My Quick Take on Gold as an Investment, a Currency & Money

Here’s a common question I get:

Question: I’ve read some of your stuff on gold, but can you give us a general opinion of the gold standard, gold as money and gold as an investment?

Thanks!

Answer: This one’s pretty simple. Here are my basic views on gold:

1) Gold is definitely money. Remember, anything that is accepted as a means of final payment can serve as a form of money (see my paper on the monetary system for more on this). Gold is definitely accepted as a means of final payment so it serves as a reliable medium of exchange. But gold has a number of characteristics that make it a bad form of money. First, gold isn’t accepted for payment in many places. So that’s a big problem. It’s also very difficult to transport. So gold is money, but it’s a crappy form of money.

2) The gold standard has some serious problems. The biggest is the inherent trade imbalances that would result from such a currency system. Any single currency system like the gold standard is a lot like the Euro in which everyone uses the same currency so there’s no floating exchange rate, the govt’s can’t print money and have trouble redistributing funds from imbalances to rebalance economies and so deflation is the only real answer. That might sound reasonable, but deflation tends to be catastrophic if prolonged. If you see what’s going on in Spain and Greece today you get the gist. They’re locked in a single currency, trade doesn’t rebalance through FX because they all use the same currency, the govt’s can’t print money and so they’re suffering through a depressionary deflation. It’s a disaster. So I dislike the gold standard because I think it’s like putting ourselves in a straight jacket.

Another problem with a true gold standard is that it constrains our money supply to the quantity of existing gold. In other words, if you need money, for instance, to buy a home, then the quantity of money is contingent on how much gold people can dig up out of the ground. This doesn’t make much sense and it’s why we have an elastic money supply in the form of bank issued deposits. Banks can issue money on demand when they issue new loans to creditworthy investors. Of course, this can be an imperfect system at times when too much credit is issued and asset bubbles like the housing bubble occur, but no system is perfect. The gold standard, unfortunately, is far less perfect and often led to sharp economic contractions and depressions because the booms and busts often coincided with how much gold was discovered or not at certain times.

Now, you might say that a gold standard makes sense with a credit based system because the quantity fo credit could be tied to the existing quantity of gold, but you run into the same basic issue. What happens if lots of young entrepreneurs need funding for brilliant world changing innovations and they can’t obtain the funding because there is just not enough gold outstanding to support the new money issuance? In that case we are worse off than we should be solely because we constrained our money supply by the quantity of rocks in the ground.

Another common point is that some people want to put the government in a straight jacket, but that’s not entirely rational. Government should work with us and for us. Our government should be constrained by budgeting and checks and balances, not by the quantity of rocks on Earth.

3) Gold is basically a commodity with currency components. I really dislike commodities as a core piece of a portfolio. I am not, however, against using currencies as a hedging component at times. Gold has tended to perform well when real rates are negative. That is, it acts like a super long duration bond because it is viewed as an ultra safe form of currency. There’s some logic and research behind that position. But still, gold is a commodity at the end of the day and should never be held in huge quantities in a portfolio, in my opinion.

The more interesting aspect of gold is what I would call its “faith put”.  This is the idea that gold is a global currency and therefore has a price premium embedded in it due to higher than normal demand for use as a currency.  This makes it unlike most other commodities and gives it a certain property that differentiates it to some degree from other commodities.  Whether this “faith put” can sustain itself is a highly dubious position in my view.  Said differently, would you rather own real assets generating income and output or would you rather own a rock that looks pretty, but lots of people BELIEVE has value?   The value of gold is largely contingent on belief rather than something fundamental like its underlying output or cash flow generation and that, in my view, makes the concept of a “faith put” incredibly fragile.  If the idea of gold as money were to disappear from our social structure, it’s not unreasonable to assume that gold prices could fall substantially.

That’s the long story, short. Hope it helps.

Cullen Roche

Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.

He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.