My two “Gold Is Not Money” articles (HERE and HERE) provoked numerous disagreeing responses, the majority of which were polite and well-meaning. Despite presenting various arguments, these responses had one thing in common: they did not offer a practical definition of money that gold currently meets. As I mentioned previously, a practical definition of money cannot avoid the primary economic role of money, which is to facilitate indirect exchange*. If something is not generally used to facilitate indirect exchange, then regardless of what other attributes it has it cannot be money; at least not in the way that money is commonly understood today and has been commonly understood through the ages. When people willingly perform logical contortions in an effort to show that something is money even though it doesn’t fulfill the primary role of money, all they are actually showing is the lengths to which they are prepared to go to ignore a reality that is not to their liking. Would gold perform the monetary role far better than the US$ and any of the other monies in common use in the developed world today? Yes. Would I rather that gold was money today? Yes. Is gold money today? Unfortunately, no. However, the main purpose of this post isn’t to rehash the reasons that gold can no longer be correctly viewed as money in any developed economy. It’s to consider the claim, which was made by more than a few of the respondents to my “Gold Is Not Money” posts, that gold is an economic constant.

Such a claim ignores good economic theory. Gold, like all of the elements, is a physical constant, but there is no such thing as an economic constant or yardstick. The reason is that value is always subjective. Every individual will have his/her own opinion on what gold is worth and these opinions will change based on circumstances.

Currently, most people in the Western world own no gold and have no intention of buying gold. This will change, but the reality is that gold is presently very low on the ‘utility scale’ of the average person. At the same time, there are plenty of people who place a high value on gold, which is why gold’s price is what it is.

The market price at any time reflects the collection of all the differing opinions about value, but the market price is constantly changing. The market price, therefore, does not measure value in the way that the mass of a physical quantity can be measured.

The claim that gold is an economic constant also ignores the historical record. For example, there has been a large decline in gold’s purchasing-power (PP) over the past 4 years. Prior to that, there was a huge gain in gold’s PP during 2001-2011, a huge decline in gold’s PP from January-1980 through to early-2001, and a spectacular rise in gold’s PP during 1971-1980. Over the same period the dollar’s PP has been vastly more stable, although certainly far from constant.

It could be argued that the large swings in gold’s PP over the past 45 years are due to changes in the perception of the official monetary system. This is true — the perceived value of gold as an investment or a speculation or a vehicle for saving has undergone large oscillations over the past 45 years due to changing perceptions of the US$ (money in the US). These oscillations are secondary evidence that gold is no longer money in the world’s largest economy, the primary evidence being that it isn’t generally used as a medium of exchange.

It should also be understood that gold was not an economic constant even when it was money. In general terms, even the best money imaginable would not be an economic constant, because even if its supply were kept constant its demand would be continually changing. Again, we stress that there is no such thing as an economic constant (an UNCHANGING quantity against which everything else can be measured).

When gold was money neither its supply nor its demand were ever constant over what most people would consider to be a normal investment timeframe or holding period, although it still performed admirably in the monetary role. It would have performed even better — and its reputation would not have been unfairly tarnished — if fractional-reserve banking had not been permitted. Fractional-reserve banking was to blame for the financial crises that occasionally erupted during the Gold Standard era.

Over extremely long periods the swings in gold’s PP have evened-out in the past, but something that starts at a certain level and can be relied on to return to that level at some unknown point in the distant future cannot be legitimately called a “constant”. Moreover, to be useful as money it isn’t necessary that something maintain relatively stable purchasing power over centuries; it is necessary that it maintain relatively stable purchasing-power from one year to the next.

Something won’t survive as money if it tends to experience wild swings in its purchasing-power over periods of a few years or less, but it can survive as money if its PP can be relied on to change by no more than a few percent in either direction from one year to the next. There is no need for money to have constant PP to remain useful as money, which is just as well because economic constancy is an impossible dream.

*Here’s what I mean by “indirect exchange”. In an economy without money a tomato farmer who wanted bread would have to find a baker who wanted tomatoes. A direct exchange of ‘wants’ could then take place. However, in an economy with money a tomato farmer who wanted bread could sell his tomatoes to anyone in exchange for money and then use the money to buy bread. This is an indirect exchange of ‘wants’, with money providing the link.

Early last year I gave banking behemoth Goldman Sachs (GS) credit for looking in the right direction for clues regarding gold’s likely performance, which is something that most gold bulls were not doing. In November I again gave them credit, because, even though I doubted that the US$ gold price would get close to GS’s $1050/oz price target for 2014, their overall analysis had been more right than wrong. It was clear that up to that point the US economy had performed better than I had expected and roughly in line with the GS forecast, which was the main reason that gold had remained under pressure; albeit, not as much pressure as GS had anticipated.

But this year it was a different story. Here’s what I wrote in a TSI commentary in January-2015:

“This year, GS’s gold market analysis begins on the right track by stating that stronger US growth should support higher real US interest rates, which would be bearish for gold. Although we expect that the US economy will ‘tread water’ at best and that real US interest rates will be flat-to-lower over the course of this year, GS’s logic is correct. What we mean is that IF the US economy strengthens and IF real US interest rates trend upward in response, there will be irresistible downward pressure on the US$ gold price.

However, the analysis then goes off the rails. After mentioning something that matters (the real interest rate), the authors of the GS gold-market analysis then try to support their bearish case by listing factors that are either irrelevant or wrong. It actually seems as if they’ve taken the worst arguments routinely put forward by gold bulls and tried to use the same hopelessly flawed logic to support a bearish forecast.

For example, they argue that the demand for gold will fall because “inflation” levels are declining along with oil prices. They are therefore unaware, it seems, that “price inflation” has never been an important driver of the gold market and that the latest two multi-year gold rallies began with both “inflation” and inflation expectations low and in declining trends. They also appear to be unaware that the large decline in the oil price is very bullish for the gold-mining industry.

Their analysis then gets even worse, as they imply that the price weakness of the preceding three years is a reason to expect future weakness, whereas the opposite is closer to the truth. They go on to cite outflows from exchange-traded funds (ETFs) and reduced investment in gold coins as bearish influences, apparently unaware that the volume of gold coins traded in a year is always too small to have a noticeable effect on the price and that the change in ETF inventory is a follower, not a driver, of the gold price.

Finally, just when it seems as if their analysis can’t possibly go further off track, it does by asserting that lower jewellery demand and a greater amount of producer hedging will add to the downward pressure on the gold price. The facts are that jewellery demand has always been irrelevant to gold’s price trend and that gold producers are part of the ‘dumb money’ (meaning: they tend to add hedges at low prices and remove hedges at high prices, that is, they tend to do the opposite of what they should be doing based on gold’s intermediate-term risk/reward).”

I concluded by stating that in 2014 the GS analysts were close to being right for roughly the right reasons, but that in 2015 they could not possibly be right for the right reasons. They would either be right for the wrong reasons, or they would be wrong.

At this stage it looks like they are going to be wrong about 2015, but not dramatically so. My guess is that gold will end this year in the $1100-$1200 range, thus not meeting the expectations of GS and other high-profile bears and at the same time not meeting the expectations of the bulls. However, GS is on record as predicting a US$1000/oz or lower gold price for the end of next year. I think that this forecast will miss by a wide margin, but I’m not going to make a specific price forecast for end-2016. Anyone who thinks they can come up with a high-probability forecast of where gold will be trading 15 months from now is kidding themselves.

Officially, the US has a fractional-reserve banking system (as does almost every other country), meaning that a fraction of deposits are backed by cash reserves held in bank vaults or at the Fed. In reality, the US has a zero-reserve banking system.

I don’t mean that there are no reserves in the banking system, as currently there are huge reserves courtesy of the Fed’s QE programs. What I mean is that there is no relationship between bank reserves and bank lending and that bank reserves do not impose any limit on bank deposits. It has been this way for about 25 years.

To further explain, the most important aspect of a fractional reserve banking system is that a bank can create new deposits by lending out existing deposits up to the point where its total deposits are a predetermined multiple of its reserves. The aforementioned multiple is called the “money multiplier” and the maximum “money multiplier” is the reciprocal of the minimum reserve requirement. For example, in a system where a bank’s reserves are required to be at least 10% of its total deposits, the potential “money multiplier” is 10. In the current US system, however, there is effectively no lower limit on reserves, which means that the so-called “money multiplier” can correctly be thought of as either non-existent or infinite.

Regardless of their deposit levels, US banks are able to reduce their required reserve levels to zero. This is possible for two reasons. First, only demand deposits are subject to reserve requirements. Second, banks employ software that shuffles money between accounts to ensure that they fulfill the regulatory reserve requirement regardless of their actual deposit and reserve levels. For example, you might think you have a demand deposit, but for regulatory purposes what you might actually have is a zero-interest CD.

The absence of any relationship between US bank reserve levels and US bank credit is illustrated by the following chart. The chart compares total US bank credit and total bank reserves (vault cash plus reserves held at the Fed) from the beginning of 1989 through to mid-2008 (just prior to the start of the QE programs that swamped the normal relationships). During this period, bank credit shot up from $2,400B to $9,000B while total bank reserves oscillated between $50B and 65B. Notice that the volume of bank reserves was actually a little lower in 2008 with bank credit at $9.0T than in 1989 with bank credit at $2.4T.

An implication, even prior to the QE programs that inundated the banks with reserves, is that the US fractional-reserve banking system will never go into reverse due to a shortage of reserves. In other words, US banks will never contract their balance sheets due to a lack of reserves. Another implication is that having a huge pile of “excess” reserves will never cause banks to expand credit. Instead, regardless of their reserve levels banks will expand or contract credit to the extent that their overall balance sheets can support additional leverage and they can find willing/qualified borrowers.

I opened a blog post on 7th October with the statement that gold was money in the distant past and might again be money in the future, but isn’t money in any developed economy today. I then explained this statement. The post stirred up a veritable hornet’s nest, in that over the ensuing 24 hours my inbox was inundated with dozens of messages arguing that I was wrong and a couple of messages thanking me for pointing out the obvious (that gold is not money today). The negative responses were mostly polite*, but in many cases went off on a tangent. Rather than trying to respond individually, this post is my attempt to rebut or otherwise address some of the comments provoked by the earlier post on the same topic.

In general, the responders to my earlier “Gold Is Not Money” post made the same old mistakes of arguing that gold is an excellent long-term store of value, which is true but has nothing to do with whether gold is money today, or confusing what should be with what is. Some responders simply asserted that gold is money because…it is. Not a single responder provided a practical definition of money and explained how gold fit this definition. That’s despite my emphasis in the earlier post that before you can logically argue whether something is or isn’t money, you must first have a definition of money.

Due to the fact that many different things (salt, tally sticks, beads, shells, stones, gold, silver, whiskey, pieces of paper, etc.) have been money in the past, a reasonable definition of money MUST be based on money’s function. Also, the definition must be unique to money. In other words, when defining money you must start with the question: What function does money perform that nothing other than money performs?

“General medium of exchange”, meaning the general enabler of indirect exchange, is the function performed by money and only by money within a particular economy. Now, there are certainly pockets of the world in which gold and other items that we don’t normally use as money in our daily lives do, indeed, perform the monetary function. For example, there are prisons in which cigarettes are the most commonly-used medium of exchange. It is certainly fair to say that cigarettes are money within the confines of such a prison, but I want a definition that applies throughout the economy of a developed country. Gold is not money in the economy of any developed country today, although there could well be small communities in which gold is money.

I’ll now address some of the specific comments received in response to my earlier post, starting with the popular claim that there’s a difference between currency and money, and that although gold is no longer a currency it is still money. The line of thinking here appears to be that currency is the medium that changes hands to complete a transaction whereas money is some sort of esoteric concept. This is hardly a practical way of thinking about currency and money. Instead, it appears to be an attempt to avoid reality.

A more practical way of thinking about the difference between currency and money is that almost anything can be a currency whereas money is a very commonly-used currency. In other words, “currency” is a medium of exchange whereas “money” in the general medium of exchange. The fact is that gold is sometimes used as a currency, but it is currently not money.

Moving on, some people clearly believe that gold is money because the US Constitution says so. Actually, the US Constitution doesn’t say so, as the only mention of gold is in the section that limits the powers of states and is specifically about the payment of debts, but in any case this line of argument is just another example of confusing what should be with what is. The bulk of what the US Federal Government does these days is contrary to the intent of the Constitution.

Some people apparently believe that gold is money (or money is gold) because JP Morgan said so way back in 1912. My response is that JP Morgan was absolutely correct. When he made that statement gold was definitely money because at that time it was the general medium of exchange in the US. However, today’s monetary system bears almost no resemblance to the monetary system of 1912. For example, when JP Morgan said “Money is gold” the US was on a Gold Standard and the Federal Reserve didn’t exist.

Several people informed me that gold must be money because some central banks are buying it or holding it in large quantities. OK, does this mean that something is money if central banks are buying/holding it regardless of whether or not it is being used as money throughout the economy? If so, then Mortgage-Backed Securities (MBSs) must now be money in the US because the Fed has bought a huge pile of MBSs over the past few years, and T-Bonds must now be money throughout the world because most CBs hold a lot of T-Bonds. Obviously, something does not become money simply because CBs hold/buy it.

A similar mistake is to claim that gold must be money because major clearing houses accept gold as collateral. The fact is that the same clearing houses also accept the government bonds of most developed countries as collateral. General acceptance as collateral clearly does not make something money.

Lastly, some readers came back at us with the tired old claim that gold has intrinsic value whereas the US$ and the rest of today’s fiat currencies don’t. At the risk of seeming arrogant, you can only make such a claim if you are not well-versed in good economic theory. All value is subjective, which means that no value is “intrinsic”. Most people subjectively assign a high value to gold today, but they also subjectively assign a high value to the US$. In any case, even if the “intrinsic value” statement had merit it wouldn’t be a valid argument that gold is money.

In conclusion, gold is something that is widely perceived to have substantial value. Furthermore, good arguments can be made that its perceived value will be a lot higher in a few years’ time. However, it is currently not money.

*Those that weren’t polite have had the honour of being added to my “blocked senders” list.