Is gold transitioning to become money?

February 12th, 2009

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In response to our previous article (What will happen if RBA cuts to zero?), one of our readers asked,

Hi, This article concludes with a disturbing scenario. Asset price deflation with consumer price inflation. Gold is as asset class, how will it fare in this scenario? It seems that gold is starting its transition back to being money, what would it take for that transition to happen, do you think its under way or likely?

Firstly, for those who are new to this publication, we would first refer you to this guide, Why should you invest in gold?. It contains quite a number of useful articles for you to understand gold. We recommend you to read them first.

Now, back to our reader’s questions. The first one is, how will gold fare in times of debt deflation, foreign capital flight and price inflation? Let us go through each asset class one by one:

  1. Property is definitely a loser because it is highly geared asset class. Since business and personal solvencies will be threatened en masse in a debt deflation, highly geared assets will be falling rapidly in prices. Rising price inflation of inelastic non-discretionary goods will worsen the solvency situation of many.
  2. Stocks are unlikely to well in a sick economy.
  3. The same goes for debt securities.
  4. Assuming that more and more foreigners are holding Commonwealth Government bonds (thanks to the growing budget deficit from the bigger and bigger ‘stimulus’ packages), they will become increasingly nervous of the falling Aussie dollar. Thus, a sell-off in government bonds cannot be ruled out. This implies foreigners’ fear of sovereign debt default.
  5. As foreign capital flees Australia (due to the deteriorating economic situation), a banking crisis cannot be ruled out. It’s one thing for the government to guarantee bank deposits but another to actually implement the guarantee. How much can cash at bank be trusted? Perhaps the government will ‘guarantee’ bank deposits and at the same time, put in capital controls (e.g. restrict foreign capital from fleeing, limit the amount of cash that can be withdrawn, etc)?

As you can see, this disturbing scenario is one in which there are no textbooks to refer to. The government will be making rapid-fire decisions in real-time. Thus, all our projections here are guesstimates and speculations. But one thing is certain: uncertainty and unpredictability will rule the day. As a result, physical gold (and silver) is the only asset class that can give you a sense of security. In such a day, the nominal price of gold is irrelevant.

Next, our reader asked: Is gold starting its transition back to being money?

We do not know the answer to this question. But we are sure the government will be hell-bent in preventing it from happening as long as it remains strong. The qualifier in bold is a very important one that you should take note. Hitler once said that the gold standard is not needed because the state will be so strong that such a standard is unnecessary (we do not know whether this is true or not, but history buffs may want to dig out the reference for that). Also, Marco Polo was astounded that the authority of the Khan could turn paper into something that was as good as gold and silver, on pain of death. In the US in the 1930s, gold ownership became illegal. Hence, a strong government is anti-thesis to gold being money. Conversely, if the government is weak, gold stands a much better chance of functioning as money.

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  • David

    Hi CIJ,
    Thanks for answering my questions. One thing I am starting to read about is a situation where multiple domestic currencies might compete in the same economy. The US constitution only limits State organized currencies to gold and silver. New Hampshire is among 3-4 states that have proposals to reinstitute gold and silver as money that will work alongside Federal Reserve Notes. This creates the competition that might force the FED to be more responsible in its creation of money as that will hurt it in competition with other currencies. Other privately created local currencies have started to form in Germany, the US and other places, and the ideas of barter have been expanded to labor exchanges using a system called LETS (Labor Exchange Trading System, I think) that currently fall outside taxation in the US. These systems and are trying to get away from dependence on Debt Based Money, that is currently used throughout the world. Debt Based Money is particularly bad during periods of negative growth, something that the world may be facing in the next few years, because there is always more debt than the debt plus interest that the system needs–normally growth provides the lubricant to make the system function. What do the Austrian Economists say about multiple currencies, things like LETS, and monetary policy in times of Negative growth? Thanks!

  • David

    Hi CIJ,
    Thanks for answering my questions. One thing I am starting to read about is a situation where multiple domestic currencies might compete in the same economy. The US constitution only limits State organized currencies to gold and silver. New Hampshire is among 3-4 states that have proposals to reinstitute gold and silver as money that will work alongside Federal Reserve Notes. This creates the competition that might force the FED to be more responsible in its creation of money as that will hurt it in competition with other currencies. Other privately created local currencies have started to form in Germany, the US and other places, and the ideas of barter have been expanded to labor exchanges using a system called LETS (Labor Exchange Trading System, I think) that currently fall outside taxation in the US. These systems and are trying to get away from dependence on Debt Based Money, that is currently used throughout the world. Debt Based Money is particularly bad during periods of negative growth, something that the world may be facing in the next few years, because there is always more debt than the debt plus interest that the system needs–normally growth provides the lubricant to make the system function. What do the Austrian Economists say about multiple currencies, things like LETS, and monetary policy in times of Negative growth? Thanks!

  • Hi David!

    One thing I am starting to read about is a situation where multiple domestic currencies might compete in the same economy.

    We have a discussion forum about complementary currencies. One of our readers have more in-depth understanding about this idea.

    As for the Austrian School’s view on complementary currencies, we have not yet read about the view of that school on that.

  • Hi David!

    One thing I am starting to read about is a situation where multiple domestic currencies might compete in the same economy.

    We have a discussion forum about complementary currencies. One of our readers have more in-depth understanding about this idea.

    As for the Austrian School’s view on complementary currencies, we have not yet read about the view of that school on that.

  • Niko

    No chance. Currency is undergoing a linear historical progression. Physical commodity(gold), to redeemable notes (Bretton Wood agreement), to fiat currency……., to one world currency, to eventually ‘pure credit’.

    The current financial crisis was partially the result of currency pegs and devaluations. With global currencies in crisis the logical flow on will be a global currency…..after several wars mind you.

  • Niko

    No chance. Currency is undergoing a linear historical progression. Physical commodity(gold), to redeemable notes (Bretton Wood agreement), to fiat currency……., to one world currency, to eventually ‘pure credit’.

    The current financial crisis was partially the result of currency pegs and devaluations. With global currencies in crisis the logical flow on will be a global currency…..after several wars mind you.

  • exazonk

    You mention that stocks are unlikely to do well. But what about Australian companies that produce gold?

  • exazonk

    You mention that stocks are unlikely to do well. But what about Australian companies that produce gold?

  • Hi exazonk!

    In short, gold mining stocks have to be assessed on a case-by-case basis. Everything else being equal, a rising gold price is good for gold mining stocks (the ones producing the real gold). But in the real world, the everything-else-equal assumption is suspect (e.g. cost is a big question mark). But this is not the real problem.

    The problem is, there’s a practical difficulty with gold mining stocks. Let’s say you have gold ETFs or gold mining stocks in your broking account. Let’s suppose they’re doing very well nominally in such a scenario. The question is, is it possible to realise the value in those paper assets? Should there be a banking crisis, capital controls and bank deposit freeze/limit, etc, it may be practically very difficult to unlock the value in your paper assets.

  • Hi exazonk!

    In short, gold mining stocks have to be assessed on a case-by-case basis. Everything else being equal, a rising gold price is good for gold mining stocks (the ones producing the real gold). But in the real world, the everything-else-equal assumption is suspect (e.g. cost is a big question mark). But this is not the real problem.

    The problem is, there’s a practical difficulty with gold mining stocks. Let’s say you have gold ETFs or gold mining stocks in your broking account. Let’s suppose they’re doing very well nominally in such a scenario. The question is, is it possible to realise the value in those paper assets? Should there be a banking crisis, capital controls and bank deposit freeze/limit, etc, it may be practically very difficult to unlock the value in your paper assets.

  • Hi Niko, what do you have in mind with the end game of a “pure credit” system? How is it different to what we have now?

    Hi David, yesterday I read F.A. Hayek’s lecture, “A free market monetary system”. In it he talks about the idea of competing currencies. He claims to have essentially come up with the idea. He didn’t believe that gold was a necessity to private currencies – merely the trust of a company not to expand it’s money supply. Rothbard supports a return to a true/real gold standard and had some ideas about how to transition over from fiat/debt currencies. I haven’t read much Rothbard yet though. I heard Lew Rockwell say that he favours a gold coin standard (rather than using tickets).

    It sounds like you’ve watched the Money as Debt video which has it’s merits but I think it may go too far to say that the problem is the interest and that somehow, because there are interest payments, that there will be exponential growth which is unsustainable. I liked that video when I first saw it. In fact, it a major contributor to my interest economics and finance. However, can lead people to conclude that the govt should instigate a debt jubilee from the current system and then provide a new debt-free money system with interest free loans. That sounds enticing at first but what is the incentive for savings? or the incentive to pay back loans? As always, keep your bat-sense about you and don’t always believe what you here.

    An eternal sceptic.

  • Hi Niko, what do you have in mind with the end game of a “pure credit” system? How is it different to what we have now?

    Hi David, yesterday I read F.A. Hayek’s lecture, “A free market monetary system”. In it he talks about the idea of competing currencies. He claims to have essentially come up with the idea. He didn’t believe that gold was a necessity to private currencies – merely the trust of a company not to expand it’s money supply. Rothbard supports a return to a true/real gold standard and had some ideas about how to transition over from fiat/debt currencies. I haven’t read much Rothbard yet though. I heard Lew Rockwell say that he favours a gold coin standard (rather than using tickets).

    It sounds like you’ve watched the Money as Debt video which has it’s merits but I think it may go too far to say that the problem is the interest and that somehow, because there are interest payments, that there will be exponential growth which is unsustainable. I liked that video when I first saw it. In fact, it a major contributor to my interest economics and finance. However, can lead people to conclude that the govt should instigate a debt jubilee from the current system and then provide a new debt-free money system with interest free loans. That sounds enticing at first but what is the incentive for savings? or the incentive to pay back loans? As always, keep your bat-sense about you and don’t always believe what you here.

    An eternal sceptic.

  • Steve Netwriter

    David,
    It’s brilliant to see someone else looking at complementary currencies.

    I’d love it if you’d join in the discussion.

    Steve

  • Steve Netwriter

    David,
    It’s brilliant to see someone else looking at complementary currencies.

    I’d love it if you’d join in the discussion.

    Steve

  • travelite

    Hi Steve,
    Ideally no currency should be imposed on a free market system, the market will provide the money of choice.

    Rothbard makes the excellent argument in “What has Government Done to our Money” that all money must start from a commodity initially. Gold and sometimes silver has always risen as the money of choice in free market systems where a society has access to the metals.

    Hi Niko, there is a global currency in existence already – it’s called Gold! As for a pure credit system, I would have thought that the current financial crises and credit/debt destruction is a solid answer to the chances of credit being the future.

  • travelite

    Hi Steve,
    Ideally no currency should be imposed on a free market system, the market will provide the money of choice.

    Rothbard makes the excellent argument in “What has Government Done to our Money” that all money must start from a commodity initially. Gold and sometimes silver has always risen as the money of choice in free market systems where a society has access to the metals.

    Hi Niko, there is a global currency in existence already – it’s called Gold! As for a pure credit system, I would have thought that the current financial crises and credit/debt destruction is a solid answer to the chances of credit being the future.

  • I believe that the gold standard is returning in the form of gold ETF:s.

    E-gold charges fees, but involves no credit risk. It is a rothbardian 100% reserve bank or more correctly a vault.

    However, there is a japanese gold ETF not holding physical gold as assets but instead gold denominated debt. However, they charge a 0,5 % per annum fee, which is less than e-gold but still not too attractive. They do not hand out gold either, just a yen amount sufficient to buy one gram of gold. The unit of account is the gold gram.

    As soon as they offer all the services e-gold offers free of charge there will be a system in operation tantamount to the fractional reserve gold standard in operation until 1914.

    I believe that once there is a such opportunity on the market this system will gradually get more and more liquid and one day we are all on gold again. The more central banks inflate, the quicker the process.

    One important step on the way to an international gold standard will be when you can as easily trade the gold/dollar rate as you can trade the dollar/euro rate now.

    Before that will happen I believe that “fractional e-gold” will have to emerge. Let me describe “fractional e-gold”.

    Fractional e-gold is payable in US$ and holds gold-denominated debt as assets. The rate of interest offered is 0%, but on the other hand it does not charge any customers fees. It offers people all the services e-gold offers free of charge, but on the other hand there is a credit risk.

  • I believe that the gold standard is returning in the form of gold ETF:s.

    E-gold charges fees, but involves no credit risk. It is a rothbardian 100% reserve bank or more correctly a vault.

    However, there is a japanese gold ETF not holding physical gold as assets but instead gold denominated debt. However, they charge a 0,5 % per annum fee, which is less than e-gold but still not too attractive. They do not hand out gold either, just a yen amount sufficient to buy one gram of gold. The unit of account is the gold gram.

    As soon as they offer all the services e-gold offers free of charge there will be a system in operation tantamount to the fractional reserve gold standard in operation until 1914.

    I believe that once there is a such opportunity on the market this system will gradually get more and more liquid and one day we are all on gold again. The more central banks inflate, the quicker the process.

    One important step on the way to an international gold standard will be when you can as easily trade the gold/dollar rate as you can trade the dollar/euro rate now.

    Before that will happen I believe that “fractional e-gold” will have to emerge. Let me describe “fractional e-gold”.

    Fractional e-gold is payable in US$ and holds gold-denominated debt as assets. The rate of interest offered is 0%, but on the other hand it does not charge any customers fees. It offers people all the services e-gold offers free of charge, but on the other hand there is a credit risk.

  • Hi Flavian!

    Welcome here!

    Have you heard of complementary currencies? We’re wondering, perhaps e-gold can function as a complementary currency.

    One of our readers, Steve Netwriter is very passionate about the idea of complementary currency. You may want to chat with him more about this interesting idea at our forum here.

  • Hi Flavian!

    Welcome here!

    Have you heard of complementary currencies? We’re wondering, perhaps e-gold can function as a complementary currency.

    One of our readers, Steve Netwriter is very passionate about the idea of complementary currency. You may want to chat with him more about this interesting idea at our forum here.