Friday, September 22nd, 2017 MST

The demand for gold and the demand for money

The demand for gold is largely driven by people’s desire for jewelry and artistic creations from the pure, soft metal.  This is particularly important in Asian countries such as India where it plays a strong role in the culture and religion.

But as we also know, from the reports by Vietnamese “boat people” who escaped the Communists after 1976, and stories from Europe after the Holocaust, the use of gold to buy escape and safety was critical.  This second source of demand can be expected to grow stronger in the future.  I am not predicting the collapse of America, but the science of economics teaches us some important facts about this essential “safety” demand for money.

Economists have asked, if cash money does not pay any interest, why should anyone hold cash?  Even bank savings accounts and liquid money market funds hardly pay interest these days.  Why do people keep sums in cash?  Aside from the obvious motives, to hide it from tax collectors, legal judgments, and ex-spouses, having a certain cash balance in your pocket or in your bank account is what we all prefer.  Even with a pocket full of credit cards, many of us want to have a few coins and paper money there too.  Economists call this “the precautionary demand,” since nobody knows what can happen later today, much less tomorrow, and a little bit of cash can come in handy.

With modern technology, the precautionary demand for money has been going down for years.  Today we have lots of “money substitutes” and we use them – particularly electronic payments, including debit cards and on-line bill payments.  The only detail about “money” that is used this way is its NAME (“dollar”) because what is actually paying your bills is just some bookkeeping by your bankers.  Real money is not used.

This brings us to the precautionary demand for gold.  It used to be said in basic economics class that money is also a “store of value.”  The idea is if you have a $20 bill today, it will still be worth $20 tomorrow and next week, so you can store its value in your pocket.  This is today a smaller and smaller part of the demand for money because other assets and investments might actually pay interest or dividends.  This all depends on how “liquid” those other assets and investments might be.  Some people like the idea that a $20 bill is still worth $20 years from now, but more and more people understand that the dollar is shrinking.

This is a graph of the value of one dollar in terms of milligrams of gold.

dollar-graph

A graph of the price of oil or houses would show the same decline in the value of one dollar although the shape of the graph would be different for every asset.  The trend is still downward.  It is called “money illusion” when someone believes a $20 bill will hold its face value over time simply because the portrait of Jackson and the printed digits do not change.

The key to demand is “substitution”

Most things we buy have substitutes.  Different brands of gasoline or food items are close substitutes.  Competition among substitutes determines what a competitive price will be, and a monopolist has power because it can get government to forbid substitutes.  When telephone service was provided by a monopoly, its prices were much higher than today.  When government tariffs keep Korean steel out of the U.S. market, the price of steel is higher for anyone who needs it and clever users of steel will move their factories outside the country to pay the lower world price.  The tariff affects all imported steel, so leaving the country is the substitute.

Many substitutes are not close, but they exist.  The substitute for driving to work is walking, riding a bicycle, a horse, or taking a bus.  Sometimes your substitute for something very expensive is not to buy it at all, or at least to wait to afford it.

What is the substitute for one dollar in your pocket?  A close, but not perfect, substitute is one dollar in your bank account.  Another substitute is the credit card, which lets you use a pre-calculated loan to buy things.  The issue with substitutes is always “how close” or “how convenient” do they get you the same result as the dollar in your pocket?  As the chart of the value of dollars in terms of gold shows, over time the dollars are not a good store of value.  Most substitutes for your dollars are also denominated in “the name” of the dollar, so they only store your value if they keep up with the devaluation of the dollar.  There is no guarantee of that.

Readers do not need to be told how effective gold and silver have been as “store of value” investments over the centuries.  Indeed, as a substitute for money, gold has performed very well. Investment advisors, who receive commissions from buying and selling assets tell you, “Gold does not pay interest,” but today even your dollar-assets hardly pay interest.  And dollar-assets do decline over time just as the dollar itself depreciates.  Any “store of value” has to hold the value so you can sell or trade it in the future and still find its relative value in terms of other goods, like gasoline or food.  Gold has shown it is almost a constant over 200 years in terms of trade value for other real goods and services.

The future value of anything, including the dollar, will be determined by what anyone will give you in trade for it.  As money becomes less and less useful as a store of value, people will look for substitutes and the relative price of the best substitutes will go up faster than other substitutes.  You can save for the future by investing in a warehouse full of commodities, which your family can use in case the stores all close, but an easier substitute might be a small pile of gold or silver coins.  You just need to make sure you can trade them for the commodities, and that is another article – about “liquidity.”

The bottom line is the dollar-price of gold will increase faster than the average loss in value by our government money, because people will increasingly find its long-term store of value more attractive.  Gold is such a close and nearly perfect substitute.

Joe Cobb was staff economist to Ron Paul in the 98th Congress.  He drafted the legislation, introduced by Ron Paul, to create the American Eagle gold bullion coinage.  This became Public Law 99-185 on December 17, 1985.  Joe Cobb is an advocate of replacing government currency with private alternatives and abolishing the Federal Reserve System.

One Response to “The demand for gold and the demand for money”

  1. Joe Cobb

    In June, in my comment “Should Government Abolish It’s Paper Money?” we questioned the idea, from a Financial Times article by Prof. Ken Rogoff. He wanted to make it possible for the Federal Reserve to impose “negative interest rates” on the economy, and buying currency would always be an escape for people who didn’t want to receive “negative interest” payments.

    I was disappointed no one came back with the offer to create a substitute paper currency, in small denominations. How about a paper “5 Cent” silver ounce (= 5 x .01 x Ounce .9999 Ag). All kinds of denominations might be more useful. The only difference between these “payments currency” and payments cards is that cards use an Internet linking system. I half expected Bill Haynes to offer this new product, since CMIGS could always redeem the tokens.

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