The Great Gold Argument (Fortune Classics, 1931)August 14, 2011: 9:21 AM ET
Editor's note: Every week, Fortune.com publishes a favorite story from our magazine archives. This article from February 1931 explores a topic that's still hotly debated today -- what is the true value of gold? Back then the U.S. economy was in the throes of what would become known as the Great Depression, gold was the monetary standard, and it traded for just over $20 an ounce.
In two parts, hereunder. Part one, a free-hand sketch of the gold-money-credit machine which links gold dollars to doughnuts. Part two, bold summaries on what's said to be the matter with that mechanism. The whole, a primer designed to give the lay executive a running familiarity with the most bitterly discussed economic question of the day.
FORTUNE -- In the vaults of the Bank of England (Threadneedle Street, London), men are piling gold on a truck. The gold they lift has been bought and paid for by a foreign country and is about to be delivered. In the factory of Henry Ford (Dearborn, Michigan), men are tightening bolts on a moving automobile chassis. The car they are building will presently roll away and be offered for sale. Does every bar which is lifted from the vaults, 4,000 miles away, change the value of "the automobile Henry Ford's men are bolting together? If so, how? Conversely, will every new Ford which rolls from the line change the value of those so-accurately weighed bars under Threadneedle Street? FORTUNE here presents a working drawing of the machine which links them, an inconceivably complex machine in the study of which a known fact is something to cling to in a whirling eddy of hypotheses, trends, theories, nebulous generalizations, and conflicting interpretations. For the lamentable fact is that the engineers who watch over this machine disagree on its nature, about how to operate it, about what, if anything, is the matter with it, and, if it is malfunctioning, about how to fix it.
This much is certain: the commodities of the world are priced, first, in the money of the country in which they are produced. The nations of the civilized world (China is practically the only exception) relate their moneys to gold. Thus in the last analysis, according to the laws of today, gold is the common denominator in whose terms everything the world produces may be measured. Mechanically this involves:
I.-The physical existence of a supply of gold somewhere in the world.
II.-The issuance of currency against this supply of gold, extending and facilitating its everyday use.
III.-The establishment of credit beyond the limits imposed by any strict ratio of gold to currency.
The fundamental facts behind the ideas of currency and credit are (1) that there isn't, today, enough gold in the world for the everyday use, at current prices, of 1,906,000,000 people; and (2) that even if there were, the metal would be too unhandy.
In the evolution of the machine, then, the first thing the peoples of the world did, after deciding that gold was a good standard and getting a supply of it, was to manufacture a convenient substitute for it -- a coin, a piece of paper -- so that, the gold stored in some secure place, they might have handy mediums for exchange. Growing apace, the world found even the most convenient paper not wholly adequate, and developed the idea of credit. The basic idea of giving a man a piece of paper and telling him it represents gold involves confidence; the extension of credit is merely an extension of confidence. Thus, early in the game of weighing Ford (F) cars with gold in London, we find so nebulous a factor as public confidence entering the balance, and, as the machine is taken apart, you'll find this factor becoming larger and larger until you realize that the whole machine runs on it and that mass psychology is as important a cogwheel as a ton of gold.
There are some 525,000,000 ounces of monetary gold in the treasuries of the world. In terms of dollars, this is worth almost $11,000,000,000. Of this supply, over $4,000,000,000 is in the U.S. in the vaults of the U. S. Treasury and the Federal Reserve Banks, $2,000,000,000 is in the vaults of the Bank of France, some $700,000,000 in the Bank of England, and the rest in bank vaults scattered over the earth.
This supply is increased, each year, by a percentage of the new gold mined. The amount varies, but for the last five years the mines have supplied about $400,000,000 worth of gold a year. Of this, some $88,000,000 has gone to India to be hoarded by individuals. Some $73,000,000 has been used in the arts (including dentistry), leaving less than $240,000,000 to enrich the treasuries of the world.
Of the whole $400,000,000, the South African Rand mines have furnished over half. The U. S. and Canada come next, with around $40,000,000 apiece, then Russia (about $20,000,000), and Mexico, Australia, and Southern Rhodesia (each with a dozen-odd million). The balance is distributed about the globe. A summary shows that English-speaking countries produce over 80 per cent of the yearly increment.
This much is uncertain: the future of the mines which supply this gold, an even more important factor in gold shortage arguments. The Rand mines, being the largest, dominate this situation, and experts are pessimistic about their future production. A mine, however, does not produce. It merely takes out of the ground what is there. Hence its supply is limited. But the nature of such limits are matters of geologic opinion. A man can't walk around a body of ore 6,000 feet beneath the surface. He can drill holes in it, study the structure of the rock, take samples, and use all the tricks he knows, but, at best, the minute he begins to quote figures to you he is guessing. At present, the majority of the geologists guess that within ten years the production of the Rand mines will be cut in half. They guess again that the American continental output will remain constant for "many years." Nor, even if they guess right, have they given you the whole answer to the future of gold production. For the process of taking gold out of the earth and crushing and refining it is a technical process, subject, like all technical processes, to improvement. When a method called the cyanide process was invented, men made fortunes buying dumps of rock abandoned as commercially worthless and putting them through the new method.
There is still another factor. Mining-gold is a business, like any other, but differing from most in that the price of its product is fixed by law, inexorably. Nor has the miner any sales problem. The profits he makes are influenced solely by his cost of production. The mounting labor and material costs of good times cut down his margin until it disappears and he abandons his mine. When compressed air and steel and dynamite and men are cheap, he may reopen it. Hence, as a gold shortage approaches and the metal's value measured in these commodities rises, more and more mines may be operated profitably, and production rises. Prophets of lean years admit this, but reply that the number of known mines affected is not large enough to offset the indicated shrinkage in reserves.
One last consideration: such arguments as have been suggested above are based on gold deposits known to exist. It is not logical to suppose that man has located and marked on a map every yard of gold-laden rock. The gold in California or South Africa or the Yukon gave no warning. Man stumbled on it. Just when he may stumble on another bonanza none knows but, to date, the Lord has provided. He further provides that as gold grows more desirable to man, more of the species look for it.
Remember these figures and these considerations if you are interested in holding your own in an argument on the world's gold supply. And, if the current depression is prolonged, there will be more and more such arguments, for in the darkness of hard times is the hour of great argument about gold reserves. Which comes about this way.
Since man has come to measure his handiwork in gold, any increase in the amount of gold available, it is argued, will make his goods more valuable in terms of gold. Other factors may make them worth more, too, and we shall come to these; but everything else aside, there seems no doubt that since the world's worth is measured in gold, if there were more gold the world would be worth more. Thus every discovery of a new supply of the metal has been accompanied by a boom. Happy days followed the discovery of America and the return of gold in galleons, the prospecting of the Forty-niners, the opening of South African and Alaskan fields. The effect, of course, is comparatively temporary, because once the world has become used to its new wealth, things settle down again -- an individual may get twice the wage, but it will cost twice as much to live. Nor is the wealth evenly distributed, nor does it increase the cost of living according to mathematical formulas, nor in direct proportion to the amount of gold discovered. But while a balance is being struck, while the new millionaire is scattering his shekels, the upward curve persists. The nouveau riche is hiring more people to wait on him and paying them more.
The reverse of this process would occur when the world's goods increased faster than the gold supply. Relatively, gold becomes scarcer and men are willing to exchange more commodities for a given amount of it -- in other words, prices fall and the deflation is on.
Now most arguments on gold shortage start -- with these considerations in mind – on the assumption that the world's commodities are increasing by about 3 per cent a year, so that, to maintain a stable price level, the gold on hand must increase a like amount. This it has not been doing. The rate of increase for the last ten years has been fraction less. The future, as noted, appears even more dubious. Hence, reasons one school, something must be done about it, and one of the things would be to produce more actual metal.
However, just as we observe uncertainties in the thesis that the supply of new gold must inevitably dwindle, there are also uncertainties in connection with the computed 3 per cent increase. This much is true: if, tomorrow, very large amounts of gold were added to the world's treasury, boom times would begin the day after -- and last until that gold had been, largely speaking, digested.
Gold Into More Money
Consider now the machinery by which gold measures the commodities of the world. Exhibit A: the gold standard. As there is not enough metal for everyday use, each nation issues currency and agrees to relate its currency to gold or to go on what is called a gold standard. There are, broadly speaking, three types of gold standard in use. There are (I) the absolute or orthodox standard: paper money is redeemable in gold -- the U. S. and Sweden are committed to this make of gold standard; (2) the gold bullion standard: paper money is only redeemable in gold in large quantities (you can buy a gold bar but not a gold coin) England, France, and Belgium use this type; (3) the gold exchange standard: paper money is supported by the reserves of some other country which is on a strict gold standard -- in other words currency is exchangeable for paper based on gold. The reserve behind credit issued on gold exchange may or may not contain gold metal along with the paper of a gold standard country. Austria, Poland, Rumania, etc., are on this paper-based-on-paper-based-on-gold basis.
There are dozens of different sub-species, hybrids, etc., etc. The subtleties involved in these arrangements are enormous, and the introduction of the relatively new gold exchange standard (Austria used it before the War, but its present popularity was born of post-War necessity) opens up a whole new field of international relationship. It also introduces the paradox that, while any country may use it, if every country did, it would, ipso facto, cease to exist. For being based on a gold standard, it implies the existence of one. The whole machinery of gold exchange standard is in the formative stage. But the idea of a country's using another's gold as a reserve does exist and does work, if only with the din of controversy in its metaphorical ears.
Having suggested the methods, the next step is to observe what we may of the execution. The first problem is how much gold or gold exchange should be reserved against currency. Experience has convinced governments that they should have gold on hand to the value of 30 or 40 per cent of their currency in circulation. And gold exchange nations keep about the same ratio of gold exchange. The ratios are, generally, fixed by law. But the legal requirements are universally based on banking experience and represent roughly what the financiers of the nation think a safe margin. The U.S. requires 40 per cent, France 35, Italy 40, etc. England's system is involved, and legal requirements are phrased in terms of maximum amounts of currency authorizable against certain sums of reserve, in effect necessitating a 33 per cent ratio. The gold a nation possesses may be figured as reserve behind actual bank notes issued, or as backing up these notes and other obligations. Reservations are the rule, and a lifetime could be spent studying the laws of various lands. But back of all systems runs this idea: a country must keep enough value -- gold or gold exchange -- on hand to preserve man's confidence in its currency, to have enough cash in the till to meet its obligations as presented. Once more: if everyone asked for his money at once, he couldn't get it. But experience has shown that a stable country maintaining about these ratios will never find itself embarrassed by too many of its citizens demanding gold at the same time. This issuance of more currency than gold does not end the expansion of the metal's use as a final guarantee, and before we can take up the problems which have arisen as a result of such expansion we will have to touch on the further projection.
Gold Into Credit
Here banking enters the picture. The fashion of today is for a country to organize its finances by means of a central bank (Bank of England, Federal Reserve System, etc.) either owned, controlled, or largely influenced by its government and doing business with the private banks of the country. This central bank is the custodian of the gold supply (except what part might be held by the Treasury) and issues the country's currency, governed strictly by the gold ratio. The private banks of the country, however, may issue their own credit (presumably redeemable in currency), and to control this, each is required to keep, or has made a habit of keeping, an amount equivalent to a percentage of the money it owes (its deposits) with the central bank -- 10 to 15 per cent is the rule. Thus for the possession of $1.00 of gold, the central bank may issue $2.50 of credit to a lesser institution which, in turn may, theoretically, extend $25 worth of credit to a customer and still be within the law, abiding strictly by the gold standard which says that each and every paper dollar may be redeemed in grains of gold!
The exact methods of effecting this elasticity vary widely. In the U. S., we have our Federal Reserve System's twelve central banks, each lending money to member banks. At present, $1.00 of gold supports about $14 of credit. In Great Britain, £1 supports £19 of notes and credit. Less developed credit machinery allows less expansion.
Underlying all systems, however, is the central fact that each must have its supply of gold to support it (or currency based on gold, as in the Gold Exchange Standard). From which it becomes immediately apparent that, having split up the common supply, there may be a plethora of gold in the world and a shortage of it in one country. Which factor we would like you to file away for future reference (it will be discussed presently) and consider first the significance of this involved system of levers whereby $1.00 may be stretched to $25. Item: it is essentially a contrivance which substitutes paper for gold in the process of weighing values (the paper is defined as being exchangeable for gold but there isn't enough gold to exchange for it, hence paper is really used in the balance). Item: it is immensely convenient. Besides being handy, it accelerates the speed with which gold money changes hands (the velocity of money is another factor suggested here, to be taken up in turn), which makes it more effective. Item: observed casually, it appears the answer to gold famine alarmists. If gold production doesn't keep pace with commodity production, all the world has to do is to allow itself a little more credit. The U. S. only stretches $1.00 into $14 when its laws allow it to reach to $25; when it reaches $25, change the laws to let it touch $50. One catch is that whenever the world, or any part of it, does allow itself more credit, it may lose its self-confidence. The basic ratios of around 30 per cent to 40 per cent gold in reserve are, generally, fixed by law. But if the laws were repealed tomorrow, most of the nations of the world would make no move to take advantage of the respite, and any that did would be in danger of finding their credit vanishing. This country stretches $1.00 to $14, can stretch to $25. Yet if it raised the mark to $16 or $17 (still well within the legal limits), the cry of inflation might be raised. Herein we observe the cogwheel "public confidence" turning. Collectively, the world mutters in its beard that it "has had a lot of experience with inflated currency." Yet, obviously, all its currency is inflated. It's inflating it any more which bothers our people. The relation is, patently, far from absolute. The U. S. extends more credit than Brazil, yet its credit is better; it is better now than when in mid-19th century, it only stretched $1.00 to $4.00 or $5.00. Still, governments have given a good deal of concern to the problem of palming off paper for gold in a genteel way.
This section has dealt, characteristically, with the problem from the mechanical viewpoint -- how the machine might influence the credit. The converse is, of course, the larger conception. It is, essentially, man's confidence in himself and in his future that permits him, to extend himself credit. The machine is only a machine, man-made. Hence it would be quite proper to say that man's self-confidence, interpreted in credit, governs it. The part played by confidence, faith, or whatever you wish to label man's belief in himself, cannot be overemphasized.
There is still another, and very active, part of the machine over which governments and international committees have no direct control, and that is the extension of credit in trade. Every merchant, manufacturer, broker, or tradesman who gives a customer time to pay is really loaning his customer the money. The customer gets credit from the merchant instead of borrowing from his bank and paying cash.
At this point we had better pause to examine that least controllable and most mysterious of all elements in the machine, the velocity of money. The subject is apropos, for it is in the above last far-flung extension of credit by individuals that the velocity factor is especially potent. The principle advanced is simple: the same dollar bill, used twice, is as effective as two individual dollar bills; the same amount of gold reserve has done twice the work. The credit you extend to me in loaning me $10 is, far away across a sea of subtlety, linked to buried gold; but there is no link between that treasure and the number of times that $10 bill will be used. Nor the number of times the same amount of money in a bank may be checked against, if I pay you back with a check and you deposit it in the same bank and draw against it again. There has been much research done, and many theories have been advanced on the subject. The velocity seems to indulge in cycles "sympathetic to business," and the circulation may, in a single upswing, treble. This much is certain: the tendency is upward with the march of civilization, toward a higher velocity.
To review rapidly: the machinery for the use of gold as an instrument for valuing commodities spreads fan-wise from a base of gold. Central banks, banks of issue, etc., grant credit (paper money, etc.) up to not more than two and one-half times their gold reserve; private banks, recipients of this credit, grant further credit based on it; individuals, in proportion to their dispositions and financial security, give one last-and powerful-fling to the value of those precious grains in the closely guarded vault. Through all of which the "velocity of circulation" factor enters, and no man knows, for certain, just how much work those same grains may eventually accomplish.
Leaving the consideration of the extension of the total actual credit already created on the world's gold, let us return, as we promised, to the proposition that ills may arise as readily from shifting the gold we have as from any general shortage. It is written that each country committed to a gold standard must have its own gold to back up its own bank notes. But the idea of a common gold standard entails the free passage of gold from country to country in settlement of international balances, in stabilizing the world's moneys in terms of gold. Nations must pay their debts in gold (if asked) and, allowed to choose its home, free gold will always go where (1) it will be safest and (2) make the most money. A run of commercial bad luck, then, means a tendency on the part of a nation's gold to run where it can make more money or feel safer -- and in payment of the money the nation owes.
(Here we have taken the easiest course in describing the machine and sketched in a part [the reason for gold movements] by the use of a theory, a popular one, but still a theory. Many and elaborate are the explanations advanced for why gold moves. Whichever is right, gold does move, from nation to nation, wandering.)
Now there is no panacea for diminishing gold reserves -- no handy cure-all for what is often a symptom of economic distress. By far the happiest way to keep gold at home is to be more prosperous than your neighbor. But if, as a nation, you can't manage this, you may be tempted to resort to artificial (and temporary) expedients. And a common artificial respirator of gold reserves among perhaps half-dozen leading countries is the raised rediscount rate. It works thus: the central bank announces that it will charge more interest for the money it loans (in "rediscounting" obligations), hence other banks must charge higher rates, and money throughout the land becomes dear. The gold which was so anxious a minute before to get somewhere else now may prefer to stay at home to benefit by these higher rates. The disadvantages of this system are that it entails charging your own countrymen more money for their loans, handicaps them, and may eventually lower their scale of living. Also, you may be overbid and have to raise again. If you don't care to raise your rediscount rate, you may place some kind of an embargo on outgoing gold-tax exported capital, or only deliver gold metal in an unacceptable form, i.e., make it inconvenient for export and so slow the process -- or you can up and make it against the law to export gold, a drastic step almost always taken in war but extremely disturbing to peace-time commerce because it removes the guarantee of gold redemption, at least in foreign parts.
Another method of expanding and n contracting credit which is worth your knowing about might be titled "Open Market Operations of Central Banks," and it is used, principally, by the U. S. and England. The idea is ingenious. When the central bank wants to make money easier to get, it goes out into the market and buys securities. For them, the bank gives a check which soon finds its way back to the central institution as a deposit, credited to the account of some member bank. The result is an increase in the member bank deposits with the central bank, which allows the former to extend some ten times as much credit. The central bank has only to maintain its customary percentage of gold behind the deposit. Thus large credit is made available with little metal, is literally forced on the market. Reverse the process, and you have the central bank selling securities, lowering member bank balances, and tightening credit.
Do not let the comparative simplicity of this exposition deceive you. The physical operation is complicated, the issues involved are subtle, and the use or abuse of open market operations is hotly disputed.
But the draining of one nation's gold credit base is not the only way in which the necessarily free movement of metal may upset the smooth functioning of the machine. If you start with the thesis that gold reaches its fullest value to the world only when the maximum sound credit is being advanced on it, it at once becomes evident that, theoretically, for the ultimate welfare of mankind, an individual nation may have too much gold. For the mechanical efficiency of gold is, per se) its ratio to the credit built on it. Hence if one nation owns so much gold that, even after allowing the most generous factor of safety, it has no use for the excess of credit its gold could supply, that excess of gold is doing no useful work and is what is happily called "sterilized." Of course the laws of supply and demand should tend to counteract this tendency of too much gold to pile up, but as intimated, normal times are matters of history – perhaps never existed. Moreover, the legal requirements of individual systems may, conceivably, nullify supply and demand. Indeed, for theoretical perfection, all the nations would have to have identical systems the same gold reserve ratios, the same volume of trade to be financed, the same banking laws, the same facilities, and their peoples the same habits. A nation on a 40 per cent reserve would use more gold for the same credit structure than one on 30 per cent reserve; so would a nation whose people always paid in cash. Their machines would have lower coefficients of efficiency. Now even adjusting the ratios, etc., to allow for the fact that one country may need a more efficient credit system to do its more complicated and demanding work, it is obvious that a vast disparity in the efficiencies of credit systems of leading nations exists. Some parts of the gold machine have evolved faster than others. The result is that the backward members with their lower efficiency require more than their share of the common fuel to keep them running.
Summing up this phase of the business, then, the efficient use of gold as a common base may conceivably be endangered (1) by a country's having more than it can use and (2) using more than it needs.
The main outlines of the working drawing of the gold machine are now sketched in. Observe, to review, the credit structures of the individual nations, the same general principles underlying each and linking each to its, or somebody else's, supply of gold. Between them all, the mechanics of foreign exchange, constantly shifting (and not always happily) the raw metal at the base of each structure. Now go back to the original conception of an automobile rolling from the line in Ford's Dearborn factory and gold being lifted from the Bank of England. Every wheel and lever and piston suggested in the picture of the machine which links them operates inevitably to change their values, the one in terms of the other, interchangeably.
So far there has run through our analysis the tacit assumption that the machine's raison d' etre is economic, i.e., that it was conceived and set in motion for the benefit of all the peoples of the world and that while jealousy and greed and stupidity might, unhappily, have entered in the making, the common goal was the creation of an efficient instrument of commerce and an efficient instrument of commerce only. There is a good deal of evidence that other and less beneficent motives sometimes make its wheels go round, tinker with its governors, and handle monkey wrenches carelessly. In fact, a popular generalization of the day is that "the gold problem is no longer economic but political."
The ground hereabouts is dangerous. Many assertions are made and few are proven. Statesmen and politicians move in devious ways with red herring in every pocket. This much is true: the existence of a state of war tends to divorce gold from its credit structure and make the physical metal the only ultimate reality. The first thing a country usually does when it declares war is to go off the gold standard. This means that it runs its internal affairs on credit, using the expectation of victory as collateral, and saves its gold for dealings with neutral countries. Its "gold reserve" is now definitely a hoard, something to be saved for the last emergency, the only reality in a barbaric chaos. Hence back of all the fine subtleties of the world's economic system there lies this atavistic instinct to hold on to the metal itself.
This fundamentalism is not war's only hold on the gold machine. Obviously the financial balance between nations -- as between individuals -- affects their relationships. And, the millennium not yet at hand, offensive and defensive alliances, with war in mind, may still be sought after. The lending or borrowing of money may still be a part of such machinations.
It is evident, then, that these two factors, the premium which war places on possession of gold metal and the idea that large financial policies may have political rather than economic aims, may have a profound effect on the functioning of the gold machine, influencing alike the bar of gold in Threadneedle Street and the automobile in Dearborn.
What does all this machinery do? There it stands in all its unbelievable complexness, its wheels whirring, stopping, starting, insanely complicated, affecting the lives of nearly 2,000,000,000 people, giving them more to eat or less, making their beds for them or letting them sleep on the floor. Man created it, but it has grown too large for the mind of any man to understand in one conception as a mind understands a steam engine or a simple chemical formula. All one can say is that basically it works thus and so, and it tends to effect this and that. And the major this and that, in terms of your welfare and mine, is the price level. The price level rises -- good times. The price level falls -- hard times. Not necessarily and invariably. Nothing so certain as that in this business. But generally speaking.
A version of an equation explaining a shifting price level is not hard to diagram, although there is some doubt, in higher academic circles, as to whether any such equation is of real value. But the following may help to visualize one conception. The ultimate price of the world's goods is the ratio of supply to demand. The supply is the sum total of everything for sale. The demand is the sum total the world wants and can afford to pay for. These are large conceptions, but relatively clear. Now, relating this equation to the money machine, it is obvious that the latter enters directly into the demand factor only. And the demand factor, expressed in the financial resources of the world, divides itself into two parts: the aggregate of cash available and the credit available. In this last factor, and in this last factor alone, can the engineers of the money machine take a hand in controlling the answer to this equation, or any other such. Deviously they work, through the whole top-heavy contraption, two men tugging at the same lever in opposite directions, the machine running amuck while a dozen others debate on which control to pull next. On one valve especially they all concentrate: the valve labeled "central bank rediscount rate," which we have already seen in action.
If from anyone central point the machine can be maneuvered, it is here. For at this bottle neck in the spreading of credit from gold, the supply can be choked off, thrown wide open. A group of men sit about a mahogany table and agree; the next day their countrymen have that much more money to spend, that much less. A grave responsibility. If their people get more than is good for them, they will indulge in excesses; too little will depress them. Quite obviously, the control is not absolute. Today they have not only their own people to think of, but the whole world.