Monday, May 31, 2010

Paper Money Versus Gold

Tim Iacono takes on the gold critics, including Warren Buffet who said gold has no utility. He argues that gold critics tend to ignore the weaknesses of paper money including its poor record of storing value. See the following post from The Mess That Greenspan Made.

How can you write an entire article that bashes gold (e.g., how it has no intrinsic value, pays no dividend, etc. ) and not once mention the negative attributes of paper money – what replaced gold for good (supposedly) about 40 years ago?

Really! Think about it for a second. You can’t.

Why? Because once you start talking about how you don’t really need a gold standard or anything backing a currency so long as governments and central banks act prudently, you realize that governments and central banks are completely incapable of doing so over long stretches of time and the end result will always be the destruction of the currency.

But that’s what Brett Arends does in this report on investing in gold and, in the process, he quotes famed investor Warren Buffett who also seems to be deficient in this area:

Warren Buffett put it well. “Gold gets dug out of the ground in Africa, or someplace,” he said. “Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

It’s a currency “substitute,” but it’s useless. In prison, at least, they use cigarettes: If all else fails, they can smoke them. Imagine a bunch of health nuts in a nonsmoking “facility” still trying to settle their debts with cigarettes. That’s gold. It doesn’t make sense.
Honestly, the Wall Street Journal has been one of the more enlightened mainstream media outlets when it comes to gold, but this really sets them back a few notches in my view.

This is like something that you’d read in Money Magazine.

With the help of Wikipedia, let’s review what’s sorely missing from this story by recalling the most important attributes of “money”, whether its pure fiat money or dumb ‘ol gold coins.

Medium of exchange
When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange. It thereby avoids the inefficiencies of a barter system, such as the ‘double coincidence of wants’ problem.

Unit of account
A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a “measure” or “standard” of relative worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of commercial agreements that involve debt.

* Divisible into smaller units without loss of value; precious metals can be coined from bars, or melted down into bars again.
* Fungible: that is, one unit or piece must be perceived as equivalent to any other, which is why diamonds, works of art or real estate are not suitable as money.
* A specific weight, or measure, or size to be verifiably countable. For instance, coins are often made with ridges around the edges, so that any removal of material from the coin (lowering its commodity value) will be easy to detect.

Store of value
To act as a store of value, a money must be able to be reliably saved, stored, and retrieved – and be predictably usable as a medium of exchange when it is retrieved. The value of the money must also remain stable over time. In that sense, inflation by reducing the value of money, diminishes the ability of the money to function as a store of value.

While paper money does exceedingly well as both a medium of exchange and a unit of account, when governments and central banks are given free reign with a nation’s currency, it functions horribly as a store of value, a point that, somehow, is glossed over in every single negative story about gold.

Arend’s report uses the word “value” twice, first noting that “gold is hard to value”. Duh!

Then, the author does what every other gold-basher does and cites what happened in 1980 – when Fed chairman Paul Volcker crushed the gold price (along with inflation) by raising interest rates to almost 20 percent.

As for being a “store of value,” anyone who bought gold in the late 1970s and held on lost nearly all their purchasing power over the next 20 years.

Yes, the next twenty years were not kind to gold investors but they are not representative of the other 6,000 years since Man discovered the yellow metal, a period that is also notable for the dearth of responsible central bankers and elected officials.

As for Buffett’s comments, I suspect Martians – or any life form more advanced than ours – would be far more surprised that there is nothing backing any currency on this planet than they would be that a scarce commodity was used as money. They’d scratch their heads and say, “How do you prevent the government from printing too much of the stuff?”

This article has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

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