Sunday, July 22, 2007

The “utility” of gold

Gold and gold stocks seem to be gaining more and more attention among the investing public lately, and for good reason: although they may be overbought in the short term, they have likely started another exciting upleg. Said “attention” is often based on gold’s traditional role as an inflation hedge or as a counter to the declining dollar. More often than not, I read comments along the lines of “It sure is nice to look at, and I wouldn’t mind owning as jewelry, but I just don’t see any investment value in it.”

This post is not for those of you for whom an uptrend in price along is a justification for buying in and of itself, in fact I salute you as a trader. For the rest of us who prefers our investment decisions seasoned with a little logic I want to present a case for the utility of gold.

The real value of base metals is quite apparent. Even silver, the other precious metal, has plenty of industrial uses besides a favorable supply/demand outlook. On the other hand, gold interact with us daily predominantly in the form of jewelry and on rare occasions as an anti-oxidation coating. However, the real use of gold is monetary. Over half of the gold ever mined resides in the vaults of central banks as part of their reserves despite the fact that no country today has a gold backed currency.

To appreciate the utility of gold, we have to first appreciate the utility of money.

Money is evil (an interesting digression)
This is not an uncommon uttering among liberal ideologues. I only want to mention it in the context of this amusing “proof” (apocryphally?) attributed to Albert Einstein:

Proof that women are evil It is well known that Woman takes Time and Money,
==> Women = Time X Money
Since Time is Money,
==> Women = Money * Money = Money2
And Money is the root of all evil,
==> Money = Sqrt[Evil]
==> Money2 = Evil
==>Women = Evil

Ok, now back on topic.

Money is good
This sounds a lot like what Gordon Gekko would say (he actually said “Greed is good”, but I’m sure he’d agree), but there is a lot of truth in it. Money, or the medium of exchange, arose out of necessity as commerce developed beyond the stage of barter. If there are 100 items to be transacted, rather than having to establish 100 * 99/2 = 4450 bartering cross rates, only 100 separate prices (in the medium of exchange) are needed. Further, money comes very handy when exchanging goods across both distance and time. It is no coincidence that some form of money developed in every human civilization that I’m aware of.

Gold as money
Many objects, from salt to rare sea shells, have served as money. But over time, metals emerged as the dominant form of money because they are durable, compact and easy to work with. Among the metals, gold stood out because of its rarity and for thousands of years, gold was the standard against which all other money was measured. Gold won this role by its innate attributes, well before any biblical or Koranic prescriptions. For the majority of human history where there was commerce as we would recognize today, gold (and sometimes silver) had served as a monetary standard. That is, until 1971 when Nixen closed the gold window, making the US$ inconvertible into gold directly.

Problems with gold money
Gold is not without its detractors. No less a respected investor than Warren Buffett has ridiculed using gold as money “digging it out of ground then putting it back”. While it is true that there is a cost associated with mining gold, it goes hand in hand with the non-counterfeitability of gold, by both unscrupulous individuals and governments. Besides, the mining cost is becoming ever miniscule in comparison with the size of the world economy.

The gold (or silver) standard is not an absolute guarantee against big jumps in money supply as new supplies of gold (and silver) could suddenly materialize which was what the Spaniards discovered in the New World. However, today the possibility of such a find is remote and gold remains the only monetary anchor when world governments are inflating their money supplies as far as eye can see. I once said of democracy: human nature being what it is, it’s not a perfect system, just better than the rest. The same can be said for gold money.

The point of this post is to convince you that there is a use for gold, a crucially important one at that. The logic goes like this: Money (medium of exchange) is necessary or commerce, i.e., money is useful. Gold was the chose form of money for much of human history, due to its intrinsic properties. Half of all gold mined remain in central banks’ vaults as their reserves, hence gold remains money today. Therefore, gold maintains a monetary utility.

There are those who claim that one cannot “invest” in gold, since gold is a store of value, one can only “save” in gold. To me that is a matter of semantics. I chose to hold gold because I believe its monetary utility, or value as money, is underappreciated. I’m betting on a more general acceptance of that value which is the essence of value investing.

Other thoughts
There is a persistent misconception that investing in physical gold is costly. As I discussed in my guide to invest in gold and silver bullion, the internet has made owning bullion much easier. One can readily find buy/sell spread of around 5%. Besides, there is a myriad of ETFs that replicate the price movements of gold.

The media has often associated gold’s rise with geopolitical instability, hence gold investors are often compared with Chicken Littles or survivalist kooks. More than once have I heard the line, “if these end-of-the-world scenarios really pan out, better trade in your gold for guns and ammo”. Incidentally, I have no problems with preparing for the worst; I carry plenty of insurances. However, to imply that gold will only function as money in chaos and anarchy is to widely miss the mark. The fact is that gold has never ceased to be money, despite being vilified as a barbaric relic by bankers who nonetheless have never ceased to account for it as a monetary asset. Owning gold has little to do with surviving catastrophic events, but everything to do with guarding against the on-going, persistent debasement of all currencies.

I’ll end with a chart on the trade-weighted dollar index from the St. Louis Fed. A lot of attention has been paid to the regular dollar index which is heavily weighted in the Euro. It has yet broken the long term support at 80. On the other hand, the trade-weighted dollar index, which has much stronger dependencies on Asian currencies, has been in a downtrend since 2002.

Once again, it’s the problem of which yardstick measures what. In the end, what matters is that gold has been rising against all currencies since 2001. That and a little conviction in its utility should make everyone a believer in gold.