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2011-10-28 07:51:30
"We have gold because we cannot trust governments." President Herbert Hoover's
statement in 1933 to Franklin D. Roosevelt foresaw one of the most draconian
events in U.S. financial history: the Emergency Banking Act occurred that same
year, forcing all Americans to convert their gold coins, bullion and
certificates into U.S. dollars. While the Act successfully stopped the outflow
of gold during the Great Depression, it did not change the conviction of gold
bugs, those who are forever confident in gold's stability as a source of
wealth.
Tutorial: Commodity Investing
Before investing in gold, you must understand its history - a history that,
like that of no asset class, has a unique influence on its own demand and
supply today. Gold bugs still cling to a past when gold was king. But gold's
past includes also a fall, which must be understood to properly assess its
future.
A Love Affair That Has Lasted 5,000 Years
For 5,000 years, gold's combination of luster, malleability, density and
scarcity has captivated humankind like no other metal. According to Peter
Bernstein's book "The Power of Gold: The History of Obsession", gold is so
dense that one ton of it can be packed into a cubic foot.
At the start of this obsession, gold was used solely for worship. A trip to any
of the world's ancient sacred sites demonstrates this. Today, gold's most
popular use in the manufacture of jewelry.
Around 700 B.C., gold was made into coins for the first time, enhancing its
usability as a monetary unit: before this, gold, in its use as money, had to be
weighed and checked for purity when settling trades.
Gold coins, however, were not a perfect solution since a common practice for
centuries to come was to clip these slightly irregular coins to accumulate
enough gold that could be melted down into bullion. But in 1696, the Great
Recoinage in England introduced a technology that automated the production of
coins, and put an end to clipping.
Since it could not always rely on additional supplies from the earth, the
supply of gold expanded only through deflation, trade, pillage or debasement.
The discovery of America in the 15th century brought the first great gold rush.
Spain's plunder of treasures from the New World raised Europe's supply of gold
five-fold in the 16th century. Subsequent gold rushes in the Americas,
Australia and South Africa took place in the 19th century.
Europe's introduction of paper money occurred in the 16th century, with the use
of debt instruments issued by private parties. While gold coins and bullion
continued to dominate the monetary system of Europe, it was not until the 18th
century that paper money began to dominate. The struggle between paper money
and gold would eventually result in the introduction of a gold standard.
The Rise of the Gold Standard
The gold standard is a monetary system in which paper money is freely
convertible into a fixed amount of gold. In other words, in such a monetary
system gold backs the value of money. Between 1696 and 1812, the development
and formalization of the gold standard began as the introduction of paper money
posed some problems. (Learn more in What Is Money?)
In 1797, due to too much credit being created with paper money, the Restriction
Bill in England suspended the conversion of notes into gold. Also, constant
supply imbalances between gold and silver created tremendous stress to
England's economy. A gold standard was needed to instill the necessary controls
on money.
By 1821, England became the first country to officially adopt a gold standard.
The century's dramatic increase in global trade and production brought large
discoveries of gold, which helped the gold standard remain intact well into the
next century. As all trade imbalances between nations were settled with gold,
governments had strong incentive to stockpile gold for more difficult times.
Those stockpiles still exist today.
The international gold standard emerged in 1871 following the adoption of it by
Germany. By 1900, the majority of the developed nations were linked to the gold
standard. Ironically, the U.S. was one of the last countries to join. (A strong
silver lobby prevented gold from being the sole monetary standard within the
U.S. throughout the 19th century.)
From 1871 to 1914, the gold standard was at its pinnacle. During this period
near-ideal political conditions existed in the world. Governments worked very
well together to make the system work, but this all changed forever with the
outbreak of the Great War in 1914.
The Fall of the Gold Standard
With the Great War, political alliances changed, international indebtedness
increased and government finances deteriorated. While the gold standard was not
suspended, it was in limbo during the war, demonstrating its inability to hold
through both good and bad times. This created a lack of confidence in the gold
standard that only exacerbated economic difficulties. It became increasingly
apparent that the world needed something more flexible on which to base its
global economy.
At the same time, a desire to return to the idyllic years of the gold standard
remained strong among nations. As the gold supply continued to fall behind the
growth of the global economy, the British pound sterling and U.S. dollar became
the global reserve currencies. Smaller countries began holding more of these
currencies instead of gold. The result was an accentuated consolidation of gold
into the hands of a few large nations.
The stock market crash of 1929 was only one of the world's post-war
difficulties. The pound and the French franc were horribly misaligned with
other currencies; war debts and repatriations were still stifling Germany;
commodity prices were collapsing; and banks were overextended. Many countries
tried to protect their gold stock by raising interest rates to entice investors
to keep their deposits intact rather than convert them into gold. These higher
interest rates only made things worse for the global economy, and finally, in
1931, the gold standard in England was suspended, leaving only the U.S. and
France with large gold reserves.
Then in 1934, the U.S. government revalued gold from $20.67/oz to $35.00/oz,
raising the amount of paper money it took to buy one ounce, to help improve its
economy. As other nations could convert their existing gold holdings into more
U.S dollars, a dramatic devaluation of the dollar instantly took place. This
higher price for gold increased the conversion of gold into U.S. dollars
effectively allowing the U.S. to corner the gold market. Gold production soared
so that by 1939 there was enough in the world to replace all global currency in
circulation.
As World War II was coming to an end, the leading western powers met to put
together the Bretton Woods Agreement, which would be the framework for the
global currency markets until 1971. At the end of WWII, the U.S. had 75% of the
world's monetary gold, and the dollar was the only currency still backed
directly by gold.
But as the world rebuilt itself after WWII, the U.S. saw its gold reserves
steadily drop as money flowed out to help war-torn nations as well as to pay
for its own high demand for imports. The high inflationary environment of the
late 1960s sucked out the last bit of air from the gold standard. (Learn more
in An Introduction To The International Monetary Fund.)
In 1968, a gold pool (which dominated gold supply), which included the U.S and
a number of European nations stopped selling gold on the London market,
allowing the market to freely determine the price of gold. From 1968 to 1971,
only central banks could trade with the U.S. at $35/oz. Finally, in 1971, even
this bit of gold convertibility died. Gold was free at last. There was no
further reason for central banks to hold it.
Source: World Gold Council
Summary
While gold has fascinated humankind for 5,000 years, it hasn't always been a
guarantee of wealth. A true international gold standard existed for less than
50 years (1871 to 1914) - in a time of world peace and prosperity that
coincided with a dramatic increase in the supply of gold. But the gold standard
was the symptom and not the cause of this peace and prosperity.
The events of the Great War changed the political, financial and social fabric
of the world - the international gold standard would be no more. While a gold
standard continued in a lesser form until 1971, the death of it had started
centuries before with the introduction of paper money - a much more flexible
instrument for our complex financial world.