vulnerable. Instead of getting your money back if the bank fails, your IOU (yes, that’s the legal status of a bank deposit – read more here: next banking crisis) would be forcibly exchanged for worthless bank stock.

Sure, the first $250,000 in your account qualifies for deposit insurance through the Federal Deposit Insurance Corporation (FDIC). But that reassuring FDIC logo on your bank’s front door masks the fact that the FDIC Insurance Fund has a reserve ratio of 1.06%. For every $100 on deposit, the FDIC has only $1.06 with which to back it.

And when a banking crisis hits, it won’t occur in a vacuum. It will likely coincide with a collapse in stock prices, real estate, and other assets. It might take some time to retrieve funds from your insured bank account. That’s true even if the feds create more money out of thin air to honor the FDIC’s commitment.

Uninsured deposits, of course, would be bailed in. That prevents those inconvenient – and politically unpopular – bailouts of too-big-to-fail banks.

The Appeal of Gold During Economic Uncertainty

More and more people have decided to prepare themselves for the plundering of their wealth by getting a portion of their nest egg assets out of the financial system by buying gold. For me, that’s about 25% of my net worth.

Given the alternatives, can you think of any reason not to join us?

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Since 1984, we’ve helped more than 15,000 customers and clients protect their wealth. For its proven record as a wealth preservation tool, gold has often been a part of that planning.

If you’re looking to use gold for the same purpose, and aren’t quite sure where to start, please book a free, no-obligation call with one of our Associates to see if a wealth protection plan is right for you.