Why Gold?

There is one and only one reason to use gold as a monetary benchmark: because its value is stable, or at least stable enough that it is very difficult to argue that its value has changed. In other words, it is stable enough that the effects of any changes in gold's value are too small to perceive, thus evidence of such changes is scarce and ambiguous, which is also to say that such changes are too small to disrupt the normal course of business and trade. People have used gold for a very long time. There are ancient mines in the Zambezi river basin of Africa that have been dated to 100,000 BC, which should give archaeologists fits but there it is. Ibn Khaldun, the great 14^th century Arab genius, put it simply enough:

And God created the two precious metals, gold and silver, to serve as the measure of value of all commodities. They are also generally used by men as a store or treasure. For although other goods are sometimes stored it is only with the intention of acquiring gold or silver. For other goods are subject to the fluctuations of the market, from which they [gold and silver] are immune.

--Ibn Khaldun, Al Muquaddimah, c.a. 1379¹

Most people don't really care about gold one way or another. They see it as just another commodity speculation like natural gas or soybeans. The much smaller group of people who have some understanding of gold's monetary role do not seem to have a very firm grasp of why gold has a monetary role. Here are a few reasons put forward:

1) because it can't be counterfeited

2) because it can't be printed on demand

3) because worldwide supply grows slowly, around 2% per year (although that figure has been dropping recently)

4) because it prevents governments from running a budget deficit (Hellooo? Weren't there governments with budget deficits before the end of the gold standard in 1971? At the end of World War II, the US government's debt/GDP ratio was well in excess of 100%!)

5) because it prevents countries having "trade imbalances."

Some of these are mostly true (1,2,3). Some are simply gaagaa (4,5), although that doesn't keep them from popping up in virtually every college economics textbook (5). Nevertheless, whether true or fallacious, none of these factors, or a dozen others one could name, would make gold a good monetary basis if it were not also true that gold is stable in value. Likewise, if gold is stable in value, then it is a good monetary basis, whether or not any of these factors are true or not.

There has been a surprisingly successful movement in Mexico to reinstate silver as the monetary basis of the country. Mexico has a long history of using silver as money, as the country is one of the great silver mining districts of the world and provided bullion for monetary use all over the globe, including Europe and China. When the United States was founded in the latter 18^th century, almost all the money circulating in the country consisted of silver coins from Mexico. Because of this, the "dollar" was defined to be the weight in silver of the common Mexican silver peso, and an amount of gold worth a roughly equivalent value. Many Latin American countries have had dire problems with currency stability over the years, and it is no surprise that many would like their money to be something more substantial than a "trust me" from the government. However, the problem today is that silver is highly volatile in value. In the past it reliably traded at a 15:1 or 16:1 ratio to gold, for centuries at a time, but that has not been the case, for various reasons, since the 1870s. Thus I personally cannot recommend a "silver standard" for Mexico at this time, despite the long and generally positive history of using silver as money in the past.

Another hobby-horse of certain "gold bugs" is the notion that only full-weight bullion coins should be used as money. While one or another small countries might get away with this (not the US), this is quite impossible for the world as a whole (barring economic annihilation and general depopulation) for the simple reason that there isn't enough gold in the world to do it. Actually, that has been the case for about a hundred and fifty years now, which is one reason for the gradual movement toward gold-linked paper currencies in the latter half of the 19^th century. This fringe group argues that, in their future vision, gold will simply become much, much more valuable, perhaps 10x more valuable. Then it would take only 10% as much gold to serve the same monetary duties. Makes sense, right? Of course, the only reason to use gold in the first place is that it doesn't become much, much more valuable, as that would obviate gold's sole attraction of being a stable measure of value. Thus, these plans are inherently flawed, and basically impossible, as I doubt gold's value could be budged very much anyway no matter what one theorist or another would like to argue.

Then, there is another, larger group who focuses on the fact that the supply of gold in the world expands very slowly due to mining, at a rate of 2% (or less these days) per year. I might point out that this is another example of a mistaken attention to quantity rather than value, and is all too similar to Milton Friedman's notion of introducing a Constitutional Amendment to require the rate of growth of "money supply" (mostly short-term credit) to be kept at some figure like 5% per year. Friedman's notion would never have produced a dollar that was stable in value, and indeed would probably have guaranteed that the dollar sink into the mists of oblivion, as the idea would have required by Constitutional Amendment that the dollar be grossly mismanaged. Would you use a dollar if this were the case? Nor would anyone else, as the first mishap -- and the fact that the government was prevented by Constitutional Decree from fixing the problem -- would guarantee that people would find a better currency to do their business with. (For being a "monetarist," Friedman never did grasp monetary matters very well. He owes his reputation mostly to being a champion of liberal "free market" capitalism in general.)

Understand, then: the reason to base a monetary system on gold is that gold's value is stable. Or, at least more stable than anything else we can identify. There is no other reason. You will notice that hardly anyone seems to grasp this today, which is just one more illustration of the very low depths of understanding to which we have fallen.

Nathan Lewis

Nathan Lewis was formerly the chief international economist of a leading economic forecasting firm. He now works in asset management. Lewis has written for the Financial Times, the Wall Street Journal Asia, the Japan Times, Pravda, and other publications. He has appeared on financial television in the United States, Japan, and the Middle East. About the Book: Gold: The Once and Future Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at bookstores nationwide, from all major online booksellers, and direct from the publisher at www.wileyfinance.com or 800-225-5945. In Canada, call 800-567-4797.