All paper money has historically proved defective in terms of one of the classic functions of money. Nineteenth century economists such as William Stanley Jerons – a great economist by any test – taught that money ought to act as a “store of value”. There is no fiduciary issue which has survived the period since the end of the Second World War in 1945 without very substantial depreciation. Even comparatively respectable currencies, like the pound or the dollar, have lost a significant proportion of their purchasing power since 1945, and are expected to continue to lose purchasing power for the foreseeable future.
The classic statement of the problem comes in David Ricardo’s book “On the Principles of Political Economy and Taxation”, 1817. Ricardo, whom our Victorian ancestors regarded as the scientific authority on financial questions, stated: “Experience shows that neither a State nor a Bank ever had the unrestricted power of issuing paper money, without abusing that power: in all States, therefore, the issue of paper money ought to be under some check and control, none seems so proper for that purpose, as that of subjecting the issues of paper money to the obligation of paying their notes, either in gold coin or bullion.”
This established the rule, on which the historic gold standard was based, that convertibility is the test of value. A non-convertible paper money can be expected to depreciate over time, more or less rapidly. In the twentieth century, the great majority of non-convertible paper currencies depreciated by more than 90 per cent in purchasing power, and money depreciated to zero.
Gold, on the other hand, has a high degree of stability in the purchasing price over very long periods, as demonstrated in statistical studies by Professor Jastrom and others. English statistical series suggest that the purchasing power of gold in 1913, immediately before the First World War, was about 90 per cent of the value of gold in 1700, when Isaac Newton was Master of the Mint.
One should not expect too much precision in these series of price indices, but the evidence is conclusive that gold tends to return to a constant purchasing power, hence Jastrom’s phrase “the Golden Constant”, while paper currencies tend to go to zero. For that reason the Ricardian requirement of convertibility, which existed for the period between the Napoleonic Wars and the First World War, is a requirement that paper money should only be issued in quantities which maintain its level of scarcity, and therefore its purchasing power.
All of this obviously depends on acceptance of the quantity theory of money. Since the 1960s there have undoubtedly been economists who held the quantity theory of money in a naïve and therefore misleading form. The quantity theory is probably best understood in terms of Irving Fisher’s relatively simple equation: mv = pt, where m is the money supply, v is velocity of circulation, p is price and t is the number of transactions, or level of activity. One can see that these variables have to move together. If the money supply doubles, prices will double, unless the velocity of circulation falls. If there are ten walnuts on the tree and ten pounds available to buy them, walnuts will cost a pound each. If there are twenty pounds available to buy walnuts, they will cost two pounds each. This is not an econometric calculation, but it is a useful way of thinking about the relationship between money and prices.
The gold standard, and indeed the principle of stable money, had two great enemies. They were, and are, war and democracy. The gold standard had to be suspended by the European powers in 1914, when the First World War broke out. It has never been fully restored. The Bretton Woods system, which was based on international convertibility into the dollar, and dollar convertibility into gold, lasted for about twenty five years before President Nixon suspended gold convertibility in 1971. After the Bretton Woods system collapsed, the final link of currencies to gold was broken.
This led to a boom in the gold price which rose from the old fixed price of $35 an ounce to a high of $860 in 1980, before moving into a 20 year bear market which took the price down to about $260 in the late 1990s, the point at which Gordon Brown sold a large part of the U.K.’s gold reserve. Politicians always get markets wrong. Gold has now reached a new nominal peak of $900 an ounce a price which is still only about half the 1980 level in real terms.
Gold still has a significant role in national reserves. In recent years, the reserves of the major Asian economies have been increasing much more rapidly than those of the West. The U.S. dollar has been falling, though the Euro has been firm. As a result, China has been increasing the holding of reserves in Euros, and has incurred significant losses in the dollar content of China’s holdings.
In the earlier stages of Chinese growth, this loss on dollars was offset against the growth of Chinese exports to the dollar zone, but there has been increasing reluctance to continue to add to dollar holdings, not only in China, but in the Asian countries generally.
Unfortunately, Asian countries have long term reservations about the economy of the European Union. From the Asian point of view, the European economy, indeed Europe generally, seems to be in long term decline. European costs are high. With the exception of German machinery, much of European manufacturing is seen as uncompetitive. Britain is respected as a financial centre, but that only supports the value of sterling when financial activity is rising. At present Asia expects an American and European slow down, which will affect the earnings of London as banking centre.
The modern pattern of global trade is one of the transfer of wealth from North America and Europe to Asia, and particularly to the three largest Asian economies, China, India and Japan. That movement has created the surplus of reserves in the Asian countries, and a reduction of reserves in the West. The Euro may at present be preferred to the dollar or sterling, but Asia has little confidence in the underlying European economy and the high price of the Euro makes the European economy even less competitive.
One cannot expect gold to take the place of the dollar in Asian reserves; there are too many dollars already in existence, and too little gold. Yet the surplus that exists of the Western currencies makes gold a very attractive alternative, particularly as Asia has always had a preference for the precious metals. Gold has its niche.
The supply position of gold is favourable to further rises in the gold price. Despite the rise in the price that has taken place already, there is no sign on the production side of the creation of excess supply, though of course, stocks are high relative to industrial and jewellery outtake. Because it acts as a reserve currency, gold stocks are always large.
There is also a link between the price of oil and the price of gold. In the 1970s, which the OPEC cartel raised the price of oil exports, gold rose with oil and with the general increase in world inflation. For some years I have been forecasting an oil price of $100 a barrel – which has now been reached – and a gold price of $1,000 an ounce. It would only take another 10 per cent for the second target to be reached.
The oil price has traditionally been volatile. A short term surplus could see a short term fall in the oil price just as a war with Iran could force the price up to $150 or even $200 a barrel. However, the long term problem of oil supply, and the insatiable growth of Asian demand, suggests that the long term price of oil will continue to rise.
The same, in my view, is likely to be true of the price of gold. The great democracies of the West will find it difficult to make the sacrifices necessary to deal with the growing shortage of fundamental sources of energy, including oil, gas and uranium. The excessive levels of debt are likely at some point to lead to inflation – which wipes out the real value of debt. In these conditions, the underlying economic pressures are for a still higher gold price. In the last decade, the gold price has been doubling every five or six years. My own guess would be that gold will hit $2,000 an ounce in the early 2020s, but some analysts think that will happen much earlier.
for Markets and Money
Editor’s Note: Lord William Rees-Mogg is the former Editor-in-Chief for The Times of London and a member of the House of Lords. Lord Rees-Mogg has been credited with accurately forecasting glasnost, the fall of the Berlin Wall, as well as the 1987 crash.