Gold: Its Role within the Modern Investment Strategy – Aug 1994

Its Role within the Modern Investment Strategy

© 08/94 Princeton Economic Institute
By Martin A. Armstrong

There have been numerous people who have argued that gold is THE hedge against inflation. Many will tout their fancy statistics and point to all sorts of charts in support of their case. Others will argue that gold rises during geopolitical uncertainty and at the first outbreak of war it should be bought. And yet there are still others who claim that gold has LOST its luster and is a throw back to ancient times. In their boasts, they claim that inflation has been vanquished and that gold is no longer needed to stabilize the world monetary system.

In an effort to answer these questions in hope of separating the MYTH from REALITY, it demanded that a very long database be constructed. Looking at gold’s performance over the past 20 or 30 years is simply NOT enough historical perspective to come up with a realistic outcome untainted by subjective theories and biases.
To start, we gathered one of the more consistent time series on inflation – the US Wholesale Price Index. The prices of raw commodities at the producer level have always been a more definitive view of inflation rather than the politically manipulated CPI (Consumer Price Index). Due to the fact that the CPI is used to adjust taxes, real interest rates, social security payments and entitlement increases of all sorts, the formula for the CPI has undergone at least 14 MAJOR revisions since World War II. The last revision of major importance took place back in 1983 when real estate was largely replaced by rents. This revision was significant due to the fact that it accounted for 40% of the total CPI prior to that time. The revision was carried out under the pretense that housing was better reflected by rent than value. Appreciation in housing itself was viewed as an investment – not part of the true cost of living.

As real estate escalates, each subsequent generation not only get less for their income, but are also forced to rent for greater periods of time than the previous generation. Despite this fact, government chooses to IGNORE this aspect. The fact that the standard of living is persistently reduced by this form of long-term inflation and others is of no consequence to politicians who also exclude taxation from the CPI as if this too had nothing to do with net disposable income. Over the long-run, it does NOT take a genius to see that a middle income family during the 1950’s and 1960’s could buy a home and get by with only the man bringing home the bacon. Today, even if women’s rights groups were not around, few newly married couples can survive on only one income no less buy a house and car under such circumstances. This is perhaps above all the most visible effect of long-term inflation and constant escalating taxation. The growth of Government itself has been the single greatest cause of the reduction in the standard of living for all Americans. Where in 1920 it once accounted for 20% of the Civil Work Force – today the government has exceeded 33%. If you simply add all the non-producing government employees, unemployed and welfare groups, you will quickly approach 50% of the Civil Work Force. This means that every privately employed worker must be taxed at least 50% to pay for the unproductive group within society. As this group grows, it reduces the standard of living for the whole. For these reasons and still others, any attempt to adjust a commodity backward in time relative to inflation is not as easy as some would have us think. Consequently, for this discussion, the PPI (Producer Price Index/Wholesale Index) will be used. A valid criticism of our selected index adjustment is the fact that the implied inflation is far less than the “real” inflation experienced by the consumer. Therefore, this study for discussion purposes should be regarded as EXTREMELY conservative and an understatement of inflation as a whole.

Essentially, there are 5 major rallies in gold that took place in the US dollars or its predecessor during the years 1780, 1814, 1864, 1920 and 1980. At first glance it is easy to see that the overall trend for gold has actually been bearish in real terms. The rallies aside, this bearish trend in gold has represented the accomplishments of man. As he has built the great nations of the world and emerged out of the depths of the Middle Ages, inflation has tended to decline on the average since the middle of the 16th century. By our analysis of many sectors, we see that the overall LOW in the long-term historical trend for inflation most likely took place during the 1991 time period. This year also represents the low for gold expressed in 1982 dollars. Accordingly, it appears that we may be on a serious change in long-term trend and that inflation as a whole will tend to rise at least over the next three decades and perhaps even much longer.

This alarming change in trend in long-term inflation is most likely being caused by the opposite reason for its decline. This suggests that what we are going to witness is the overall decline of society from an organized perspective. This declining organizational trend will therefore be accompanied by a higher inflation, as was the case for the fall of the Roman Empire. Inflation rises as confidence in government declines! It is interesting to note that the two strongest rallies for gold in “real terms” (excluding the American Revolution) took place between 1864-1869 and 1971- 1980. During both periods, inflation advanced, as did the price of gold due to the lack of confidence in government. The 1864- 1869 period emerged as the US abandoned the gold standard during the Civil War. The paper currency, which began to flood the economy in 1861, was backed by nothing but the green ink used to print the reverse side of the note thus giving rise to the term “greenback.”

The 1971-1980 era marked the next major period when the United States government was unable to meet its foreign obligations under the Bretton Woods Agreement. As a result, the gold standard was abandoned in 1971 once again and the confidence in government declined taking gold straight upward eventually into a 1980 high of $875.00. This entire period was marked but not merely a collapse in the gold standard, but also a collapse in the confidence of government itself. This period marked the fall of Richard Nixon in August 1974 only to be followed by Presidents Ford and Carter. Ford FAILED to instill a high level of competence in the eyes of the people. President Carter was viewed as honest, yet totally inept. Clearly this was a period where confidence in the Presidency could not have been skewed lower.

The re-emergence of stability was brought about by the Reagan Administration, which talked a good game at restoring the “respect” that America deserved. That change in the way the people looked at President Ronald Reagan helped in bringing about the “DEFLATIONARY” era. Reagan ran on a platform vowing to reduce inflation and the marketplace believed him. Almost immediately, inflation began to subside and the recession began before Reagan even took office. This was a sign that the populace was willing to step back and see what would happen rather than assume that everything would simply move higher in price from one year to the next. There are naturally going to be those who question this interpretation on political grounds. However, the point is “CONFIDENCE” – NOT political agendas. Despite the fact that the National Debt DOUBLED under Reagan while money supply rose dramatically, inflation declined! The Monetarist’s view of inflation FAILED to hold during the Reagan years. If the money supply rose and the National Debt DOUBLED, then inflation should have risen! The reality of the situation is that inflation declined! The only difference between Reagan and the preceding period back to 1971 was a level of “CONFIDENCE” on the part of the people both domestically as well as internationally. As a result, the dollar declined during the Carter era to its lowest point in time since World War II. Under Reagan, the dollar rose to all time record highs by 1985 due to international CONFIDENCE in America’s new role.

It is widely known in medicine that a person CAN make himself ill should he believe he IS sick in the first place. Doctors will confirm that the “will to live” is critical in recovery. It would appear that the economy responds in a similar manner. If things are absolutely disastrous, but the people do not believe so, then the economy holds its ground. The recession under George Bush was far less in magnitude than any previous recession in the postwar era. Unemployment remained well below 10% when it had reached 12% under Reagan. Despite the statistics that support this case, the “feeling” prevailed that the Bush recession was far worse than anything previously experienced. Obviously, Bush lost the election on grounds of appearance or lack of “confidence” rather than hard statistical reality. Hence, the facts are almost irrelevant when anticipation and assumption affect the underlying confidence in any situation.

PANIC OF 1869 The period of 1864-1869 is an interesting one to say the least. The confidence in government was at an all time low. The infamous “Black Friday” was a term first coined to describe September 24, 1869 (See NY Times 9/24/1869). This was a day of financial panic of major proportions – so serious that the government called out the militia to suppress the mob that was storming into banks and hanging the tellers. In an effort to corner the gold market, speculators, including Jay Gould and James Fisk, sought the support of federal officials of the Grant Administration in order to push the price of gold up before the US government returned to the gold standard after the Civil War. The scheme would be for the government to accept whatever free market price gold would reach helped by the “gold-ring.” Therefore, the government was the intended exit strategy for the market manipulators.

James Fisk —————- Jay Gould

The political corruption at the time was ramped and the President’s brother-in-law was rumored to be part of the gold-ring. The attempted manipulation failed as the federal government announced that it would release 4 million ounces of gold – when in fact it intended to release only $4 million worth. Nevertheless, the rally collapsed overnight and the panic ended on a “Black Friday” when many thousands were ruined (See Daily Chart 1868-1869).

The gold-ring’s leader was Jay Gould (1836-1892). From the humble beginnings of a country-store clerk, Gould rose to control half the railroad mileage in the Southwest, New York City’s elevated lines, and the Western Union Telegraph Co. Aided by James Fisk, he defeated Cornelius Vanderbilt for control of the Erie RR. However, this visible episode led to huge public protest over Gould’s stock manipulations and resulted in his expulsion in 1872. Gould then bought in the Union Pacific and other Western roads, and by keen business practices gained control over four rail lines that eventually made up the Gould system. Gould’s scheming with Fisk to corner the gold market in 1869 resulted in the “BLACK FRIDAY” panic.

The lack of confidence at the time was sparked by not only the corruption within the Grant Administration, but also due to the existence of the greenback itself. Although the greenback was legal tender, the unsecured by specie status brought back horrid memories of the Continental Currency Crisis, which was still as fresh in the minds of the populace then as the Great Depression is today. The greenbacks were first issued in 1861 by the US government in an effort to fund the Civil War. By 1865, greenbacks in circulation totaled more than $450 million. Originally issued as temporary, the notes were to be recalled following the war. However, the hard times of 1867 led to demands, particularly by Western farmers, for an inflated currency through the creation of more greenbacks. A compromise was finally reached in 1869, whereby greenbacks to the amount of $356 million were left in circulation; the law creating them was made constitutional in the Legal Tender Cases (1868, 1870, and 1871). The issue reappeared during the Panic of 1873, with hard-hit agrarians, intensely opposed by conservatives, once again demanding creation of more greenbacks. The conservatives triumphed and the Resumption Act of 1875 fixed Jan. 1, 1879 as the date for redeeming greenbacks. With returning prosperity, however, confidence in the government began to soar, and few greenbacks were surrendered. In 1879 Congress provided that greenbacks then outstanding ($346,681,000) would remain a permanent part of the nation’s currency.

The inflation that was created by issuing unbacked currency was viewed as a benefit in those days, particularly among commodity producers. There was even a Greenback political party for a few short years between 1874 and 1876 to promote currency inflation. Its principal members were Southern and Western farmers stricken by the Panic of 1873. They nominated Peter Cooper for president in 1876, but he received only 81,737 votes. Uniting with labor in the Greenback-Labor party (1878), they polled over 1 million votes and elected 14 representatives to Congress. Thus encouraged, and with a broadened program that included woman suffrage, federal regulation of interstate commerce, and a graduated income tax targeted at the rich, they nominated James B. Weaver for president in 1880. But the return of prosperity had suppressed the discontent, and their vote declined to a little over 300,000. Following the 1884 election, the party was dissolved with many of its members joining the Populists movement.

The violent swings within the economy of the United States during the second half of the 19th century can all be largely attributed to a lack of confidence. Political and corporate corruption was ramped and with them – volatility rose causing severe fits between inflation and depression. Panics have been with many since the dawn of time. Historians have recorded real estate panics and debt crisis at the time of Julius Caesar. More recently, perhaps the earliest panic of modern capitalism occurred in France and England in 1720, touched off by wild speculation in the stock of John Law’s colonizing company. The first real panic in the US came during 1819. Others were to occur in 1837, 1857, 1869, 1873, 1893, 1903, 1907, 1929 and of course 1987. Banking instability has also been a historical major contributor to panics along with government.

PANIC OF 1837 The Panic of 1837 was one such incident involving an unstable currency and financial system resulting in a lack of confidence in both government and the banks. An independent treasury system emerged when President Andrew Jackson transferred in 1833 government funds from the Bank of the United States to state banks. The Bank of the United States was a national bank created by the U.S. Congress. The first bank (1791-1811), proposed by Alexander Hamilton and the Federalists, aroused opposition, especially from the West, for its conservative policies, which meant it was against inflating the money supply through means of unbacked paper currency. Its charter was therefore allowed to expire. Difficulties in financing the War of 1812 caused the creation of a second Bank

of the United States (1816-36). It prospered under the management of Nicholas Biddle and effectively served as a central bank. However, this again was viewed as a “TOOL” of eastern commercial interests by the Jacksonians.

Andrew Jackson came to fame when in 1818 he led a reprisal against the Seminoles in Florida and captured Pensacola, involving the US in serious trouble with Spain and Britain. The conduct of “Old Hickory,” as he was called, pleased the people of the West and he was regarded as the greatest hero of his time. Jackson became associated with the increased popular participation in government, which later became known as “Jacksonian Democracy.” His liberal style movement almost won him the presidency in 1824, but the election ended in the House of Representatives, with a victory for John Q. Adams. This left a bitter taste in Jackson’s mouth and pride. Still, he ran again and won the presidency in 1828. Jackson’s victory brought a strong element of “personalism” to Washington and his administration became known as his “Kitchen Cabinet.” Andrew Jackson was also the first President to create the “SPOILS SYSTEM,” which simply meant that all your buddies who helped in the election got fat paying jobs in government – the “spoils” of victory were given to the troops. From this anti-establishment and anti-Eastern States perspective, the fight against the Bank of the United States became an important issue in the presidential election of 1832, in which he defeated Henry Clay. Following his victory, Jackson went about destroying the central banking system of the US and transferred federal assets to chosen state banks, which became known as Jackson’s “pet” banks. This action seriously impaired the confidence in the currency and in 1836 Jackson issued the “Specie Circular,” which said that all public lands must be paid for in specie. This in effect hastened the Panic of 1837 and tended to contradict the private script system where individual banks were allowed to issue their own paper currency.

In 1840, under President Martin Van Buren, an independent treasury isolated from all banks was set up. However, in 1841 the Whigs repealed the law, and it was not until 1846 that the Democrats restored the independent treasury system. The Act of 1846 ordered that public revenues be retained in the Treasury building or in subtreasuries in various cities. The Treasury was to pay out its own funds and be completely independent o f the banking and financial system of the nation; all payments in and out were to be in exclusively specie. In practice, the system created problems in prosperous times by amassing surplus revenue and thus restraining legitimate expansion of trade; in depressed times, the treasury’s insistence on being paid in specie reduced the amount of specie available for private credit. The large expenditures of the Civil War also revealed problems, and Congress created the national banking system in 1863-1864. The independent Treasury was later used to stabilize the money market, but the Panic of 1907 proved the attempt futile. The Federal Reserve Act of 1913 marked the end of the system and the emergence of our current reserve bank establishment.

PANIC OF 1893 Confidence and Panic have always gone hand and hand. In most cases, the Panic has been worse whenever the perception of insolvency within government is greatest. The later part of the 19th century was yet another period when turmoil and chaos seemed to rule.

Grover Cleveland was one of the few presidents to serve two terms that were not consecutive. Cleveland was both the 22nd (1885-89) and 24th (1893-97) President of the United States. An enemy of the “machine politics,” Cleveland was named the Democratic “clean” government candidate to oppose James G. Blaine in 1884, and was elected after a bitter campaign. As president, Cleveland pursued his conscientious, independent course, offending the left-wing zealots of his party by his moderate use of the Spoils System. In the 1888 election, Cleveland campaigned on a lower tariff, but in spite of a popular majority he lost the election to Benjamin Harrison. The Panic of 1893 struck a hard blow at his second administration, and he angered radical Democrats by securing repeal of the Sherman Silver Purchase Act. The Democratic Party stood on the old inflation platform. The Democrats had overvalued silver relative to gold by taking 72 cents worth of silver and calling it a $1. This persistent policy led to the near collapse and bankruptcy of the US government. Cleveland repealed the Sherman Act and attempted to restore a sound currency. In the midst of that chaos, President Grover Cleveland stood before a special session of Congress on August 8th, 1893 and said…

“At times like the present, when the evils of unsound finance threaten us, the speculator may anticipate a harvest gathered from the misfortune of others, the capitalist may protect himself by hoarding or may even find profit in the fluctuations of values; but the wage earner – the first to be injured by a depreciated currency – is practically defenseless. He relies for work upon the ventures of confident and contented capital. This failing him, his condition is without alleviation, for he can neither prey on the misfortunes of others nor hoard his labour.”

Cleveland was a conservative within the midst of a very liberal Democratic party. In hi s Second Annual Message of December 1886 he stated… “When more of the people’s sustenance is exacted through the form of taxation than is necessary to meet the just obligations of government and expenses of its economical administration, such exaction becomes ruthless extortion and a violation of the fundamental principles of a free government.” During his second Inaugural Address [March 4, 1893] he stated… “The lessons of paternalism ought to be unlearned and the better lesson taught that while the people should patriotically and cheerfully support their government, its functions do not include the support of the people.”

Nevertheless, the rift within the Democratic Party widened when Cleveland refused to sign his tariff measure as altered by the protectionist Senator A.P. Gorman. In the Pullman strike of 1894, Cleveland sent in troops and broke the strike on grounds that the movement of the US mail was being halted. In foreign affairs he took a strong stand on the Venezuela Boundary Dispute, and refused recognition to a Hawaiian government set up by Americans. Cleveland’s independence marked him as a man of integrity – a man destined to clash with the liberal inflationist within his own party. That contrast was perhaps never so immortalized as it was by William Jennings Bryan at the National Democratic Convention (Chicago 1896) when he stated…”You shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.” Glorified words that simply called for unsound finance and inflation as a means to prosperity once again. Conclusion The illustration of gold’s rise in the face of declining confidence in government is endless. The hoarding of gold was so severe during the Great Depression that Roosevelt ended up outlawing the private ownership of gold and confiscated everything the government could find. Quite a drastic police state tactic. Nevertheless, it did happen here in the United States!

In this brief overview of financial history, one striking common theme arises from the trials and tribulations of man – gold rises NOT as a hedge against mere inflation, but as a hedge against the UNSOUND PRACTICES OF GOVERNMENT and/or POLITICAL UNCERTAINTY. Steady rising inflation DOES NOT act as an underlying support mechanism for gold. Its role within the modern investment strategy is a hedge against political and economic uncertainty. Gold has always risen the MOST when the confidence in the government is at its LOWEST! The History of Gold
by Martin A. Armstrong © Princeton Economic Institute