‘Quintessentially’ is one of those words which tends to get associated with England and English things - cups of tea, trooping the colour, losing at cricket. The derivation of the word itself (quint-essence or fifth essence) actually comes from medieval alchemy, the idea being that base metals, if refined five times, became gold.
No less august a figure than Sir Isaac Newton, famous math-guy and Master of the Royal Mint until his death in 1727, was a keen alchemist, so much so that on his death, his hair was found to be laced with mercury from his experiments to transform base metals into precious ones. He may well have died of mercury poisoning, and this poisoning may also have explained some of his eccentric behaviour.
Short story long, the reforms of the coinage in England in 1696, subsequently overseen by Newton, helped to shift England from a largely silver coinage to a gold-based one. In time, particularly with Britain’s global dominance in the nineteenth century, the gold standard was adopted amongst the then-developed nations until its demise at the start of World War I in 1914. Attempts to resurrect it occurred in the inter-war years, and the Bretton Woods agreement of 1944 created a gold-backed dollar. This Bretton Woods system lasted until August 1971, when President Nixon ‘temporarily’ suspended gold convertibility. 300 years of monetary history in four sentences.
The gold standard is fairly easy to understand. Not all transactions happened in gold - the Bank of England often held less than 5% of the currency outstanding in gold reserves during the gold-standard period. Money and credit circulated for the most part, with gold flowing out of a country as it imported and flowing in as it exported. This was essentially a self-balancing system; growing economies exported and gold flowed in as payment. This in turn saw rising domestic consumption and credit, which resulted in higher imports and gold flowing out.
The boom-bust cycle was very much part of the gold-standard set up. Cycles in bank lending (and of the Bank of England altering interest rates and in extremis discounting paper to aid liquidity in a banking crisis) all worked around the idea of the ability to ‘go to coin’ - when lending looked risky, banks would call-in loans, reducing credit, slowing the economy. You could always ‘go to (gold) coin’ if things looked economically hairy.
Changes to money systems are always political acts. World War I saw a suspension of the gold standard as nations turned to deficit financing to fund the fighting. In order to fix its dominant position after the anticipated end of World War II, the US insisted at Bretton Woods in 1944 that a gold-backed dollar be the centre of the new monetary system, deposing the pound sterling. In 1971, President Nixon, with a US economy mired in stagflation and still funding operations in Vietnam, suspended the gold convertibility of the dollar with a view to a devaluation to improve the America’s terms of trade. This ended the gold era, and ushered-in the fully-fungible credit era of money, otherwise known as the fiat era. The interesting question is whether gold is about to make a comeback - extra time in a crisis perhaps, or will it be playing in a more-permanent third half?
Following the Taliban takeover of Afghanistan in August last year, the US suspended the Afghan US-dollar reserves held at the New York Federal Reserve. So while the ‘weaponization’ of the dollar is clearly not a new thing (Russia itself was hammered with sanctions following its occupation of the Crimea in 2014), the events of the last few weeks have been recognised by a number of market commentators as a step-change in the process.
Suspending some $500 billion or so of Russian reserves (in dollars, euros, pounds etc) has clearly raised a long-term question about the sustainability of holding central-bank currency reserves at a foreign central bank whose government may at any time confiscate them. Relating as it does to Russia, the world’s second largest commodity exporter, this clearly makes the current sanctions a political decision of a 1914 or 1971 magnitude. We are sadly in an ‘us or them’ moment - the US is threatening India and China with sanctions for their failure to condemn Russia’s invasion of the Ukraine. There is no ‘going to coin’ if the reserves are held abroad - Russia appears now to be left with balances in yuan, but for the most part, with gold in its central-bank vaults in Moscow.
The gold price has risen sharply in the last few weeks as its traditional haven status has come to the fore, but behind this is a growing sense that its importance as a monetary asset independent of outside influence is returning. While there has been some market chat of ‘Bretton Woods III’ 1, this is decidedly not a question of gold transfers between friendly nations. Russia may yet opt to stabilise its currency by closing its capital account and insisting on payment in bullion for its commodity exports. There may yet be a scramble for physical gold on the various commodity futures exchanges in London and New York.
A rise in the importance of gold (as a commodity) may indicate that the wider implications of the current economic conflict between Russia and the West are that it ultimately represents a global battle for resources. The question is whether those sanctioning countries who until recently relied on Russian commodity imports can survive the elimination of a major marginal producer and exporter without the likely inflationary effects swamping their economies and ultimately leading to recession.
With respect to this, Europe is right in the headlights of the economic consequences of the war. Not only have the sanctions disrupted the banking system, the inflationary effect of rising commodity (particularly gas) prices is already making its mark felt. Italian producer price index (PPI) inflation for February came in at a whopping 41%, year-on-year, the sort of levels that will cripple industry and lead to business insolvency and lay-offs. The slide in the euro and of the value of European bank equities should be viewed as the market pricing in these problems.
Highly indebted and with low growth, sticky unemployment and central-bank interest rates still negative despite historically-high levels of inflation, the European economies are not in a strong position. Yet gold may yet have a part to play here too - should the national central banks of Europe need to strengthen their balance sheets in the case of a banking and/or sovereign debt crisis, a large upward revaluation of their gold reserves (which are held nationally not at an ECB-level) may yet be an act of last resort. Gold is one thing that Europe’s central banks do have a fair stack of - the Bank of Italy holds 2,452 tonnes of the stuff for example.
Gold is one of those things which tends to arouse either derision or fanatic loyalty. There is the pet-rock crowd on one side (joined nowadays by the Bitcoin maxis), while on the other you have the tactical-clothing, tinned-food libertarian types. Stepping beyond the he-said-she-said arguments about the relevance of gold, central banks do still hold a lot of it on their balance sheets, and what will be interesting to track over the coming months is how if at all it plays a role not only in the resolution of the current Russian conflict, but whether it ends up playing a monetary role which for many it had long since ceased to perform.
‘Bretton Woods III’, Zoltan Pozsar, Credit Suisse Research, 07/03/2022
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