The Root of this Financial Crisis, and Why You Must Buy Gold Now
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How the current financial crisis was born in the 1970s. Whether it’s Northern Rock (NHRKF), Fannie Mae (FNM), Freddie Mac (FRE), Indy Mac (IMB), the Labour Government, the State of California, or whoever is going to run into trouble next week, the sirens are blaring, ‘global financial emergency’.
So it’s little wonder that gold has rallied sharply in the past week or so, to more than $970. But what is it about gold that actually makes people want to own it when the financial system is in turmoil? Investors say it’s a hedge against inflation; it’s the anti-dollar; or they just see that everyone else is buying it, so they pile in afterwards.
But what is the point of owning a lump of metal that doesn’t pay a dividend, isn’t edible and actually costs you money to keep safe? To understand why gold is the ultimate safe haven in this financial crisis, we have to get to the root of our current problem. And that’s money…
How it all started: a brief history of money
Why do we need money at all? The barter system had plenty of attractions – it can’t be taxed, for one thing. But it’s inefficient. Say I sell spades, and you sell dressing gowns. For any deal to happen you must want a spade at just the moment I happen to want a dressing gown. So even the most primitive societies developed some kind of payment system, or money, that was accepted by everyone in exchange for goods and services.
Money has to have two qualities. It must be portable and it must have a purchasing power that lasts, so it can be used at a later stage. Shells, cocoa beans, even feathers have been used over the years as money. At one stage Roman soldiers were paid in salt, from where we derive the word, ’salary’. These early forms of money were ‘commodity money’.
Gold and silver were widely used. Their rarity gave them value – a great deal of worth could be stored in a single gold coin – as did their immutability. Gold doesn’t tarnish. You could dig up a gold coin buried in the ground a thousand years ago and it would be more or less intact. And just as gold preserves over time, so does its purchasing power. An ounce of gold would have bought a Roman Senator a jolly decent toga and perhaps a pair of sandals; today the sterling equivalent (£500 or so) would buy your local MP a respectable suit and shoes.
To facilitate trade, gold was turned into coins of a certified weight and purity by goldsmiths. The goldsmiths, who had built vaults to store their gold safely, also began to store the gold of their fellow townsmen, issuing a certificate as receipt for the gold deposited. Over time these certificates were used in the marketplace as if they were the gold itself. World trade had slowly moved from a ‘commodity money’ to a ‘representative money’.
Seeing that very few depositors ever removed their actual gold, instead using their certificates for trade, goldsmiths realised they could make money by lending out certificates against depositors’ gold. Despite the inherent duplicity in the scheme – lending what is not yours to lend - it worked. The depositors did not lose anything. As long as there was no bank run, their gold was all still safe in the goldsmith’s vault.
Depositors, however, soon wanted their share. Rather than taking back their gold, the depositors simply demanded that the goldsmith, now in effect their banker, pay them a share of the interest. The goldsmith paid one rate on deposits and then lent at a higher rate.
But in times of panic some borrowers would demand their real gold back, instead of the paper certificates. Before long, you had the dreaded run on the bank, with the banker not having enough gold and silver to redeem all the paper he had put out. It would have been straightforward to outlaw this new lending practice, but the large volumes of credit the bankers had created had become vital to the success of European commercial expansion, so, instead, the practice was legalised and regulated. The monetary system had moved on from representative to debt.
Bankers agreed limits on the amount of loan money that could be lent out, limits still much larger than the amount of gold and silver on deposit. Usually the ratio was nine loaned units to one actual unit in gold and these regulations were enforced by surprise inspections. It was also arranged that, in the event of a run, central banks would support local banks with emergency gold. Only if there were runs on a lot of banks simultaneously would the bankers’ credit bubble burst and the system come crashing down,
Source: The Root of this Financial Crisis, and Why You Must Buy Gold Now
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Tags: Dominic Frisby, FNM, FRE, Gold Prices, IMB, investing in gold, NHRKFAbout the Author
Dominic Frisby is MoneyWeek’s commentator on commodities, and is an active private investor in junior mining and energy companies. He is the presenter and producer of Commodity Watch Radio - an internet radio show run in association with Minesite, where Dominic discusses the commodities and financial markets with leading lights of the sector.