The Rise of Gold and The Death of God

By Michael Lewitt Jun 14 2010 11:45AM

“The abandonment of the gold standard had broad cultural significance.  It is no exaggeration to insist that going off the gold standard was the economic equivalent of the death of God.  God functions in religious systems like gold functions in economic systems: God and gold are believed to be the firm foundations that provide a secure anchor for religious, moral, and economic values.  When this foundation disappears, meaning and value become unmoored and once trustworthy symbols and signs float freely in turbulent currents that are constantly shifting.” ------Mark C. Taylor

It is no wonder that the price of gold is rising to record levels in a period of time in which the legitimacy and efficacy of governments is being called into question.  The crisis of confidence that began battering financial markets in 2008 has now entered its second phase with the European financial crisis of 2010 and the BP oil spill.  But this crisis of confidence is not so much a lack of confidence in economies so much as a lack of confidence in governments’ ability to manage those economies – and in particular the governments of developed Western countries.  The 2008 financial crisis did not originate in the emerging markets; as noted in my new book, The Death of Capital, it was spawned in the canyons of Wall Street and the City of London, the hearts of Western capitalism.  The democratic model of free markets is proving incapable of managing human affairs effectively or prudently.  But blaming governments does not satisfactorily explain what the failure of governance either, because it avoids pointing to the real parties who are responsible for allowing governments to mismanage societies – the voters who elect them.

In a democracy, a country gets the government it deserves.  Unlike countries that are ruled by non-democratic means (despite the fact that they hold elections), democratic societies freely choose their leaders. The great tragedy of today’s Western democracies is that voters continue to demand that their leaders engage in self-destructive economic policies instead of demanding accountability and tough choices.  The political systems of the major Western democracies have become captive to powerful special-interest lobbies that place their interests ahead of those of society as a whole.  This makes it almost impossible to develop sound policies to deal with complex problems.  The hegemony of powerful special interest groups also distorts economic incentives and the directions in which economies evolve.  The result is that massive amounts of intellectual and financial capital are diverted to unproductive uses as society’s most powerful interest groups fight over the distribution of wealth rather than focusing their energies on increasing society’s overall wealth. 

One of the major manifestations of financial instability today is the intangible forms that money assumes.  Markets are dominated by fiat currencies, debts in all shapes and sizes, and all types of derivative financial instruments.  These are all, as James Grant famously described them, “money of the mind.”  They are anchored in nothing other than human faith, and human faith is being shaken every day by inability of governments and businesses to control an increasingly complex world.  Recent events, from the 1000-point, 7-minute plunge in the Dow Jones Industrial Average on May 6, 2010 to the Gulf Oil Spill, suggest that man’s reach is exceeding his grasp.  The fact that one of the largest industrial enterprises in the world actually had the temerity to drill for oil a mile below sea level without a contingency plan to deal with a worst-case scenario suggests that man’s both grossly hubristic and severely limited in his ability to control his environment.  Watching computers cause stock prices to violently seesaw without any discernible reason, not just on May 6 but virtually every day, in the process wiping out billions or trillions of dollars of wealth in the blink of an eye, is deeply unsettling to the psychological health of investors.  It is no accident that investors would look to sturdier fonts of value in a sea of instability.  Hence the love affair with gold.

Most noteworthy about the current rise in gold prices is the fact that it is occurring in an environment in which deflation poses a much greater immediate risk than inflation.  In May, commodity prices experienced a drop of almost 60%, their largest decline since the Lehman Brothers bankruptcy.  Such a decline would normally suggest a cessation of economic activity, yet there are few indications that the global economy slowed down dramatically.  A more satisfactory explanation for the decline is that in a world in which all types of financial instruments – stocks, bonds, mortgages, bank loans – can be reduced through digital technology into the same constituent parts (1s and 0s), commodities simply shared in the overall decline in stocks and bonds that was caused by the combination of the European debt crisis and Gulf Oil Spill.  But in the face of this commodity sell-off, the price of gold still managed to rise.  As Christopher Wood points out, the best explanation for this is that gold is now trading as a financial asset rather than a pure commodity. It trades in tandem with government bonds and the U.S. dollar, other safe haven assets.  This is not your grandfather’s gold any longer (although if you inherited your grandfather’s gold, hold on to it!).

The end of the gold standard (1973) unfettered the dollar from precious metal backing and laid the seeds for unconstrained credit growth.  The economic consequences of the movement off of the gold standard have been incalculable, but the psychic effects have been no less profound.  In a world in which financial promises are only as good as the counterparties that make them, gold is a promise kept.  Gold is the anti-derivative, the anti-credit default swap, the anti-LBO.  More important, it is the anti-dollar, the anti-fiat currency.  And a fiat currency is the ultimate example of a promise, increasingly, a promise that can’t be kept. Gold is a tangible object in a world that came to overvalue intangible things.  It is grounded in a world where few values are grounded.  Most important, it is a physical good that is limited in supply.  If the end of the world ever comes, gold will be your best friend.  And it is indisputable that the end of the world is closer today than it was yesterday, and will be closer tomorrow than it is today.

Michael E. Lewitt

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Michael E. Lewitt is the author of The Death of Capital  How Creative Policy Can Restore Stability (John Wiley, May 2010) and the editor of The HCM Market Letter, a widely read investment newsletter.  You can find him at www.hcmmarketletter.com.