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Wednesday, April 1, 2009
Paper trail

The original idea of issuing ‘bank notes’ was to provide a medium of monetary exchange in the form of paper that was freely convertible into a pre-set, fixed quantity of gold. In Britain, for example, back in 1833, Bank of England notes were made legal tender, while redemption by other banks was discouraged. This was reinforced by the Bank Charter Act of 1844 whereby Bank of England notes were fully backed by gold, and thus could be termed ‘Hard currency’. Such notes bore the inscription:  ‘I promise to pay the bearer the sum of...’, which meant the bank note was a certificate or bearer cheque entitling the owner to go along to his central bank and cash it in for a bit of gold. Thus the hard currency system allowed individuals and businesses to transfer wealth through handing over bits of paper instead of having to lug the gold around with them.

And so life went on until, eventually in 1931, the British government was the first to abandon the gold standard – and many other countries followed.
In 1944 the Bretton Woods Agreement established the International Monetary Fund which provided for fixed currency exchange rates linked to the price of gold (rather than to the physical amount of gold held in reserves). It was hoped that this would stabilise international exchange rates and facilitate development through working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty (an ideal everyone is still searching for to this very day). The IMF also wanted to prevent countries from manipulating their domestic currency value in order to gain international trade advantages. The US dollar was set as the arbiter of value.
This system was finally ended in 1971, however, by the then President Richard Nixon, at a time when the US gold coverage of the paper dollar had deteriorated from 55% to 22%. So, for the first time in history the link between world currencies and real commodities had been severed. And, by 1976, all world currencies had become ‘free floating’.
This was the real start of ‘fiat money’, whereby the value of a currency was no longer determined by gold holdings or links to any commodities. Instead the amount of currency in circulation was to be controlled by law, rather than the holding of real physical assets. This law included bank cash reserve requirements and capital reserve requirements.
Though they vary from country to country and are, indeed, quite complicated, the various reserve requirements allow banks to “create credit”. Nigel McKenzie of Stanlib says, for example, that one major ingredient of financial distress in the US was the fact that some banks were very heavily geared, up to 50 times their capital base. What this meant was that for every dollar they had as deposit they had lent $50. “Just how precarious this is,” he says, “concerns the ability of a bank to manage bad debt. At this sort of gearing you only need to write off 2% of your debt and you have run out of capital – the bank is technically, and literally bankrupt.”
In South Africa our reserve requirements are more stringent but the gearing nevertheless stands at between 15 to 18. In this country banks must adhere to a liquid reserve ratio of 5% of bank deposits, that must be held in government bonds. A further 2,5% of deposits must be lodged at the Reserve Bank in the form of interest-free cash. Though the rate is adjusted for certain classes of bank deposits, working on a total of 7,5% is sufficient for illustrative purposes. It therefore leaves R92.50 in deposits that the bank can lend to its customers. Where these loans are re-deposited in a bank account (for example, you borrow money, buy a car, and the motor dealer banks the receipts), then the funds, less 7,5%, can be leant to another customer. This in simple terms is how banks can create credit, increase the money supply without there being any gold or other reserves to back up the promise intrinsic in the bank notes of the Nineteenth Century.
Banks, incidentally, must also hold capital reserves which relate to overall assets. For example, for every R10 of capital held in terms of ordinary shares issued and retained earnings, a bank can lend R150 (a gearing of 15 times). Of course the difference (R150 less R10) has to come from deposits amounting to R140. These funds are then controlled by the above cash reserve requirements.
One can now perhaps understand why, in times of a crisis of confidence, there can be a ‘run on the bank’ whereby customers go into a panic and try and withdraw all their deposits. However, there is no bank in the world today that would be able to pay out all its customers’ deposits; even the largest, most revered and trusted of banks is ‘out on a limb’. It is a system based entirely on trust and a degree of legal control.
This is one point that relates to the question of a gold standard. There could not be a run on a bank under such a system; people are simply given the appropriate amount of gold since all deposits are fully backed by the metal. Of course, there is a corollary: many countries have banned individuals from amassing gold bullion, which make it a bit of a moot point.

Gold supply and demand

Whatever the arguments are for or against adopting a gold standard, there is a major stumbling block: given the amount of currency that is issued globally, at even $1 000/oz there is simply not enough bullion to meet the task.
According to information from the World Gold Council it is estimated that the total amount of gold ever mined is 158 000 tones which, if valued at US $1 000 per ounce would indicate a total value of some US $5 trillion. At present the US alone is sitting with about $7.6 trillion of notes in circulation plus bank deposits. Perhaps one could speculate and suggest that total global currency notes in circulation and bank deposits at the moment amount to an equivalent of about $30 trillion. If it was all backed by gold we’d need some 930 000 tonnes of the stuff – or six times total production in the history of mankind to back up the currency in circulation. The alternative would be to increase the value of gold to, say, $10 000/oz. But you’d still need another 93 000 tonnes and, again according to the WGC we only mine about 2 500 tonnes a year.
As it is, central banks hold in reserves only about 19% of all above-ground gold – or some 29 873 tonnes – that’s enough to convert notes in circulation and cash in bank deposits into real money at the rate of about 3 cents in the dollar. Even if the central banking system had all the world’s gold in its vaults – which it hasn’t - you couldn’t expect more than 17 cents in the dollar (or $17 for every $100 of deposits). Your wedding ring might well be worth more than your bank deposit!
So what we have now is a bit of a mess, because there is no mechanism in place to prevent central banks from printing money; or, to put it another way, there is nothing to stop governments from undermining the value of its citizen’s assets. Since the currency in circulation is no longer backed by anything, least of all gold, it is essentially ‘useless’ – well, unless we all of course have faith in it. By Nigel Benetton

Copyright © Insurance Times and Investments® Vol:22.4 1st April, 2009
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