Why oil cannot function as currency reserves?

February 28th, 2010

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Not long ago, we were talking to an analyst from a pretty reputable value fund manager. He was adamant that gold is in a bubble because “everyone is buying it.” When we heard his rationale for this belief, we knew straight away that he had not clearly thought through his underlying beliefs about gold and the nature of money.

In fact, his understanding about the nature of money is closer to the level of an uninformed person on the street than what we expect from an investment professional. For example, this analyst was completely blind to the colossal difference between the rarity of gold and the rarity of rocks, citing that there are heaps of gold in the world! It is one thing to have a different opinion about gold because one belongs to the deflation camp. But it is just simply too shocking to hear a suit-wearing investment professional from a reputable fund manager sprouting such nonsense! If a person cannot see the difference between the rarity of gold and rocks, then it will be beyond his level to even understand the properties of good money, which is critical to understanding gold.

Now, if you are new to this blog, you may wonder whether gold is a bubble or not, since there is no (or rather, very limited, to satisfy the pedantic) industrial use for it. If this is your question, we recommend that you read If gold has no intrinsic value, is it a bubble?. Or better still, you may want to read our book, How to buy and invest in physical gold and silver bullion for a fuller picture.

At this point, this analyst posed a very good question. Given that everyone agrees that the US dollar is going to depreciate further in the long run, then wouldn’t oil be a better substitute (e.g. as currency reserves) for it than gold? As that analyst said, oil should be a better substitute because it is a vital commodity, whereas gold has hardly any practical and industrial use? In other words, will oil function better as money than gold?

To answer this question, first we have to understand what money is. At the root of its nature, it is a medium of exchange. From this nature, it then follows that money functions as unit of accounting, store of wealth and so on. The question then becomes, is oil a better medium of exchange than gold?

At first glance, it seems that the answer is yes. But if you think carefully, if oil ever becomes a medium of exchange tomorrow, it will bring about disaster to humanity. To understand why, let’s have a thought experiment. Remember, back in If gold has no intrinsic value, is it a bubble?, we wrote,

Now, imagine if one day the US government decree that all tooth-pastes become legal tender for payment and settlement of debt (i.e. function as money), how would you feel if you have to physically consume your money daily for the sake of oral hygiene?

Let’s say the government declares that 30 days from now, tooth-pastes will function as legal tender money. What will happen? Firstly, the prices of tooth-pastes will sky-rocket. Next, tooth-pastes will disappear from the shelves of supermarkets. People will be hoarding and stockpiling tooth-pastes. After 30 days, when tooth-paste officially becomes legal tender money, people will start to have bad breath, especially the poor, who can’t afford to consume tooth-pastes for the sake of oral hygiene. Then the demand for tooth pastes will rise to the moon, not because the demand for oral hygiene increases, but because the demand for tooth-pastes as money increases. Not only that, no matter how much tooth-pastes Colgate produces, there will always be shortages because there will be mass-hoarding of them as money.

This may be a funny though-experiment. But if oil should ever function as medium of exchange, the outcome will not be funny. There will be an acute shortage of oil, as nations will be hoarding and stock-piling oil in a frenzy. Guess what will happen if we have acute oil shortages in a Peak Oil world that is addicted to oil? The way of life as we know will grind to halt and we will all be back to travelling in horse-drawn carriages.

That is why, when governments undermine the store-of-value function of money (something that can only be done in a fiat monetary system), investors will flock to useful, vital and scarce commodities to store their wealth. This in turn will result in those scarce commodities becoming scarcer. The food riots around the world in 2008 were an example of how this can happen (see Who is to blame for surging food and oil prices?). That also explains why the housing ‘shortage’ situation in Australia is an intractable problem (see Does rising house prices imply a housing shortage?).

That is the reason why gold and silver?functioned as money historically. The free market tried using scarce, useful and vital commodities (e.g. salt, sugar, tobacco, cattle) as money before and it didn’t work out. Those that did probably did not evolve into more advanced civilisations.

Of course, just because it is stupid to let oil function as currency reserves does not necessarily mean it wouldn’t. As Albert Einstein said, two things are infinite: the universe and stupidity.

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