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| Picture Courtesy: digitalmoneyworld at flickr.com |
There are many sites and books that cover the concept of money or currency and its journey since medieval times. I will try and cover it in brief for the benefit of everyone. When civilizations developed, people specialized in various skills and they exchanged the goods they produced with others through a system called barter. If some one produced rice and wanted fruits, they would exchange rice with the person that produced fruits. They could exchange it for some service like say haircut as well. While this continued for sometime, as trade increased it was difficult to barter as it brought limitation due to economies of scale. So, they switched to some other things that everyone considered valuable. Things that were used ranged from sea shells to exotic and rare stuff to heavy stones. Slowly due to whatever reason, the only exchange that became commonly accepted while trading internationally was precious metals like gold, silver etc. with gold leading all metals because of its scarcity. This was going for many many years.
When countries like US, Spain etc. found and mined lot of gold, they became rich because they had the reserves. It became very difficult to carry these precious metals across the country for trade because of its weight as well threat of robbery. So, some of the bankers came up with an idea of IOUs in form of receipts (IOU is abbreviated form for I Owe You) which are almost like travellers checks. If you have say 100 grms of gold, you could deposit your gold and get a receipt and then just carry that receipt with you. When you buy the goods, you can just sign and give that receipt to another person who then can go and redeem that receipt with the bank any time and get back gold. So, the receipts became paper money which derived its value from the gold that was kept in bank.
Some of the bankers got greedy and started issuing more IOUs than the gold they have as they found that not all the gold is redeemed by people and they only were trading the IOUs which moved from one person to another. However, people got suspicious and they started lining up at the bank to redeem gold which led to classic bank run. Banks did not have gold to backup IOUs and went bankrupt.
To avoid such things, central bank concept was created and only the central bank could issue IOUs based on the gold that they hold as reserve. There are lot of conspiracy theories around FED creation but this is out of scope of this article. US had the biggest gold hoard and other countries also kept their gold stored in US fearing invasion by other aggressive European countries. The FED created dollar as the IOU and the old dollars clearly mentioned that you can redeem it for gold anytime. During great depression (around 1930s), the FED could not increase money supply as the currency was pegged against gold and they could not increase the reserve. Franklin Roosevelt was the president then and he signed an order to confiscate all the gold that was with the public and US collected all the gold from public and kept it at Fort Knox. After collecting the gold, US then pegged the official value of gold higher and then issued more currency. In 1944, US signed Bretton Woods agreement with all their major trading partners.Dollar as a currency was acceptable because it had underlying value based on the gold it held. All other countries that did not have enough gold as reserves, pegged their currency against dollar as dollar was pegged against gold and it made sense. So, slowly from gold being a reserve currency, dollar became the reserve currency for all central bankers around the world.
Things went on until 1971 (Year I was born). Most of the trading partners of US got suspicious about dollar and started giving back the dollar and redeeming gold instead. This almost created another bank run and Nixon ended the Bretton Woods agreement and said that gold will not be redeemed against dollars. He made dollar a complete fiat currency which did not have any backing. Imagine if your banker says that the paper statement that he gave you based on the money you kept with him cannot be redeemed for money. Anyway, US being a major contributor to world economy could do that and dollar became a free floating currency. All other central bankers followed suit and now everyone has fiat currency with no underlying real reserves. Mostly of the central banks reserves are other currencies like Dollar, Euro, Yen etc. Its like one paper backed by another.
Till date, I have heard many people say that all the central banks issue currency based on only the amount of gold it holds. This is not true and all central banks have been out of this gold backing for about 41 years now. Since the gold peg is removed, central banks print as much paper money as they want with only paper and ink being the cost. There has been multiple crashes where the general public were taken for a ride due to money printing by these central bankers ever since. If you want a sneak peek of these horror stories google or bing hyperinflation and you will see a lot of example like Weimer Republic of Germany, Roman Empire, Argentina (multiple times), Zimbabwe etc. They continue to print money as long as you and me have faith in it. Now they cost of paper and ink is also gone. It only takes a few clicks of mouse and voila the amount gets deposited and no real money is printed. No, wonder the central bankers (read Mr. Bernanke) say there is no cost to this massive printing. But the actual cost will be felt when everyone understand what is going on.
Since 2008, all central banks have been on steroids with regards to money printing and all are competing to win the ugly contest. While big and deleveraging economies like US, Japan, Europe etc do not have inflation currently, others who have smaller economies but not deflationary like India and China have already faced rising inflation.
This participation in ugly contest by the central bankers is the reason gold went up as sensible investors (including some smart central banks) knew what was going on and started accumulating gold. The price could have shot a lot due to this in short term. Long term only time will tell who is going to have the last laugh.
If you take Indian Rupee and try to buy something in Thailand, good luck with that. If you take US dollars and go to a remote village in India and try to buy something, chances are very high that it will not be accepted (US has the highest acceptance amongst fiat currencies across the world). However, if you have gold, you are sure to trade it with any other asset or service you want anywhere in the world.
Gold may be a barbaric relic, it may not be a productive asset and it may be very volatile but no one can debate the fact that gold has the longest record as currency and fiat currencies have increased the frequency of crashes and pain to the general public. If gold is useless, why are the central banks still hoarding it and in fact buying more? Why is it the German Supreme Court asking its government to get back the gold from US and keep it with them. It had also asked them to test the gold to check the purity.
As far as I am concerned, gold is the real currency and it has all the attributes of a currency. Paper currencies neither have a long history nor a good track record. This is not an opinion, it is a fact. While gold has corrected recently, if you look at how it performed against all currencies in the past 10 years the minimum appreciation of gold is 10% per annum in Australian Dollars and maximum of 15.6% per annum against GBP and Indian Rupee. You can find this information at goldprice.org. Gold may under perform and lose value against all other fiat currencies provided they stop printing and the productivity / economic output increases. Otherwise, it will continue to remain our best hedge against paper currencies.
I hold gold as a insurance. When we buy insurance, we buy it to protect it from any big shocks in our life. Insurance is a cost and we should not seek profit from it. We should buy insurance and pray that we never get to use it (since it gets paid only when there are unbearable losses). Similarly, we should buy gold as an insurance against world fiat currency system. Never expect gold to give you returns. Personally, I intend to hold atleast 5% of my entire liquid networth in gold. What is your threshold ?
