Saturday, November 23, 2013

The return of gold as currency?

This post is part of a series on gold as currency that originates from the study of mineral resources done for the book "The Plundered Planet". Previous posts were: The Physics of Money, The Strategy of Dragons, and "The Lady doesn't wear gold"

Shops that convert gold into banknotes have made their appearance everywhere in the world. In a sense, it is the return of gold as currency. This post examines the current situation starting with Roman times and arriving to discuss a question that surely many of us have been considering: is there a convenience in investing in gold today?

There is a lot of interest in gold as currency, nowadays. With the world's financial system in turmoil, it is not surprising that some people are advocating a return to the gold standard and that others are busy at buying gold coins and gold-based assets. There has even been a proposal for a return to the Arab gold dinar as the basis of trade. But what could be the advantages of a return to gold? And is it really worth investing in gold; maybe physical gold in the form of gold coins?

As it is often the case, past history can tell us a lot about the present. Here, we find that the disappearance of the gold (and silver) as currency is an unusual event. With only one major exception, the late Roman Empire and early Middle Ages, for thousands of years, gold has been recognized everywhere as the basic medium of commerce. In modern times, gold coins were still circulating in the world throughout in mid 19th century but they became increasingly rare and, with the 20th century, they disappeared completely. Silver resisted a bit longer, the last silver coins meant as currency were minted in mid 20th century, but never really circulated. It was around that time that currency officially ceased to be based on gold. It had become what economists call "fiat money" borrowing a world from the Bible as to indicate a supernatural act of creation (something, that, incidentally, tells us something about the way a banker's mind works).

These are well known events, but what happened that had so deeply changed our attitude towards money that made us accept pieces of paper instead of metal coins? There follow some considerations of mine on this subject; mainly dedicated to gold, but generally valid also for silver. I argue that the disappearance of gold was due to its physical properties that made it scarcely suitable for the size of modern commerce. I also argue that the rapid inversion of several world trends, including the movement toward a new concentration of wealth in the hands of few people, may bring back gold as currency in a not too remote future. Finally I discuss whether it is worth investing in gold, today.

This text is part of the research I performed on the mineral history of the world that I wrote in the form of a book titled "Plundering the Planet". I don't claim that it is the last word on the subject but, if you bear with me, then you'll tell me what's your impression.

1. Gold as currency

Gold as currency is a commodity and its diffusion in the market depends on the balance of demand and supply; as it happens with all commodities traded in markets. Demand for gold has always been strong as everybody seems to love it (except for hermits, philosophers, and like minded characters). But the supply of gold is limited by its cost, in turn determined by its physical characteristics.

In a previous post, "the physics of money", I examined the factors that limit the amount of gold available as currency to the economy. One is the cost of producing it: it can be mined, raided, or traded, but in any case, these activities require considerable investments. The other factor is the density of metallic gold which dictates that a gold coin cannot weigh less than 3-4 grams (around 0.1 Oz.), otherwise it would be difficult to handle. These factors combine in limiting the number of gold coins that can exist at a given time. This number seems to have remained roughly constant over history; in the range of around 10 coins per person, perhaps less than that. (incidentally, silver could provide about ten times as many)

Clearly, you can't base an economic system on ten coins per person, not any more than we could base our current system on $100 bills only. Smaller denominations are needed for everyday transactions, say, buying groceries at the market. Before paper currency was developed, that could be done using coins made of lower value metals, typically copper coins, or copper-silver alloys. Gold was way too expensive for that but, as it often happens for expensive goods, it could still occupy the top layers of the market. Gold was money only for the rich; "prestige money" for large transactions. The 10 coins per person were far from being equally distributed: the rich had plenty, while the poor were not supposed to have any. In ancient times, up to relatively modern ones, it is likely that a peasant wouldn't ever see a gold coin in his or her life.

Even though expensive, gold has been well entrenched in its niche market for most of the known history. What could make it disappear? As we said, the market for gold as a currency is determined by supply and demand. So, the first thing we may imagine as the reason for the disappearance of gold is a reduction of the supply. In that case, prices would rise so that the market niche of gold as currency would shrink so much that it would become just too small to be exist at all. Imagine that peak oil reduces crude oil production so much that gasoline prices rise to - say - $100/liter ($350/gallon). Then, most of us won't simply reduce their use of cars: we'd have to stop using them. Having private cars would make no sense anymore and gasoline would disappear as a commodity for private users.

Something like that, a sharp rise in gold prices due to increasing rarity, may have taken place during the declining phase of the Western Roman Empire and in early Middle Ages. The Roman Empire, in more than a sense, was created by the wealth of gold that the Romans could mine in Northern Spain. But when the mines were depleted, the Roman gold started disappearing; spent for purchasing luxury items from abroad or for paying foreign mercenaries. At this point, it is likely that gold coins started to be perceived as very valuable and even relatively rich people would be wary of using them as currency, preferring to wait for better times (that never came). As a result the remaining gold was hoarded (or "vaulted"); it completely disappeared as a currency for several centuries (something that, incidentally, may have originated the many legends of dragons hoarding great treasures in their caves). Silver underwent the same fate and the whole European Economy had to adapt to the lack of currency during that period (they found some clever ways, but it wasn't so practical). A consequence of this phenomenon was that gold started to be used as jewelry for personal use, rather than as a currency, something that the Romans of better times would have considered tacky.

Fast forward to the disappearance of gold in our times: did our economic system go through something similar to the fate of the late Roman Empire? Apparently not, at least not in terms of availability of gold until very recent times. First of all, there is no evidence of a rise in gold prices in 19th century in correspondence to the disappearance of gold coins. Then, you can see below how the gold supply varied in comparison with the world's GdP (data from Maddison, 2010 for the world's GdP and from the Gold Money Foundation for the gold stock)

As you see, gold production from mines more than matched the growth of the world's GdP up to the 1940s. By then, gold coins had disappeared from common usage for almost a century and the convertibility of banknotes in gold was already purely theoretical, although that would be officially sanctioned only with the demise of the Bretton-Woods agreement in 1971. Clearly, we are seeing something different here that what we can imagine had happened during the last phase of the Roman Empire.

There were two main factors which drained gold coins from the market. Both are due to physical facts: gold is limited in amounts and gold is heavy. Let's see how these facts affected the economy.

2. Why gold disappeared:
   The sheer growth of the economy

We saw that the ratio of the amount of gold to the economy didn't decrease, it actually increased up to ca. 1940. But that didn't help to solve a problem related to the sheer size of transactions in the modern world. To explain this point, let's say that you want to buy a house with gold coins. Assuming that the house costs $100,000, at the present price of 40 $/gram you need around 2.5 kg of gold - less than one thousand 3 gram coins. Even an expensive mansion would not require quantities of gold so large to be impossible to handle and transport.

We have records that transactions in ancient times - e.g. buying and selling houses - involved actually paying the total amount in gold (e.g Verboven 2009). That doesn't mean that it was strictly necessary to move these amounts of gold. The Roman trapezitai (the way ancient bankers were called, from a Greek term for "table") could easily have taken care of that by using equivalents of the modern letters of credit. But, as we said, gold was associated with "prestige" and the fact of showing off one's gold assets had a certain value in itself - just like today people use expensive and impractical SUVs for transportation.

But, then, consider the enormous expansion of the economy in 19th century. It was the result of the availability of fossil fuels, mainly coal, that created gigantic commercial flows. And, at this point, large transactions, millions of dollars and even much larger, were no more the exception, but the rule. Not that there wasn't enough gold, but, if moving around hundreds of tons of gold each time would have becom really awkward.

At this point, there was a logic solution and it was adopted: store the gold as bullion inside bank vaults and use bills as currency. These bills were pegged to the stored gold, but were much easier to move and store. So, gold coins were melted and disappeared into the vaults of banks. They may still be there. We know that, at the end of the 19th century, a total of about 30,000 tons had been mined. Assuming that most of that gold was in the form of coins at that time, it may not be a coincidence that, today, the amount of governments' gold reserves in the world is about the same; about 30,000 tons. These are the gold coins that circulated in the world two hundred years ago!

  The rise of the middle class in the West

There is a second possible reason why gold currency disappeared from the economy. It is related to the rise of the middle class in the 19th century and the fact that this class claimed a share of the wealth that, as a consequence, was not monopolized by the elites any more.

The data on social equality trends are very uncertain, but it seems clear that in 19th century, the newly gained riches that came from commerce and conquest led to a considerable decrease in social inequality in Western Europe and in North America - as we can read in a hugely interesting paper by Joerg Baten and others. It turns out that, up to recent times, in the "rich" world the poor were becoming less poor, sharing a higher fraction of the national wealth. That makes sense in light of the growing economy and the rise of democracy, of political parties, of workers' movements and more. From the same paper by Baten et al., we see how this development was being paid with a considerable increase in inequality in Asia, Africa, and other regions of the world, but let's not consider that, right now.

So, with the progress of the 19th century, more and more people had access to the market and for this reason, they needed money. But gold couldn't provide it. As we said, there has never been enough gold in the world to provide coins for the pockets of everyone, and that's likely to have been true even for that fraction of the population that we call "middle class".

The member of this class had access to some wealth, but not enough that they could have so many gold coins as the rich would have in earlier times. So, they tended to see gold as rare and valuable and they would hoard it in the form of jewelry. Probably, every middle class family in the west, still today, has at least several grams of gold stored as jewelry: rings, necklaces, watches and the like. That's where another large fraction of the newly mined gold went from mid 19th century onward. It never had a chance to become "currency." Probably, this gold amounts to the difference of the total of gold mined (around 150,000-170,000 tons) minus the amount stored as government's reserves. In this case, it should total some 120,000-140.000 tons. (The amount of "technical gold" that has gone in circuitry and other devices is probably much smaller in comparison).

3. The end of the gold standard

So far, we have been discussing of gold as currency (i.e. something that actually circulates) which is something different from gold as a standard, (i.e. something stored in governments' vaults).  From late 19th century to 1971, most of the world's currencies were pegged to an equivalent amount of gold. Theoretically, every paper bill in circulation could have been redeemed into a certain amount of gold. But that concept officially disappeared when the United States unilaterally abandoned the Bretton Woods agreement in 1971.

If we go back to the figure presented before we see that the demise of the Bretton Woods agreement came after that the gold supply had started to collapse in comparison with the rapidly growing world's GdP. What had happened, probably, is that the economy, at this point, had fully "decoupled" from gold and had become pegged to fossil fuels. It was the acceleration of a trend that had been ongoing for decades but that, in the post-war period, had become impossible not to notice. Unlike what was the rule in ancient times, at this point the wealth of nations was not measured in gold any longer, but in oil, coal, and gas.

Gold had ended its monetary role because there was far too little of it to use it as a standard for what we call "currency" today, unless its price were to skyrocket to impossibly high levels.  It has been estimated that all the gold mined by the end of 2011 totalled 171,300 ton. At a price of US$1500 per troy ounce, reached on April 2013, one ton of gold has a value of approximately US$48 million. The total value of all gold ever mined should be around US$8.2 trillion. Compared to the world's GdP as it is estimated today (ca. 85 trillion) it is way too little.

A lot of people thought that the sky would fall because of the loss of gold standard, but nothing horrible happened, at least not right away. The end of the Bretton Woods agreement didn't mean that currency had become truly "fiat" - that is unpegged from any physical commodity. Currency just became pegged to another, and more important commodity: not gold any longer, but crude oil. As long as the US military will control the flow of oil in the empire we call "globalization", the US dollar will remain pegged to oil and it will remain the monetary standard of the world. That cannot last forever, of course, but for the time being it is the way things are.

4. The future of gold currency

As it is the rule in history, things always change. The trends that have brought the present situation with gold and all the related monetary issues are rapidly changing. So, what can we expect for the future?

The main problem for the economy, at present, seems to be able to maintain oil production to the levels which have created the globalized empire. In this sense, our situation is very similar to that of the Romans of the 1st-2nd centuries A.D. who were desperately trying to maintain gold production to the levels which had created their empire. In the case of crude oil, depletion is biting hard on traditional producers and gigantic investments are needed just to maintain things as they stand. So, far, it has been possible, but that won't last forever. Already now, the need of these gigantic investments for the extractive industry are draining resources from all the other sectors of the economy. The industrialized West, the backbone of the empire, is becoming progressively poorer. And we know that when society becomes poorer, hardship is not equally distributed.

Today, we are seeing the inversion of the trends that were leading to increasing social equality as the result of the increasing wealth brought by cheap oil. In the early 1970s, the US saw its local "peak oil" and, with it, what was deemed "the great U-turn of the US economy" by Bennett Harrison and Barry Bluestone. The Gini coefficient started increasing, indicating growing inequality. The rich were becoming richer and the poor poorer. The same trend appeared in later years in Europe

The trend spread all over the world and, today, we see it in full swing. As a result, middle-class families in Western countries keep becoming poorer and, possibly, the very concept of "middle class" is on its way to disappearing. People relentlessly pushed into poverty are exchanging their gold for their groceries with pawn shops acting as intermediaries. In practice, they are returning to the elites the gold they had hoarded as jewelry and, by now, the elites must be really awash in gold. It has been said that crude oil had made Arab sheiks so rich that they would use toilets made in solid gold (you can read this story in Oriana Fallaci's book "An Interview with History" - but it is a horrible book, not suggested). These Arab golden toilets are probably just a legend, but real solid gold toilets - exist, even though are reported to be not for sale. Bathroom fixtures in solid gold seem to be available for whoever wants to purchase them.

Apart from this show of tacky gadgetry, will we see the a return of gold as currency? Possibly yes, especially if the world's economy shrinks considerably as the result of the decline of the production of fossil fuels. But not immediately. As long as crude oil keeps flowing, the dollar remains strong as the world's currency. But, if (when) oil production starts to dwindle, a lot of things will change and, at some point, people will start losing their trust in small pieces of paper showing the face of Benjamin Franklin.

Then, a new market for gold will develop. That doesn't mean a return to the gold standard - although that might happen. But, more likely, it will mean the development of parallel markets in which some highly valuable goods and services will be paid in gold. Right now, mafia bosses, drug cartel leaders, and assorted local criminals and warlords are using dollars for their transactions (maybe you know that by far the largest number of $100 bills is found outside the United States). That could become a good market for gold coins. After all, gold coins were invented, back in the 6th century BCE, as a way to pay mercenaries and it may well be that the military all over the world will focus their sights on gold, after that they discover that oil is not so interesting anymore. Some things in history never change. But, as in the past, gold as a currency will not be for everybody and don't expect to be able to use gold coins to buy your groceries!

5. Investing in gold.

After so much reasoning, we are arrived to the focal point - investing in gold. If you are reading Cassandra's blog, you probably belong to the Western middle class and you know that it is an endangered species. If you have some liquid assets left, you may wonder if it is appropriate to transform them into gold. Is it worth investing in gold based funds or to buy gold coins to keep well hidden somewhere at home or in a bank safe?

Here, obviously, we enter a slippery ground and I can only propose my opinion on this matter, with the caveat that I take no responsibility for what may happen to you if you decide to follow my advice. This said, let's see to examine the question.

First, investing in gold in the form of stocks and futures, well, it is very risky. It is said that gold is a safe refuge from the financial crisis, but in the great collapse of 2008, gold lost about 25% of its previous value. It is also true that it fared better than oil, which lost  2/3 of its value in 2009. Consider, though, that in recent times gold has lost again more than 30% of its value, while oil has maintained its high prices. So, there is no guarantee that investing in gold assets you would make money (or you'll be able to buy crude oil on the cheap). Besides, you are still tied to the financial system and, if things get really bad, you can hardly claim your physical share of a gold that exists (if it exists) as ingots vaulted somewhere far away.

Then, you could buy physical gold in the form of coins or ingots. These are nice things to have, but suffer from the same problem as gold financial assets - it is not obvious at all that you'll make money when you trade in your coins or your ingots. Then, there is the obvious problem that physical gold can be stolen; so you may have to pay for a bank safe and even that may not be completely safe (in 1933, President Roosevelt ordered the confiscation of all physical gold owned by everyone in the country).

Nevertheless, if things get really bad, it may be a good idea to keep some gold at hand as an emergency tool that you may use, for instance, to bribe the custom officers and leave the country before it is too late. But also remember that gold, just like paper money, has no value in itself. In a sense, all currencies are "fiat" currencies. Gold has value only if someone is willing to accept it in exchange for goods; that depends on the availability of goods and also on the social conventions that drive exchanges. In our society, it is legal and acceptable for everyone to own gold but that may change in the future.You probably know one version or another of the story of the peasant who found a treasure of gold coins. Sometimes, the story has a good ending, but the lot of the peasant in the story is always to face great difficulties. In ancient societies, you just couldn't be a peasant and have gold at the same time. That was either illegal or unacceptable (or both) and, normally, when it happened society proceeded to redress the situation by removing the gold from the peasant (or removing the peasant from society). It is not just fiction, it may be a real story as the one that as Ali Morteza Samsam Bakhtiari tells us in his book "The Last of the Khans."

In the long run, as the very concept of "middle class" disappears, if you have managed to keep some gold with you, you may find yourself in troubles even in exchanging it for groceries, because groceries may become more valuable than gold. In any case, remember that your local warlord or mafia boss can take your gold without having to give you anything in exchange (it is a small scale version of what, on a large scale, is called "taxation"). So, a few gold coins may be fine to keep, but remember the advice of Lao Tzu in the "Tao Te Ching" "A house full of gold and jade cannot be defended".

h/t Tatiana Yugay for a suggestion on an improvement of this article


Ugo Bardi is a member of the Club of Rome, faculty member of the University of Florence, and the author of "Extracted" (Chelsea Green 2014), "The Seneca Effect" (Springer 2017), and Before the Collapse (Springer 2019)