Why Warren Buffett is wrong about gold

It is sad that Warren Buffett has never gotten around to writing a book. But every year towards the end of February he writes a letter explaining his investment decisions as well as how he sees things panning out in the days to come, for the shareholders of Berkshire Hathaway.

This year’s letter was released on February 25. But Buffett has already explained some of the key points in a column he recently wrote for the Fortune magazine. The key point in the column was why an investment made in stocks was likely to beat an investment in gold over time.

His reasons for not investing in gold are similar to the reasons offered by all gold bears from John Maynard Keynes to Buffett himself: gold is incapable of producing anything. “Gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end,” writes Buffett.

So why do people buy gold then? “What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade, that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm,” explains Buffett in the column.

Buffett is not far from the track when he says what he does, the smart man that he is. Yes, gold has very little industrial use. And at the same time people beyond a point do buy it because others are buying it. But then, that is true about every other investment we human beings make.

Buffett’s America has made this mistake twice in the last 20 years. First, every American wanted to buy dotcom stocks. Once he was done doing that, he only wanted to buy some real estate.  In both cases, investors lost a lot of money.

But some of them who got their timing right did make pot-loads of money as well.  As George Soros, the biggest speculator of them all, once wrote, “Nothing is quite as profitable as investing in an early stage bubble.”

But that’s deviating from the point.  We’re talking about gold here. Gold that does not produce anything but is likely to give you good returns in the years to come and prove the Oracle of Omaha wrong.

Let us get into some history before we get back to gold.

Sir Thomas Gresham was a financial advisor to Queen Elizabeth I. Gresham helped Elizabeth clean up the monetary mess created by her father Henry VIII and her brother Edward VI, who ruled before her. Between them, they had almost managed to completely debase the pound by ensuring that it had very little silver left in it.

Kings and governments throughout history have been debasing coins. Nero, who watched while Rome was burning, was one of the first kings to debase money.  Debasement was a practice where the ruler lowered the metal content of the coin while keeping its value unchanged. So let us say one coin weighs five grams. The king decides that from now on the coin will weigh only four grams. Earlier 20 coins could be made out of 100 grams of metal. Now 25 coins can be made from the same amount of metal.

There is another other way to explain this. Let us say a particular coin has a face value of 100 cents (or paisa or pence for that matter). The face value of a coin is also referred to as its tale. Initially, the metal content in the coin is also worth 100 cents. The value of metal content in the coin is referred to as specie. In this example, the tale value of the coin is equal to the specie value.

Now the ruler decides to debase the coin and reduce its metal content by 10%. So the specie value of the coin will now be 90 cents even though the face value of the coin continues to be 100 cents. As explained above, by doing this, the ruler could mint more coins out of the same amount of metal.

The situation prevalent in Britain at that point of time was similar. The market was full of debased coins launched by the earlier rulers. Elizabeth wanted to launch new coins were the face value of the coin was equal to the amount of metal in it; that is, tale was equal to the specie.

In such a situation, Gresham felt that bad money will drive out good money. This meant that the citizens of the country will hoard onto the new coins whereas they would continue using the existing debased coins in the market for making payments.  The new coins, because they had a greater amount of silver in it, would be melted and sold for their precious value content. Hence, the bad money would drive out the good. This, in later years, came to be known as the Gresham’s Law.

To get rid of this problem, Gresham decided that the old coins would be exchanged for new coins. So there were no old coins in the market, and the market moved onto using the new coins as the currency.

This phenomenon of bad money driving out good money has been observed time and again through the centuries, even before Gresham’s name became attached to it. As John Mauldin, a hedge fund manager explains it,  “Under the Greeks and Romans, when gold coins were debased, few people were dumb enough to want to exchange their old coins that had high gold content for newer ones that had low gold content, so older good coins disappeared as people hid them.”

It is even being observed today, though in a slightly different form. Governments across the world have been printing more and more paper money to tide over the various financial crises. When a government resorts to printing more of its currency, it leads to a situation where there is much more currency in the market than before and hence it is getting debased.

To protect themselves from this debasement, people buy another asset; that is, gold in this case, something which cannot be debased. During earlier days, paper money was backed by gold or silver. When governments printed more paper money than they had precious metal backing it, people simply turned up with their paper at the central bank and demanded it be converted into gold or silver. Now, whenever people see more and more of paper money, the smarter ones simply go out there and buy that gold.

So gold keeps disappearing from the market and hence its price keeps going up. And as was the case earlier, bad money (that is, paper money), drives out good money (that is, gold) away from the market.

And that is why Warren Buffett will be wrong when it comes to gold. As long as governments around the world keep printing money to fight the financial crisis, gold as an investment class will keep doing well.

The question that remains here is: why doesn’t Buffett look at gold as an investment class? A major reason for it is the fact that Buffett is a follower of the school of value-investing, established by Benjamin Graham.  For most of the period that Graham was an active investor, private ownership of gold in the United States remained banned. Franklin D Roosevelt outlawed it in 1933 and it remained so till 1974. Graham passed away in 1976. Hence, during the years of his life as an investor, gold was never an investment class. To him, investments were limited to stocks or bonds. Hence, the theory of value-investing never got around to talking about gold as well.

chandniburman@yahoomail.com