Recently I had a conversation with a friend, who asks me, “why is gold valuable? It is just a metal that people dig it up and bury it again underground. It is not income-generating. You can’t eat it or use it in any productive purpose. Then why do people buy it and invest in it?”
I think he is right in that gold does not have much value as a productive asset. The value of gold, however, comes from it being a globally recognized hard money. Money is what makes trade and division of labor possible. Without money, trade breaks down and society would go back to bartering. That means, if you want food, you have to produce some type of goods or services and trade them with the farmers directly. Therefore, money comes to existence to support indirect exchange.
Being a medium of exchange, there are some attributes that any form of money should have:
1. Durable. Meaning it should last a long time without changing or corroding. Therefore metals like iron would not work because it rusts.
2. Portable. Meaning people can easily carry it. Therefore assets like real estate would not work because one cannot carry land with them to trade. And oil would not work because to carry $700 dollar worth of money in oil means carrying 10 barrels of it.
3. Divisible. Meaning it must be easily divided into small pieces. Therefore valuable stones like diamond would not work because it takes a lot of technology to cut a diamond into smaller pieces, and the value of a diamond decreases exponentially when it is divided.
4. Has limited supply. Meaning that it must be rare and difficult to be brought into existence. Therefore sand would not work because there are abundant amount of it easily accessible to the public.
Throughout human history, gold has been the ideal form of money because it satisfies the above requirements. In modern society, paper money has replaced gold as the medium of exchange. Paper money is fairly durable; it is certainly portable; it is divisible into paper money of smaller face value or coins. The only problem with paper money is that its supply is artificially controlled.
Central banks controls the monetary supply in modern economies and they have the rights to print money. Therefore with undisciplined central banks, the supply of paper money can easily get out of control. When the supply of paper money in an economy increases, the value that existing paper money holds are diluted. This means inflation: prices go up and the same amount of paper money cannot buy as much stuff as before the dilution. When inflation gets out of control, as inflation usually breeds more money printing and more inflation, trading with paper money breaks down. Who would want to offer their products or services for pieces of paper that lose value the next day? But then, how can anyone survive in today’s society if trading reverts to bartering? And thus, people would start to use gold and would only accept gold as payments.
That’s the value of gold. Even though it is not used as money today, it reflects the risks of a complete break down of the paper money currently in circulation.