http://keithweiner.posterous.com/
The title of this essay is a quote from JP Morgan. Despite being officially vanquished from the financial system, people have not treated it as a barbarous relic or a commodity like frozen pork bellies. My goal in this essay is to explain why.
Gold is a physical good, a commodity. Unlike fiat paper money, gold cannot be debased, requiring through all of history about one gold ounce worth of effort to extract from the ground.
More importantly: gold is what it is. It is not dependant on a counterparty to perform, a government regime to remain in power, or any other future events. If one has an ounce of gold, then one has an ounce of gold, full stop.
And it is an extinguisher of debt. If one borrows real value from someone else, it is important that the debt can be repaid. If one hands to one’s creditor an amount of gold equal to one’s debt, then one has eliminated the debt. If one pays in paper, one transfers the debt to a bank or perhaps the central bank. But the debt is not extinguished, and system-wide debt grows exponentially until its crashes.
There are many physical commodities that cannot be debased, do not depend on a counterparty’s future performance, and which would extinguish debt if used in payment. Why was gold selected?
There are several properties that are desirable for a monetary commodity. While people have used rice or even cattle as money, both are foodstuffs which can rot or degrade over time. Iron would have this problem also.
As the commodity itself is the value, and not some regime’s imprint on it, it must be dividable into the smallest pieces to fit any transaction. It would be highly convenient to be ale to recombine these pieces to prevent the entire money supply being turned into sand. A related characteristic is that any piece is equivalent to any other of equal weight.
Only a metal can meet these requirements. And in particular gold does not tarnish, even slowly. When the next physical requirement is added, gold emerges the clear winner. The monetary commodity should have enough value that one can carry considerable value on one’s person, even over great distances, without the necessity of trusting others.
The last physical requirement is that there must be enough of it that the people can have some. An exotic, unobtainable item is not suitable for use as money.
In fact, gold is the most abundant commodity known to man. One does not measure abundance in terms of absolute mass or volume, but in terms of stocks to flows (inventory to annual production). There is around 80 years of current mine production in human hands. No other commodity (except silver) comes even remotely close, having stocks to flows ratios less than one year.
Economists use the concept of marginal utility. How much less does one want the next unit of a good compared to the current unit. For example, if one is walking through a desert, one wants the first liter of water. And maybe one wants a second and third. But before one gets to 100 liters, one wants no more. Economists say that the marginal utility of water declines rapidly to zero.
What does it say that people have kept 80 years of gold mine production in inventory? The marginal utility of gold does not decline (or if it does, it declines so slowly as not to resemble the decline of any other good). In fact, the marginal utility of gold—the value one places on the next unit—is no lower than the utility of the highest good that one might buy with the gold. Gold’s marginal utility may be higher because one can save gold to buy something next year that is not even available this year.
There is another property, not a physical property, but an economic property that is essential to the monetary commodity. This property is a requirement for the commodity to be actually used in trade. To understand, look at the evolution of money in ancient times.
Before money, there was the problem of “coincidence of wants”. The chicken farmer wants to buy a pair of shoes so he goes to the cobbler. But the cobbler does not want chickens. No direct trade is possible. Most trade is only possible indirectly, i.e. if both parties adopt the use of money. In order for this to occur, one commodity must emerge which is more marketable than all others. Economists define marketability as the efficiency of buying and selling it, i.e. the bid-offer spread. The spread for gold, even today, is the narrowest (around half of the S&P 500).
Two related concepts are liquidity and hoardability. As someone attempts to buy a larger quantity of a good, he lifts the offer. The larger the quantity, the more the offer is lifted. The net effect is that the bid-offer spread widens as the quantity increases (similarly, if one tries to sell a large quantity, the bid is depressed). Liquidity refers to the commodity’s resistance to this spread widening. Gold has the greatest liquidity.
If someone tries to buy or sell a really small quantity, the spread also widens. There are real costs to breaking a commercial-sized lot, and handling costs are almost the same whether one is dealing with a full lot or a tiny quantity. Small quantities are essential to one kind of important economic activity: savings kept by wage earners. Over an entire working career, a wage earner may keep 1% or 5% of his weekly wage. If the spread is wide, then he loses value coming and going. Hoardability refers to a commodity’s resistance to the spread widening as the quantity gets smaller. Nothing has better hoardability than gold, except silver.
In summary, civilization requires money because direct barter trade is too inefficient. Money must be a commodity because only a tangible good can extinguish a debt. Gold was selected over a period of thousands of years as being the commodity which best fit the need for money. If governments repealed the laws that forcibly keep people from using it, then gold will resume its role as money par excellence . There is nothing else like it.
© Keith Weiner, 2011