Indian shoppers look for gold jewellery and ornaments. (NARINDER NANU/AFP/Getty Images)
Snapshot
  • The act of hoarding, whether it is money or gold, depresses economic activity. In successful societies of the world, very few invest in gold and even the holding of gold jewellery is minimal relative to their wealth or income.

I read Shanmuganathan Nagasundaram’s (SN) article, “Gold Can Help India Set Global Agenda On Monetary Policy”, with great fascination and despair. The article is replete with misconceptions about fiat money, gold, and the role of state in a successful society. Contrary to SN, timeless obsession of Indians with gold has been a weakness through history, not a strength. Indians would do well to shed their irrational fascination for the barbaric relic and embrace financialisation. There lies the path to broad-based economic prosperity.

Fiat Money

What is fiat money? Fiat money is currency that is not backed by any physical commodity (historically this has been gold or silver). Does that mean fiat money is “mere pieces of paper with nothing backing them other than the misplaced confidence of gullible citizens” as SN states? People’s confidence in a currency stems from its network effect — that how many people use it and are willing to accept it as a form of payment, as a unit of account, and as a store of value.

However, there is more backing a fiat money than mere confidence. Fiat money is also legal tender — it must be accepted as a form of payment for financial obligations, including taxes. So, a government’s capacity to tax — which depends on how productive the society is and how effective the government is in collecting taxes — is ultimately what backs fiat currency. Contra SN’s colourful assertion, “A piece of paper printed by US Federal Reserve Chairperson Janet Yellen has pretty much the same intrinsic value as the one printed by Gideon Gono, former central bank governor of Zimbabwe,” thus, the Zimbabwean dollar (which was finally abandoned), with an unproductive economy and dysfunctional government, had little backing and even its own people were unwilling to hold it. On the other hand, the US dollar is backed by the productive capacity of the world’s largest economy with a government which has a 200-year record of collecting taxes efficiently. Unsurprisingly, it is not just accepted by its citizens but by people world over as a safe haven.

SN is careful to add the codicil that, “In the long run, tulips have far greater intrinsic worth than unbacked currencies”. Of course, no country lasts forever, and we can be sure that all fiat currencies will end worthless. But it may last for decades if not centuries — certainly beyond the time frame of most human decisions. So, the endgame, while clear, is not very useful for making decisions here and now.

To complete the circle, while fiat money’s usage stems from its status as legal tender, its ultimate value rests on its network effect, which may transcend its link to the taxing power of the sovereign issuing the currency.

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Gold Is Not Money

SN states that “Gold is just money — has always been money — and if I may add, will always be money”. I find the faith in making forecasts about eternity, touching. Leave that aside. Money is a social construct — it exists only because society confers value to it. In that sense, gold’s value derives from the value conferred by society over millennia. However, the government and the laws are also part of society. They do not exist apart from society. Laws as they stand today do not accord gold the legal status of money. It may well change in the future if the gold bugs are right but it will only reinforce the fact that gold’s status as money rests on the legitimacy provided by governments not the other way around.

To those who are not convinced, I will present the contrasting fortunes of gold and silver to drive home my point. Before the 19th century, gold and silver were equally widespread as monetary assets — with many countries on a bimetallic standard. This was reflected in the steady 16:1 price ratio of gold/silver (see chart below). However, beginning in the mid 19th century, western countries started to demonetise silver and switch exclusively to the gold standards.

The United States joined the bandwagon in 1873 and by the early 20th century, silver was not a monetary asset in most countries. The result was dramatic. The ratio of gold to silver price shot up. Although the ratio has fluctuated since then, it has been far above the 16 level that persisted for centuries. (There was a brief period in 1980, when the Hunt Brothers’ efforts to corner the silver market sent the ratio back to 16.) If “gold is money and always has been money,” the same applies for silver too, which has been extensively used in coinage especially in India. So, governments moving away from bimetallism should have had no effect on the long-term price of silver. Yet, silver never regained its former status with respect to gold after “demonetisation” by governments. Thus, the value of gold/silver, at least partly, derives from the monetary status accorded by governments.

One can argue that, with the final abandonment of any link between gold and fiat money in 1973, gold too is no longer a monetary asset. Yet, central banks/governments continue to hold significant amounts of gold in reserves, implicitly according it quasi monetary status. Moreover, in contrast to silver, which was demonetised a century ago, gold’s demonetisation has been recent — many investors have not fully comprehended or adjusted to the new reality.

The gold and silver price ratio The gold and silver price ratio

Why Gold Standard Is Not Feasible

I have partly dealt with why any kind of a return to the gold standard is simply not feasible. In short, capitalism is prone to bouts of financial instability. In periods of financial crises, investors will flock to money or money substitutes. In a fiat system, the government accommodates this excess demand via lender-of-last resort operations as well as automatic fiscal stabilisers. A gold standard constrains the government’s ability to fight crises (some would say this a feature!). Few governments can sustain power amid widespread misery caused by strict adherence to the gold standard in a crisis. Indeed, the countries that dropped out of the gold standard early enjoyed relatively better economic outcomes in the 1930s.

Actually, contrary to the conventional view, the gold standard itself was adopted because it was seen to serve a public purpose at that time. Knafo (2006) has a fascinating analysis of the history of the gold standard. Below is a quote from Knafo:



Knafo Knafo

In my view, the gold standard served a purpose historically and it was discarded because it had outlived its utility. Knafo makes the point eloquently:



Knafo Knafo

Gold bugs often point to accumulation of gold by some central banks as foreshadowing an eventual return to the gold standard. Yet, central bank holdings as a share of reserves is at an all-time low. Some central banks continue to accumulate gold in order to diversify their reserves from fiat currencies and also to cock-a-snook at the US. A few of these countries also hope to dent the “exorbitant privilege” enjoyed by the US from the dollar’s status as the reserve currency.

As an aside, France’s indignation at this “exorbitant privilege” is one reason why the French began to exchange their dollar reserves for gold in the 1960s, which eventually culminated in the breakdown of the Bretton Woods system. French president Charles De Gaulle wanted a return to the gold standard. Instead, after a traumatic 1970s, the world doubled down on a dollar standard, this time with not even a gold exchange clause to tie down the US. Talk about utter failure to understand money.

Knafo (2006) has a completely contrarian view of the gold standard.

Indian Obsession With Gold Has Been A Drag On Economy

Indians have been obsessed with gold since time immemorial. In Roman times, Pliny called India “the sink of world’s gold”. Charles Kindleberger in his little-known book Spenders and Hoarders: The World Distribution of Spanish American Silver, 1550-1750, talks about the Indian propensity to hoard gold. Most of the precious metals mined from Spanish Americas ended up in Asia (the hoarders) via Europe (the spenders), with the gold largely ending up in India and silver in China and Japan. The love of the yellow metal persists to this day. Although the mechanisms of obtaining gold has changed, the irrational love for gold has been a drag on our society through history.

The act of hoarding, whether it is money or gold, depresses economic activity, as demonstrated by Keynes in his paradox of thrift. Indeed, Europeans by spending all the precious metals from the Americas boosted economic activity and ultimately sparked the rise of modern capitalism whereas Asians by hoarding ended up falling behind.

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In pre-modern times, Indians obtained gold by running persistent, large trade surpluses. Essentially, Indians produced much more than they consumed. My view is that the distribution of income was skewed in India relative to Rome in ancient times, which allowed the hoarding of gold. Poor people tend to have a high marginal propensity to consume whereas the extremely rich have a relatively low propensity. An analysis based on wages in the bureaucracy stated in the Arthashatra suggests that the Gini coefficient (a measure of inequality) was extraordinarily high even in Mauryan times. The extreme inequality meant that domestic demand was depressed relative to supply. The excess supply manifested as persistent trade surpluses. The gold obtained through these trade surpluses was hoarded. If income had been relatively more equally distributed, then the domestic demand would have been not as depressed relative to supply.

More important, the living standard of the average person would have been much higher had the elites not been obsessed with hoarding gold. These tendencies only worsened in mediaeval times under the Mughals, which was one of the most extractive regimes in history. Naturally, the gold and silver from Spanish Americas ended in the coffers of Indian (and other Asian) despots, while the masses lived in grinding poverty. (We do not have a great deal of information on average living standards in India before Mughal times. The reports of Faxian and Xuanzang suggest that prosperity was widespread. On the other hand, we have plenty of evidence during Mughal times that grinding poverty was the norm.)

While in the past, India accumulated gold by running trade surpluses, today gold is a major contributor to India’s trade deficit. While individuals may view gold as an asset, for society as a whole, it is a dead investment, producing nothing. If instead of importing gold, India imports capital goods, then it will be increasing its productive capacity and making the society richer. Instead, a relatively poor country like India sits on 40 per cent of the world’s private holding of gold. What an utter tragedy.

Investing In Gold Does Not Make Sense Even For The Individual

I often hear gold bugs praise the sagacity of the average Indian for their hoarding of gold, apparently to escape the depredations of the state. Let us see how sagacious this gold-hoarding Indian is. Consider the returns on the Indian stock market and gold (both in dollar terms). Starting in 1998, the Indian stock market has beaten gold by more than two times, this despite the fact that 1998 was a low point for gold and marked the beginning of a historic bull run in the shiny metal.

S&P GSCI gold total return index S&P GSCI gold total return index

Taking a longer view, from 1979, the Sensex has outpaced gold by about eight times, and this does not even include dividends.



S&P GSCI gold total return index: Sensex in dollar terms S&P GSCI gold total return index: Sensex in dollar terms

India does not have good data on real estate prices, but my casual analysis suggests that it too has been gold handily in investment returns. Gold does better than fixed deposits. D Muthukrishnan has done extensive analysis comparing the returns on the Sensex, gold, and fixed deposits (FD) for Indian investors. However, investors in FD do not bear any risk at all, whereas gold prices are subject to significant volatility. Moreover, liquidating gold jewellery incurs a significant loss. In short, holding gold has not been a particularly wise decision by the Indian investor.

Gold Hoarding A Sign Of Failure As A Society

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In successful societies of the world, very few invest in gold and even the holding of gold jewellery is minimal relative to their wealth or income. Most people hold their wealth in the form of real estate or in financial assets. Successful societies are marked by a high degree of trust and cooperation and building a modern financialised economy requires cooperation at the highest level — in a national government. It is easy to distrust government and fall back on empty slogans, yet governments are a social construct too and their success/failure is a manifestation of our success/failure as a society.

The many steps taken by the Narendra Modi government to formalise the informal Indian economy and reduce graft in delivery of public welfare schemes will hopefully build trust in the system, lead to greater financial inclusion, and hopefully reduce the need to hoard gold. Time will tell.

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