Gold Bites the Dust
John Mauldin's Outside the Box

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Confirmation bias is a very real psychological phenomenon. It especially infects investors. What we mean by confirmation bias is the tendency of people to read material which reinforces their present views. They associate with people who agree with them and who think like them. So their biases are constantly confirmed.

The antidote is to read material, and associate with people, that/who do not agree with your views. It is more important (and profitable) to learn why you are wrong than to hear why you are right.

Because of this, I spend a lot of my research time trying to figure out what is not common knowledge. While running with the herd is safe most of the time, it is not very rewarding. It is one of the reasons I started "Outside the Box," to bring you thought-provoking and challenging ideas.

Today we are going to look at an essay by a guy who definitely does not run with the herd. Indeed, he may be the anti-herd. My good friend Andy Kessler has just written Running Money about his days running what was the fourth most successful hedge fund for its time. He and a partner launched a Silicon Valley technology hedge fund in the mid-90's and began selling and taking profits in 1999. He ran all the way up the market, sold at the top, making his investors six times their money. He subtitles the book "Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score." His book, like Kessler himself, is funny and irreverent. His publisher describes him as a brilliant investor, a born raconteur and an overall smart-ass. The Financial Times says this is going to be one of those books like Liar's Poker or Den of Thieves which is required reading for those in the industry. I agree. If you are in the game of running money, you gotta read this one. This should be required reading for brokers and advisors. Besides, it is a lot of fun. (

The next two weeks "Outside the Box" will probably be two of the more controversial of the year. Andy Kessler has a very different take on the one investment that inspires more passion than any other - gold. It is unlike the normal pablum from those who feel along with Keynes that "In truth, the gold standard is already a barbarous relic." But he does ask hard, thought-provoking questions. Gold bugs are warned to drink a few glasses of wine before reading.

I will be upfront that I do not buy all of his arguments. Next week, at the end of his piece I will do a short rebuttal. But he makes some very good points. We had a very pleasant lunch this last weekend in Palo Alto, discussing gold, the meaning of value and other pleasantries. Andy is one bright guy. Now, let's read part one.

All That Glitters is Not Gold

Since John Mauldin was kind enough to run his comments on my new book Running Money (read original article here), I've been flooded with feedback on my margin surplus theory. Some agree, some disagree. Like my eighth grade algebra teacher, most wanted me to show more of my work on how I got to my conclusion. Fair enough. Luckily I am in possession of The Missing Chapters, a section of Running Money that ended up on the cutting room floor (to make room for some other fun story, probably the Elvis Impersonator CEO!)

I had spent some time in the book describing the industrial revolution so I could look for patterns in Silicon Valley today. I did the same for money and banks and classical gold standards, which got cut. So here it is - I hope it can provide more insight into international trade and an intellectual property world.

Gold Bites Its Own Dust

So why in this modern world of microchips and genomics do we still talk about gold? Do we still need it? Why do we have it at all? Is a "gold standard" necessary? Are banks even necessary? Let's look back at the jolly old England and see how we got all this stuff and why.

So how do you get paid for running an industrial engine and an empire like the Brits? Very carefully. It's one thing to make cheap comfortable underwear and deliver it via railroad and steamship to a customer's doorstep, it's another thing to get properly paid for it, create lasting wealth, and maintain your lead.

By mid 19th century, England was running huge trade surpluses, exporting more in value than it was importing. Hey, that is what an industrial engine should be doing. The difference between exports and imports was made up in gold. Sort of a "if you want our goods, fork over the glitter." Gold (the Brits never trusted silver) was the only accepted form of payment and it became the only form of international settlement. England did anything to get it.

* * *

Economists like to point out that an ounce of gold represents the price of a men's suit, and has for thousands of years. That ounce of gold represents the cotton or wool, the creation of the thread and the cloth, the tailor cutting it to size and sewing it all together, and perhaps a modest profit. There's a lot going on there.

But while you can wear the suit, you can't do much with the gold, or four Ben Franklin greenbacks today. You've got to spend it on something to redeem its value. I know this is obvious, but it's still worth repeating. Money is just a conduit. It is the value of work already done. Borrowing or credit is the opposite, the value of work to be done.

Spain discovered gold in the New World. OK, to be fair, the Aztecs had discovered gold and in 1519, Hernando Cortez and the Spanish discovered the Aztecs. This increased the world's known supply of gold, and like magic, economic activity and trade increased. Why? I suspect the Aztec gold was a shot in the arm, a bump in the world's money supply. Of course, there was no official trade bureau keeping track of such things, so the correlation was probably not noticed. Spain faded into oblivion because all it did was steal gold, and rarely created enterprises. Other countries from France to England used the gold as a unit of money for transactions and built enterprises and robust economies, i.e. true wealth vs. the transient kind.

Sherman, set the Wayback Machine to 1694 England (said Peabody) and let's see if gold is all that it is cracked up to be.

* * *

Mercantilism is all the rage. The British monarchy has the crown jewels, but not much gold and not much liquidity. So joint-stock companies are formed to explore/exploit India and points east as well as the New World to the west. The Bank of England is established as the banker to the government, which put a better way, means it would handle the government's debts.

As such, the Bank of England was in charge of issuing currency in the form of banknotes. It would trade a piece of paper that said 100 pounds for the equivalent value (not weight) of gold. The currency was backed by the gold in its reserves. This so-called commodity money sure beat carrying around heavy bars of gold for big ticket items.

But hardly anyone ever came into the Bank to ask for the gold. It just sat around tarnishing. Goldsmiths in London had long before figured out they could lend money against the gold they held, making money on the interest payments. As long as they were careful to only write good loans, and not everyone asked for their gold back at the same time, this so-called "fractional reserve banking" was a hugely profitable business.

Well, the Bank of England existed to make money for its secretive shareholders. So it implemented this goldsmith sleight of hand, and jumped into fractional reserve banking in a big way, by issuing loans, sometimes for 10 times as much gold as it had on hand, mainly to the government. These loans were secured by future tax payments. The more gold in their reserves, then the more loans they could write. Mercantilism was the government's plan to stock those reserves with lots of gold, so it selfishly could borrow more.

The banknotes the Bank of England issued were known as fiduciary money, money based on trust. There were gold reserves backing the banknotes, sort of, and not enough if people really wanted the gold. More gold meant the money supply could increase as more of this fiduciary money was created. It wasn't a bad system, money supply had to come from somewhere. Using gold as a store of wealth was already a sleight of hand, money only fractionally backed by gold was a sleight of a sleight. So what. But then someone messed it all up.

* * *

Sir Isaac Newton had leveraged his planetary dreaming into a real job, as Master of the Mint. In 1717, the Newt decided that the Guinea would represent 129.4 grains of gold. Put another way, an ounce of gold was worth 4 pounds, 4 shillings and 11 1/2 pence. You can tell Sir Isaac was a scientist, if he was an engineer he would have rounded it down to 4 pounds per ounce and called it a day.

He also set the price of silver at the same time and overvalued it relative to gold. Newton noticed that because of trade deficits, the East India Company was shipping most of England's silver to India to pay for tea and spices, and probably overvalued it on purpose. It didn't matter since holders of silver quickly sold it and bought gold for the one time arbitrage, but it was the end for silver in England. Newton couldn't have known that silver had real industrial uses, that when formed into the compound silver halide it would be sensitive to light and usher in a huge photography business in Rochester, NY. Nor would he have known that the photographs would each be worth 1000 words.

Newton's fixing of the exchange rate between money and gold was the market price in 1717. Fair enough. But like Newton's Third Law of Motion concerning momentum, that same exchange rate would last until 1931. It would take the world that long to embrace an alternative to the limiting gold standard. Until then, gold ruled.

David Hume argued in 1752 that more gold and more money supply didn't necessarily mean an increase in wealth for England. Ask Spain. He had a good point, but no one listened.

* * *

The Bank of England and other local banks issued fiduciary money, and in normal times, money supply was supposed to increase to the level needed in the economy. But if a profit was to be had loaning out new money by leveraging the gold, then the money supply would have to increase beyond what was needed. Econ 101 says too much money chasing too few goods means prices go up, i.e. that nasty word inflation. And this is in normal times. In abnormal times, all hell breaks loose.

That's what happened during the Napoleonic Wars. In 1797, there were rumors, which were not true, that French troops had invaded England. This caused a huge run on banks and financial panic, as everyone demanded their gold, to which the banknotes strongly suggested they were entitled. Knowing these gold reserves were needed to pay for the War, William Pitt as Prime Minister had the Bank of England suspend convertibility of its banknotes into gold, via the so called Bank Restriction Act. Instead, the Bank issued banknotes backed only by the fiat or command of the government (maybe that's why those Italian Fiat cars never start up in the morning, no matter what commands you swear at it!) That's it. "We said thee is worth a pound sterling, so thee is, got a problem with that?" Fiat money was an interesting concept, the government could issue as much or as little money as it wanted to, gold be damned.

Between 1797 and 1821, during the Restriction, England's economy took off, partially because it was wartime, but also because the industrial age had begun. Steam engines ran mills. The triangle trade ran circles around everyone else in the world. Affordable English goods were in high demand as substitutes for home spun and home made.

Manufacturers got wealthy, but landowners, who still controlled Parliament, were being left behind. One reason was that while English exports were growing, countries on the Continent, including post war France, had nothing to pay for these goods with, except corn and grain. Parliament, in the pocket of landowners, passed stricter and stricter Corn Laws. This had the effect of raising food prices for workers in factories, who demanded higher wages, but it also decreased the market for goods from these factories, because there was no way to pay for them, except with the grain that was more or less banned from England. How stupid is that? This was a double knock on both mercantilism and the gold standard.

This set up a huge debate between Bullionists, who demanded convertibility to check inflation, and anti-Bullionists, who argued against it. The anti-Bullionists conjectured that banks would only issue banknotes as merchants turned in their "bills of exchange," sort of like selling their accounts receivables. This was known as the Real Bills Doctrine, stating money was credit, and money supply would only grow to the level of actual credit in the system. John Law first developed it in 1705.

This was not good news for anti-Bullionists, even though they were probably right. Law was soon exiled after winning a duel and lived in Paris. While there, he became buddies with the Duke of Orleans. After the death of Louis XIV, the French monetary system was une mess, and with the Duke's help, Law volunteered to fix it. He set up Banque Generale, which issued fiat currency, backed by zip. And despite his Real Bills Doctrine, Law issued currency like it was, well, paper. Around the same time, he set up the Mississippi Company, whose stock ballooned concurrent with the English South Sea Company, eventually being worth more than all the gold and silver in France, which from the looks of the reserves of Banque Generale, was not very much. A bursting of the Mississippi Bubble in 1720 caused a run on the Banque and a depression in France for years to come. Almost three hundred years later, the French don't call their banks, Banques, but Credits, as in Credit Lyonnais.

John Law proved economists shouldn't be businessmen and his reputation killed the Real Bills Doctrine. Even when "invisible hand" Adam Smith backed Real Bills the Bullionists weren't swayed. Too bad. Real Bills was only slightly flawed in that it didn't check the amount of speculative loans a bank could issue, since loans are the source of bank profits. A floating reserve requirement, putting limits on fractional reserve banking in good times, could have fixed that flaw. Perhaps a Real Bills Doctrine could automate the creation of money supply today, in a modern non-gold standard world. But Reserve Bank chairmen have too much fun adjusting interest rates and turning on and off money supply at their whim to entertain the thought.

Inflation raged throughout the Restriction period, up until 1814, helping the Bullionist's argument that a strong gold standard would hold off inflation. But there was a war on, so the economy was working overtime to supply both the military and the regular economy, and it was hard to keep prices from going up.

* * *

The protectionist Corn Laws were inflationary. Workers demanded higher wages to pay for higher food costs. Add to that the unrestricted loans from banks, which increased the money supply, and it was no wonder that inflation was rampant during Napoleonic War England. Peel, who had implemented the Bank Restriction halting convertibility, knew something had to be done. But he couldn't pass anything through Parliament, to either cancel the Corn Laws, which would hurt landowners, or restrict bank loans, which would hurt bankers.

Peel turned to gold for the magic he needed to kill inflation. He put together a Bullion Committee filled with, you guessed it, Bullionists who pushed through a repeal of Restriction, meaning a return to convertibility.

After Wellington whacked Napoleon and ended the war, like magic, a period of deflation or dropping prices, occurred. This strengthened the anti-Bullionist's case: A fixed price of gold is no way to run an economic system; especially when the output drops in price. Nonetheless, a Resumption Act (they should have called it anti-Restriction) passed in 1819, and mandated convertibility by 1821. Memory of John Law's buffoonery cast a long shadow and convertibility was the damper on runaway money supply.

The Bank of England and other banks went back to fiduciary money, loaning out banknotes with fractional reserves of gold. Still, there was another nine years of deflation until 1830, most likely because the gold exchange rate had been fixed for the last century thanks to Sir Isaac and prices during the war had gotten out of whack and needed 15 full years to adjust.

How strange. In times of peace, banknotes are not trustworthy enough and must be backed by gold in reserves, but in times of war, when nobody trusts anyone, banknotes are based on pure fiat, trust out of thin air. Welcome to the backwards world of banking.

As an aside, it is bizarre that fractional reserve banks, which describe just about every bank in existence today, are basically bankrupt. A deposit in a bank is an asset for you and me, but it's a liability for the bank, since it owes us the money. But then the bank lends out the depositors' money as loans, and those loans are a bank's assets. Banks almost always have "assets" less than "liabilities," and therefore a negative net worth. And great profits until everyone wants his or her money back. So Trust with a capital T is key. It's the same for stock markets. If everyone sells Intel on the same day, its price would go to zero, there are not enough buyers or capital to handle a run on the stock. But it doesn't go to zero. At a low enough price, some investors see the value of Intel's future earnings and start buying it. So stock markets are built on Trust with a capital T as well, but there is a price mechanism to hold off runs and panics. Not so with banks.

* * *

More trade meant even more gold flowed into England, but unfortunately, there was no outlet for it. The Brits could have bought more foreign goods, which would have reduced their trade surplus and incoming gold, but there was not much to buy, and the echo of mercantilism of times past still encouraged exports and hording gold. England might have bought foreign fixed assets, maybe land or buildings, but they weren't necessarily for sale. Even if these assets were for sale, the legality of a foreign ownership or even getting legal title was questionable. The best solution to England's gold buildup would have been to use it to set up factories in France or Germany or America. Politically, this was a dead issue. No way was that going to happen.

So England was destined to suck up every last nugget of gold. Two major events kept this economic system alive well past its usefulness. Both happened around 1850. The first was the new discovery of gold in California, Australia and South Africa. The money supply to run the world's economy got the bump it needed to buy British goods. The other was the creation of screw propeller steamships, which lowered transportation costs by 50-70%, and increased demand for British products.

The more gold England had, the higher its bank reserves. With no outlet, this led to more banknotes in circulation, whether the economy needed that increased money supply or not. Too much money chasing too many goods meant price inflation. Wages went up. Interest rates went up, another byproduct of too much money and inflation, which often caused banks to fail, and resulted in runs on those banks. The fractional reserve banking was anything but stable, all because too much gold was in the British banking system. England had become Spain, laden with gold and not enough to spend it on.

So England devised a way to get rid of gold. It turned out, at least in my opinion, to be the wrong way.

* * *

Bank runs and financial crises from too much gold became common: They occurred in 1825, 1847, 1857 and 1866. Think about it. In periods of inflation, money loses its value relative to the goods it is buying. This lack of faith in money causes people to move into real assets, including gold. Even though money was exchanged into gold at a fixed rate, the fear that the rate would change when the money lost value, caused depositors to ask for real gold from banks. Plus, if a local bank failed, their banknotes would be worthless. Better to convert to gold quickly. Lack of faith is disastrous.

Something had to be done. For answers, most economists looked back to something David Hume had written back in 1752:
"There seems to be a happy concurrence of causes in human affairs, which checks the growth of trade and riches, and hinders them from being confined entirely to one people; as might naturally at first be dreaded from the advantages of an established commerce. Where one nation has gotten the start of another in trade, it is very difficult for the latter to regain the ground it has lost; because of the superior industry and skill of the former, and the greater stocks, of which its merchants are possessed, and which enable them to trade on so much smaller profits. But these advantages are compensated, in some measure, by the low price of labour in every nation which has not an extensive commerce, and does not much abound in gold and silver. Manufactures, therefore gradually shift their places, leaving those countries and provinces which they have already enriched, and flying to others, whither they are allured by the cheapness of provisions and labour; till they have enriched these also, and are again banished by the same causes. And, in general, we may observe, that the dearness of every thing, from plenty of money, is a disadvantage, which attends an established commerce, and sets bounds to it in every country, by enabling the poorer states to undersell the richer in all foreign markets."
The best and brightest economists of the time met in Paris in 1867, to discuss a way to have both sound money and increased international trade. They came up with a system known as the "Price specie flow." Sounds like a case of the runs, rather than a cure for bank runs. It messed up the financial digestive system for another century.


We will stop here and conclude next week. Again, I highly recommend you read his book Running Money (for more details see

I write this piece from a conference at Stanford which is exploring the technologies and society of the future. It has been a lot of fun, and definitely has me playing in a very different sandbox than the normal investment conference. I get on the plane early tomorrow with a lot to think about.

Have a great week.

Your still trying to figure out memespace analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 11-08-2004 4:05 AM by John Mauldin