Why Gold is not money

As explained by my friend David Kotok:

April 19, 2013



Gold made the headlines with a rapid plunge, some possible basing, and then another plunge. Let’s talk about gold for a minute.


Central bankers prefer to have the public, the investor class, and the holders of institutional wealth believe in the credibility of their central banking skills and their ability to manage their respective currencies. But central bankers miss a critical point.


When it comes to gold, the gold bugs argue that gold is money. Simply put, that is not exactly correct. Gold was money 150-200 years, and even centuries, ago. In the US, if you wanted to buy something, you could pay for it with a gold coin.


Those days are long gone. I repeat, those days are long gone. But gold still maintains one important characteristic out of the three that we attribute to a functional currency.


So let us get to this question of whether or not gold is money. To be money, you have to have the ability to exchange easily in transactions. When you go to the store and pay for something in dollars, those dollars function as money. You can pay in paper currency, write a check, transfer it electronically, or pre-purchase the electronic entry on a piece of plastic that is carried and use it for payment. Money is a way in which payments are conducted. You cannot easily buy something with a bag or bar of gold, not even with a gold coin. There are not many people in the world who will take gold for payment. The payment mechanism of money is conducted in the currencies managed by the central banks, regardless of whether the currency is the dollar, pound, yen, euro, franc, krona, dinar, yuan, peso, or something else.


The second characteristic of money is to act as a unit of account, a method of measurement. Open up the income statement of your favorite company. It shows how much revenue, expenses, profits, assets, and liabilities they have in dollars as a unit of account or way of measurement. The same is true all over the world. We use these measurement tools constantly, so money has to provide easy, secure ways of measurement.


The problem with money substitutes that fail these two initial tests is that they become subject to volatilities that disrupt their use. Gold is such an item. Bitcoin is another one. Pay for something with bitcoin and how do you know how much you are paying in comparison to the rest of your daily transactions?


The third characteristic of money is that it is a “store of value.” It supplies an answer to the question, “Where can I safely place my accumulation of wealth, the result of my work effort, the gathering of my savings, –and have it hold its value?” Store of value is very important to gold.


Historically, gold, as well as silver and other precious items like diamonds to a lesser extent, has been seen as a place to store value. Gold worked in this regard: it was fungible, it was measurable by weight, and it was the same worldwide; and so it remained for many centuries the traditional place to store value.


In the beginning, central banks traded gold and used it as a reserve because it was such a successful store of value. The central banks still retain their attachment to gold, even when they do not want to admit it.


Now let us get to the wild volatilities of the gold market in the last few days and weeks. In Europe we have a crisis. The crisis involves Cyprus and its ability to pay. Cyprus is broke. It owes more than it has and more than it can earn. And it is beset by a banking collapse in the midst of all this. Cyprus uses the euro for money like the all other Eurozone members. With the euro, the monetary characteristics needed for transactions and pricing still apply, and so Cyprus now has to lock up part of its money because capital controls have been imposed. Furthermore, Cypriots have been restricted in their ability to take their euros and convert them to another currency such as dollars, yen, or pounds. Lastly, Cyprus has some gold, as do most other countries around the world.

The Eurozone colleagues of Cyprus are proposing that Cyprus sell some of its gold. They are very public about it. And the government of Cyprus may have to engage in some negotiation over that gold due to the pressure from its European colleagues. If it does not continue to receive Eurozone assistance, it will not be able to obtain money and make the payments it owes.


The Central Bank of Cyprus does not want to sell the gold. It knows it will not get it back. It also knows that if it holds the gold, it will maintain this mystical store of value that is associated with gold. But if it sells the gold, it will not have that store of value. The central bank resists the sale of gold for two reasons: (1) It has a historical basis on which to maintain the reserve of gold, and (2) It knows that it cannot replace its position if it sells.


In pressing Cyprus to sell, Europeans have announced to the world that there may be a large seller of gold. World traders in gold and other commodities will quickly jump on that trade. They know that if Cyprus breaks loose with the sale of its gold, countries like Greece, Portugal, and Slovenia may be next. They cannot see buying gold, thereby raising gold’s US-dollar-denominated price, in such a circumstance; but they can see selling it short, or otherwise trading it to the downside.


Result: gold plummets and there is massive selling. That terrifies the ETF holders and the retail buyers of gold. They pile on the trade, and gold gaps down to an unexpectedly low price.


What happens next?


First, the European drama around gold has to run its course. That is going to take a while.


Second, the terrified retail investors who panicked and sold have to become exhausted sellers. That is happening very quickly, though it is not over. The notion that gold can no longer be trusted as a store of value was clubbed into investors without any preparation. They saw the consistently upward movement of gold prices as confirmation that gold would continue to increase in value. They failed to see that volatilities could be very high in a market that is relatively thin worldwide. Now, disillusioned, they are reacting out of panic.


What happens after the retail investors are exhausted and the curtain is drawn on the European gold drama?


We believe there will emerge a new set of buyers of gold. They will be emerging-market institutions including central banks whose gold holdings are much lower as a proportion of total reserves than the Europeans have maintained. There will also be some larger purchasers of gold.


Here we are going to propose that the Japanese view gold as a new addition to their reserves. Japan has already said it is going to up its reserves. It has already said that it’s going to implement highly stimulative monetary policies. It has already launched that program in a very substantial way. Japan is printing yen and buying assets. Simply put, that raises the price of all assets.


Now Japan has a problem. It has to negotiate its policy change in a world in which colleagues in other major countries do not like this rapid weakening of the yen against their own currencies. And they do not want the Japanese to directly buy sovereign debt in other countries by converting newly printed yen into another currency and using that currency to buy the government debt of the country in which they have made the conversion.


But there is another option for Japan. Japan can print yen and buy gold. If it buys metal instead of a bond issued by a sovereign country, it will raise the price of the metal. It will exchange yen for currencies and diversify its exposure among all of the currencies. It will not be able to be accused of direct interference with the bond markets of other sovereign countries. Nor will Japan be able to be accused of interfering with the Federal Reserve’s present policy of buying US dollar-denominated, government-backed debt, or with the policies of the Eurozone’s central banks or those of the Bank of England. Furthermore, with central banks and other institutions in Germany, France, the US, India, Russia, and elsewhere continuing to buy gold, Japan is in a position to ask, “Why can’t we buy gold, too?”


Other emerging-market countries also have gold-buying programs. In our view, we are now likely to see more of them.


Our conclusion about gold is this. It is not money in the traditional sense of a currency in which transactions can be made. It does not facilitate payments. It is not a unit of account. We do not print financial statements in terms of ounces or tons of gold. Instead, we use currencies to measure our financial status.


Gold does have a historical store of value characteristic. It is held by central banks and institutions as a reserve. They do not want to sell it. On the contrary, many of them want to buy and accumulate it. Therefore, gold’s characteristic role with regard to sovereign reserves is still intact, even amid the fascinating evolution of central banking and institutional finance we witness today.


Our view about gold as an investment is slightly different from that of a trader. Gold is a long-term investment. We think it should constitute a small portion of a portfolio and be maintained on a continuing basis. It should be a relatively passive investment. Think of it as a type of insurance policy. So we would recommend gold acquisition, for those who are inclined to pursue it, on a very modest level, utilizing a dollar-cost averaging method. Buy a little gold and put it away. Forget the price. Come back again, buy a little more, add to your hoard, and forget the price. Look at gold as an insurance policy that you hope you never need to use. We do believe that abandoning gold completely and disparaging it as a barbarous relic is too extreme.



David R. Kotok, Chairman and Chief Investment Officer


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On Markets

By my friend David Kotok

Markets Today
April 15, 2013

Happy US Income Tax day.

We still hold some cash reserve in our US ETF accounts. Of course, that could change at any time. There are a number of world events that concern us. Markets seem complacent about them.

BIRD FLU.  Note that the latest case is in a four year old and experts do not know how it got there.  “If the H7N9 virus – as it is – were readily sneeze-transmissible, there would tens of thousands of cases. Even China could not conceal such an explosive spread. The gauge is the H1N1 strain, which spread explosively in 1918-19. That no explosive spread has occurred does not mean we’re out of the woods. Flu viruses mutate constantly. The good news: a Chinese lab reports finding nothing in H7N9 DNA, that suggests the virus spent time in pigs. That matters. Pigs can host both avian and human flu viruses, and so serve as a “mixing bowl”, in which a bird flu virus could acquire DNA from a human flu virus. Such a DNA pool promotes a mutation that allows for sneeze-transmissibility. China is the usual source of new flu strains, as it has in close proximity, hundreds of millions of pigs, poultry and persons. Ducks, wild and domesticated, may harbor bird flu without necessarily being made ill. This H7N9 does not appear to make birds sick. The CDC’s raising the alert level is driven by the agency chief’s recognition that if the alert is not raised, and the virus spreads explosively, it will be condemned. By contrast, if the alert is raised, and the H7N9 fades, the agency will be seen to have done its duty. The N-95 mask is better than nothing. However, it cannot exclude viruses, only viruses that may be on a droplet of liquid. The only sure protection against viruses is a hazmat suit and a sealed-system respirator.” (Research summary by Jay Simkin, International Representative, The Stratecon Group LLC)

ECONOMIC PICTURE. This is clearly mixed. Housing and industrial production are the big items this week. We expect housing to continue improving. The bond market indicates that economic weakness is continuing. The stock market is pricing in positive earnings news. This remains a tale of two cities: New York sources the stock market outlook; Washington is the home of the Federal Reserve, which dominates the levels of interest rates with its ongoing QE policy.

CORPORATE PROFITS AND EARNINGS. “Q1 corporate profits: the earnings season heats up this week with financials, and tech are among the heavyweights reporting, along with various consumer goods firms. Citigroup paves the way Monday, along with Charles Schwab, and several other smaller financial firms. Tuesday has Yahoo!, Goldman Sachs, BlackRock, Intel, Coca-Cola, Johnson & Johnson, Comerica, and CSX Corp. Bank of America leads off Wednesday, along with American Express, eBay, AMR, Mattel, and McMoRan Exploration. Thursday could be the biggest day in terms of the number of big announcements that include Google, Microsoft, IBM, Morgan Stanley, PepsiCo, Philip Morris Industries, United Health Care, Verizon, Blackstone Group, Capital One, and E*TRADE. There is GE, Kimberly-Clark, McDonald’s, and Under Armour winding up on Friday. Q4 profits surprised on the upside, but analysts are now taking a more conservative approach for Q1, looking for earnings to be up 1.0-1.5%.” (Summary provided by Action Economics)

EUROPE. The Eurozone mess continues. Rumors of a grand plan to “fix” the Eurozone banking system circulate without any official validation. Meanwhile, Slovenia is in the spotlight now, while Cyprus demonstrates that the first estimates of the cost of trouble are usually low. Cypriot gold sales show how a news item causes front running of markets.  Will the actual sales mark the bottom of the gold price?  Italy, the world’s third-largest debtor nation, is approaching 130% debt/GDP. Italian politics are at the top of European news. GIC will be in Milan for a conference next month. See: www.interdependence.org. We expect to be on the program with comments about markets and the central banking situation. There is room for conferees, if any reader wants to register and enjoy Italy in mid-May.

KOREA. Markets think North Korea is just blustering. We hope so. But the risk of an accident or incident is high. Armies are on alert, poised for trouble. Communication between the adversaries has been dampened. History has not been kind in such circumstances. The behavior of young Kim is unfathomable.

TAX-FREE MUNIS. The White House proposal to cap the benefits of tax-exempt interest at 28% and to do so retroactively is the focus of much research. No one knows how this issue and many others will be resolved. State and local officials oppose the proposal because it will raise their borrowing costs to build schools, sewers, airports, etc. Democrats have trouble with this issue on their home fronts. They also do not like the President’s attack on retirement plans. Meanwhile, it was the Republicans who stopped the extension of the Build America Bond program. Specifically, Senator Kyl of Arizona blocked it even as a Republican-controlled House committee was ready to advance it. So much for how we are governed. Democrats and Republicans seem to want to bicker and finger point, not move the country forward. Oh, if there were only a way to throw them all out and start over again.

Stock prices in America are no longer cheap. Earnings levels and profits are very high. Inflation is low and interest rates are very low, because the labor share of the US economy is weak and there is a long way to go to get it healthy. We will discuss this in full detail in a presentation at the GIC-Drexel University annual Monetary and Trade Conference in Philly on Wednesday, April 17. Any last-minute signup can be done at www.interdependence.org.

David R. Kotok, Chairman and Chief Investment Officer

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For personal correspondence: david.kotok@cumber.com

Twitter: @CumberlandADV


 From my friend David Kotok:

Bail-In vs. Bailout
April 8, 2013 In the aftermath of the bungled Cyprus affair, we are now observing a major transition underway with regard to bank-deposit safety.

In the Eurozone and in Europe generally, the sacredness of an insured deposit was bludgeoned by the finance ministers in their botched attempt to impose a cost on insured deposits in Cyprus. The finance ministers were taken to task decisively by their political constituents. Imagine: it was the parliament of Cyprus that stood between the insured depositors in Eurozone banks and the outrageous attempt to breech the sacred promise that insurance entails.

One has to be thankful for the democratic political process that elects parliaments, even in Cyprus.

 Now we are seeing a different form of attack on depositors. We are transitioning from a system of bank bailouts to “bail-ins.”

 In the bailout approach, banks that fail are resolved through some form of governmental, taxpayer-backed initiative. That is what we mostly have in the US, with the Federal Deposit Insurance Corporation (FDIC) as the resolution entity. The FDIC honors insured depositors’ claims. The uninsured deposits become a liability of the resolved banking institution. Those depositors may suffer losses along with shareholders, debt holders, preferred stock holders, and others. That hybrid system includes the attempt to consolidate banking institutions. Most bank failures in the US are resolved through a merger.

We see this all the time. On a Friday afternoon at the close of business, the FDIC seizes a bank. The shareholders are wiped out, the books and records of the bank are carefully maintained so that they can be converted, and the new bank or new banking system opens for business on Monday morning. The insured depositors are completely covered, and the transition is nearly seamless. Announcements of this type of activity occur frequently in the US and cause no particular market reaction.

In the bail-in situation, on the other hand, uninsured depositors have thrust upon them a new role. They must do credit analysis on the exposure they or their firms have to a particular bank. This requirement causes deposits to gravitate to those banks that are viewed as “fortress banks.” Fortress banks are deemed to have sufficient capital, size, and management quality so as to be above and beyond risk as it is perceived by the large depositor. The outcome here is to concentrate large deposits in what are viewed as the strongest banks. The strongest, largest banks are, however, the same banks that regulators express concern over because they are systemically risky. They are systemically risky precisely because they have such a large concentration of banking deposits and services attached to them.

Where does this all lead from a market point of view? It seems to us that one thing it will do is change the behavior of depositors. Those depositors that are able to distribute funds across multiple banks at very low cost will do so, because they will thereby raise their level of insurance coverage. Other large depositors who, because their deposits are so large, do not have that ability to diversify their deposit base will have to find different ways to protect themselves.

Credit analysis on large banks can now fetch a premium. After all, anyone who can create an early warning about problems in a large bank, so that depositors can move their money, is offering a service that is in greater demand in the bail-in situation. But providing that warning also puts the service provider at great risk, because there are laws, in most jurisdictions, against sharing information that might trigger a run on a bank.

Take the example of a large bank with large deposits and a credit-review service concerned about the deterioration of that bank’s quality. What is the service provider to do? If they warn their business customer that the bank’s circumstances could be weakening, that customer could move very large deposits out of the bank. In doing so, the customer would accelerate the weakening of the bank. With the bail-in approach, we then have the makings of a negative-feedback loop that could render very large banks even more systemically risky than they were under the bailout regime.

Another behavior could occur within the bank itself. Banks that are part of the bail-in system know that they have to maintain a higher level of liquidity. They have to demonstrate that they are safe institutions. Their capital and liquidity requirements are raised, and their business model must conform to this new regime.

For policy makers such as the central banks, this regime shift also has implications. Are large banks with large deposits less likely to engage in lending at the same ratios and in the same capacities as they did when they were subject to bailout rather than bail-in? Does bail-in reduce the money-multiplier attributable to reserves and excess reserves? If it does, then a central bank policy that is expanding excess reserves might not be robust enough. Remember, creating a credit mechanism by which reserves in a system are multiplied 10 times means that a reduction in the money multiplier will have a 10-fold impact on the eventual economic outcome.

At Cumberland, in thinking about bail-in vs. bailout, we see the following issues in portfolio management. First, credit analysis is important. Risk needs to be identified and evaluated with the highest standard of integrity. In a private firm, one can give counsel to banking clients and portfolio-management clients and act to sell securities in which there may be very early warning signs of credit deterioration. From a portfolio-management point of view, one should not wait around. Our approach is to run quickly from credit deterioration and hope it does not get worse. Let someone else take that risk, not our client.

The second issue is how to deal with exposure of investments to the financial sector and banks. Clearly, a transition from bailout to bail-in will mean that some banks will do much better than others, and very large banks may do much better than smaller ones. Redeployment of investments within the financial sector is an issue that has to be reexamined.

Lastly, jurisdictions become important. New Zealand, which is moving away from bailout to a complete system of bail-in, is an example of a place where banking has become more dangerous. The government of New Zealand has essentially declared that insurance is too costly and cannot be accurately priced. It has stated it will resolve banking difficulties with the help of larger depositors.

In Canada there is now some discussion of the introduction and development of bail-in. Canada has a fairly clean history when it comes to bank capital and bank supervision. Is this about to change? In the Eurozone and Europe generally we have had this discussion about bail-in vs. bailout for months. Clearly, the proponents of bail-in are growing stronger in Europe, and they are going to affect the characteristics of banks and central banks and the behavior of the finance ministers who determine bank-resolution policy.

Other places in the world where regulation and supervision are strong and dependable, such as Singapore, rise in terms of desirability. Governance of financial systems is paramount. Singapore is a place where governance is very high and perpetrators of bad behavior are punished severely. Perhaps due to that standard, Singapore does not suffer the financial incidents that we see elsewhere in the world, including the US.

The Bob Dylan song says, “The times they are a changin’.” Dylan was probably not thinking about banks and financial assets when he wrote the words, but they certainly do apply today.

David R. Kotok, Chairman and Chief Investment Officer

To sign-up for Market Commentaries from Cumberland Advisors: http://www.cumber.com/signup.aspx
For Cumberland Advisors Investment Portfolio Styles:http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: david.kotok@cumber.com

Twitter: @CumberlandADV