Debased dollar making gold glitter more
Vivek Kaul. Mumbai
I kept looking.
"OK, tell me why everyone's talking about gold now," she said in an obvious bid to distract me.
"Well, the price of gold is inversely proportional to the value of the US dollar versus other currencies. If the dollar falls against other currencies, the price of gold goes up and vice versa. And I have already told you why I feel the US dollar will collapse in the days to come," I said, still looking at her, making it obvious that her ploy wasn't working.
I wonder if she sensed what I was up to, for she suddenly looked pretty serious about the issue at hand.
"I don't mind going over all that again, unless you do," she said.
"All right, you have it," I conceded, not sure if I had annoyed her or whether she was feigning it. "Let us go back in time. Gold coins were first used as currency in present day Turkey, way back in 600 BC. Over the years, people realised that using metals for currency made immense sense. So, gold, silver and bronze coins replaced other forms of currency such as sea shells, tea, slaves… for that matter, anything that could be exchanged."
"Interesting," she mumbled.
"I have been reading this book by James Turk and John Rubino titled The Collapse of the Dollar and How to Profit From It," I said, acknowledging the source of information out of habit. "The book offers some interesting insights..."
"I'll look that book up later, but I'd rather hear from you first," she said, goading me on.
"Well, metal coins were not really perfect either. They were noisy, heavy and they wore out with use, leading to a decrease in their value. So in the late 1690s, someone at the Bank of England had this brilliant idea of locking up all the gold and silver and issuing paper notes against it. Bank of England was the world's first central bank, set up in 1694. The paper notes it issued could be converted back to gold and silver coins at any point of time. But pretty soon, the weakness of the system started to come out. Can you guess what might have happened?" I asked.
"I think the bank started issuing more notes," she replied.
"More notes?"
"I mean the bank must have issued more notes than what was backed up by real gold and silver they had with them," she said.
"You are right. The bank had indeed issued more notes than it had gold and silver reserves for. People soon figured this out and wanted their gold and silver back. To manage the situation, Sir Isaac Newton, the famous physicist, was brought in as the Master of the Mint in 1699. He fixed the value of one ounce (around 28.35 gram) of gold to a little over three pounds. This was the most primitive form of what became famous as the gold standard in the years to come. What this did was to ensure that amount of paper notes issued at any point of time could not exceed the total value of gold that the bank had. This standard was followed for the coming years. As Niall Ferguson explains in The Ascent of Money - A Financial History of the World, "So restrictive was Bank of England that its bullion (gold) reserves actually exceeded the value of notes in circulation from the mid 1890s until the First World War." This ensured that paper money was always backed by gold, a physical asset," I explained.
"Interesting, but where does all this lead up to?"
"Have some patience. After the Second World War, European and American leaders met at Bretton Woods in the state of New Hampshire in the United States. Here, the value of one ounce of gold was fixed at $35. The values of other currencies were fixed to the US dollar. This effectively meant that the US Federal Reserve at any point of time was willing to convert the US dollars to gold. Since other currencies could be converted into US dollars, this effectively meant that the US Federal Reserve was ready to convert other currencies to gold as well. This is how the world worked for the next 20 odd years. Like all gold standards before, this gold standard too restricted the ability of governments to print paper currency beyond the total value of gold they had in their vaults."
"So what went wrong?"
"Well, by the sixties, the US had entered into a war in Vietnam. A cold war was also on with the erstwhile USSR. For all this, it needed a lot of dollars and the US government decided to print these dollars. And as they printed more and more dollars, the link between the amount of gold in their vaults and the amount of paper dollars in the market broke down. People soon found out and started to exchange their paper currency for gold. Now, there was only so much gold in the vaults of the US government. So on August 15, 1971, Richard Nixon, the then President of the United States, decided that the US would no longer convert dollars into gold. And that broke the last gold standard that prevailed."
"I kind of get what you are trying to explain. The gold standard essentially ensured that governments could not print money beyond a point. Like, now with no gold standard in place, the US government is simply printing more and more dollars to counter all the financial problems that are cropping up. As the US prints more dollars, the supply of dollars in the market is increasing and this over a period of time will lead to the value of the dollar against other currencies going down. Seeing this, investors and central banks of other countries seeing will start getting out of dollars and getting into other currencies and physical assets such as gold, so the price of gold will keep spurting up," she took off.
"Right. But the only worry is that a number of experts are talking about this now, and when experts talk about something, the opposite usually happens," I quipped.
"What makes you feel so?" she asked.
"I think theoretically the premise makes a lot of sense. But whether it will happen, I don't know. So the way to play it is to have 10-20% of your total investment in gold. So that if this investment theme does play out, you will be well-placed to cash in on it. And if it doesn't, you won't go down the tube either."
"Cool," she said. "But why have you been staring at the woman over there?"
(The example is hypothetical)
k_vivek@dnaindia.net
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