»The Daily Reckoning by Bill Borner

Why governments, politicians and businessmen hate gold
1 DECEMBER 2014

- By Vivek Kaul

Vivek Kaul
Yesterday Switzerland voted on whether its central bank should be holding more gold as a proportion of its total assets. Gold currently makes up for around 7% of the total assets of Swiss National Bank, the country's central bank.

The proposal dubbed as "Save Our Swiss Gold" had called for increasing the central bank's holding of gold to 20% of its total assets. It was more or less rejected unanimously with nearly 78% of the voters having voted against it.

This proposal was backed by the right-wing Swiss People's Party and came out of the concern that the Swiss National Bank had sold too much of its gold in the years gone by.

Interestingly, Switzerland was on a gold standard till 1999 and was the last country to leave it. In a gold standard the paper money issued by the central bank is backed by a certain amount of gold held in the vaults of the central bank.

What this means is that the central bank and the government cannot issue an unlimited amount of paper money. The total amount of paper money that can be issued is a function of the total amount of gold that the central bank holds in its vaults.

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In April 1933, when the Great Depression was on in the United States, the Federal Reserve of the United States had around $2.7 billion in gold reserves, which formed around 25 percent of the monetary gold reserves of the world. At the same time, the ratio of paper money to gold was at a healthy 45 percent, more than the decreed 35-40 percent. (Source: J.W. Angell, "Gold, Banks and the New Deal," Political Science Quarterly49, 4(1934): pp 481-505)

That's how the gold standard worked.

Getting back to the Swiss vote on gold, other than the Swiss People's Party, the other parties as well as businessmen were opposed to it. As the Wall Street Journal reports "The initiative was widely criticized by Switzerland’s political and business communities."

This isn't anything new. The politicians over the last 100 years have not liked the gold standard because it limits their ability to create money out of thin air. And as far as businessmen are concerned they usually tend to go with what the politicians are saying.

As Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists: "The First World War and the Great Depression created great dislocation and unemployment... Workers, many of whom had become politically aware in the trenches of World War I, organized to demand for some form of protection against economic adversity. But the reaction really set in during the Great Depression, when they were joined in country after country by others who had lost out-farmers, investors, war veterans, the elderly."

The politicians could not do much about it given that most of the world was on the gold standard. And given this, they could not print money and flood the financial system with it. "The gold standard ... imposed tight budgetary discipline on governments, which made it difficult for them to intervene much in economic affairs... Politicians had to respond, but such a large demand for protection could not be satisfied within the tight constraints imposed by the gold standard. Hence, the world abandoned the straitjacket of the gold standard... With their ability to turn on or turn off finance, governments obtained extraordinary power," write Rajan and Zingales.

This explains why governments hate gold.

In 2012, I had the pleasure of speaking to the financial historian Russell Napier. And he made a very interesting point about the rise of democracy and paper money having gone hand in hand. As he put it: "The history of the paper currency system, or the fiat currency system is really the history of democracy... Within the metal currency, there was very limited ability for elected governments to manipulate that currency."

Napier further pointed out that most people don't have savings. As he explained: "And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money. But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn toward paper currency and unless you see the destruction of democracy in the developed world, and I do not see that, we will stay with paper currencies and not return to metallic currencies or metallic based currencies."

With paper currencies around, politicians (even honest ones) feel that they have the ability to bring an economy out of a recession, by getting their central banks to print money and flood the financial system with it, so as to maintain low interest rates.

At low interest rates the hope is that people will borrow and spend more. In a gold standard all this wouldn't have been possible. But that as we have seen over the last few years has led to other problems.

Having said that, the fundamental problem with paper money, that it can be created out of thin air, remains. Or as Ben Bernanke, the former Chairman of the Federal Reserve of United States, put it in 2002: "The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

This is what the US government has done with the help of its central bank, the Federal Reserve, over the last few years, largely during the years in which Bernanke was the Chairman.

As on September 17, 2008, two days after the investment bank Lehman Brothers went bust, and the financial crisis well and truly started, the Federal Reserve held US government treasury bonds worth $479.8 billion. Since then, the number has jumped up to $2.46 trillion. Where did the Fed get the money to buy these bonds? It simply printed it. And then it bought bonds to pump that money into the financial system.

In fact, it also printed money to buy bonds other than treasury bonds as well. This was done so as to flood the financial system with money, in the hope of keeping interest rates low, in order to get people to borrow and spend again, and hopefully create economic growth.

While that has happened to a limited extent, financial institutions have borrowed this money at low interest rates and invested this money in large parts of the world chasing returns.

The Fed decided to stop printing money towards the end of October 2014. But now it needs to keep telling the financial markets that it won't go about withdrawing the trillions of dollars that it has printed and pumped into the financial system, any time soon. We need to see what happens when it decides to start withdrawing all the money it has printed and pumped into the financial system.

To conclude, it is worth remembering what economist Stephen D. King writes in When the Money Runs Out "A central banker who jumps into bed with a finance minister too often ends up with a nasty dose of hyperinflation."

Where do you see the price of gold heading in the days to come? Post your comments or share your views in the Equitymaster Club.

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