What should be your fundamental reason for accumulating gold?

March 15th, 2007

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For those of you who are with us long enough, you would have known that we are always in favour of accumulating gold. But that fact in itself still leaves a lot of questions with regards to the details unanswered. Today, we will examine a little more on one of the details?what should be your fundamental reason for accumulating gold?

First, why should we accumulate gold? We have mentioned this before in What should be your real reason for buying gold?:

…your real reason for investing in gold is not to ?make money??you do so as a hedge to preserve your wealth.

We accumulate gold not just simply because we believe its ?price? is going up (though we think it is most likely to be so as a side effect?in case you are confused by what we mean, read on). This is because if we do so, the implication is that we are calibrating the value of gold in terms of units of fiat paper money (see Entrenched perception on the value of paper money). As we said before, money is fiat if it enjoys legal tender status through the authority of the government instead of through the choice of the free market. This means that fiat money is not backed by anything physically tangible?it derives its value from an elusive intangible called ?confidence.? Simply put, fiat money is backed by nothing!

What if we lack complete confidence in fiat money? In this case, the ?price? of gold in units of that fiat money is irrelevant. For example, Zimbabwe is today suffering from hyperinflation (price inflation rate is 1600% from what we last read about) as its fiat currency is practically worthless. The ?price? of gold in Zimbabwean currency has skyrocketed. But really, if you are a Zimbabwean in Zimbabwe, will you really care about the ?price? of gold in Zimbabwean money? No, in such a situation, gold is a vastly superior form of money as its supply can never be conjured up into existence by the will of the central bank (or government if it controls the central bank). Thus, your desire for wanting to accumulate gold should be proportional to your lack of confidence in fiat currencies. So, the next question is, do we have good reasons for such lack of confidence?

To answer this question, we will first look at the past. Throughout the entire history of human civilisation, humanity?s experimentation with fiat money always (i.e. 100% of the time) resulted in that money eventually becoming worthless. In our previous article, Have we escaped from the dangers of inflation?, we have a short paragraph on the ancient Chinese’s flirtation with fiat money. History buffs may want to research more on this. If you are interested, we have two more articles on the history of money: A brief history of money and its breakdown- Part 1 and Part 2. So, with the entire weight of history on our side, we believe the chances of today?s global fiat currency system (which became completely fiat in 1971) eventually becoming a failure is pretty much very likely. The only question is when it will happen. For one of the many episodes of the ancient Chinese?s use of fiat money, it took a process of a couple hundred of years to result in a complete breakdown. Therefore, even though we believe history will inevitably repeat itself, we cannot really predict when it will do so. However, having said that, we have reasons for believing that the end of fiat money is near and it may happen within our lifetime.

Next, we would ask ourselves this question: why did fiat monetary system always fail? To answer this question, we look at this time tested maxim: Power corrupts, absolute power absolutely corrupts. In a fiat monetary system, the authority to create money is concentrated on one institution?the central bank. Yes, we may say that the central bank is (and should ideally be) independent from the government. But in practice, this is not often the case?at least not perfectly so. For example, in the US, the Federal Reserve is a creation of the Congress. This means it is doubtful that the former can be perfectly independent from the latter, which is an extension of the government. In Zimbabwe, the government had even wrested control of the central bank. If you are given the authority to create the only legal tender money, we can be sure you yield a lot of power. Likewise, through the authority to create money, the government can wield a lot of power through monetary inflation (see How to secretly rob the people with monetary inflation?). Eventually, through the passage of time, such power will subtly corrupt even the most benevolent government. We can think of today?s Venezuela as a very good example. The result is that power is always exercised through monetary inflation (or in layperson?s term, ?printing? of money), which will ultimately result in price inflation (see Cause of inflation: Shanghai bubble case study). Hyperinflation is the terminal stage of the monetary breakdown.

Finally, why do we believe we may be able to see the end of fiat money in our lifetime? For this, we will look at today?s money supply. The US Federal Reserve has stopped publishing the M3 money supply figures, citing reasons which we feel is more of excuses (our cynical mind tells us that they have something to hide). The US money supply has always been increasing. But it is over the past several years that the increase in liquidity (which includes money created by the Federal Reserve and money substitutes created by the financial system) is growing at an exponential rate (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of liquidity). It has come to the point that central banks around the world cannot control it and that there is great uncertainty on where the risks are (see Prepare for asset repricing, warns Trichet). That is why we are seeing incredible asset price bubbles all over the world. As we all know, all bubbles ultimately pops (see Spectre of deflation). In view of all these, how can we still remain confident in fiat currencies?

If you cannot remember anything else, please remember this: gold is a hedge against loss of confidence in fiat paper currencies.