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Why Gold Should Be Avoided As An Investment Tool
Part 2 of 6
by James Nelson, originally published June 2007
GOLD
What Is Gold Anyway?
Gold is not money; it is actually a commodity. Put another way, gold has no intrinsic value, its only value is what a buyer is willing to pay for it. In this sense gold is similar to wheat and coffee and exactly like copper and palladium. All commodity prices, whether the commodities are the sort of thing we consume (wheat and coffee) or whether they are something with which we manufacture goods (copper and palladium . . . and gold), are ultimately determined by the market. If people are unwilling to pay $5.00 for wheat, the price will begin dropping to $4.75 or $4.50, or even $4.00 or $2.00—whatever the market is willing to pay. Once the price reaches a reasonable point, consumers will begin buying.
Of course, we all realize it's not quite that simple. Governments can impose price supports (such as the price of sugar in the U.S., which is completely disconnected from the world sugar price due to artificial price supports imposed on the market by the U.S. government) or industry cartels can conspire to prop up prices (as OPEC does with the price of crude oil). But even though the system is not perfectly driven by supply and demand, by and large, for most commodities, it is the demand that determines the price, and the price that, in turn, leads to increases or decreases in the supply.
This is largely how the price of gold is determined. At the end of the twentieth century (and especially in the 1980s - but more about that later) gold prices were low and it was no longer cost effective for many gold mines to operate. As a result many operations were shut down and many gold-related companies ceased to do business. But in the last few years, gold prices have gone up dramatically. Mines that had ceased to be cost effective are being reopened and new gold deposits are being actively sought out.
The "Good-Suit-to-Gold" Ratio
But there's another dynamic at work that sets gold apart from copper or palladium. (Or wheat and coffee, for that matter.) For as long as history has been recorded, gold is also the "currency" of last resort. Gold seems to have an inherent value that human history itself has bestowed upon it. It is not an absolute value. For instance, we could not say that gold will never again go below $400 an ounce. But on the other hand, when financial instruments and whole economies begin to get shaky, people like to trade in their other assets for gold, because in bad times gold has historically always maintained its value.
I grew up hearing that a good suit had always been worth about an ounce of gold. (It was a way of figuring out how much to pay for a suit - check this week’s gold price.) In today's market, that means that a good suit should cost around $600. And in fact that is about what a good suit costs. Using this measure, if gold dropped to $400/oz, we might think it undervalued. If, on the other hand, the price rose to $1200/oz (and you don't have to look too far on the Internet to find someone predicting that this will happen in the near future), based on the cost of a good suit, we might decide that gold is over valued.
The "good-suit-to-gold ratio" is hardly scientific, but it is a way of understanding the dual nature of the yellow metal: While the price of gold is not fixed (since it’s actually a commodity rather than a currency), over time it's value in relation to other goods and services has remained fairly steady. There is a long and hallowed tradition of consistent value when it comes to gold.
FIAT MONEY
This is not the case with "fiat" money (literally, "money by order"). Fiat money is typically paper currency printed "by order" of a government that is backed solely by "the good faith and credit" of the government printing the money. The United States has had a series of essentially different currencies throughout its history, and several were fiat money.
Greenbacks
In the early 1800s, U.S. paper currency was the "gold certificate." The holders of a five dollar gold certificate could trade in the certificate for a five dollar gold coin. But the government needed cash during the Civil War, so in 1862 it began to circulate a new currency, U.S. Notes, that were not "gold backed," but rather backed by "the full faith and credit of the federal government." This new currency, green in color, became known as a "greenback" because it was backed, essentially, by itself, and not by gold. It was, for all practical purposes, a loan, by the holder of the currency, to the U.S. government so that they could finance the war.
After the war came to an end, the government found it was nice to have the extra money around, so they continued printing "U.S. Notes." In turn, most everyone was satisfied with them as a legitimate currency. Since then, fiat money has been very much a part of the American financial landscape.
Breton Woods and Beyond
From after World War II until 1971, following the Breton Woods treaty, the value of American money was once again loosely connected to the value of gold. It wasn’t a true "gold standard," but the government did have to keep a percentage of gold on hand. But in 1971/72 the U.S. dropped any pretense of a gold standard. The value of the dollar became completely arbitrary. The amount of money in circulation had no real relationship to the underlying goods and services, but rather was determined "by order" of the government. In other words we went back to a fiat currency like we had following the Civil War.
The historical fact is that all fiat currencies have failed. (The great financial disasters in the history of the United States are almost all related to the failure of the then-current currency system. History tells us that all governments that have been unencumbered by other rules and regulations have eventually printed money willy-nilly, in order to cover their deficit spending. When this happens the value of the money is reduced because there is not an equivalent increase in the value of the goods and services.
NEXT: Monetary Inflation and the Dollar.
Copyright © 2007 James E. Nelson (Just Another Jim). All Rights Reserved.
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