Why gold is money

Most people believe that gold is simply a commodity, a valuable commodity, but a commodity none the less. The truth however, is that first and foremost, gold is money, and this article examines why that is the case.

What makes good money?

In order to understand why gold is money, and why it has been the most widely accepted form of money for thousands of years, it is first necessary to understand what constitutes good money.

In the past, various things have been used as money. Spearheads were one of the first items used as money. Shells, beads, salt and several other food stuffs have all been used as money. However, while these items met some of the criteria for money, they all had their flaws.

Money must meet all of the following criteria:

  • It must be easily divisible into standardised units
  • It must be easily recognisable and verifiable
  • It must have a high value density
  • It must be difficult to replicate/ forge
  • It must be easy to transport
  • It must be durable and almost indestructible

Important also is that the existing supply of money must be small relative to new annual supply so as to avoid rapid dilution/ debasement.

There are plenty of items that satisfy some of these criteria, but only gold (and silver) satisfy all of them.

“Gold was not selected arbitrarily by governments to be the monetary standard. Gold had developed for many centuries on the free market as the best money; as the commodity providing the most stable and desirable monetary mediumMurray Rothbard.

The roles of money

As discussed before, money must perform three primary roles: It must act as a medium of exchange to facilitate trade. It must serve as a unit of account, i.e. a standard monetary unit that enables the measurement of the value/ cost of goods, services, or assets. And lastly it must provide a store of value or wealth.

This last role of money, its ability to preserve wealth, was given clarity by Austrian economist Ludwig von Mises in his 1912 work, The Theory of Money and Credit.

“People value units of money because of their expected purchasing power; money will allow people to receive real goods and services in the future, and hence people are willing to give up real goods and services now in order to attain cash balances. Thus the expected future purchasing power of money explains its current purchasing power”.

Mises believed that past experience is the decisive factor when it comes to trust in the future stability of money. People only put their trust in money as long as it offers a certain degree of safety with regard to its future supply, and thus to its future purchasing power.

When gold’s vital role as a store of value (wealth) is understood in the context of the true definition of inflation, we can see that today’s fiat (paper) money is not “good money”, as it does not provide a store of value.

 “Gold, unlike all other commodities, is a currency. And the major thrust in the demand for gold is not for jewellery. It’s not for anything other than an escape from what is perceived to be a fiat money system, paper money, that seems to be deteriorating”. Alan Greenspan, March 2011.

The chart below shows the value of various forms of paper money, i.e. dollars, euros, pounds and yen, against the value of gold.

Chart of gold in various currencies 1999 – 2012 (Click on the chart for a larger version)

Chart of gold in various currencies 1999 - 2012

Chart data courtesy of World Gold Council. Chart indexed to 100 (01/01/1999). Gold price used is London PM fix.

This chart can be interpreted in two ways. The first is that the value of gold is rising in these different currencies. The second, and more accurate way of interpreting the chart, is that the purchasing power of these currencies is falling versus gold. It therefore takes more and more dollars, euros, pounds or yen to buy the same quantity of gold.

The fact is, today’s paper money doesn’t function as good money because, thanks to the actions of profligate governments and central bankers, it does not provide a store of value. In contrast, thanks to it’s limited supply, gold has a long history of preserving wealth and that is why central banks around the world hold so much gold (around 31,490 tonnes), and why are continuing to add to their holdings.

According to data compiled by the World Gold Council, central banks from around the world (who have been net buyers of gold since 2010) have purchased a record 500 tons of gold this year, up from 465 tons in 2011.

 “We see gold as an officially recognised form of money for one primary reason: it is widely held by most of the world’s larger central banks as a component of reserves”. Ray Dalio of Bridgewater Associates, one of the most successful hedge fund managers of all time.

Further evidence that gold is money can be seen if we compare its behaviour with that of ordinary commodities. Between 1999 and 2009 gold had a high negative correlation (-0.85) with the US dollar, whereas crude oil and the Goldman Sachs Commodity Index had correlations of 0.29 and 0.31 respectively, suggesting that gold acts much more like a currency than a commodity.

The bottom line

Investors and those with wealth are beginning to realise that today’s fiat money is not “good money”. In fact, it is fatally flawed, allowing its value to be continually debased by central bankers via their inflationary monetary policies. As a result they are turning to the only real money, i.e. gold, and that is why over the past nine years gold purchases for investment purposes have increased by 366%.

However, according to the latest data from the World Gold Council and Deutsche Bank which examines asset class allocations within global portfolios, gold still only represents around 1%. For comparison in the 1930’s gold made up around 20% of investment portfolios worldwide, and in the 1980’s when gold spiked to US$850 an ounce, it represented 26% of assets.

Gold is slowly reclaiming its rightful role as money, and although it will likely be many years before it is once again part of the official monetary system, there can be little doubt that that is where we are heading.

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