Posted by donyocham on 11/03/09Last updated 11/03/09
[I originally posted this article on my company website on September 3rd of this year. Click http://www.harnessimg.com/blog/2009/09/store_of_value_myth/to access this article there.]
Imagine, for a moment, a penny's worth of pure gold[1]. Do you suppose anyone would leave said penny in the ubiquitous "Leave a Penny, Take a Penny" trays at convenience stores? Would people accidentally drop gold pennies and not bother to pick them up? A rationalist view would lead us to believe that a penny is worth a penny and people should be indifferent to either form of money. Therefore, they would be as likely to leave either coin in the tray. However, this view ignores human nature and the intrinsic value that human nature has accorded gold since we[2] began digging it out of the ground. While that same rationalist would claim such value as irrational and temporary, anyone that understands people, or even themselves, knows that such intrinsic value, however irrational, is far from temporary and, more likely, permanent.
Human Nature Seeks Out Something to Trust
The aspects of human nature that drive this intrinsic value have much to do with trust. That gold cannot be counterfeit, is rare, and is permanent all contribute to this source of trust[3]. The trust that we place in gold being gold does not depend on any other entity to decree it is so; gold is what it is. That gold is rare is testified by the fact that all the gold dug out of the ground throughout human history would fit on a basketball court with 60 foot ceilings. That gold is permanent is attested to by the fact that nearly all of that gold is still around, i.e., it didn't rust, much less get thrown away.
"The word value, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called "Value in use'" the other, "Value in exchange." The things which have the greatest value in use have frequently little or no value in exchange; and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use."
Adam Smith - The Wealth of Nations
These factors all speak to the source of gold's value, which is not its value in use, but rather, its value in exchange. Gold's value is its utility as a medium of exchange[4]. So long as we have the propensity to "truck, barter and exchange one good for another", gold has value as a medium of exchange. Precisely because gold has so little other utility is why we can accord its value as a medium of exchange. It is ultimately verifiable, storable, portable and exchangeable.
The Myth
This brings us to the store of value myth. Nothing, not even gold, retains its value relative to everything or anything else. The supply and demand of anything relative to anything else is in constant flux, so to expect any one thing to always purchase a fixed quantity of anything, forever, is folly. However, if the supply of a medium of exchange is moderately stable, its ability to command an ever increasing quantity of goods and services over time will improve with growth and productivity. In that sense, gold, as a medium of exchange, will also provide a store of value -- provided growth is positive and productivity improves. That gold is globally recognized makes its potential as a store of value dependent on global growth and productivity, not a particular country's relative growth or productivity.
Stores of Utility, Not Value
While there is no true store of value in any and all conditions, there are stores of utility, each of which have their own particular value in use. For example, oil is a store for the utility of energy, (provided we don't tax it out of use). Your house, if you own it, is a store for the utility of shelter. Arable land, barring environmental disaster, is a store for the utility of food. This simple fact certainly hasn't eluded those in charge of the vast pools of savings around the globe. It is stating the obvious to say that excess reserves and sovereign wealth fund assets are being used to aggressively secure stores of utility wherever they can. While this trend is clear, inexorable and secular in nature, how the competing interests ultimately resolve the inevitable constraints that will result is far from certain. In my view, hoarding a reliable medium of exchange is, or soon will be, part of the broader trend of securing stores of value.
"For in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal, which had been originally contained in their coins."
"Such operations, therefore, have always proved favourable to the debtor, and ruinous to the creditor, and have sometimes produced a greater and more universal revolution in the fortunes of private persons, than could have been occasioned by a very great public calamity."
Adam Smith - The Wealth of Nations
Chinese Finger Trap
The reason why there seems to be a growing search for alternatives to the most common medium of exchange, the U.S. Dollar, is because there is a deliberate effort to debase most current mediums of exchange, i.e., the U.S. dollar and other major currencies. Whether this will result in a total collapse of the fiat currency system may not yet be a certainty, but given the desperate attempts to keep the game going for just one more turn, I would suggest it is highly likely. It is one thing for purchasing power and exchange rates to fluctuate based on the natural ebb and flow of relative productivity and terms of trade between countries. It is entirely another thing to purposefully alter that balance.
Indeed, the most politically tolerable way to pay our personal, corporate and governmental debts is through inflation (i.e., currency debasement). This has been true ever since governments took over the issuance of money and is almost always the path chosen. At present, sovereign creditors and debtors are all sitting around the table staring at each other in the hopes they can maintain the current medium of exchange, status quo. However, they all know that they have competing interests and that there is no elegant end game because all parties are really out for themselves.
The tricky part is understanding when the first of them will blink or what other games can be played that are not on the table. It's as though they all have their fingers stuck in a massive Chinese finger trap with 500 finger holes. If they trusted each other and relaxed all at once, they might be able to pull their fingers out. But this type of coordination, as we are seeing, is not possible when competing interests are involved. What's more, the Chinese have their fingers caught in this same eponymous trap.
For creditor nations, namely China, that have accumulated too many U.S. dollars or dollar denominated debt, they are indeed in a tight spot, but not without options. For the debt they hold, their only collateral is the U.S. dollar. When a creditor suspects the value of their collateral is questionable, they typically have five options: 1) foreclose, 2) call the loan, 3) demand new collateral, 4) renegotiate or 5) sell the debt. Foreclosure doesn't really apply between sovereigns and calling the loan is not part of the deal with Treasury debt, but the last three options are possibilities.
While selling the debt does not seem like an option, as they fear it will spook the market and harm the value of whatever debt they still hold, that option can certainly be used as a threat to demand more collateral, especially if selling the debt will harm the debtor more than the creditor. While this is not an economically optimal choice, in the context of global politics and relative power, such gamesmanship would be quite effective. What collateral can they demand? For an off-the-wall suggestion, the Federal Reserve holds about $1 trillion in US mortgages and will likely soon own debt backed by commercial real estate. In a world where what was inconceivable three years ago is now possible, consider the possibility that the Federal Reserve swaps their real estate secured debt to the U.S. Treasury in exchange for TIPS and the U.S. Treasury then posts that collateral with the Chinese government to keep the game going. As unusual as that sounds, it is important to remember that the Chinese government will be participating in the PPIP, (Public Private Investment Partnership).
As a way to renegotiate terms, in the September/October 2009 issue of Foreign Affairs, Barry Eichengreen[5] suggests the possibility that China could demand payment of interest and principle for a fixed number of renminbi. If China aspires to have the renminbi achieve reserve currency status, the ultimate appreciation that will result from achieving that status will make this a good trade for the Chinese government.
"If Your Competition is Drowning, Jam a Fire Hose Down His Throat" - Ray Kroc
Another option would be to find a way to plough some of their dollar denominated assets into a more reliable medium of exchange, i.e., gold. Any direct currency transactions on the open market would create a dollar scare much as selling treasuries would spook a sell-off in treasuries, as noted above. However, I am confident that there are ways for the Chinese government to accumulate significant amounts of gold in exchange for dollars without drawing much attention to their activities. Whether this involves the IMF or other middle-men, I am certain the means to affect such exchange is possible. Exchanging their U.S. dollars for gold is not nearly as transparent as exchanging their dollars for another currency. Also, the Chinese do not necessarily need to only buy physical gold to effect this trade; they can also buy up controlling stakes in gold mining operations, ensuring a long-term supply of gold. Suppose they have already acknowledged that they will never receive everything their owed in current purchasing power terms and mentally settled for some fraction of the dollar value they are owed, they could buy a third of that reduced amount in gold and gold mining operations and wait for gold to triple when they start selling their dollars and dollar denominated assets on the open market. This would indeed be painful for the Chinese from the perspective of booked losses, but from a geopolitical power perspective, it could prove to be a winner. James Bond fans will recall that Goldfinger had a similar strategy.
In this same bucket, I would throw other real assets, such as industrial metals mining and oil, natural gas and agricultural production. All of these assets provide utility to the Chinese government and are ways of getting out of the way of the U.S. dollar. While one single option may not be executable or effective on its own, a combination of all of these options is possible.
While we are at it, we could imagine the Chinese government attempting to smuggle U.S. bonds into Switzerland via Italy. Wait! That was already tried, but the bonds were forged. We know that they were forged because the official statements that backed up the press reports said so. And we know that the press should only report the statements provided by governments rather than digging deeper to uncover some unsettling, contradicting facts.
To Propensity to Truck, Barter and Exchange Requires Trust in Something
We began with a thought experiment and so we will end with one. Imagine that the Fed froze the money supply at current levels and replaced all currency with bills that are impossible to counterfeit, are indestructible, and the Federal Reserve was forbidden by law from creating or destroying the quantity of money in circulation. Those bills would then possess all the advantages of gold, (could not be counterfeit, and would be rare and permanent), plus not have the disadvantage of being able to pull any more out of the ground. The supply would be fixed and certain. In this case, the U.S. dollar would actually be "better than gold" rather than simply as "good as gold", as it once was. It would not rely on the faith or trust we place in institutions; it would rely on the rule of law. The viability of this thought experiment hinges on the question of whether people would place faith in the institutions to abide by the law or whether those laws can change. That same question of trust can be applied to the topic of SDR's or some other form of global currency taking hold as a universally accepted medium of exchange. What is the likelihood of citizens of countries, particularly democratic ones, placing trust in an entity to uphold the rule of law with no accountability to them? Would countries submit to the discipline of a fixed quantity of money administered by a supranational entity?
Think of trust as something that is neither created nor destroyed, but can be easily shifted from one thing to another. From this perspective, we're bullish about the long-term prospects for gold because trust in it as a viable medium of exchange will progressively increase as trust in other mediums of exchange deteriorates.
[1] Ignore, for the sake of the thought experiment, that such a coin would weigh 1/100,000th of an ounce.
[2] By we, I mean human societies that have an ethic of individual property rights, not communal property rights. Indeed, the latter viewed any gold they might possess as merely a trinket with no value other than merely decorative.
[3] I'll submit here that counterfeit can be more broadly defined. That gold cannot be counterfeit could include the fact that neither governments, nor any other entity, can create gold at will, (i.e., printing and distributing fiat money without an exchange of value is counterfeit money).
[4] A medium of exchange is anything that can easily be exchanged for a good or service, Cigarettes serve as a medium of exchange in prison. Without a medium of exchange, we must resort to bartering, which is exchanging one good or service directly for another good or service. For example, if I have extra bread and want beer (to use Adam Smith's example, I have to find someone with extra beer that wants bread. Otherwise, I'm stuck with bread that will eventually spoil while without any beer to drink, an intolerable situation.
[5] Foreign Affairs, September/October 2009, The Dollar Dilemma, Barry Eichengreen
Categories: Finance, Commodities, Current Events, Economy, Monetary Policy
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