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Farr: Dollars and Gold: What Are They Worth?

As metals go, gold is not particularly useful.

It does very few things that other metals can’t do or do better. It’s soft and quite heavy. BUT, the stuff is really popular and worth a lot of money right now. We talked with a hedge fund manager yesterday who had just returned from a hedge fund conference in New York. He reported that the large majority of hedge funds are bullish on gold right now. So we scratch our heads, as we are want to do, and wonder why these aggressive investors want this stuff and what makes the stuff worth so much. It strikes us especially unusual because gold is already up about 200% over the past five years (and has been a horrible long-term investment over the decades).

But first a little background.

For much of its existence, the US was on the gold standard. Dollars were backed by “x” amount of gold that the US Government actually held in a vault somewhere. But there were problems managing an economy on that system. Specifically, it was too difficult to maintain price stability and respond to exogenous shocks to the economy. Therefore, in 1971, Richard Nixon ended the gold standard. The US dollar (and most other currencies today) has been by fiat ever since. (Track Gold Here)

Fiat is defined on the web as ‘a decree or legally binding demand.’ A fiat currency, therefore, has value because of the decree or legally binding demand of the issuing government. This means that to a large extent, a dollar is worth what the US government says it is worth. It can print as many of them as it wants and use them to conduct trade and settle indebtedness. Like the banking system, the government’s ability to establish value in the dollar relies on the perceived ability of the government to be good to its word. In short, it comes down to confidence.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

Greece’s current deficit and debt are great examples of the tie between confidence and value.

World trading partners lost confidence in Greece’s ability to exercise any financial discipline, and they pulled back their financial support. Greek interest rates went up, and the value of the Euro fell. Greece is hurting because this already struggling economy has now seen its interest expense go up and its purchasing power fall. Neither will help the Greek economy recover. And once lost, confidence is hard to get back.

Before we move on, remember what Ayn Rand wrote about money, “Money is a tool of exchange, which can't exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. Money is not the tool of the moochers, who claim your product by tears, or of the looters, who take it from you by force. Money is made possible only by the men who produce.” (Read more on Rand here.)

Basically, gold strikes us as something of a fiat currency as well because the metal does not have much value beyond jewelry. That gold has increased so much in value makes a deafening statement about the market’s world economic view, and it is not good. In good times, money flows and value are afforded to investment opportunities with promise, potential and possibility. Presently, value is being afforded most to whatever is perceived to be safest.

As we think about gold and dollars, our ruminations continue to arrive at confidence. The entire banking system relies on confidence. Most people realize that banks don’t actually hold stacks of money in some vault that represent all of their depositors’ savings. Therefore, when confidence wanes, banks theoretically should have to offer higher interest rates to attract deposits to account for the higher perceived risk (For purposes of this discussion, disregard deposit insurance). Various crises in history have seen runs of depositors to the banks demanding the return of funds which the banks of course don’t hold. Jimmy Stewart as George Bailey in “It’s A Wonderful Life” saved his Building and Loan by appealing to his community for their trust in him. His bank was saved because his character was judged to be golden. Almost 30 years ago Secretary of State George Shultz said, “Trust is the coin of the realm.”

Sufficient confidence is the most precious commodity in today’s global economy. When confidence fails, unpleasant results follow. As Greek debt topped 130% of GDP, the world balked from offering further credit. It is important to note that Greece has yet to default. Confidence disappears not when failure occurs but when it seems highly probable if not inevitable. Anticipating and avoiding future crises of economic faith is crucial. Confidence is there one minute and gone the next. Emotion takes over, and the “flee or fight” decision lands on flee. Gold is the destination of risk aversion, and it has been making new highs.

Caution is entirely warranted. Large multi-national corporations with strong balance sheets and superior management teams are the destination of our dispassionate investment discipline and dogged research. Good things are happening, but the uncomfortable necessity of free markets being allowed to clear may take a while.

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Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.