Thursday, 25 February 2010

Why gold and not paper money?

John Mangun
Outside the Box
Business Mirror

Two days ago I wrote that there is a fundamental change coming in the global monetary system as the use of fiat money—currency not convertible by the government to a hard asset—is replaced with currency that is backed and convertible to something of value.

There is no more an emotional debate in economic and financial circles than this topic. You can find a thousand well-researched opinions on both sides of the issue.

For example:

The question if gold works as an inflation hedge always comes up. No, gold is not a hedge against inflation. Sometimes the nominal price of gold lags behind. Had you bought gold at $800 an ounce in 1980, you would have had to wait 20 years to break even. On the other hand, using 2000 as the starting point, crude oil dominated in gold costs exactly the same today whereas it takes 3.5 times as many US dollars to buy the same amount of oil. And why do we even talk about gold at all?

A little history.

The Egyptians traded goods for gold with the Nubians in Ethiopia. In ancient times, virtually every society loved gold for its ornamental and decorative beauty. In other words, there was a demand for gold every place that you might go. No matter what goods were produced in a particular region, you could buy those goods with gold.

A trader could take gold to Persia and buy textiles. Move the textiles to Egypt and exchange them for gold. Buy salt in North Africa with that gold and sell the salt in West Africa again for gold. Gold was and is the universally desired commodity.

The demand for gold has never decreased throughout history. That is why gold has always been a useful way to store wealth. The demand has been constant (or increasing) and as a result, the purchasing power of gold has been relatively constant in comparison to currency in the modern era.

It is an old story, and maybe a bit simplistic, but it is true. In 1900, a man’s suit of clothes cost about $15 and an ounce of gold was priced at $25. 1n 1940, the prices were $25 and $35. In 1980, $450 and $600 while in 2007 a suit cost about $600 and gold traded at $700 an ounce.

However, it must be said that had you put $25 in the bank at 3-percent interest in 1900, by 2007, it would have grown to $620, or enough to buy that same suit of clothes.

Nonetheless, it is also true that the amount of goods that could be purchased with gold has remained fairly constant through almost any time frame, whereas the amount of goods purchased with non-asset-backed currency has decreased over the same time period.

This fact is not noticeable to the average person and seems unimportant, because as prices have risen, so, too, have wages. Wages have risen almost as fast as the price increase for goods, and technological advances through the decades have brought down the nominal price of almost all goods. Food is actually less expensive in comparison to wages than 100 years ago because of more efficient, cost-
effective production. Look at the “high tech” items such as computers and televisions. Thirty years ago, a television cost a month of wages; now it takes less than a week for the average American wage earner to make enough to buy a TV set.

But for purposes of international trade, currency must retain a constant value. Imagine my business is washing cars. You sell chickens. I print my own “money.” Each one “Mangun money” is worth one car wash. I give you my money in return for two chickens. I redeem the money the following week by washing your car. But then I print thousands of “Mangun money” and buy goods all over town. Eventually, there is no way that I can wash all those cars and redeem all my money in a reasonable amount of time.

The next time I come to “buy” your chickens, you charge me two “Mangun money” because you know it will take me several months to get around to washing your car. My money is now devalued and the “price” of your chickens has gone up.

I have devalued the value of my money by printing too much of it.

Those who believe currency does not need to be asset backed would say, “So what?” It really does not matter if the chickens cost one or two “Mangun money” as long as we keep doing business with each other.

But if I keep printing more money, at some point, it will be very hard to
determine the “true value” of my currency. The people that I do business with will not be sure if they should charge me two, three or how many “Mangun money” for the goods they sell me. If the trend of my printing unlimited amounts of currency continues, you will lose confidence and eventually stop accepting my currency.

That is exactly what has happened to the US dollar. The US dollar is the world’s reserve currency, meaning, that like gold of ancient times, every country is supposed to desire dollars and accept the dollar for all trade purposes.

But countries now are creating currency/trade agreements that do not include the dollar. China is signing deals around the world that will allow its trading partners to settle trade obligations in local currencies and not the dollar.

The dollar’s days as the “world’s currency” are over and the next world reserve currency must include a hard asset, like gold, no matter what form that currency may eventually take.

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