Mistrusting Money Whatever the Price

by Adrian Ash

“…Raising interest rates is supposed to restore confidence in a currency. But what if it fails like it failed in Mexico ’94…Britain ’92…and the U.S. in 1933…?”

On the morning of Wednesday, September 16, 1992, the Bank of England in London hiked U.K. interest rates from 10% to 12% – the biggest jump in more than eight years.

The Old Lady promised a further hike to 15% for later that same day, too.

Why the surge in borrowing costs? The Old Lady wasn’t trying to kill inflation. She was trying instead to defend the pound sterling. Somebody had to.

Speculators across the world, most famously George Soros, had got it into their heads that Europe’s exchange rate mechanism (ERM) – the precursor of today’s Eurozone currency system – was about to collapse.

Britain was three years into a house-price collapse, and the ensuing recession had put more than a million people out of work. Both sterling and the Italian lira looked horribly over-valued inside the ERM’s “trading bands” set two years earlier…or so the speculators thought.

And, as it turned out, the speculators were right. The Bank of England was wrong. By the close of trade on that autumn day in 1992, the United Kingdom had abandoned the ERM. It had also spent the equivalent of $1.6 billion, trying to prop up the pound.

George Soros, on the other hand, was $1 billion richer. And sterling interest rates were cut back to 10.5% the very next day.

Two years later, higher interest rates failed to defend the Mexican peso. The government in D.F. had squandered more than 80% of its foreign reserves in 1994 trying to prop up the currency. Its devaluation in December scared foreign investors so much that they deserted Mexican bond auctions despite interest rates topping 40%.

Yet again, the markets were right and the government was wrong. The Mexican peso had already lost half its value against the U.S. dollar in just 12 months. Over the next five years, it halved again.

This same mistrust of money at any price also whacked the U.S. dollar in the early 1930s…even as deflation hit and the value of money seemed to be rising.

The Great Depression led American citizens to hoard gold before cash. “During 1932 the U.S. Federal Reserve raised its discount rate to defend the dollar,” as Sam Hewitt noted for Sun Valley Gold in a paper, 10 years ago. But fearing an imminent devaluation of the dollar, “the American public continued to hoard non-interest bearing gold.”

The American public was right to fear devaluation – just as the sterling raiders and foreign investors fleeing the peso were right to mistrust rising interest rates, too.

In the end, it took the Presidential executive order of April 5, 1933 to force U.S. citizens back into the dollar. President Roosevelt made gold ownership illegal, punishable by $10,000 fines and/or imprisonment.

He also devalued the dollar by 40% at a stroke.

Fast forward to March 2007. Investors, householders, businesses and governments right across the developed world now refuse to hold cash. They’d rather spend it, gear it up for investment, lend it out or swap it for financial assets – any financial assets – rather than hoard it.

But no one’s refusing to accept money in payment, not yet. So the issue of what it would take to restore confidence in official currency – including the dollar, sterling, euros, pesos and all the rest – looks purely academic. Today’s disdain for paper currency remains a long way from loathing.


“Gold is a depletable resource,” wrote David Ranson of H.C.Wainwright & Co. for a World Gold Council research paper in 2005, “and large discoveries are becoming increasingly rare. Thus gold’s purchasing power will remain stable, and its role as a measuring rod will become still more secure.”

Ranson’s study found that changes in the price of gold bear a 0.50 correlation with consumer price inflation 12 months down the road. Oil prices, on the other hand, have only a 0.23 correlation with the cost of living one year later. That conclusion might be at odds with the received wisdom of CNBC and Bloomberg pundits. But rather than gold acting as “an inflation hedge”, the metal in fact gives us a lead indicator of inflation in the cost of living.

Put it another way, and that means gold signals the forthcoming devaluation of paper money.

“Inflation is a monetary phenomenon,” Ranson went on, “by which we mean it is governed by the purchasing power of a currency in terms of ‘hard money’ benchmarks. How to tell whether government actions are combating or accommodating inflation? Watch gold, not oil.”

The U.S. Fed once knew this, too. And it might still today, according to the debate that rages over illegal manipulation of the gold price in the open market. But under Paul Volcker, the famously tall chairman from 1979-87, the Fed clearly saw gold as a barometer of inflationary expectations.

At one policy meeting in late ’79, the Fed committee noted that “speculative activity” in the gold market was spilling over into other commodity markets. An official at the U.S. Treasury called the gold rush “a symptom of growing concern about world-wide inflation.”

“There was a kind of great speculative pressure,” said Volcker in a PBS interview of Sept. 2000. “We had to deal with inflation.”

“It was the years when everybody wanted to buy collectibles from New York. The market was booming, and other markets of real things were booming – because people had got the feeling that things were inflating and there was no way you could stop it.”

Volcker hit on one way of stopping inflationary expectations, however. He took U.S. interest rates to 19% and stopped the great gold speculation dead in its tracks.

His strong medicine also took real U.S. interest rates – above and beyond increases in the cost of living – to more than 9%. That destroyed long-dated bond prices, but no one wanted them anymore anyway. Treasury bonds had become known as “certificates of confiscation”. Only high real returns, guaranteed by the U.S. government, could entice fresh finance via the bond market once again.

So far, no one’s prescribing the same kind of strong medicine for paper money today. But how might this slow-motion destruction of confidence in government-issued currency be resolved in the long run?

It might take more than a few 0.25% hikes in interest rates. But if Washington were to make owning gold illegal once again – just as it did to defend the dollar in 1933 – at least U.S. investors now have the option of hoarding physical gold offshore…beyond the reach of their government’s caprice and diktat.

Editor’s Note: Adrian Ash is the City correspondent for The Daily Reckoning in London and is formerly the head of editorials at Fleet Street Publications Ltd. He has been studying and writing about the investment markets for the last 9 years, and is now head of research at BullionVault.com – giving you direct access to investment gold, vaulted in Zurich, on $3 spreads and 0.8% dealing fees.

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