Gold is money not because it is scarce but because it is abundant

The Honorable Ron Paul says:

Why is gold good money? Because it possesses all the monetary properties that the market demands: it is divisible, portable, recognizable and, most importantly, scarce – making it a stable store of value.

True. Yet those properties are not the most relevant today. The most important characteristic that makes gold a good reference point for money today is its enormous stock to flow ratio as the recent gold report by Erste Bank points out.

By neglecting the stock to flow ratio argument and using other, less important ones, it is much easier for anti-gold economists to confuse the public. For instance, Paul Krugman and others mercilessly criticize gold by conflating deflation with contraction and inflation with expansion.

Gold is money not because it is scarce but because it is abundant (relative to its production and consumption). This factor makes for a huge buffer that stabilizes its value against other things.

The same can be said about water. Water is abundant on Earth. Water evaporates from the land and oceans, falls down as rain and snow, rivers bring it back to oceans – at widely volatile rates.

Approximately 505,000 km3 of water falls as precipitation each year. But the world’s water supply is estimated at 1,386,000,000 km3 (97 per cent of which is stored in oceans). A huge stock to flow ratio that makes for a useful reference point.

The Erste Bank’s Gold Report concludes:

We believe that gold is not precious because it is scarce, but because the opposite is true: gold is precious because the annual production is so low relative to the stock. The aggregate volume of all the gold ever produced comes to about 170,000 tonnes. This is the stock. Annual production was close to 2,600 tonnes in 2011. That is the flow. Dividing the former by the latter, we receive the stock-to-flow ratio of 65 years (which is far more than for any other good offered in the world economy).

Gold has acquired this feature over centuries, and cannot lose it anymore.

Most commodities are consumed, whereas gold stocks are augmented, gradually.

Let’s suppose then that production of gold increases twofold or is cut in half. No big deal. There is a huge reserve to make up for difference. This does not really apply to any other commodity.

It should be also noted that CPI is a sum of two different and separate things.

CPI has a monetary component and a component related to business cycle.

When too much money is created the prices rise – prices of gold first, then other commodities and liquid assets. The prices of goods that are included in CPI rise thereafter.

But there may be other reasons for a rise in CPI. Let us assume that monetary policy in a given country is OK, but the economy is growing really fast, as was Ireland and Estonia before the crisis. CPI had been rising there due to the (relatively) huge inflow of capital – there was more demand than supply for everything, especially immovable property. Symmetrically, one can get a drop of CPI in a recession.

This is how adjusting interest rates works. Interest rates are not a monetary instrument, but an instrument to effect business cycle. By raising interest rates central banks depress economic activity and force marginal firms out of business. This reduces CPI. Symmetrically, central banks try to revive growth by reducing interest rates in an attempt to bring about an increase in CPI.

Why was there no surge in CPI after such a huge injection of money after September 2008?

There appear two things working in opposite directions here: too much money pushing prices up and severe recession bringing them down. Taken together they made, and are making, for modest CPI increases. In 1970 monetary expansion was much stronger (23X rise in gold prices against 3 fold now) and real economic growth as weak as it was, was stronger than it has been.

This article was previously published at The Gold Standard Now.

8 Comments

  • mrg says:

    Gold is money not because it is scarce but because it is abundant (relative to its production and consumption). This factor makes for a huge buffer that stabilizes its value against other things.

    The same can be said about water. Water is abundant on Earth. Water evaporates from the land and oceans, falls down as rain and snow, rivers bring it back to oceans – at widely volatile rates.

    Approximately 505,000 km3 of water falls as precipitation each year. But the world’s water supply is estimated at 1,386,000,000 km3 (97 per cent of which is stored in oceans). A huge stock to flow ratio that makes for a useful reference point.

    Err … I don’t follow. Surely a an extreme stock-to-flow ratio on its own isn’t sufficient, as the example of water proves. Among other reasons, water is not money because it is far too abundant.

    As for gold having a stable value, that’s not really true over timescales that matter to human beings. If you’d bought gold at the 1980 peak, at the age of 50, you’d be 83 now and still waiting for a real-terms return on your investment.

    • George Thompson says:

      Mr. mrg, Your statement “If you’d bought gold at the 1980 peak, at the age of 50, you’d be 83 now and still waiting for a real-terms return on your investment” needs clarification so that my simple mind can comprehend it. Compared to what? By what measure? I am not invested in Gold seeking a real-terms return on my investment. I am invested in Gold because it is real and not just paper with decipherable ink-stains scattered about it, or worse but a digital mimicry of such paper. Back in 2007-2008 I watched a huge wad of my paper-denominated retirement become depression-era Oklahoma dust on the wind. When, inevitably, the house of fiat currency is collapsed by the huffing and puffing of a big bad bear, those invested in paper will be left with something only of value in toilet tissue scarce Venezuela. I will be left with something that at the least can be used to dent the pointy head of a randomly targeted politician who only excels at putting lobsters in a pot of cold water before bringing it to a slow boil. The ability to so dent is priceless.

    • Craig Howard says:

      Surely a an extreme stock-to-flow ratio on its own isn’t sufficient, as the example of water proves.

      No, you are correct. It isn’t. But added to the other monetary qualities of gold [divisibility, easy to test for purity, recognizable, historically-valued, etc.], the amazingly stable quantity of the stuff really adds to its, um, lustre.

  • Mr Ed says:

    Water may be ‘abundant’ but as the Rime of the Ancient Mariner put it ‘…Water, water every where, nor any drop to drink…’. The quality of the water, chemical or biological contamination, fresh or saline, matters to its value, as well as location. Water is not as fungible as gold, whose very atoms are fungible.

    Gold is precious because (i) people have valued it, and (ii) a lot of people expect that other people will value it, at the point of exchange in the future. They may be wrong, but they are speculating. iPads might become almost worthless should some fantastic device outstrip them in every respect for the vast majority of consumers, but the future is unknowable.

  • chuck martel says:

    A particularly significant advantage of gold as a medium of exchange is that the element itself has no nationality and is beholden to no regime for its legitimacy. An ounce of Philippine gold is no different, in monetary terms, than an ounce of Alaskan gold. The fact that a gold coin is emblazoned with the profile of a long dead sociopath doesn’t reduce its value. This is why gangster-run nation/states abhor gold. They are unable to manipulate its world-wide value, at least for the present.

  • Gary says:

    I contend that the high stocks to flows ratio of gold is precisely because of its monetary properties. People hold large stocks of gold because it is a store of value, ie. it is money and that in turn is due to its unique monetary properties.

  • Krzysztof Nedzynski says:

    Water is like gold in a certain aspect. It is a reference point, for the very reason I described.

    In the 1980 an ounce of gold was $850. Being a reference point says nothing about real-terms returns. It says that is perhaps more sensible to think that something wrong was going on with the dollar and not with gold per se. And it seems to me that it was something very wrong with the dollar. Volcker was giving a try to monetarist formula to increase money suppy by a constant rate which was very inflationary at the time (as the economy was contracting and did not need more money). But the markets soon started to discount Reagan victory and that is why gold declined substantially.

    • Mr Ed says:

      Indeed Krzysztof, the problem with comparing the gold price in $ terms is that the constant inflation of the money supply means comparing $850 in 1980 with $850 today is very difficult.

      Today’s $850 is a considerably smaller sum of money, but it buys things that weren’t around in 1980. I have often heard of 1 troy oz of gold being compared to the cost of a bespoke suit as a fairly constant measure, but by definition to two bespoke suits are the same. It can be used to make comparisons of purchasing power parities on a broad-brush approach, which is simply informative rather than illustrative of any economic principles.

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