Perhaps you have an occasional nagging feeling that you should hold some gold “just in case.” You might already hold some gold. Perhaps gold is a major component of your portfolio.
Gold is part of many people’s lives – much jewelry is gold, and married couples often wear gold wedding rings.
But does gold belong in your portfolio? What is gold’s investment value?
Any of three beliefs might motivate an investor to hold gold:
- In some future crisis, gold might become money.
- Gold is often said to be a good inflation hedge.
- Gold is an interesting speculative investment – its price has risen a lot recently.
I look at each of these in turn. Spoiler alert – none of them stand up to scrutiny.
For this article, I will delve into the concept of using gold or silver as money and whether that would work today.
Gold as money
Belief 1: Someday the truth will out, paper and electronic money will become worthless, and the world will be forced to go back to using gold as money. Investors who hold gold will be prepared, and those who do not will suffer.
Gold (and silver before it) once was money. You may have heard of the gold standard (which the US subscribed to until the early 1930s). You’ve probably seen a pirate movie or two with a treasure chest full of gleaming gold ducats or pieces of eight.
At first blush, it seems that using gold (or silver) as money has a lot to recommend it. Both metals are durable, easy to work, and easy to coin. They can also be quite beautiful.
The world has a lot of experience with these “commodity monies.” That experience has led us to the money we use now, which is called fiat currency. Fiat currency is a liability of the country that issues it, a promise to pay. The monetary authority decrees that the holder can use this money to pay all financial obligations. All users of the money, which includes just about everyone, trust that they can use the money as a:
- Medium of exchange: You can use the money to buy and sell goods and services. For this to work, a seller must accept money in exchange for something of value and believe that she will be able to, in turn, buy goods and services from other sellers. The economic community that shares a willingness to accept money as payment must be large enough to offer a reasonably diverse range of goods and services.
- Unit of account: You can use the money to keep track of economic activity and success. Businesses can assess their profitability in terms of money, individuals can track their economic progress in terms of money. Prices in terms of money are relatively stable – you can assess how much of a good or service you could buy with the money you have.
- Store of value: You can hold (at least some of) your wealth in money. This allows you to carry your wealth from one year to the next using money. Participants in the economy must plan to accept the money next year, and expect that other participants will do so, too.
The history of commodity money
Historically, when commodity money began, the commodity aspect was most salient (this discussion follows and drastically simplifies the argument in Sargent and Velde, The Big Problem of Small Change). People didn’t understand much about money (monetary theory was rudimentary at best), but they understood a lot about commodities.
The history of commodity money is largely the story of how monetary authorities gradually learned that commodities and money differ qualitatively and behave differently.
In successful economies, the government provides a good money that offers stable services as medium of exchange, unit of account, and store of value. The big problem with commodity money is that people can decide it’s worth more as a commodity than as money. They can melt the coins, and then the money supply shrinks. That can have a big negative impact on the economy.
Through long and painful experience, governments found that using commodities (gold and silver) as money did not work well. There were two major problems:
- The relative prices of small and large coins changed relative to each other. Imagine if quarters declined in value relative to dollars. Today they are worth a quarter of a dollar (“quarters,” right?), but tomorrow it takes 5 quarters to make a dollar. That’s what happened. The monetary authorities in many countries found they couldn’t maintain the purchasing power of smaller coins. It just didn’t work! They learned that the best approach was to issue smaller coins as tokens with minimal or no commodity content. They promised that people could exchange tokens for the higher value commodity coins in fixed proportions. People could exchange 4 quarter tokens for 1 silver or gold dollar.
- Commodity currencies are expensive! Commodities can be used for purposes other than money. They are valuable commodities. Economies that use commodities as money can’t use their “money commodities” for anything else. No more gold or silver jewelry, tools, or fillings! Thus, economies that use fiat currency have an advantage over those that use commodity currency.
Is there enough gold?
In addition, as a practical matter, there isn’t enough gold to serve as money in today’s world.
There is almost $18T worth of gold available (above ground). Of that, nearly half is gold jewelry. The amount in coins, bars, ETFs, and central banks is smaller, totaling about $7.1T.
The US economy alone would need all the gold in the world to serve as its money – roughly $18T. That would require melting all the world’s jewelry and acquiring all the gold in ETFs and other countries’ coins. This seems implausible at best. For the world’s major economies to adopt gold would require their money supplies to contract drastically. There would be a global depression.
But maybe, in certain dire circumstances, gold will just emerge as money, without any government support.
To work well, however, money seems to require a monetary authority to:
- Define the monetary units
- Authorize the designs (define what counts as money and what doesn’t)
- Protect against counterfeiting
- Maintain the stability of the money’s value
The successful commodity monies that we know of were all issued by governments: the Roman Empire, the Holy Roman Empire, the English monarchy, and so on. A government imprimatur seems to be required to engender trust in the currency among the citizenry.
Do inflation-racked countries turn to gold?
There have been several recent cases of countries suffering very high inflation and dysfunctional economies. I list a few in the table below. These appear to be circumstances begging for gold (or silver) to be used instead of the local currency. However, that didn’t happen.
It seems that gold did not compete successfully with well-managed foreign fiat currencies (like the US dollar) even in these extreme situations.
To be fair, Zimbabwe issued a new currency in April 2024 which it says is backed by gold. The US dollar is also legal tender there. There is too little experience with the new currency to determine whether it will succeed. Early indications are not positive.
As money, commodities like gold and silver were once dominant, but in the last 100 years or so, fiat currencies have largely swept the field.
In my next article, I’ll discuss whether gold works as a hedge against inflation.
This article appeared originally in Forbes.com.
Photo by Anne Nygård on Unsplash