The root of this financial crisis, and why you must buy gold now

published 16 July 2008

How the current financial crisis was born in the 1970s

This feature is just part of our FREE daily email. Sign up for Money Morning here.

Whether it's Northern Rock, Fannie Mae, Freddie Mac, Indy Mac, the Labour Government, the State of California, or whoever is going to run into trouble next week, the sirens are blaring, 'global financial emergency'.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

So it's little wonder that gold has rallied sharply in the past week or so, to more than $970. But what is it about gold that actually makes people want to own it when the financial system is in turmoil? Investors say it's a hedge against inflation; it's the anti-dollar; or they just see that everyone else is buying it, so they pile in afterwards.

But what is the point of owning a lump of metal that doesn't pay a dividend, isn't edible and actually costs you money to keep safe? To understand why gold is the ultimate safe haven in this financial crisis, we have to get to the root of our current problem. And that's money

How it all started: a brief history of money

Why do we need money at all? The barter system had plenty of attractions it can't be taxed, for one thing. But it's inefficient. Say I sell spades, and you sell dressing gowns. For any deal to happen you must want a spade at just the moment I happen to want a dressing gown. So even the most primitive societies developed some kind of payment system, or money, that was accepted by everyone in exchange for goods and services.

Money has to have two qualities. It must be portable and it must have a purchasing power that lasts, so it can be used at a later stage. Shells, cocoa beans, even feathers have been used over the years as money. At one stage Roman soldiers were paid in salt, from where we derive the word, 'salary'. These early forms of money were 'commodity money'.

Gold and silver were widely used. Their rarity gave them value a great deal of worth could be stored in a single gold coin as did their immutability. Gold doesn't tarnish. You could dig up a gold coin buried in the ground a thousand years ago and it would be more or less intact. And just as gold preserves over time, so does its purchasing power. An ounce of gold would have bought a Roman Senator a jolly decent toga and perhaps a pair of sandals; today the sterling equivalent (£500 or so) would buy your local MP a respectable suit and shoes.

To facilitate trade, gold was turned into coins of a certified weight and purity by goldsmiths. The goldsmiths, who had built vaults to store their gold safely, also began to store the gold of their fellow townsmen, issuing a certificate as receipt for the gold deposited. Over time these certificates were used in the marketplace as if they were the gold itself. World trade had slowly moved from a 'commodity money' to a 'representative money'.

Seeing that very few depositors ever removed their actual gold, instead using their certificates for trade, goldsmiths realised they could make money by lending out certificates against depositors' gold. Despite the inherent duplicity in the scheme lending what is not yours to lend - it worked. The depositors did not lose anything. As long as there was no bank run, their gold was all still safe in the goldsmith's vault.

Depositors, however, soon wanted their share. Rather than taking back their gold, the depositors simply demanded that the goldsmith, now in effect their banker, pay them a share of the interest. The goldsmith paid one rate on deposits and then lent at a higher rate.

But in times of panic some borrowers would demand their real gold back, instead of the paper certificates. Before long, you had the dreaded run on the bank, with the banker not having enough gold and silver to redeem all the paper he had put out. It would have been straightforward to outlaw this new lending practice, but the large volumes of credit the bankers had created had become vital to the success of European commercial expansion, so, instead, the practice was legalised and regulated. The monetary system had moved on from representative to debt.

Bankers agreed limits on the amount of loan money that could be lent out, limits still much larger than the amount of gold and silver on deposit. Usually the ratio was nine loaned units to one actual unit in gold and these regulations were enforced by surprise inspections. It was also arranged that, in the event of a run, central banks would support local banks with emergency gold. Only if there were runs on a lot of banks simultaneously would the bankers' credit bubble burst and the system come crashing down.

The root of our current financial crisis

Over the twentieth century, this fractional reserve system, where you need only hold a fraction of the money you lend out, became the dominant money system of the world. But, at the same time, the fraction of gold backing the paper money steadily shrunk. With the Bretton Woods agreement of 1944, which established monetary order between the major industrial nations after World War Two, the USA was the only nation left with a currency backed by gold, and the dollar became the global reserve currency. But in 1971, under pressure from the French, who were demanding gold instead of dollars, and faced with the rising cost of the Vietnam War, President Nixon removed this backing. Now, for the first time in history, no currency on the planet, nor any small fraction of any currency, was backed by anything tangible. The basic nature of money had changed again.

We were now in an era where money is money by government edict - by the law. In the past, people had the choice to refuse privately created bank credit notes, but now legal tender laws declare that citizens must accept this government-edict money or fiat currency - as payment. Their value is determined by how they trade against other fiat currencies on international currency markets. Belief in the integrity and competence of the central banks and government that issue a currency is essential to its success.

And that's where the problem lies. As Winston Churchill put it: "All previous attempts to base money solely on intangibles such as credit or government edict or fiat have ended in inflationary panic and disaster."

Sound familiar? The greatest credit expansion in history was only made possible under this post-1971 system of currency by government decree. But now it's unravelling. Fears over Fannie and Freddie and the integrity of the US banking system are pushing the dollar the world's reserve currency - down to record lows against the euro (it's even fallen against the pound, which shows just how bad the market fears things could get).

Investors are losing faith in the most important form of paper money in the world. What will take its place? One thing's for sure even if we don't return to a commodity-backed currency, for as long as the financial turmoil continues, gold, the oldest and most consistent money in history, is likely to be a benefactor. If you don't own any. I suggest you get down to your local coin shop and buy some.

Learn more about how to invest in gold.

Turning to the wider markets

Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here: FREE daily Money Morning email.

UK shares hit their lowest point since October 2005 as the FTSE 100 index slid 129 points in a 2.4% drop to 5,172. Banks led the market down, with Royal Bank of Scotland slumping 7% to a 10-year low, while HBOS lost 4.4% and Barclays 3.4%. Commodity stocks also suffered as Vedanta and Antofagasta both shed 6%, while retailers had another bad day after the latest BRC survey said that June sales fell 0.4%, much worse than expected. DSG dropped 6% while Kesa slid 3.4%. Ironically, the London Stock Exchange bucked the trend with a 0.4% rise.

It was much the same story in European markets, with the German Xetra Dax and the French CAC 40 both slipping 2% to 6,082 and 4,061 respectively.

In the aftermath of the Fannie and Freddie bailout, US stocks declined again, with the Dow Jones Industrial Average dropping 93 points to below 11,000 for the first time since February 2006. It closed at 10,963, a 0.8% fall, while the wider S&P 500 slid 1% to 1,215. But the tech-heavy Nasdaq Composite actually added 0.1% to 2,216.

Overnight the Japanese market was almost flat, with the Nikkei 225 adding 6 points to 12,761, while in Hong Kong the Hang Seng put on 0.2% to 21,214.

Brent spot was trading this morning at $139, while spot gold was at $975. Silver was trading at $18.86 and Platinum was at $1956.

In the forex markets this morning, sterling was trading against the US dollar at 2.0083 and against the euro at 1.2607. The dollar was trading at 0.6277 against the euro and 104.11 against the Japanese yen.

And this morning, plumbing and heating group Wolseley has scrapped its full-year dividend as it reported that pre-tax profit had fallen by 35% in the 11 months through June. Collapsing global property markets, and the US in particular, have lead to the plunge, and chief executive Chip Hornsby warned that "it's very hard to predict" when a recover may come, said Bloomberg.

Our recommended articles for today

Why savers should return to Northern Rock

If you've got some money to put away right now, it makes sense to go for a fixed-rate savings bond. And one of the best deals you can find right now is at Northern Rock.

How the dollar crisis is going global

There's a real crisis in the US dollar and it's spreading: Asian stocks are plummeting and Europe is still sliding. Your best global diversification strategy may be to just 'get out'.