Gold Production and Investments

ALTHOUGH the world’s gold output began to increase in 1891, and in three years had reached figures never before recorded, it was not till the first years of the present decade that discussion became general as to the effect of this very great production of gold upon prices of commodities, wages, and interest rates. That the first would rise, followed more slowly by the second, seemed to be the consensus of opinion, though reached by different lines of reasoning, the quantity theory being perhaps the favorite argument. The effect on interest rates was widely disputed. Some authorities said rates would decline because there would be more money to lend; others thought rates would rise because, money being a commodity like any staple article, its price would rise in common with other prices; while still others whose judgment was entitled to consideration expressed the opinion that the rates of interest could not be affected one way or the other.

These questions are of very great interest to the holders of investment securities, a class to which, in this part of the country at least, a considerable part of the people belongs. It is of importance to them to know if the mortgages, bonds, and stocks, which represent their own savings, or savings of which they have come into possession, are increasing or decreasing in value because of some great general cause absolutely beyond their control. Or, if the value of some is thus increasing and the value of others decreasing, to know what securities belong to the first class and what to the second.

Precedent will be of very little assistance to us in our attempts to solve these questions. There have been only three periods of great increase in gold production in modern history: in the sixteenth century directly following the discovery of America; the period of 1849-57 when gold was found in California and Australia; and the present time. The first period is too remote to be of value for comparison, and our knowledge of the economic conditions that then prevailed is too slight. The second period is of more interest. In 1852 the world’s gold output was $132,000,000, or three times as much as the production of 1850 and about 8 per cent of the estimated world’s visible supply at that time. To-day the production is over $400,000,000, or three and one-half times that of 1890, about 11 per cent of the stock estimated to exist in 1890 and about 6 per cent of the stock of to-day.

On the face of it there is a striking resemblance between the two periods, and since then, as now, prices of commodities rose, it is not unlikely that in each case it was in large part due to the increased gold production. But statistics are apt to be misleading, and especially in a case like this. Though the two periods are only fifty or sixty years apart, they are widely separated by the extraordinary commercial development that has taken place in that time. In the fifties, active business men could remember the introduction of machinery; railroads and the telegraph were new, the ocean cable and the telephone unknown; and, last but not least, banking by check was in its infancy. So great has been the progress in methods of production, distribution, banking, and the dissemination of news, that it would be very rash to say that because the effect of a cause was such fifty years ago, it would be the same to-day.

As precedent is therefore not of much value in helping us to understand the situation, we must rely upon plain reasoning and clear thinking. First, what are the facts? Gold production has very much increased; prices of commodities have risen very considerably; interest rates have advanced; and prices of stocks have risen, while bonds have declined. The question is, Is the first fact the cause of the others? and if it be, will it continue to produce the same results in the future?

Before trying to answer the question, one word of explanation may not be unnecessary. The following is not an analysis of the financial situation, but only an attempt to discover some of the effects of one of the factors in the situation. Therefore, for the sake of simplicity, and in order that the question under discussion may not be befogged, no consideration will be paid to other factors. When mention is made of the probable movements of securities, it is fully realized that the movements may be obscured or temporarily checked or emphasized by the influence of one or more factors other than the one under discussion.

Credit is perhaps the chief factor in the expansion of trade. The invention of each new instrument of credit, such as bank-notes, bills of exchange, and checks, has made possible greater and greater developments of commerce. These credit instruments form the chief parts of the machinery of banking, — the business of manufacturing credits. Bank credits depend upon the bank reserves of cash. The greater the foundation of bank reserves, the greater the superstructure of credit that can be built upon it. An increase in the world’s supply of gold renders possible an increase of bank reserves and an increase of credits. As credits increase, trade expands; and with expanding trade, prices rise. Human energy thus stimulated, the appetite grows with what it feeds upon, and more than keeps pace with the supply of credits. The use of stimulants is apt to lead to their abuse. The desire increases to do more and more business, and demands more and more capital with which to do business. This growing demand for capital, increasing faster than the supply of credits, advances the rates of interest. The increased stock of gold thus seems to have been a factor in raising prices and interest rates.

At this stage the effect on securities is obvious. Those companies producing commodities do a larger and larger business, and because wages respond more slowly, at an increasing profit; their shares therefore advance in price. In the case of railroads, though it is more difficult for them to advance the price of their product, they also prosper because of the increased business they do; and their shares advance. On the other hand, the advance in interest rates causes a decline in the price of bonds; and, for the same reason, a decline in the price of preferred or guaranteed stocks whose dividends are limited and cannot be increased. Such have been the broad features of the security market for the past ten years, and they would seem to be in logical harmony with our argument so far as we have gone. At this point it may not be out of place, though anticipating a bit, to note the effect on earning power if this onward march of business, and upward movement of prices, were to continue unchecked for a very long time. Gradually, the increase in the cost of production would catch up with the advance in the price of the product, and the profits would gradually decrease to what was considered normal before the great expansion began. As the earning power diminished, so the value of the ownership of or of the equity in that earning power would decrease, and the prices of stocks decline proportionately.

Sooner or later, in this great expansion of credits, the desire to do more and more business is indulged to such an extent that the superstructure of credits is out of safe proportion with its foundation of cash reserve; and then there is trouble. Such was the case in 1907, when the ratio of the actual cash reserves of the national banks of the country to their net deposits fell to below 13 per cent as compared with 17 per cent in 1899, in spite of the fact that the reserve held was $700,000,000 in 1907 asagainst $500,000,000 in 1899. In the past, in similar crises, the only remedy was a forced contraction of credits, which resulted in panic followed by a long period of depression. This was expected by many wise observers to be the outcome of the troubles of 1907, but it was averted by the constantly increasing stock of gold, which made it possible within a wonderfully short time to increase the bank reserves to such an extent as to avoid any considerable contraction of credits. In other words, the superstructure was saved by enlarging the foundation. This, with an ensuing short period of rest and recuperation, saved the day and made it possible to resume within a few months the onward march of business, and the upward movement of prices.

It is not generally realized howsmall the curtailment of credit was that actually took place in the fall of 1907. The total decrease in loans by the national banks of the country was only $250,000,000 out of a total of $4,600,000,000 and probably represented largely the calling of collateral loans, or loans with stocks and bonds as security. By February or March of 1908 the curtailment ceased, and by July the loans were nearly equal to the highest of 1907; and on March 29 of this year had increased to $5,400,000,000. Broadly speaking, commercial credits were not curtailed. In the height of the trouble they could not be; and, thanks to the heavy imports of gold, in a short time there was no need. That there was no curtailment of commercial credits the almost immediate resumption of business in record volume is proof, if proof be required.

This is the amazing feature of the panic of 1907, — the non-contraction of commercial credits. Indeed there has been, broadly speaking, no contraction of commercial credits in this country since 1896. This is the reason why the upward movement of prices and interest rates has been checked for such very short periods by the financial upsets of 1903 and 1907. And it may be fair to infer that until there is a decided contraction of commercial credits there will be no downward movement of any duration in prices or rates.

If the enormous gold production makes it possible quickly to increase the foundation of bank reserves whenever the superstructure of credits expands beyond safe proportions, is there any cause that will produce a contraction of commercial credits? If there is not, there is apparently nothing to prevent a continuation of the present movement of prices and rates for an indefinite time. Such an indefinite movement is inconceivable, though theoretically it may be possible. Our common sense tells us that, it is not practical. There must therefore be some cause that will operate to check and reverse this movement. Such a cause may well be the inability of the consumer to purchase in present volume, due to the increased cost of living, and to the extravagance of the times which has caused the old-fashioned quality of frugality to disappear, and has led the average consumer to live up to the limit of his income. Or it may be the diminishing profits of the producer, due to the increasing cost of production. Either of these causes, or any one of a dozen others to which we give little thought to-day, might bring about a questioning of individual credits. Whenever such suspicions exist, and prove to be not unfounded, there is bound to be a general liquidation. Such a liquidation may not take place in the immediate future, but it is sure, sooner or later, to occur. When it comes it will result in lower prices for commodities. The effect on interest rates may be even more pronounced. After the acute panic, the bank reserves will be as large as ever, though the superstructure of credits be much contracted. Though credits be shattered, the gold will remain.

The relation of bank reserves to interest rates is more intimate than might be supposed. The great bulk of loanable funds is bank credits, and interest rates reflect the demand and supply of these credits, and are affected by whatever affects them. Bank reserves affect the supply of bank credits or loanable funds, and therefore affect interest rates. When the ratio of bank cash-reserves to bank credits rises, interest rates decline; and when it falls, interest rates advance. At the time we are considering, the period following the collapse, the curtailment of commercial credits or bank loans has equally curtailed bank credits or deposits, because loans and deposits move practically pari passu. The bank cash-reserves, after the moment of panic is over, being as large as ever, and the bank credits much reduced, it follows that the ratio of cash reserves to credits will have materially risen, and interest rates will decline. Because therefore the volume of bank reserves has been made possible by the increased gold production, credit must be given the gold production of becoming at this time a positive factor in assisting the decline in interest rates. This is not always true of any kind of an increasing volume of money, but it is true of an increasing volume of gold, because gold is bank-reserve money the world over. If, for example, the increasing volume of money were national bank notes, it would not swell the bank reserves; though it might, by acting as a home circulating medium, prevent in some degree a decrease in reserves by a demand for circulation. On the other hand, if issued to a dangerous degree, bank-notes might drive gold from the country and deplete the reserves. In any event, they could never actually increase the reserves as gold does. The character of an increasing volume of money determines its effect at this stage on interest rates. Only an inflation of the best money can at this stage produce a positive effect toward a decline in rates.

After the acuteness of the liquidation is over, for the reasons given above interest rates on unquestioned security should run very low, perhaps lower than in years, and should so continue until confidence in credits is slowly restored. During this period, securities of the first rank, whose earning power is unquestioned, should advance in price, reflecting the decline in interest rates.

The decline in interest rates would probably be sharp and quick, and in strong contrast with the movement of commodity prices, which would continue doubtless to decline while the depression in trade lasted. This would result in bonds and stocks taking widely different courses: bonds moving up, and stocks continuing to decline even after the liquidation was over and until the subsequent period of depression was at an end.

It goes without saying that recovery would follow the collapse of credits, and its coming would perhaps be hastened by the constant increasing of bank reserves by the gold production; though it is not unlikely that the effect of the gold production would be less and less as the years go on, and the ratio of yearly output to stock on hand declines.

In conclusion, the last fifteen years have been a period of expanding credits and trade; stocks have advanced through increased earnings, because of increased volume of trade and higher prices for products; and bonds have declined because of higher interest rates. In all these results, the increased gold production has been a factor of importance. We have seen that moments of financial stringency have been quickly remedied, without the contraction of commercial credits, through the quick reinforcements of bank reserves, thanks to the great production of gold; that such moments have, relatively speaking, had little, and no lasting, effect on prices or interest rates. It is unlikely that any lasting effect will be attained until there has been a serious contraction of commercial credits. Until that time comes, the prices of bonds will continue to decline or not advance, because interest rates will be maintained; stocks, on the other hand, will continue to rise, provided the earning power they represent continues to increase, with the probability that it will wane because of the increasing cost of production. When a contraction of commercial credits occurs, as it must sooner or later, the fact that increased gold production has brought into existence such vast bank reserves should cause interest rates to decline to perhaps the lowest on record. While the prostration of credit would bring about a decline in commodity prices, it is doubtful if the decline would bring prices to what they were when the increase in the production of gold began.

If there be logic and truth in the above, it will be seen that the increased production of gold will have had quite different effects on prices and on interest rates. On the former it will have had the positive effect of assisting an advance, and after a collapse of commercial credits it will have a negative effect to diminish the extent of the decline. But on interest rates its influence may be found to be twofold: first, as a positive factor in aiding an advance; and second, after the acute moment of panic is over, as a positive factor, through a large permanent increase in bank reserves, in assisting a decline. Those effects that have not. already been felt will, when they occur, be reflected in the movements of securities.