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The True Role of Gold – Alasdair Macleod

At a time of growing concern about the global financial system, it is time to remind ourselves why physical gold is so important, as well as those who might be considering what the benefits are of owning gold.
This article explains the role of gold as money, and the dangers of leaving money on deposit in the banking system.

In the interests of informing and educating a wider audience about the potential benefit of using gold for day-to-day payments, I would be grateful for readers to share this article with their friends and family as widely as possible.

We all know that for thousands of years, gold has been used as money. It qualified for this role because of its rarity and its ornamental utility: in other words, it will always have a value, come what may. This contrasts with unbacked paper money issued by governments, which has no such fundamental value. It is no accident that all collapses in money’s purchasing power have involved either debasing gold and silver coinage, or far more often the over-issuance of government paper currency. To these two versions of fraud on ordinary people, we must add a third, and that is by banks licenced by governments to create credit out of thin air.

How banking works

Let us look at bank credit for a moment, because that is the source of most money in circulation today. If a bank agrees to lend you money so you can pay your creditors or buy new equipment, you pay these obligations by transferring money from your loan into their banks. Meanwhile your bank does not need to have the money to lend to you. It balances its books by borrowing the funds from other banks with surplus funds to lend.

To illustrate the point as simply as possible, imagine there is only one bank. The bank lends you money, and you spend it. And as you spend it, the people and businesses who sell you stuff see their bank balances rise as they are paid. The bank created the loan for you, which was then covered by the deposits created by your spending, as you draw down funds from the loan. This works for multiple banks as well. All they need is a mechanism to ensure deposits are efficiently allocated between them, so that all the banks end up with balanced books. That is the function of the money market.

So by this magic, the money originally lent to you was created out of thin air by your bank, and then covered by deposits taken from the other banks where necessary. Banking is in effect a closed money-creation system. Note that your bank has not had to use its own money to create the loan to you. So a simple banking balance sheet consists of its own money (its capital, or shareholders’ funds), money owed to it by borrowers, such as you in the example here, and owed by it to depositors, such as the people you have paid.

If you borrow money from the bank, they will charge you a rate of interest, which if you are an ordinary person, can be anything perhaps between five and twenty per cent. With interest rates close to zero, the bank can fund this loan to you at about half of one per cent. That is nice business, particularly when it doesn’t have to put up its own money. Obviously the bank faces a risk which it it has to cover out of its own capital if necessary, and that is if you default on the loan.

A cautious bank will take note of lending risks, and restrict its lending to an amount it can comfortably cover. But the temptation to lend many times the bank’s own capital is strong. If, for example, a bank has $100 million of its own money, and it lends the same amount to borrowers at an average rate of say 7%, which it can fund through the wholesale market at ½%, then it generates a gross income of $6,500,000, out of which it will pay its operational costs. Now let us assume it lends ten times its own money on these terms; now its gross income becomes $65,000,000. That, my friends, is what a license to print credit does for a bank.

Wouldn’t it be nice if we could all do this! Unfortunately, it is criminal fraud, unless the government regulator has given you a license to do so. We can now see how bankers can become driven by greed, particularly when they think economic conditions are set fair. Equally, we can see how they might be driven by fear, when economic conditions deteriorate and the risk of losses on loans increases. This is the driving force behind alternate booms and busts, the expansion of bank credit in good times, and the withdrawal of credit in bad times.

You may reasonably think banks creating credit out of thin air to the extent that it is ten times their own money is highly risky, but in the world of banking it has become something of a baseline. In the Eurozone, the most recent figures from the European Central Bank tell us that the average ratio of bank capital the total balance sheet is double that. This means the average margin available to absorb losses is only five per cent. More worrying still, is the fact that an average always includes banks with an even higher exposure to risk in the event of lending mistakes or a deterioration in lending conditions.

Admittedly, what is described above is only one activity banks indulge in, others being investing depositors’ money in government bonds, and also dealing in securities markets. There are other obligations, such as derivatives, which are bets of one sort or another on future prices, which can add hugely to the risk to a bank’s own money. Then there is physical paper cash, which banks don’t like, because it allows you to take your money out of the system, which when enough people do so leads to an old-fashioned run on the bank.

People write whole books on this stuff, but this is all you really need to know to understand that behind all the soothing words from bankers, economists and politicians, there is always a risk that the whole banking system could become unstable, crash, and make your deposits worthless. Of course, for small deposits, some governments guarantee protection, but it is worth asking yourself whether you should place your entire trust in a government discharging all its obligations in a financial crisis. Importantly, you must appreciate that when you deposit your money in a bank, it is no longer yours. From that moment, the money is the property of the bank, and you are just a creditor. No bank tells you this unless pushed.

Owning gold as money

We all know how convenient modern paper currencies have become for everyday spending. In contrast, gold, and also silver for that matter, is no longer used as spending money, except in a few parts of Asia. So does this mean that gold is no longer money? Well, no, because circulating as everyday money is only one function money offers. Money also acts as a store of value, and here gold has the best track record. Let’s look at a simple example, measured by the US Government’s own inflation calculations. Over the last fifty years the US dollar has declined by 87%; in other words, a dollar saved when today’s retirees started work is worth only thirteen cents in today’s money. As a store of value, the dollar, and all other government-issued currencies for that matter, has been atrocious.

Over the same time-scale, gold has risen in its purchasing power measured in dollars by thirty-four times, which adjusted for a declining dollar, means that gold buys about four and a half times today what it did fifty years ago. So as a store of value, gold has continued to act very effectively as money.

The risk of bank failure is increasing

How much of your cash you should hold in physical gold depends how seriously you think there is a risk that your bank, or for that matter a number of banks in the banking system, might fail. If you follow the financial press, you may be aware that bank stocks have been falling on growing concerns about individual banks’ finances. There are other indications, such as measures of their credit risk, that have been escalating, signalling to us that all is not right. So even though ordinary people going about their daily business are generally unaware of it, the likelihood of a new banking crisis is something we should take very seriously.

Banks today face mounting losses from a number of sources, such as commodity-related loans, coupled with a slow-down in the world economy. And because the levels of outstanding debt are at the highest ever recorded in peacetime, the banks might have to absorb some big losses. When we bear in mind how banks lend many times their own capital, the danger of banks losing all of it and failing becomes all too apparent. If the average European bank is forced to write off just five percent of its loans and investments, all its capital will be eliminated.

Depositors are not stupid, and they are becoming increasingly aware that their money is at risk. Their nervousness gives rise to another problem when they try to withdraw money, because banks cannot just force their borrowers to immediately repay their loans in order to fund deposit withdrawals. Therefore, a bank always lacks the ready money to cover a run on deposits, and it may be forced to rely on the central bank to make up the difference. And as soon as the central bank is forced to intervene, confidence in a bank, which is what banks actually rely on, quickly vanishes.

If you are a depositor losing confidence in your bank, and if you are worried that banking problems could spread through the wider financial system, you won’t want to jump out of the frying pan and into the fire by transferring your deposits to another bank. Banks also make it difficult for you to withdraw physical cash in any quantity, so what else can you do?

You can buy something to get rid of your money, and give someone else the worry. But that does not resolve the problem that you will always have, and that is to be able to continue to buy the essentials of life in the event of widespread bank failures. Alternatively, you can transfer into gold and remains your property, to spend as you please.

This article merely draws the reader’s attention to banking risks that markets are telling us are increasing. It is not a forecast that such a crisis will actually happen. It should be borne in mind that central banks are adept at finding solutions when the financial system comes under stress, and we must all hope that markets are just being too pessimistic. Having said that, a wise person will surely think carefully about his or her options, just in case the worst happens.

Posted on February 22, 2016 by The Doc

Alasdair Macleod

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