Inflation and the Value of Gold Explained
As the story goes, someone asked an economist how his wife was doing, and the economist answered "compared to what?"
Joking aside, this is one of the most important questions one can ask when dealing with many economic problems.
In recent times, with gold reaching all-time highs, we have seen people question the valuation of assets in dollars. Basically, the yardstick used to measure your assets — your house, car, or stock portfolio — is a steadily shrinking one. This makes you wonder whether your savings are really growing in value. In other words, if the value of your savings has doubled, but the price of milk and everything else has roughly doubled, you are not getting ahead. If anything, you will likely have to pay taxes on your supposed "gain," which is no gain at all.
The way the dollar yardstick is being shrunk is by increasing the stock of money, which means that there are more dollars in circulation. Governments do this.
Why would governments want to decrease the value of our money? Well, there are many reasons why this is very advantageous to our masters.
First, creating more dollars is an easy way to pay for government expenditures. If the government wants to pay for wars, bailouts, or their own cushy salaries and perks, they can print the money instead of taking it away from us by force through taxation.
Second, we all know that scarce, desirable goods are more expensive than abundant ones. On the other hand, some goods are so abundant that they are free in spite of their desirability, such as the air we breathe. So by increasing the number of dollars — by inflating the stock of money — the state reduces its exchange value. This is very bad if you are saving money, but it's great for governments because they are usually big debtors.
Unfortunately for us, this process of devaluation can be done until money is completely worthless. It happens easier than you might think, and not only to banana republics but also to mighty countries.
Usually, cheap goods are a good thing. If you increase the amount of wheat available, we will have cheaper bread. The progress of humanity is based on making economic goods more abundant and affordable. The difference with money is that you cannot consume it in the same way you eat bread. Money is there for the sole purpose of exchange, especially when talking about our modern paper currencies. Given this fact, the cheapening of money does not bring about any well-being.
But wouldn't more money make us richer? Not really.
You see, if you were thrown in the middle of the desert, a pile of money wouldn't do you any good. Money only facilitates the exchange of goods and services, but underneath it all, it is the goods and services themselves that are being exchanged. Think of it as a highly efficient and improved barter. If you are a plumber, you don't really need money to live (you can't eat money); money just makes it possible for you to indirectly exchange your plumbing services for groceries. If money weren't there, each time you needed food you would have to find a grocer that was in need of plumbing services so that you could barter your services for food.
So if the amount of money does not determine how rich a society is — if that's determined instead by the actual goods it produces and possesses — why should we object to the government's creation of money? What does it matter to me if milk is $1 per gallon and I make $10 per hour, or if milk is $10 and I make $100 per hour?
The answer to that question is that the creation of money does not affect all prices and wages simultaneously. Analogies are never perfect, but imagine that you have a pool of water (representing the money already in circulation), and that you add additional water to it (representing new money), but to keep track of the new money you add red dye to it. Obviously the red dye will not affect the pool all at once. At first you will have a very visible spot of concentrated red color in the area where the water was added, and it will take awhile for the entire pool to have a uniform color. If the amount of red dye is not huge and the pool is big enough, the final color of the water may not even be very red.
This is basically how new money makes its way into the economy. The initial recipients of the new money — the government and its friends — get to spend it first with the old, more concentrated purchasing power, and as the money makes its way into the economy it gradually dilutes the purchasing power of the entire pool of money. So, in effect, because of this uneven readjustment of prices, in some segments of the population the price of goods will go up before wages do, making these people much poorer.
This creates a shift of capital from some segments of the population to others, while not increasing the total amount of capital.
But, don't we need to make our exports cheaper? No, we don't.
By making exports cheaper through a weakened currency we subsidize our exports. The buyer of our goods in the importing country gets a good deal, the producer of exports sells more products, but this is all paid for by the population at large. Once again, the policy itself produces no increase in capital but only a transfer of it.
But if it creates export-based jobs, it must be good, right?
The problem is that you are subsidizing those jobs, not creating real productive jobs. To pay for those jobs you had to take resources from someone else. That other person was going to consume, save, or invest that money anyway. Shifting resources does not lead to increased capital, which is what ultimately leads to higher real wages.
Until the population realizes what is really taking place, politicians and the mainstream media will get away with rejoicing every time real-estate prices rise, or when the Dow Jones Industrial Average reaches a new milestone. Now, this graph shows the Dow priced in US dollars, our shrinking yardstick. It sure looks good.
How about changing the yardstick for a more stable one? You could use milk, paper clips, or anything you like. Let's use ounces of gold.
The picture is very different indeed. For one thing it shows that the rise in stock prices or any other good denominated in paper currency may not say much about the real value of your investments. You may have invested your money — in any venture — and be thinking that you are making a nice profit when in fact you might be suffering huge losses. This is one of the dangerous consequences of inflation: by distorting prices it increases the amount of entrepreneurial mistakes. Inflation can mask huge losses.
The other important thing that can be learned from this graph is that gold itself varied in its purchasing power. These variations are greatly amplified by the government-created boom-and-bust cycle.
Let's look at gold priced in ounces of silver; this is a historical chart. Look at how erratic the price of gold becomes in the 20th century with the appearance of central banking.
It is commonly said that gold is a stable yardstick, that its purchasing power has not changed since Roman times. It is said that back then an ounce of gold bought you a full outfit with sandals, and that today an ounce of gold will buy you a full suit, shirt, and shoes. It is claimed by many that gold's purchasing power does not change at all, that paper currencies depreciate against it.
While I agree that gold is much more stable than any modern paper currency, I cannot agree that it has stable exchange value. It is true that paper currencies depreciate against gold, but so does any other good whose supply increases.
At times in history, gold itself has seen its supply increase dramatically, as during the Spanish conquest of the Americas. And silver has at times been more valuable than gold, as in ancient Egypt.
The other claim regarding the value of gold is that it has what is called "intrinsic value," which basically means that the essence of gold itself, its nature, gives it value. It is also claimed that because it is hard and costly to mine, this makes it expensive and gives it a "price floor."
Nothing could be further from the truth. All prices are a product of subjective valuations. If nobody wants it, regardless of how much work it takes to produce, or how amazing its properties are, the good will have no value. It is actually the other way around. Because people are willing to pay a high price for gold, it is economically viable to embark in costly mining and production schemes.
The opposite is also true: regardless of how useless a good is, if people want it, its price will be high. Take jewelry-grade diamonds as an example.
The point that is being missed is that gold is a commodity as well as a monetary metal. There is a market for gold outside the monetary realm, and this is an additional component to its value that modern paper currencies do not have. In that sense one could say that gold's value as a commodity gives it that "price floor," or downside protection.
But above all, gold has value because people want it and because it is scarce. It is that simple.