Monday, February 7, 2011


For the last few thousand years and without a lot of economists or central bankers needed to officially proclaim it, gold has been the most widely-used form of money. This is because it meets all the criteria: it's easy to divide, hard to create more out of thin air, is the same everywhere you go, lasts forever, and you wouldn't want to eat it. Once gold is generally accepted as money, you know that the gold coin you took in today will be worth about the same when you go to buy something with it later. In fact, the value of gold - what it can be exchanged for - is amazingly consistent over time. Goods like a house or a bushel of wheat cost, in gold, roughly the same now as they did hundreds of years ago. Try that with dollars.

The last 40 years has been the only time in human history where practically all of the world's money has been backed by nothing more than government promises, instead of something real like gold. The currency system we have now is actually a very new experiment and is quite different from the way things have usually been done.

If you want to see the US dollar experiment in numbers, go to and check out the US Official Price and New York Market Price between 1800 and 2009. You'll notice a few interesting things. The first is the official and market price were amazingly similar for most of this period; this is because the dollar was literally convertible into gold, so there was no need to have a premium. For a few years around times of war, there was a slight premium. The official rate jumped once during the great depression as FDR set a new price (basically a one-time cash grab). He also made it illegal for citizens to own gold, so the market price during this time may not be a true indication. But in 1968 things get interesting. After 20 years of Bretton Woods (US dollar backed by gold, every other world currency tied to the USD), the French started getting suspicious that the gold was actually there, and had the nerve to ask for some in exchange for their US dollars. A couple of years later, Nixon decreed that nobody could convert USD into gold - look at the market price of gold after that. All hell breaks loose as the market tries to figure out what a dollar is worth, after about 200 years of the stability of gold.

Not so coincidentally, during the last 40 years the US has increased their money supply by a factor of 20. This is what happens when you go from the discipline of a hard currency, where you have to back up its worth with something tangible, to a fiat currency. ["Fiat" is not an attempt to insult a currency by comparing it to a repair-prone Italian automobile. It is Latin for "let it be" or "let it be done", as in fiat lux - let there be light. The idea is that it is created out of thin air.]

According to the official inflation rate, a dollar in 1971 would be worth about 18 cents today. So this represents about a five-fold drop in the dollar. Why not twenty-fold? Good question - I'm not sure. Part of the answer probably has to do with the "official" inflation statistics. The government has strong incentives to underreport inflation, so that it doesn't have to pay higher cost-of-living adjustments and also so people generally think things are sunnier than they may in fact be. Just why is food not included in the calculation? John Williams at has the best information about this and is a highly recommended read.

It's also possible that the world has spent the last 40 years trying to discover what a dollar is worth, and it's a moving target that we may not have caught up to yet. Maybe there's still another 75% drop in the dollar's purchasing power yet to come. And this is assuming the money supply does not keep increasing, which it almost certainly will. That's what quantitative easing is: creating money - lots of it - out of nothing.

If I had to choose something to bury in a metal box in my backyard that I wouldn't dig up for ten years, it would be gold, not paper currency. Cash has a good chance of declining in value, perhaps by quite a bit. Gold could go up or down, but given it's history over a few millennia it will probably have the same purchasing power ten years from now. In this sense gold isn't really a speculation, it's more of a conservative way to try to safeguard your wealth. The really risky thing to do is to leave a huge amount of cash in the bank. Even if inflation is modest the value of those dollars slowly evaporates; if inflation is not so tame, the decline is not so slow. Just ask anyone who had a bank account in Argentina ten years ago.

Gold is ingrained in many cultures as wealth, and it's unlikely that Chinese or Indians will wake up one day and no longer value gold. Jewelry buying is essentially saving in these countries, just like the primary function of the family silver was not its utility as eating utensils, but as portable wealth. Gold should continue to hold its value while fiat currencies, well, probably won't.

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