Unless there is a last minute change in Washington, the forty-one years of prohibition against the holding of gold by United States citizens will come to an end on December 31st, 1974. Since few bankers in this country were active in the profession before 1933, there will be a woesome lack of experience and expertise which can be brought to play in the ensuing attempt to value and control the impact on our banking system. It might, therefore, be helpful to examine the circumstances more closely with a view not only of history, but of the European experience as well. All too often the discussions which have taken place these past few months have bypassed one of the primary questions: Is gold of any value to the banking system? Likewise, they have tended to incorrectly define what its principal function is. There have been many inferences, and even outright statements (principally by non-bankers) that gold is in effect, a commodity.

The United States Government argued this after August 15, 1971 saying that gold has been "demonetized". This was part of the campaign to pacify those creditors of the United States after the gold window closed. As we learned from subsequent events, neither those creditors nor prospective purchasers of gold were convinced. The various commodities exchanges, including the New York Mercantile Exchange, the Chicago Board of Trade, and others are planning to trade options and/or futures in gold. On the other hand, many bankers, particularly outside of the United States, see gold as having a value different from that as a commodity. What is the answer?

Commodity or Money?

Can gold be a commodity in one country and money in another?

It has been said that money serves three functions. It is a means of payment, a standard of value, and a store of value. One the other hand, a commodity is generally thought of as being a product other than money to be used in commerce. There is, of course, a portion of the gold supply which is used in commerce such as jewelry, dentistry and electronics. But when gold is sold to the public (as opposed to businesses) it is normally not sold for commerce purposes. The public will generally buy gold because they think it has and will retain value. It is obvious that one of the reasons that gold historically has had value is because it has been in relatively scarce supply. Another is because it is easily identified. A third is because it does not deteriorate. A fourth is because people have historically been willing to accept it in lieu of other money.

While gold is presently not a standard of value in the United States, it is in Switzerland. And, while it is not a medium of exchange in the United States, it is or has been in many countries. It seems clear, therefore, that gold is more than a commodity, though not at the moment universally accepted as money. But, its innate and historical qualities tend to give it more a characteristic of money than anything else.

In any event, there are several virtually axiomatic statements that can be made about gold. First, investment in it is seldom a speculation except when it is bought on margin, or when it is listed on an exchange as an option or future. The purchase of gold is as stable an investment as the holding of any currency including the dollar whose interest rates can vary many percentage points, and whose value vis-à-vis other currencies continuously fluctuates. Second, gold will not replace the dollar as a medium of exchange, but will be a value to be reckoned within the financial system as long as its free ownership and transportation is allowed. Third, there should be little risk in gold dealing by banks, certainly no more so than in the handling of certificates of deposit, commercial paper, or mortgages. Fourth, in an inflationary spiral such as the world is presently experiencing, gold has a better chance of retaining its value (or a substantial part thereof) than a currency backed principally by the assets of its government. It would be easier for a government in times of inflationary pressures to simply cross out a "0" in a $10 bill thus decreasing its value ten-fold, than for it to similarity deflate the value of gold. And, this is not really such a shocking thought, since in the last half century we have seen its very occurrence twice in Germany and can observe it is Brazil on an almost monthly basis. The recent 42% devaluation of the Israeli Pound is yet another example of the danger. One might argue that the recent wide fluctuations in the price of gold seem radical and therefore indicate it is a speculative investment. However, it is well-known that the public market is rather thin, since most people who buy gold do not trade it, but rather continue to hold it. As U.S. ownership of gold brings more and more people into that market there should be fewer massive day-to-day fluctuations, and therefore its price should be more stable. This would be particularly true if banks in the United States assert their position of responsibility vis-à-vis the handling and distribution of gold.

But what should the responsibility of the United States banks be?

The Role of Banks in the New Gold Environment

Presuming that gold is more than a commodity, and that it has at least some characteristics which are attributed to money, it seems that the banks must give careful consideration to its future in the United States. At the moment, though it looks as if the non-bank financial institutions are taking the lead in the preparation for dealing with gold. Merrill Lynch has combined with several other institutions to buy, hold, distribute and make a market in gold. The various commodities and other exchanges are making plans to offer gold futures and options. The Franklin Mint is increasing its capacity to include the production of new coins and probably commemorative bars. One could go on and on. The banks, being more conservative institutions - as they must be - may very well want to wait and see whether Americans treat gold with respect over the long run, or whether they follow the path of the Japanese. This could be a dangerous situation not only for the American economy but for the dollar as well. For gold to be treated as a commodity and a vehicle for money-making by the very same institutions whose daily existence depends principally upon salesmanship would simply be an exercise in futility, because after a relatively short period of time the bulk of the citizens would become disenchanted with gold. Their lack of interest and demand would be supplanted by the demand of foreigners, and the gold would flow out of the United States, a classic example of Gresham's Law, i.e. bad money drives out good.

It might be argued by the banks that they cannot take the risk of beginning to deal in gold, because they don't know whether the people will buy it. But, if gold has any value and it is for sale, then it is a marketable value which people will buy. If Christmas savings accounts can be marketed, so can gold.

The Great American Rip-Off

It appears that our wonderful American characteristic - ingenuity - will be used by the non-financial institutions in an attempt to take control of the market in gold in the United States. There are even those who believe that the United States will become the gold center of the world. These people who are preparing for the golden day have had almost no past experience in dealing with gold. As a result, they are struggling with the most elementary problems, such as assaying, weighing and shaking gold, counterfeiting, storage and transportation. They are even trying to figure out sell-back procedures by customers who have previously bought the precious metal. Already there is talk of a rather substantial premium on the gold price (which, in any event, will continue to be fixed in London and where, we must presume the world market will not disappear overnight). Dr. Allen Abrahams, Vice President of Research for the New York Mercantile Exchange estimates that the assay costs of a one ounce wafer will be $50.00. He says further that the handling charges will also be high, because banks will have to invest in special machines. The apparent result would then be that the purchaser of gold in the United States, particularly the individual who buys 10 grams or 1000 grams, will be paying substantially higher prices than he would if he were able to buy it in London or Zürich. By the same token, he will probably have to sell it back at a discount.

The European banks, on the other hand, have had centuries of experience in dealing with gold, not only among themselves but also with customers, and as a result, their costs of handling are about the same as that for transfer of currencies. These banks rely on the day-to-day fixing price, which is a simple bid-ask price arrangement. There are no extra charges except in those countries where a sales tax is required.

Counterfeiting is another problem cited. Gold is one of the easiest elements to distinguish. And, gold bars are specifically made in such a way that it is difficult to alter them without being easily detectable, particularly by a practiced human eye and hand dealing daily in such matters. The problem of counterfeiting is not that bars will be made of substitute material, but rather that less than the required gold content will be in the bar, e.g. .865 rather than .995 troy ounces. This is, of course, a possibility just as the counterfeiting of a $100.00 bill is a possibility.

However, every time a cashier takes in a $100.00 bill she does not immediately run X-ray and other tests on it to see whether it is genuine. She will also give a known customer more credibility than a stranger. She is practiced enough to be able to see any poorly counterfeited bills. The bank usually takes the risk that very few well counterfeited bills will be presented for payment, but when they are, and are passed through the bank successfully causing a loss (excluding the insurance aspect) it is a total loss, since such a bill is worth nothing. On the other hand, a counterfeited gold bar or coin is probably still worth 50-90% of its original value.

Another problem in establishing a legitimate market price for gold will be the wholesale price that the marketing institutions themselves must pay. In reality, the same arguments can be used that the gold sold to them will be overpriced, since they will probably be buying much of their gold from a source in America (although some of the gold may have originally come from abroad). This is simply inefficiency multiplied several times.

It is submitted that the problems of assaying and counterfeiting are over-emphasized by under-experienced individuals and institutions. Surely they are problems, but they can be overcome with modern methods and procedures and without any great expense. The much greater problem is that the over-emphasis itself will be the justification, uncontested, for selling bullion and coins at higher than necessary prices, thus reducing interest by the public and consequently decreasing any potential market. Only the banks, as the genuine financial institutions, are equipped to properly tackle this problem. And, those banks which are properly equipped to buy and procedurally handle the gold in the most efficient manner will be the ones which are not only performing the best service to the public, but also will make the largest margin of profit. Unless they assume their proper responsibility, the only people that will benefit will be the ones least entitled to it.

Alternatives

Apparently, those banks that have been considering the handling of gold are planning to sell various sizes of gold bars, coins, and/or gold certificates to be backed by the gold itself. In each of these cases there would be a substantial cost factor even presuming the assaying and counterfeiting problems have been minimized. These cost problems would include establishment of new bookkeeping procedures, keeping of a current price valuation on a daily or perhaps even hourly basis, and possible expansion of existing facilities including vaults, floor space, and safe deposit boxes. The safe deposit expansion might be necessary as the banks sell bullion and coins since most people would be hesitant to hold them in their houses. Even if the sale of gold certificates were the principal activity, it would still cause substantial storage and cost overhead problems. The gold to back the certificates must be held somewhere, if not in the bank itself then at another bank or a pool of banks. But in any event there would be an additional cost. Certainly, the gold certificate would make more sense to the customer, that is as long as he has confidence in the bank itself, since it is easier for him to handle. And, it could have a least the same transfer and collateral possibilities as share certificates. This excludes, of course, the natural attraction bars and coins would have as birthday and Christmas gifts, etc.

However, the problem of how to handle the inventory itself remains, Only those very large banks which will be able to absorb these additional costs in their profit or other margins will be genuinely competitive. The Swiss banks located in New York will also be competitive, not because they are large, but rather because they already have gold procedures established and will easily be able to adapt them to the American cost and overhead structures. -- What can a bank do to participate in this very interesting market ... and at a profit? The answer would seem to be almost too simple. Presently, the most inexpensive place to buy gold in the western world is in Switzerland. There are no taxes, no extra handling charges, no assaying or weighing costs, and almost no problems with counterfeiting. The major banks (particularly the Big Three in Zürich) maintain an inventory of gold themselves which is sufficient for their necessary day-to-day activities.

If a bank were to participate in this new activity, its preferred course of action could be to buy and handle only the bare minimum of gold bars and coins at its various banking centers. It should engage principally in the activity of selling gold certificates, and they should be based on weights of gold, e.g. 10 gram certificates, 100 gram certificates, 1 kilo certificates, etc., rather than on dollar values, such as $10.00 or $100.00 gold certificates. These certificates would always be redeemable at the bank for the dollar equivalent or gold at the time of redemption. Consideration should also be given to allowing the redemption in the form of the bullion itself. But the principal gold inventory necessary to back the certificates should not be held by the bank on its premises. The costs are significant, and the procedures for purchasing at a higher than London fixing price make it inefficient to do so. The bank should, therefore, open an account with a principal bank in Zürich or one of the other Swiss banking centers, and purchase and hold its gold there. Gold should only be purchased as customers buy the certificates. The problem of communications is insignificant since telex and telephone to Europe is not much more costly in terms of time or money than it is to New York. The normal costs for storage of gold in one of these banks is minimal, but even more attractive arrangements could probably be made since the transaction is bank to bank, rather than individual to bank.

This method has an obvious cost advantage, since the costs of holding the inventory are born by an institution more appropriately organized and more experienced to handle it. The bank would then need only to hold a small reserve of bars and coins for those customers who prefer to buy them rather than the certificates. This procedure would also allow for the natural progress into more extensive international banking activities. This is possible, since once the day-to-day transactions are initiated, there should be other potential for inter-banking business. Then, at the appropriate time it would be much easier to consider opening a bank branch (or subsidiary) in Europe, since it would already have a substantial amount of funds on hand there (in the form of gold, but with a calculable dollar value), as well as a developed working relationship.

I have specifically discussed such a procedure inferentially, at least, excluding London. The reason is that there are too many potential restrictions on the flow of money there. Further, inflation is rampant, productivity is down drastically, and the general economic situation is not healthy. While this has not yet really affected The City, it is an unstable situation at best. The price of gold in London is also dearer.

So, while most institutions in the United States would be purchasing gold at a higher price, such a bank could get the best price internationally, and with that advantage plus lower overhead, could be substantially more competitive. Presumably such gold certificates could be redeemable by their owners also at the bank in Switzerland where the U.S. had its account. This would be an added advantage to people wishing to travel to Europe since they would always have a source of money if an emergency arose.

Alternatively, the bank could form a Swiss company (bank or non-bank) and act as a warehouse itself for the gold which is purchased. This would originally be more costly, but would have the added advantage of putting it in a strong position to activate its international banking plan when it appeared feasible, while at the same time paying a lower price for the formation (prices always seem to rise - even in Switzerland). But, it is not always possible for a foreigner to form a company or a bank in Switzerland. For example, after a nearly two year moratorium, Switzerland, only at the beginning of 1974, once again allowed foreigners to form companies there. So, one cannot predict the future course of events, and it may very well be that at a later date it will once again be impossible - or unrealistic for other reasons - for foreigners to initiate business activities in Switzerland. If history is any guide, it is clear, however, that once such business activity is initiated, it will not later be curtailed by the Swiss during such times of restriction.

One might argue that it would be just as easy and maybe even simpler to buy gold through Swiss banks now existing in New York, Canada, Mexico or elsewhere. However, these banks are obviously not as independent, since they must conform to the local laws as well as to some form of control - subtle or otherwise - from such institutions as the Federal Reserve. Further, it is important to be able to buy (and sell) gold at its best price, by having direct access to the markets in Europe as well as in the United States. There is, likewise, no advantage in communications by dealing with a Swiss bank in, say, New York. It is just as fast by telex or telephone to Europe. As with loans and other aspects of banking, the 1/4% or less, often makes the difference between a profit and just breaking even.

By purchasing gold in Switzerland, the bank is immediately able to integrate the new activity into its traditional banking activities with the least possible risk and lowest costs, and to provide the best possible price of its certificates to its customers. Further, it makes use of the foreign banking expertise which is based literally on centuries of experience, without the necessity of opening an overseas branch. In effect, it would be doing through gold in the 1970s what Chase Manhattan, Citibank and others did because of expanding multi-national business in the 1950s and 1960s, thus taking advantage of the new and ever increasing Eurodollar market. Then their overseas branches were able to more easily support the credit needs of their customers when the Fed began to restrict credit policies in the United States. These banks had flexibility that the others did not and could be more competitive because of the added options. Finally, this method offers a genuine and inexpensive way to become involved in international banking on a more universal scale.

Conclusion

It appears that gold will be a force with which to reckon in the United States after December 31st. There is also a very good argument that it should be viewed as more than just a commodity. And if this is so, it is the banks' responsibility as the most important financial institutions, not only because of their responsibility to the financial system itself, but also in order to protect innocent purchasers of gold from paying too high a price, to become involved in its day-to-day transactions. Since there is no track record in the United States in recent history upon which banks might base their procedural decisions, it would seem imperative that the initiation of these new activities be done with a minimum of risk, and the transactions themselves be accomplished with a maximum of efficiency. For banks that do not already have sufficient presence abroad (and particularly in Europe) their options must necessarily be more limited, but where they still must attempt to fulfill their financial responsibility, there seems little doubt that the least risky and most efficient way to proceed would be by working in conjunction with a major and well-established bank in Switzerland. Additionally, the advantages of developing a long term relationship with such a bank thus allowing future expansion in that area when bank policy and conditions permit, are at the very least, interesting. It is difficult for a medium-size bank to otherwise accomplish this on the Continent, since it normally takes more funds on the front-end that it is willing or able to commit.

Even if the American people do not purchase gold with the interest that many banking commentators expect, such a bank in the posture aforementioned will have risked little if anything in the process.

Munich,

November, 1974.