Gold, the Money Supply and Inflation

Published by clickbroker.blogspot.com.

Liaquat Ahamed’s book “Lords of Finance: The Bankers Who Broke The World” unraveled every misconception I had over the gold standard and inflation. The book traces the central banks of the United States, the United Kingdom, France and Germany from before World War I until the close of World War II. So far I have read the book through the year 1928 and would like to share some thoughts.

The story is told primarily through the eyes of Benjamin Strong (Federal Reserve Bank of NY), Montagu Norman (Bank of England), Emile Moreau (Banque de France) and Hjalmar Schacht (Reichsbank). During the first half of the 20th century European countries had been on and off the gold standard several times and have had severe bouts of both inflation and deflation. Gold stockpiles have been maintained by central banks, government treasuries and large private banks. Currencies have been pegged to gold, other currencies, and even land.

Prior to World War I, the supply of gold increased with the economies of the major European nations so gold basically kept the money supply in line with GDP and inflation in check. The US was short on gold and borrowed heavily from Europe. By the conclusion of World War I, the tables have turned. The US had a disproportionately high amount of gold to its GDP and the UK, France and Germany were severely deficient gold. The UK and France not only paid for war supplies in gold, but also incurred substantial debt to the US. And Germany was stuck with reparations beyond its economic capacity.

The UK chose to deflate its economy to match its reduced gold supply, and incurred the suffering of high unemployment. The British wanted to reassert the pound as the world reserve currency. France chose moderate inflation and economic growth while rebuilding its gold supply. Germany chose hyper inflation with no backing of its currency at all.

The US lent gold to all three nations once Germany issued a new currency backed by land. All three nations had stable currencies by the 1920’s backed by owned and borrowed gold. But reparations still hindered Germany’s economic growth. And the UK and France fought for dominance of European finance.

When the US increased its money supply in relation to its increased gold supply, moderate inflation ensued. So when gold flowed between countries disproportionately to their GDPs, currencies did not function as a constant store of purchasing power. In reality, the more gold the less purchasing power of the currency.

Early central bank theory was that lending based on commodities or other hard assets was safer. But this proved as false in the early 20th century as in our recent housing bubble. Assets in focus receive more financing which inflated their prices, giving a false sense of collateral.

Modern currencies are primarily based on GDP, with some tier 2 economies pegging their currencies to the US dollar. Unfortunately, modern central bankers don’t want to match money supply growth to a moving average GDP. They want money supply growth to lead economic growth creating an inflationary bias. This has been a slight or heavy bias depending on who’s in charge. (Paul Volcker vs. Alan Greenspan and Ben Bernanke.)

From the investors perspective the question is how does one store purchasing power? Gold even at its multi-decade high has not matched inflation. And gold has faced many bouts of competition from commercial and residential real estate, oil and food commodities among other hard assets. All hard assets incur storage expense as well as lost income opportunity cost for the money invested. Even the diehards have to admit it would be difficult to trade your gold for bread at the supermarket.

My conclusion is that there is no hard asset that can store purchasing power. Not gold nor anything else. If the economy tanks gold is useless. If you believe that over time interest rates follow inflation, then the carrying cost of gold in lost opportunity cost is the greatest when you would desire gold the most.

Trigger happy modern central bankers keep fluctuating interest rates and Wall Street is constantly running a beauty contest between sectors. Long term investors should lock in quality high interest rates during bouts of high inflation, even if that would incur a temporary negative spread with purchasing power. Inflation ebbs and flows.

Long term investors should also focus on the Select Sector SPDR ETFs to buy the most out of favor sectors one at a time. This would avoid some of the complete wipeouts seen in the financial sector recently and materials sector in previous decades. Think WaMu and Bethlehem Steel. When Wall Street rotates your sectors to the front of the dance hall, you are a winner. In the meantime you’re collecting dividends.

The Select Sector SPDRs are: Consumer Discretionary (XLY), Consumer Staples (XLP), Energy (XLE), Financial (XLF), Health Care (XLV), Industrial (XLI), Materials (XLB), Technology (XLK) and Utilities (XLU).

The sectors provide an interesting opportunity for a reformed bottom fisher in individual stocks. You get to bottom fish sectors while playing the momentum within each sector. This is because the S&P 500 sectors market weight the stocks within each ETF.

My concession to those that run real estate as a positive cash flow business is that you might be storing purchasing power in your assets, but that is not the primary reason for your success.

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