The World's Long Affair with Gold

Bitcoin will come and go, but speculative trading of this precious metal is here to stay.

After rising steadily since the turn of the century, the price of gold has fallen sharply in 2013, though it is still above its level at the beginning of 2011. What explains the price of gold, and what role is gold likely to play in the world economy in the future? These two questions are closely linked.

But before discussing them, it is helpful to think about two other items, often used as stores of value, that share some of gold’s characteristics: diamonds and bitcoins.

Diamonds, like gold, are attractive to look at and have long been used in jewellery. Also, like gold, diamonds have industrial uses. So, at some level, the value of gold and diamonds reflects their usefulness, as with other commodities.

Admittedly, there’s a sense in which the uses of gold and diamonds for display reflect social conventions rather than the physical properties of these items. At least for casual observers, gold-plated items are indistinguishable from solid gold, and gems made from cubic zirconia look much like diamonds. The value of the genuine item reflects the fact that it is scarce, and costly to produce, so that wearing them is a display of wealth.

But, as the example of diamonds shows, the value of gold in jewellery does not depend on the fact people are willing to accept it as payment for goods and services. Diamonds aren’t suitable as as a medium of exchange, and only moderately useful as a store of wealth, because their value depends on subtle variations in their characteristics, and on the way they have been cut and turned into jewellery. Gold would be valuable for  jewellery even if it had never been used as money.

Now think about Bitcoin, the digital currency that has hit the headlines recently, with wild fluctuations in its market value. Bitcoins are initially produced by running difficult (but useless) algorithmic calculations. By analogy with gold, the producers are called miners. Bitcoins have no value other than their use as a medium of exchange.

The popularity of Bitcoin reflects, in large measure, the belief that bitcoin transactions are untraceable and not subject to governmental control. In reality, as has become evident with the recent shutdown of a large-scale anonymous money exchange, Liberty Reserve, this belief is false. Governments tolerate Bitcoin precisely because its design makes every transaction traceable, even years after the fact. As I have argued previously, Bitcoins will surely become worthless in due course because they have no value outside exchange.

To sum up, gold-based currencies work because gold is inherently valuable, and not vice versa. If it had no value outside its use as currency, gold would be worthless. Nevertheless, where gold is used as currency, its value is greatly enhanced as a result. This is simply a matter of supply and demand.

If some of the stock of available gold is used to make coins, or stored in the reserves of central banks, the amount available for jewellery or for filling teeth is reduced, so the price must rise. At higher prices, some users will find substitutes for gold, or more efficient ways of using it, while more gold mines will become economically viable, increasing the supply.

For a storable commodity like gold, it’s not only current but future uses that matter. So, if the demand for gold is expected to increase in the future, its price will rise today. This fact is crucial in understanding variations in the price of gold over time.

The demand for gold in jewellery and other uses varies over time, but can broadly be expected to rise in line with population and income. Since the total stock of gold is also growing (very little is ever lost, and new gold is being mined all the time), there’s no reason to expect a strong trend in prices.

On the other hand, if gold were to become, once again, the basis of currency, its value would be greatly enhanced.

A rough calculation may help to illustrate. Currently, the U.S. money stock (currency and demand deposits) is about $2.5 trillion. The United States accounts for about 20 per cent of the global economy, but the U.S. dollar plays a bigger role. In particular about $500 billion in U.S. currency is circulating outside the US, which suggests that dollars account for at least 25 percent of the world’s stock of money. For simplicity, assume that the world economy needs a money stock of $10 trillion and that in a fully gold-based economy, half of this would either be gold currency or would be backed by gold reserves.

The total amount of gold ever mined is about 5 billion ounces, but after taking account of industrial and jewellery uses, and losses and scrappage, it is unlikely that any more than 2.5 billion ounces (70,000 tonnes) would be available for monetary purposes. At a price of $2000 a tonne, that would be worth $5 trillion.

On the other hand, if gold ceased to be used as a store of value, and central banks sold their reserves, its price would fall to the level determined by supply and demand in the market for jewellery and other uses. That would probably be something like the value of $400 per ounce observed in the 1990s, a period of low and stable inflation, when central banks were cutting their holdings of gold.  Allowing for subsequent inflation, and the need for holders of gold reserves to earn a return on their investment, that would suggest a current value of $500-600 per ounce.