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Why oil cannot function as currency reserves?

Sunday, February 28th, 2010

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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Posted in Economics/Finance, Gold | 11 Comments »

Gold and the strong state

Thursday, March 19th, 2009

Have you walked into a shop that specialises in selling paper money from the past and present from all over the world? Indeed, when holding a Riechmark (the German currency from the 1930s) on our hands, we felt a sense of nostalgia from the past. At some point in time, that piece of paper was used as money by another person to buy his/her daily essentials. Or if you want to be a billionaire, you can easily buy one of Zimbabwe’s currency at a price of say, AU$10.

Alas, all these paper money (currency) met their end and became of value only to collectors. Perhaps as an exercise, you may want to immerse yourself in one of those paper money shops and get yourself acquainted with the history of some of these currencies. Who knows, perhaps one day, the currency that you hold in your wallet will find its way into that paper money shop?

As we explained in our previous article, the whole idea of gold is money. The proper way to understand gold is to see it as money that is not currency. The fundamental reason why you accumulate gold is that (as we said before in What should be your fundamental reason for accumulating gold?) you want it as a hedge against loss of confidence in currently legal tender currency. On the other hand, if you have supreme confidence in currencies, then you will have no reason to hold gold.

As one of our readers, Pete, astutely pointed out before, there are many ways for currencies to lose the people’s rejection as money. Hyperinflation is only one of them. To illustrate this point, we have a story…

In 1940, as the German tanks rolled down to France, many French citizens hopped on to their cars to flee Paris. On the way to somewhere, some had to stop by petrol stations to refuel. It turned out that petrol stations did not accept the French currency as payment. After all, who will trust that the French currency will still be money once the Germans took charge? But if you had some gold coins in that situation, then you are in luck. Of course, when the Germans took over, they issued their own occupation currency and gold went underground.

The point we are trying to make is that gold as money is anti-thesis to a strong state. A strong political state may seek to ban gold on pain of death. That was what happened to China during the Mongol occupation of the 13th century. Marco Polo marvelled that the Mongol Khan had mastered the art of alchemy because paper currency issued by the Mongol empire became money on pain of death. It came to the point that gold, silver and other treasures were exchanged for the Khan’s paper money. Thus, Marco Polo remarked that the Khan was the richest person on earth. Thus, from this perspective, we can see that gold is a symbol of resistance against tyranny, subversion against state power and freedom.

But if you look at history, gold wins in the end because the strong state eventually falls (but the catch is, they may not fail within your lifetime). The Mongols, in enforcing their expensive occupation of China, printed money until there was hyperinflation. It was at that time that the Chinese rebelled against the Mongols and eventually drove them out of China. The subsequent Ming Dynasty continued the Mongol’s monetary policy of using paper as money. But by 1455, China had to revert back to commodity money.

Thus, the major risk of holding gold is that you can be up against the strong state (assuming that strong centralised political power will be the future) who may want to ban gold. But yet again, who knows? For example, Zimbabwe, for all the despotism of Robert Mugabe, has not or were powerless to ban gold.

But if the future turns out to be one in which political power is weak, de-centralised and rivalled by non-state power, then gold is a better bet than pieces of paper called the US dollar. This is the thesis of a strategist in the US Army War College (see From the New Middle Ages to a New Dark Age The Decline of the State and U.S. Strategy).

So, in summary, there’s risk in holding gold. But there’s also risk in NOT holding gold. So, what’s the alternative? Hold real asset (farm land, timber land, barrels of oil, food, guns, etc) instead? Well, there’s also risk as well and furthermore real assets serve a different function from gold. We will talk more about holding real assets later.

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Posted in Economics/Finance, Geopolitics & Politics, Gold, History, Looking Forward | 28 Comments »

If gold has no intrinsic value, is it a bubble?

Tuesday, March 17th, 2009

Today, we just received a comment from one of our readers,

I got two emails in my inbox today from sources I subscribe to that made me think of you and your hoard of gold. Firstly, the view of a smart guy who knows a lot about investing:

Gold is very expensive

Secondly, the views of another smart guy who knows a lot about technical analysis:

Gold Divergence Poses A Question

I think the gold/oil ratio is particularly telling, in that a gold bubble began forming in late 2008. Like I said previously, I don?t want to try to timing getting out of gold and into real assets, but good luck to you.

We took a read at the first link and saw this:

I know the gold bugs will hate this idea – because it harks back to the argument against gold – which is that it has no intrinsic value.

This is one of the most common argument against gold. While this argument is true in itself, the person who wrote that sentence has clearly forgotten the mirror image of that argument. As we wrote in October 2006 at Is gold an investment?,

This is because with its extremely limited industrial use, gold will not be worth that much at all.

So, we will repeat this point again: Gold has no intrinsic value. So, if gold has no intrinsic value and if you see its price going up, it is easy to conclude that it is a bubble. Now, having established the fact that gold has no intrinsic value, we will ask a mirror image question. What intrinsic value does a crisp piece of paper called the US dollar has?

You see, like gold, a crisp piece of US dollar has no intrinsic value too! There are completely no industrial uses for that piece of paper called the US dollar. Now, ask yourself this question: if that piece of paper called the US dollar has practical industrial use or is consumable the way tissue paper and tooth-pastes are, do you think people will still want to treat it as money? 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?

Therefore, as we said before in Properties of good money, one important property of money is that it must not be something that is consumable. The only way for this property to be fulfilled is for money not to have any intrinsic value.

Now, back to gold. As we wrote before in What should be your fundamental reason for accumulating gold?,

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).

Therefore, the fundamental reason for accumulating gold is not to ‘make’ money. The reason why you do so, is because you lack confidence in legal tender money. The bull market for gold since 2001 is an indication of a declining confidence in legal tender money, which like gold, has no intrinsic value. So, if you are very suspicious of central bankers playing hanky panky with the crisp piece of paper money called the dollar/ poound/ yen/ franc/ yuan/ etc, then your only alternative is to exchange those funny paper for physical gold.

Now that you understand this very fundamental point, what if you are still concerned about timing the market? If you are getting more and more suspicious of legal tender money (or getting more and more worried of a doomsday scenario), then market timing will be the least of your concern. Sure, you may want to time the market to get the maximum bang (gold) for your buck (paper money). But if market timing is still your over-ridding concern, then you are really missing the big picture. If you see gold price going up and up, it means you will have much greater worries than just market timing.

But if after all these explanations, you are still concerned about marketing timing, Marc Faber has this to say in his latest commentary:

I really dislike being called a gold bug. I wish I could be positive about the global economy and social and geopolitical condition, but the more I think about current condition, the more depressed I become. Amidst a global slump I believe that we are moving toward high inflation (a further depreciation in paper money?s purchasing power), evil fascism, and vicious military confrontations. In theory, gold would be the best asset to own in this condition. Also, in theory, gold should be the perfect insurance against economic, social, and political Armageddon. However, I have some reservations.

For one, gold has already experienced a powerful bull market between 2001 and the present. As a result, gold has become relatively expensive compared to equities and the CRB Index. I am not suggesting that this outperformance of gold compared to other commodities and equities cannot continue. In fact, I believe that in time one Dow Jones will buy less than one ounce of gold. However, near term, gold would seem to be both over-bought against the Dow Jones and the CRB Index. I concede that the overbought condition of gold compared to the Dow Jones and compared to the CRB Index could be corrected by a strong rebound in the Dow and the CRB Index rather than a further downward correction in gold. My bet would be that the CRB Index has significant rebound potential and…

The other concern I have about owning physical gold (and as I just said, I am holding on to my physical gold) is that things will get one day so bad in the world that governments will expropriate gold, as the US did in 1933. This is unlikely to happen this year but it is a concern I have for the long term, especially if gold rallies to several thousand dollars per ounce as a result of money printing by all central banks or because of wars! As Voltaire remarked, ?it is dangerous to be right when the government is wrong.?

Whether you should be buying, holding or selling gold today will depend on your personal circumstances, which includes what percentage of your wealth are currently in gold, your level of suspicion against fiat money and your level fear for a doomsday scenario. But remember, having some gold is better than having zero gold.

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Posted in Gold | 40 Comments »

Why should central banks be independent from the government?

Wednesday, July 16th, 2008

Yesterday, one of our readers asked us this question:

Why is it important to keep central banks independent from the government? Wouldn’t it be better if the board of directors of a central bank are selected by the people, and therefore held accountable to the people for decisions, mistakes, and misjudgements?

At what point did central banks become concerned about targeting inflation? Before they existed, inflation was close to 0%, so surely they wouldn’t have been created with inflation targeting in mind?

The more I read, the more I feel that your ideal of a 100% reserve banking system with no central bank is the best way to control inflation (and to allow the people to understand the true cost of government projects [wars, etc] that is currently paid for through inflation). But why didn’t this work in the first place?

To answer these questions, we will turn back to history. As we explained before in A brief history of money and its breakdown- Part 2,

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury.

Under an international gold standard, there was an automatic market mechanism to keep government from inflating the money supply and to keep each country’s balance of payment in equilibrium. Hence, the world enjoyed the benefits of only one monetary medium, which facilitated trade, investment and travel. Prices were also kept in check (see What is inflation and deflation?). During that time, there were periods of price rises (e.g. during war) followed by periods of price falls (e.g. when war ends), with relatively stable prices in between.

Why did it not work out in the end? Well, thanks to the First World War. As we all know, modern wars are terribly expensive. Under a gold standard, no country can ‘afford’ to fight any war for an extended period of time. Therefore, the only option was to go off the gold standard and resort to purely fiat paper money as it is today. You can read the rest of the monetary breakdown story at A brief history of money and its breakdown- Part 2.

Now, you know how the US is able to ‘afford’ to fight extended wars in Iraq and Afghanistan with expensive professional armies today.  A gold standard will make this truly unaffordable.

Today, the central banks of the US and Australia follows an inflation targeting policy. That is, monetary policy is set ensure that there is a consistent price rise within a target range. How did inflation targeting develop? Well, it is another long story. You can read about it straight from the RBA at Inflation Targeting: A Decade of Australian Experience.

Next, we come to the most important part: why should central banks be independent from the government?

First, we have to understand the basics. What is the purpose of money? In essence, money functions as (1) a medium of exchange, (2) unit of account and (3) a store of value. To perform these functions, money has to fulfil certain properties as described in Properties of good money and its integrity cannot be tampered with.

Now, consider the situation that we described in Recipe for hyperinflation:

… imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn?t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others.

Under the gold standard, gold is money that is under the control of the free market. No one or institution ‘owns’ or control the money. But today, the central bank is the only institution that has the authority to create money out of thin air. As we said in Recipe for hyperinflation,

Look at any piece of paper money today and you will find the words of a government decree (e.g. ?This Australian note is legal tender throughout Australia and its Territories?) and perhaps a signature or two.

In Australia, the signature belongs to the RBA governor.

What if we give the government (which already has executive power) the power to create money? This will give the government a deeper concentration of power! If you believe the old adage that power corrupts and absolute power absolutely corrupts, then you will not want such a deep concentration of power. As we said before in Have we escaped from the dangers of inflation?,

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

That is why today, central banks are independent of the government, with complex and elaborate rules of money and credit creation (the exception will be Zimbabwe under Robert Mugabe). Our fear is that with this credit crisis worsening by the day, deflation may prove such a unthinkable threat (e.g. see How do we all pay for the bailout of Fannie Mae and Freddie Mac?) that the government will ‘roll back’ all these rules one by one in order to keep the entire financial system solvent. As the ancient Chinese saying goes, the journey of a thousand mile begins with the first step. Therefore, the journey towards a hyperinflation hell will begin with such measures (see Recipe for hyperinflation). Your belief in whether you will see hyperinflation in your lifetime will depend on your faith on the government to maintain the integrity of money.

Next, what if we let the people vote for the board of directors who control the central banks? If shareholders have trouble keeping the directors of their company honest and accountable, then it will be the same for the central bank.

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Posted in Economics/Finance, History | 30 Comments »

What is money?

Friday, April 25th, 2008

This is a deceptively simple question. Last time, money was simply gold and silver. But today, in this modern age of finance, money is far more complicated than what it was used to be. It has come to the point that it is very hard to even define what money is, let alone measure its quantity. Alan Greenspan, the former head of the US Federal Reserve was believed to have said ?We don?t know what money is, any more.? Today, we will explain what money is by explaining the various measures of money supply, according to the definitions of Australia’s central bank, the Reserve Bank of Australia (RBA).

A good way to see money is to think of it as an inverted pyramid, the apex of which is the most liquid form (and most favoured by drug dealers). This most liquid form of money is defined as currency. Currency is the (1) physical notes and coins that can be seen, touched and smelled and (2) held by the “private non-bank sector” (which is basically institutions, companies and individuals that are not banks and governments). Currency is mentioned in the graph in our previous article, Australia?s monetary debasement & credit expansion.

The next broader measure of money is the monetary base, which is (1) physical notes and coins held by the “private sector” (which is anything that is not of the government), (2) banks’ deposit at the RBA and (3) what the RBA owes to the “private non-bank sector.” The central bank (RBA) is the bank of the government and banks. Therefore, your bank will have an account at the RBA where it keeps its money, which is the previously mentioned (2). For (3), an example would be the Medicare rebate that you receive from the Australian Commonwealth government. It will come in the form of a cheque drawn from the RBA. The difference between component (1) of currency and component (1) of monetary base is that the former excludes physical money held by banks (e.g. notes stored inside the ATM machines).

The next measure of money is M1. It is comprised of (1) currency and (2) bank current deposit held by the “private non-bank sector.” In Australia, you may have a current deposit account that pays almost no interest and you can withdraw your money from it at any time. This money will be included in M1.

The next broader measure of money is the M3. It comprised of (1) M1 and (2) other deposits with bank (e.g. term deposits, certificates of deposits, etc).

The broadest measure of money is broad money, which comprised of (1) M3 and (2) borrowings of financial institutions from the private sector. Your money kept in high-yield cash management accounts will be part of broad money.

So, how can there be so many measures of money, from the most limited currency (AU$39.4 billion as at February 2008) to massive broad money (AU$ 1074.5 billion as at February 2008)? Well, you may want to read our earlier article, 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?.

Next article, we will show you an updated graph of Australia’s money supply.

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Posted in Economics/Finance | 9 Comments »

What is the future of silver?

Monday, March 3rd, 2008

Today, we will continue from The behaviour of silver and gold prices and explain what we believe the future of silver ought to be. The assumed knowledge of today’s article will be Why should you invest in gold?. As we explained before in our previous article,

But please note that since there is a difference between what we think should be and what the market thinks is the case, then there will be a difference between what we think ought to happen and what will happen.

If you think we may sound a bit too verbose with this explanation, it is because we want to make it absolutely clear that we are not making any claims on the future of silver prices, especially in the short to medium term. This is because no matter how logical our deductive reasoning is (assuming that it is sound in the first place), there is no guarantee that the market will behave rationally. As Keynes famously said, “The market can remain irrational longer than you remain solvent.” Therefore, bear that in mind. Investors have lost money because they forgot that (including Warren Buffett, who suffered a loss in a bet against the US dollar).

Anyway, here comes the meat of this article: Will silver regain its monetary status once again, as a junior partner of gold?

First, why was silver ever money in the first place? In A brief history of silver and bimetallism,

As we said before in Properties of good money, a commodity has to be sufficiently rare to qualify as money. But it cannot be too rare. Silver, the less rare sister of gold, was useful for smaller transactions because gold was too rare for further smaller sub-divisions.

Now, assuming that gold will one day function as money (i.e. play an important role in the global monetary system), will there still be a need for silver to function as small change money? The answer to this question is the crux of what we believe the future of silver ought to be.  We believe the answer is “No.”

Why?

Obviously, even if gold is going to function as money in the near future, it is highly unlikely that no one will carry physical gold in their wallets. The inconvenience of carrying physical gold was real even more than 100 years ago. That is why, as we said before in Entrenched perception on the value of paper money, warehouse receipts for gold, which existed in the form of paper, was invented. Warehouse receipts for gold slowly evolved into today’s fiat paper money.

Today, we have a very powerful technology that can solve the convenience and sub-divisibility problem (see Properties of good money) associated with gold money- computers. All we need is a trusted central repository of gold (perhaps today’s central bank can change its institutional role for this purpose) and let computer systems keep track of ownership and transfer flow of gold money. In other words, the gold is physically kept in a secure central location while the finer sub-divisions and change of ownership of gold money is recorded as bookkeeping entries on computers. No physical movement of gold is necessary. In a sense, this is already happening with fiat paper money today. Much of today’s commerce is happening in the form of electronic transactions, with relatively minuscule amount of physical cash involved. Therefore, it should be possible with gold money. If those who still have doubts of such a possibility, we would like to point out that this idea is already implemented at GoldMoney.com. We have no doubt it is possible to be implemented on a national and international scale.

In this case, will there still be a need for silver? If not, silver is better off being a purely industrial commodity.

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Posted in Gold, Silver | 12 Comments »

The behaviour of silver and gold prices

Sunday, March 2nd, 2008

When it comes to gold, our conviction is clear (this article assumes you have read Why should you invest in gold?). But when it comes silver, the answer is not that straightforward. As we explained before in A brief history of silver and bimetallism, silver used to function as money alongside gold, albeit as a junior version of gold. Assuming that one day, gold will once again play a very important monetary role in the global financial system, will silver be reinstated as secondary money along with gold?

In the past, when silver was money, there was hardly any industrial use for it. As we said before in Properties of good money, it is due to the lack of consumable industrial and practical use that makes a commodity suitable for functioning as money. Today, there is widespread industrial use for silver- see this Wikipedia article for more information on that. In 2006, industrial usage of silver accounts for 63% of silver supply. It is expected that the industrial usefulness of silver will increase, which will, on the other hand, be offset by secularly declining usage in photography (supplanted by digital photography).

This is in stark contrast to gold. As we explained before in Is gold an investment?,

Therefore, conventional supply and demand analysis cannot be applied for gold because it is not a commodity (see Is gold a commodity?). This is because with its extremely limited industrial use, gold will not be worth that much at all. It is worth so much because its value is largely derived from outside the realm of industrial and pragmatic usage (i.e. monetary value). Similarly, how much industrial and practical value is a piece of crisp US dollar? If there is no pragmatic use for a piece of paper called the US dollar, then why is it in so much demand (e.g. drug dealers use them for transactions)? Therefore, in conventional supply and demand analysis jargon, the monetary value of gold is consigned into a conveniently labelled group called ?investment demand.?

The same could not be said for silver because currently, it has both the properties of an industrial commodity (e.g. iron, zinc, copper) and money (e.g. gold).

Since 2001, silver and gold prices have been consistently moving together at a correlation of 0.98 (0.00 means completely no correlation and 1.00 means perfect correlation). Though they tend to track each other, the ratio between them tends to vary. During the days of bimetallism (A brief history of silver and bimetallism) in the 19th century, the prices were fixed by law at a ratio of 1:15.5. During the 20th century, the ratio was at an average of around 1:47, from a low point 1:38 in 1910 and 1:101 in 1990. Currently, it is at a ratio of 1:49. There are some who analyses the trend of this ratio as an indicator of what the price of silver will be. We have not comment on that yet.

However, relative to gold prices, silver prices tend to be more volatile because of its perceived dual nature (industrial and monetary). Assuming that (1) gold and silver prices will still maintain a tight correlation, (2) gold prices (measured in terms of fiat currencies) is on a long-term up-trend (perhaps even exponentially), silver can be interpreted as a ‘leveraged’ hedge against loss of confidence against fiat money (see What should be your fundamental reason for accumulating gold?).

Now, coming back to the original question: Will silver regain its free-market status as secondary money? We have our opinions on what the future of silver should be. But please note that since there is a difference between what we think should be and what the market thinks is the case, then there will be a difference between what we think ought to happen and what will happen. This means that in the short to medium term, our ‘predictions’ will not be ‘fulfilled.’ But if we are right, then it will be ‘fulfilled’ in the long run.

We will continue on what we think the future of silver should be in our next article.

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Posted in Silver | No Comments »

Properties of good money

Monday, February 25th, 2008

Previously, in Is gold an investment?, we mentioned that we will talk about silver in the next article. However, we feel that we have to explain one more important point first before we can move on to silver. Please forgive us…

Remember, in A brief history of money and its breakdown- Part 1, we explained how money developed,

At this third stage of monetary development, a highly marketable good will eventually emerge as the most sought-after intermediate good for the purpose of exchange with other goods. This intermediate good functions as money as we know it. Obviously, such an intermediate good must have characteristics of portability, divisibility, durability and sufficiently rare (but not too rare).

Over the course of time, many commodities (e.g. tobacco, cattle, grain, cooper, seashells and tea) at one time or another functioned as money. But eventually, gold and silver became money for most civilisations and societies in history. Obviously, many of the commodities were eliminated from being money. So, the next question to ask is, what makes a commodity ideal to function as money? They are:

Portability
Ideal money must be portable. That is, it has to be convenient for you to bring it along to wherever you want. Obviously, cattle fail the portability test and was not the favoured form of money.

Divisibility
Ideally, money should be easily divisible to cater for all types and sizes of transactions. Again, cattle obviously fail the divisibility test.

Durability
Physical money should be durable. If not (i.e. can decay), it cannot be a reliable store of value. Tea fails the durability test.

Sufficiently rare
Obviously, money has to be sufficiently rare. If not, you will have to haul a massive quantity of it for transactions. Seashells fail this test. On the other hand, it cannot be too rare. Otherwise, it will be impossible to sub-divide it further for tiny transactions.

Fungible
Any commodity that functions as money ought to be fungible. That is, you can trade or substitute it for equal amounts of like commodity. Someone asked whether diamonds is a suitable commodity for money. The answer is no because diamonds are not fungible. Since each diamond is unique, they cannot be substituted or traded easily. Therefore, it cannot be conveniently used for transactions.

Un-consumable
Oil cannot function as money because because it is a consumable commodity. Obviously, it is not a good idea to consume your money! It’s pragmatic value is far too great to function as money.

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Posted in Economics/Finance | 3 Comments »

Is gold an investment?

Saturday, February 23rd, 2008

Remember that we said before in What should be your fundamental reason for accumulating gold?,

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

In other words, gold is the inconvenient torn in the flesh for fiat paper currencies. It has, for centuries (or even millenniums) being chosen by the free market to function as money in most societies (see A brief history of money and its breakdown- Part 1). It was only until recently (in 1971) that the last official monetary role of gold was abolished (see A brief history of money and its breakdown- Part 2). But given the extended historical role of gold, do you think a mere 3½ decades of government decree can really completely erase the perception of its monetary value from the consciousness of humanity? We doubt so. Many ancient governments had tried but none succeeded (see Ancient Chinese fiat paper money).

Therefore, conventional supply and demand analysis cannot be applied for gold because it is not a commodity (see Is gold a commodity?). This is because with its extremely limited industrial use, gold will not be worth that much at all. It is worth so much because its value is largely derived from outside the realm of industrial and pragmatic usage (i.e. monetary value). Similarly, how much industrial and practical value is a piece of crisp US dollar? If there is no pragmatic use for a piece of paper called the US dollar, then why is it in so much demand (e.g. drug dealers use them for transactions)? Therefore, in conventional supply and demand analysis jargon, the monetary value of gold is consigned into a conveniently labelled group called “investment demand.” But in reality, since gold is a boring, inert metal that does not have much pragmatic use and does not pay dividends, income or interests, it is completely unfit for ‘investment.’ Therefore, it has ‘demand’ the same way the US dollar has ‘demand.’

Next, armed with this understanding, we will then talk about gold’s sister, silver, in the next article.

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Posted in Gold | 8 Comments »

363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?

Thursday, February 15th, 2007

Recently, this news report came up in CNN: Lawmaker: U.S. sent giant pallets of cash into Iraq. In this report, 363 tons of cash (worth $4 billion) were loaded into pallets and transported via military transport aircraft into Iraq ?shortly before the United States gave control back to Iraqis.? Needless to say, much of the cash went unaccounted for.

As we said before in A brief history of money and its breakdown- Part 2, when much of the world was under the gold monetary standard, nations only go off that standard under exceptional circumstances, such as war. This is because war is always prohibitively expensive and thus, can only be financed if fiat money is used. Today, we look with disbelief at such a gross abuse!

Back in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we mentioned that when money is ‘created’, the ?outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom.? Imagine what this $4 billion of cold hard cash is eventually going to do to global liquidity! To see what will become of these monies, let us examine how this massive quantity of physical cash is going to swell the total money supply, which includes bank deposits. Today, we live in a time of fractional reserve banking system. Put it simply, if you deposit $100 into a bank account, the bank is going to lend out a large proportion of your $100 and keep the rest as reserves, in case you decide to withdraw some of your money as cash. The proportion that the bank is going to keep as reserves is the reserve ratio. Let’s say the reserve ratio is 10%. After depositing $100, the bank is going to keep $10 and lend out $90. The $90 that someone borrowed from the bank will again be deposited, resulting in $81 being lent out and $9 keep as reserve. At this point time, how much money has you original $100 multiplied into? In terms of the amount of bank deposits, there are now $100 + $90 + $81 = $271 of ?money? in the financial system. This can go on and on, until the quantity of money swell to the theoretical limit of $1000 (based on reserve ratio of 10%). Thus, for example, a ratio of 5% can swell the quantity of money up to the theoretical limit of 20 times.

The next question is: what is the reserve ratio? We took a look at the Federal Reserve?s requirements on reserve here. Depending on the amount on deposit, the ratio ranges from 0% to 10% (a ratio of 0% means that money can be created by the banks to a theoretical limit of infinity). Anyway, whatever the answer to this question, $4 billion of physical cash will eventually spawn many more times worth of liquidity into the financial system. It certainly would not help in the ?fight? against inflation.

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Posted in Economics/Finance, Geopolitics & Politics | 6 Comments »

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