Gold: Always a Store of Value but Never a Currency

We have been reflecting and writing on money lately. Now we turn to the question of can we return to gold or gold-backed currencies?

For a large part of human history, warfare has been motivated by and certainly directed at the acquisition of a neighboring country’s gold which represented a country’s wealth. Gold was the basis of a sovereign’s wealth and power and no sovereign, of today included, has ever had enough wealth. Until recent times, gold has been the predominate metal of currency, supported by silver and copper.

Gold Coinage As Currency

Consider an Archimedean experiment. Suppose all world currencies were in gold coins. Suppose we created a large balance such that all the gold coins in the world were on the left side and all the tangible assets in the world, ex gold, were on the right side. Suppose the balance were constructed so it was initially in equilibrium (balanced) and what the balance is measuring is value.

If we multiplied the face values or denominations of the gold coins by their numbers and added them up, we would have the value of all the money in the world.

Since it takes years (typically 5 at a minimum) and huge amounts of money (typically half to multiple billions of dollars) to explore for, develop and put into production new gold deposits, the increase in the gold supply is at a slow, fairly fixed rate. The total value of money on the left side of the balance grows slowly and cannot be accelerated to any extent.

The quantity of tangible assets or durable goods (we will ignore services for our simple example) on the other hand has expanded much faster through industrialization and the utilization of modern technologies. The output per unit of labour in virtually all industries and agriculture has been increasing steadily for centuries. The total value of assets at a fixed price on the right side grows faster than the value of gold on the left.

The experiment we have created would move away from the initial equilibrium or balance quite quickly. A free market would restore balance naturally, but let’s see what we would have to do if we wanted to maintain the balance ourselves.  We would have to increase value on the left side or decrease value on the right side. Let’s look at the left side first.

We have already argued we can’t increase the supply of gold significantly, especially in a short time frame. So we have to change the value of every gold coin so the total value on the left rises to meet the increased value on the right. This we can do in two ways.

First, we can recall and reissue every gold coin at new denominations. A 10 dollar gold coin would be reissued as an 11 dollar coin, as a 10 dollar coin slightly smaller in size, or the same size coin with some base metal added to reduce its gold content. All of these strategies reflect the fact that the value of gold has increased for each fixed denomination. Incidentally, all of these strategies have been used by sovereigns in the past trying to increase their wealth (the total value of the left side) and all have failed in time.

The other option would be to keep the coins and their gold content unchanged but publish a daily price fix on the gold content. So the face or nominal value of the coin would be fixed but the actual or real (inflation-adjusted in modern terms) value would change on a daily basis. This of course would create chaos in commerce, of the kind seen in hyperinflationary environments.

What if instead we tried to adjust values on the right side of the balance such that the total valuation equaled that of the left. We could do this by reducing prices of all goods. As long as we were experiencing productivity increase in our economy, we would create price deflation. This is the sort of notion that, while intuitively obvious and attractive to the layman, induces heart attacks in economists and central bankers.

Our first observation is that this is the problem that plagues centrally planned and administered economies such as the former Soviet Union. It is impossible to know what a proper price should be apart from market determination. Further, to monitor and constantly adjust all, or even a large number of prices in an economy is probably too mammoth a task to succeed in.

Secondly, a deflationary environment, if it were induced, would be detrimental to debtors which today includes most citizens and nations.  The nominal value of a debt is fixed while the real value of the assets it is drawn on or collateralized by decrease due to deflation. This effectively inflates the cost of the debt to the debtor when he has to pay it back.

Finally, this scenario, as with the second option above for gold coins, makes commerce difficult. Commerce functions best under stable conditions where merchants and consumers alike have a reasonable expectation of what prices will be in the short to medium term so they they can plan and conduct their affairs rationally.

Our example has been predicated on an aggregate price deflation. In a real life attempt to induce a controlled aggregate deflation through price decreases, there would be chaos in the marketplace and in every industry producing the affected goods. Producers would have no idea of the timing or the magnitude of price decreases to be imposed, both on their finished goods and on all of their inputs as well.

In summary, since price controls aren’t a feasible means of sustaining our current rates of economic growth we need a sovereign ability to control the money supply and its value. A gold currency will not work without constant sovereign intervention in the value of the currency.

There are larger problems.

Estimates place the total amount of gold mined in human history at around 4 billion oz, almost all of which is still extent. Suppose this were distributed equitably among the world’s 7 billion people. That’s about 2/3  oz per person to be generous, but let’s say 1 oz per person for easy discussion. A 1 oz gold coin would be about the size of a dollar coin today. This is your total worth! How do you buy a loaf of bread with a 1 oz coin? What do you use to make change? At $1700 gold today, a gold coin that would buy a $2 loaf of bread would be so small, it would get lost in the lint in your pocket.

Another problem is the distribution of wealth. Warren Buffet and Bill Gates will want more than 1 oz each. By the time gold is apportioned based on current wealth, most Africans will be handed at most, a grain of gold dust as their share – and probably many North Americans would get no more.

We might consider debasing the gold coins with base metals in order to create enough coins that everyone would have a reasonable representation of their wealth in denominations that would allow daily commerce. But debasement is a relative and progressive practice. Once a sovereign has the ability to freely debase its currency it has a fiat currency which is what we have today but in the much more practical form of paper notes. And as noted, all experiments in currency to date have failed because sovereigns have eventually found ways to debase them to the point of their destruction.

A final problem is the nature of gold as one of the softest and most malleable metals: it wears easily. A 1 oz coin with a $1700 intrinsic value, in daily circulation could lose significant value by wear and tear in a year. The solution is to add other metals to improve its strength and durability. This is the rational for sterling silver. This debasement can be accommodated by revaluing the coin for its reduced gold content, but loss through wear remains a costly problem over time. A $100 bill on the other hand, loses an insignificant amount due to wear because its initial cost of production – and replacement – and intrinsic value are insignificant compared to its nominal value.

Conclusion: as long as some semblance of modern society exists we will never have a precious metals-based currency.

Gold-Backed Currency

As we discussed briefly in “Understanding Money: Part 1“, in the twentieth century the role of gold changed briefly from that of a commodity currency to that of a representational currency. In this case, a paper note was issued redeemable in a specified amount of gold from a specified authority. This was a gold-backed currency.

This case reduces to the case discussed above of a debased gold currency because the value of gold that the note may be redeemed for is a fraction of the nominal value of the note. We consider the differences below.

First of all, we have a representational currency by which a paper note replaces a metal coin. Metal coins can be debased further by recalling and re-minting them with less gold content. Paper notes can be devalued in place simply by changing the specified amount of gold they will be redeemed for, especially if the exchange rate is not specified on the note. We then have a hybrid for of fiat currency.

Secondly, of the physical issues, the problem of wear is reduced and the cost of production and re-production is much lower. Physical size is no longer tied to denomination, enhancing the ability to create low-denomination currency for commerce.

The big problems remain.

First, a paper-based currency tied to the gold supply is subject to all the problems identified in our Archimedean experiment. In short, either the currency is left unchanged and the economy is either forced to grow at the rate of the gold supply (leveraged by the conversion ratio, say 2.5:1 for 40% gold backing) or we live in a deflationary environment. Since modern sovereigns like to control economic growth, this means frequent adjusting of the percentage of gold backing the currency. This has to be downward for growth, ultimately leading to complete debasement.

Secondly, the issue of distribution of wealth remains but now on two levels.

As precious metals-based currencies evolved over a couple of thousand years, the distribution of gold among countries fluctuated but in a quasi-equilibrium state related to military strength, colonizations, regular warfare and most of all, commerce. Consequently, every country had a national treasury with a gold supply whose size related to the above factors.

In the mid twentieth century, new and short-sighted attitudes by central banks of some countries, towards gold, resulted in major sales. Canada, for example, has sold most of its gold (see: “Central Banks and Gold: Part 1“). It has less gold in its treasury than Tajikistan. The irony is if Canada had kept its gold, its foreign reserves would be much higher today than what they are. If the world moved to gold-backed currencies tomorrow, Canada would instantly become a third world nation – if it isn’t on that road already.

Within a country, the same distribution problems exist as with gold currencies because it is not a currency or monetary issue, it is a social and distribution of wealth issue.

Conclusion: a gold-backed currency will never exist because for modern economic functioning, the sovereign must be able to control the money supply (this is the primary role of central banks) and mostly in one direction – debasement. For a primary reason why debasement is necessary in the modern age read: “Carney’s Carnage“.

To achieve any kind of debasement is to introduce the principal of fiat declaration. It is much simpler with a pure fiat paper currency. As a note, every currency in history has either failed due to sovereign (fiat) debasement in some form or been replaced by a form of fiat currency that allowed the fiat principal to work.

The role of gold is not to become a currency – a medium of exchange (read: “Understanding Money: Part 1“). It will however remain the premier store of wealth and value and will always fulfill that aspect of money.

A Comment on Remarks of Jim Rickards

In an interview with King World News aired on November 19, Rickards proposed a scenario in which the US would seize all foreign gold held in repositories on US soil. This would include all or part of the sovereign holdings of many foreign countries including Germany. The rationale for this was to create a large enough gold base to allow the US to back their currency once again with gold.

Apart from our arguments above that the US will never want to return to a gold-backed currency, there are other reasons why this is unlikely to happen.

The first is the seizure of another country’s gold reserves would be considered an act of war. A hot war would likely then be unavoidable. After all, such seizures historically have been a principal feature of wars if not the motivation for war.

The second reason is the rationale for establishing a gold-backed currency would be to strengthen it and build confidence in it. Having the only gold-backed currency on the block would devalue every other currency. This new US dollar would rise against every other currency and this would have an extremely negative effect on the US balance of trade. This in turn would weaken the economy, destroy jobs and possibly lead to a recession.

Commentary on “The Case for a Genuine Gold Dollar” by Murray N. Rothbard

We have devoted a separate post to this: “The Case for a Genuine Gold Dollar by Murray N. Rothbard – Commentary“.

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