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BookmarkAfter getting a sneak peek at Buffett’s Annual Letter, I decided to write this essay as it is my humble opinion that Buffett has taken his view of gold to a level that is more sophism and rhetoric than factual while completely disregarding gold’s historical role as a medium of exchange.
Before I continue, I just want to make it very clear that Buffett is my ultimate investment idol and I have learned a great deal from his writings and through two short encounters in Omaha. As far as practicing the fundamental principles of Benjamin Graham, there has been no better investor in the world.
It is my opinion that Buffett fully comprehends gold’s historical importance but has chosen to complicate the layman’s understanding of its qualities under an altruistic guise of protecting the investor from rampant speculation.
Technically, since gold is no longer legal money, Buffett’s position is in fact superior to the one I am taking. However, one must take the leap of faith that over the next fifty or even one hundred years the citizenry can fully trust their elected officials to represent the interest of the prudent saver, the capitalist, and the investor when deciding how much fiat money is “just enough” to maintain the mandate of price stability and maximum employment.
In the 2011 Annual Letter which will be fully published in Berkshire Hathaway, Inc.’s (BRK.A) annual report, Buffett makes it very clear that he views current interest rates and fixed income securities as risky due to the lack of return they produce. He then goes on to explain why it is so important for an investor to achieve significant returns on invested capital over time. Buffett produces a fantastic example demonstrating that if a US citizen were to roll his/her cash into US denominated treasuries from 1965 until today they would have only preserved their purchasing power producing no real gain.
Buffett:
Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time… During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.
Note the last sentence which I have highlighted. Buffett clearly states the sole reason for this 4.7% hurdle is due to the human element regulating the “printing press”. This point is the crux of the essay as we must understand how flawed our current monetary system is and why it produces so much destruction to the purchasing power of the prudent classes of our society.
A Brief History of Money
For nearly 5,000 years, humans have experimented with a variety of mediums that would efficiently store the value of their labored hours, goods produced, and services provided while in between transactions. The goal was to find a way to store productivity for the future, to avoid a barter based economy where transactions would only occur if two parties needed an exact amount of the same goods or services at the same time. Through all the experiments the only mediums that functioned well over time were silver and gold (Read Passport Capital’s fantastic analysis on the attributes that led to these precious metals becoming the perfect money).
These two precious metals achieved what no other medium of exchange had. They had for the first time enabled humans to trust each other when engaging in commerce and introduced a new element of confidence into the global economy. There is no doubt in my mind that without a stable and fungible global currency the rate of human procreation, mobilization, and innovation would have been slower.
Trust in currency led to progressive economies which in turn led to the development of advanced civilizations with sovereignty and ultimately democracy. Democratization led to free markets, which led to truly pronounced economic cycles that included periods of booms and busts.
As democratic principles flourished, each recession brought with it immense pressure from constituents as the lower classes often representing the majority of the electorate felt most of the pain. In an effort to manipulate the economy several academics in the late nineteenth century began to promote a new economic model based on a central bank that would regulate fiat money and the rate of interest with a stated mandate of maintaining not only price stability (the former chief attribute of money) but also maximum employment.
This novel idea, the academics believed, would prevent the unnecessary recessions and depressions that would follow periods of economic prosperity. For the most part these theories were not taken seriously until after the Great Depression of 1929. Under pressure by the elected officials, economists began to question whether the gold standard was to blame. This led to the first step in the abandonment of the gold standard when the US purposely devalued its currency and confiscated private gold ownership in an effort to prop up the economy. This marked the beginning of the end of gold backed money, which provided thousands of years of price stability.
Next, in 1971, the US formally abandoned the gold standard for a truly fiat money system. Naturally, other nations began to follow suit with Switzerland being the last country to formally abandon the gold standard in 1999. Today all currencies are now a version of the US, 100% fiat, and 100% backed by nothing.
Centrally Planned Economic System
Under the present system, intelligent but generally academic individuals with little business experience sit in an oak conference room on Maiden Lane in Manhattan and arbitrarily decide just how much money is needed to maintain maximum employment and price stability. Whenever any stress to the system occurs, such as a deflationary event, these individuals have the power to digitally create new base money and feed it into the economy, essentially diluting the value of the existing stock of money owned by the saving class. Every time this happens, the prudent saver is sacrificed for the irresponsible debtor.
The idea of fiat money in and of itself is not a terrible one given that the ability to expand or contract the money supply could in fact soften the effects of a recession and provide for important emergency liquidity to the economy in times of distress such as war or natural disasters. Unfortunately, human nature leads to situations where governments engage in fiscal excess to support their constituents and when they cannot pay for these excesses, they resort to the monetization of these excesses by way of printing more money.
This has proven to be the way of the world since 1971. In a sense fiat money supports the lack of fiscal discipline in the government by magically making up the difference between what the government spends and what it takes in through taxation. Sadly, it is the savers that are being punished and the debtors being rewarded under this scenario. It is the capitalists, who have proven economic prowess and prudence, that are being used to subsidize the government or classes that had engaged in financial excess. This is obviously wrong, and as such I have always subscribed to the Austrian school of thought, studying the teachings of Ludwig Von Mises and Murray Rothbard.
In summary, it is my belief that after nearly 41 years of this experiment, human beings are not capable of efficiently regulating a fiat money. It is this understanding that places the onus on the savers to be their own central bank by making investments that protect them from the guaranteed destruction in value of the legal medium of exchange.
Buffett understands this better than anyone but chose to go out of his way to destroy the credibility of the only tool which has effortlessly achieved the role of protecting purchasing power for its owners. Buffett attempts to disqualify gold as an asset while fully comprehending the devaluation of fiat money by man. This is historically disingenuous.
Buffett:
The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century. This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it even more avidly in the future. The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
Here we have some more ad hominem logic. Buffett first tries to group gold, one of the rarest occurring element in the earth’s crust (.0031 parts per million), with tulips, which are organic, renewable plants that only require sunlight, water, and seeds to grow out of the earth.
Next, Buffett claims, while completely disregarding any data, that the industrial and decorative demand for gold is “limited and incapable of soaking up new production”. The facts are quite different, with nearly 2,300 tonnes of annual demand flowing exclusively to industrial and decorative purposes each year. Buffett should know better as his entire jewelry business is based on the concept that prosperous human beings in a free market economy will choose to “decorate” themselves with gold and silver.
On the other hand, mine supply has proven inelastic at roughly 2,600 tonnes per annum since 1999, even though the price has quadrupled, and exploration budgets have quintupled. More importantly, to reach that number gold miners have had to mine deeper, lower grading material (moving more tonnes of rock than ever, requiring more fiat money than ever) in jurisdictions that are less stable geopolitically.
Buffett:
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth — for a while.
Again, I completely disagree. Buffett is attempting to group gold speculators and gold purchasers as one class. While it is true that there is rampant speculation in gold, it is no different than rampant speculation in equities or any other financial asset. The actual amount of gold which is absorbed for investment purposes is done by central banks themselves willing to part with newly printed money for gold, or capitalists who have enjoyed economic prosperity and wish to protect their wealth.
What motivates gold purchasers are gold’s unique attributes as a store of value with no effort required on the part of its owner. Again, the largest testament is the fact that central banks themselves use gold as a reserve. When Alan Greenspan was once asked why central banks hold gold he stated that it was due to its unique attribute of being the only liquid financial asset which does not represent someone else’s liability. In other words, when central banks seek to avoid counter-party risk, they buy gold.
Buffett:
Today the world’s gold stock is about 170,000 metric tons…At $1,750 per ounce — gold’s price as I write this — its value would be about $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
Again Buffett attempts to label gold as an “investment” when in fact it is not. Gold at its core is an alternative to money and just as paper money yields nothing unless invested, gold too yields nothing unless invested. Even Buffett’s father Howard, a US Congressman, knew the importance of having gold serve as a currency and the risks of letting humans regulate the money supply.
In mentioning gold’s physical attributes Buffett is taking one of the greatest characteristics of gold: the fact that since the beginning of time only 170,000 tonnes of have been mined, and attempting to quantify it as an alternative to investment. There is absolutely no connection between all the Exxon Mobils (XOM) of the world and the 170,000 tonnes of gold. The Exxon Mobils, farmland, and other $300 trillion in global assets must be valued with a medium of exchange or else there would be no way to transact. If I want to sell some shares of Exxon to buy farmland I need a medium of exchange to do so.
Under law, I am supposed to trust the legal tender which is fiat money. However, an intelligent citizen will note the predicament that over time fiat money loses its value. As such, the holders of 170,000 tonnes of gold currently being valued at $9.6 trillion are essentially taking the view that gold will continue to retain its purchasing power, and for this reason they hold a portion of their excess reserves in gold, while in between transactions that may include ownership of farmland, or shares of Exxon.
Gold is not a speculative tool as Buffett would like to portray it. Gold is a financial asset which serves as the ONLY method for removing wealth from our electronically securitized and interconnected financial system which has consumed nearly every asset and turned it into a bit or byte, carrying with it custodial requirements at best, or counterparty risk at worst.
Coincidentally, the “weaknesses” Buffett cited when discounting gold (not being productive) are in fact fundamental strengths given that nobody in their right mind decides to hoard gold instead of investing in equity shares or real estate. Instead, investors who own significant amounts of gold tend to use it as an alternative for cash usually representing only a small portion of their financial assets. In other words, gold holders tend to do so for the very long-term and often hold their gold forever making few purchases over their lifetime.
Simple math confirms this thesis, as 170,000 tonnes equate to only 5,465,500,000 ounces of gold mined since the beginning of time restricting maximum ownership on a per capita basis to roughly 0.78 ounce per human. But this figure is misleading given that we know nearly 35,000 tonnes or 1,125,000,000 ounces are held by central banks and ETFs. Realistically, only a few hundred thousand people on earth actually hold physical gold for investment or asset protection purposes, while 4 billion people hold some form of the nearly $300 trillion (priced in fiat money which can grow at the whims of the central banker) in global financial assets.
Buffett surely knows how small and insignificant gold ownership is as a portion of the global economy. Buffett’s own company, Berkshire Hathaway has revenues ($136 billion) which nearly match the entire global mining industry for gold ($140 billion). While I have immense respect for Buffett, it may be that he is frustrated on an intellectual level given he has publicly stated since 2001 that gold had no intrinsic value while it has performed better than Berkshire Hathaway shares during the same period.
Funny enough, it was only 1998 when Buffett bought 130 million ounces of silver (10% of world’s supply at the time) citing its “demonetization” in 1971 as one of the reasons. Buffett went on to sell silver for roughly $6 per ounce, and leaving nearly $4 billion on the table, which would have amounted to one of the best investments of his career.
Buffett:
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.
Here Buffett is purposely comparing apples to oranges. The real question should be whether the $9.6 trillion will compound at a rate far superior to that of fiat money because it is in no way competing with productive assets. It would be inconceivable to think that an intelligent investor would allocate their productive capital towards gold as opposed to an investment that could generate a return on invested capital exceeding the rate of devaluation of money (inflation).
Personally, I agree that investors should not consider gold as an alternative to Coca Cola (KO), or See’s Candy and I too agree that both should perform better than gold bullion over time. But these are rare fantastic businesses that command a durable competitive advantage and are able to raise their prices almost as quickly as central bankers are able to devalue their currencies.
Buffett makes the flawed assumption that the average investor is going to select securities as well as he does. Mathematically, this is impossible while it is a certainty that the average investor must transact in fiat money leading to a likely scenario where excess liquidity will lose its value over time. For these investors, physical gold allocation typically represents liquid capital that had been accumulated over the years through prosperous activities and is often found lying around doing nothing. Rarely do investors use gold as an alternative to buying cash flow generating businesses, or productive assets. For exactly the reason that gold does not produce anything and is no longer legal tender it will always be under-owned.
I want to make it clear that I have no idea what gold is worth to the dollar, and I don’t believe one can derive an exact price from available supply and demand figures. Further, I am not advocating investors purchase gold at 1,750 nor am I even advocating the return to a gold standard. The goal of this essay was to refute Buffett’s comments and merely highlight the disregard for history in his belief system.
Under Buffett’s view of the world, post 1971, an investor’s job is to earn a calculable rate of return on capital deployed, and as gold does not fall into that bucket he simply disregards it as an option. This is true for oil, iron ore, and even copper, or any other asset that does not have a balance sheet or income statement attached to it. You will never see Buffett purchasing these commodities outright, instead you may see him purchasing businesses which can earn a calculable return extracting these commodities just as he did with Conoco Phillips (COP) for example. With that said, this view was highly contradicted only 14 years ago when he purchased the silver position for Berkshire Hathaway.
I view things differently. While value investing still forms the foundation of my belief system as it relates to valuing businesses and securities, I have also recognized the fatal flaws of our current monetary system and have developed a view which encompasses the two schools of thought. It is with this belief system that I am comfortable making the following three predictions:
1) As long as the world economies continue operating under a fiat money system, both the monetary base and money supply will compound at rates that will continue to subsidize the debtors and punish the savers. As outlined before, these flaws reflect human nature and the lack of fiscal discipline on the governmental level.
2) This guaranteed destruction in the value of our medium of exchange will lead to higher prices in finite minerals and hydrocarbons which must be physically extracted from the earth’s crust and are essential to our modern industrial society.
3) Gold will continue to function as a store of value due to the fact that it too must be extracted from the earth but is rarer than even the rarest industrial commodity. Or more explicitly, the value of all the gold in the world (“Cube A” in Buffett’s example) will compound at a higher rate than fiat money just as it has done since 1971.
