Part 1: The Evolution of Money
The Incas called it the sweat of the sun. The conquistadors went to the New World to bring it back to the Old World. Even the crusades were as much about solving Europe’s shortage of hard money as they were about converting non-believers to Christianity.
Created by supernova explosions and when stars collide, gold has been front and centre in human societies from the very beginning. It is thought to be the first metal human beings ever utilised due to its malleability. It has been found in palaeolithic caves, while ornate golden artefacts have been discovered that date back to pre-dynastic Egypt.
In the modern era it has underpinned a global financial system, and then been used to hold that financial system to account when it decided it no-longer required gold as an anchor. In order to provide you with a broader understanding of where gold fits into our current financial system, below we’ll explore the many aspects of this fascinating element’s history. But we’ll also bring it back to the present, offer actionable insights that you can use to inform your gold trading strategy, and speculate about the future of this most ancient human store of value.
The Intrinsic Value of Commodities
From the cowrie shells of the Maldives, to the great stone discs of Yap, human beings have always valued certain physical objects higher than others.
Cowrie shells, for instance, were employed as a medium of exchange for thousands of years in places as far removed as China, India and Africa. The stone money of Yap, while a little unwieldy to carry around or wear, is valued according to how difficult each disk was to quarry and transport back to Yap. Rather than moving them around after each transaction, the locals simply keep a record of who currently owns what stone and just leave them where they are.
Over the millennia, many other goods have been used as money, including commodities like peppercorns, tea, silk, cocoa beans, barley and salt. These have been useful for trading with outsiders, particularly when there is no other agreed upon or trusted medium of exchange.
Commodity money was used across different geographies due to the underlying commodities being universally accepted as useful, scarce, and/or desirable. This is important to remember. The value of commodity money is directly understandable to anyone who would accept it as payment. Unlike later forms of money, it is not a representation of something else, neither is it a promise to pay, but intrinsically valuable in and of itself.
Metal Money: Intrinsic Value, Seigniorage, and Debasement
Coins are still recognisable to modern people, although the pace at which our societies are moving towards digital payments may mean that swapping small metal disks by hand becomes as strange to our grandchildren as cowrie shells seem to us.
What’s important to keep in mind here is that when gold, silver and copper were originally used as a form of commodity money, the value of those coins was derived from the metal that went into them. In other words, the value of the coin was identical to the metal it contained when melted down.
Sovereign Coins and Cooking the Books
However, when rulers began minting their own coins, these coins often had a higher face value than that of the raw metal they contained. This was the birth of seigniorage, which is essentially the difference between the face value of money and the cost to produce and distribute it (the state keeps the difference). The word originates from old French and refers to the right of the lord to issue money.
Rulers issuing their own gold coins as currency quickly ran up against a problem. The scarcity of the metal, while inspiring trust, also acts as a constraint on what the ruler can do (how many promises they can make). So, right away there’s an incentive for the ruler to reduce the intrinsic value of the currency, allowing for the gold that backs it to stretch a little further.
This is different from a pure fiat money system like we have today in which our physical money is completely unanchored to anything intrinsically valuable, being purely backed by the trust placed in the government that issues it. Fiat is Latin for “let it be done” which refers to the ruler’s ability to make something valuable simply by decree.
As we’ll explore below, this shift from the pure commodity, to state issued coinage with some intrinsic value, to a fully fiat system where money is not backed by anything other than say-so, is one that our societies are still negotiating. This is why gold is such an interesting financial asset. It’s the inconvenient truth beneath all the promises.
We’ve all heard the stories of Roman emperors clipping the edges of their gold coins to reduce the metal content until their soldiers refused to fight for them. This is called debasement, which takes its meaning directly from the process of mixing base metals with gold, which increases the volume but reduces the quality.
Gold investors are united by the belief that straying too far away from sound money principles, where circulating currency is backed by precious metal reserves, inevitably leads to currency debasement and eventually to collapse.
The scarcity of commodities, particularly the precious metals, have historically placed a physical constraint on the expansionary desires of rulers because one can’t just print gold and silver out of thin air in order to pay for things, now can one?
Part 2: Gold in the Modern Age
As a financial asset, gold resides in a strange in-between space. Despite our money no longer being backed by anything physical, gold still plays the role of an intrinsic store of value that can’t be inflated away.
When our global economy moved from a gold standard (paper currency redeemable for gold), to a series of fixed exchange rates after the Bretton Woods agreement, to a completely free-floating fiat system in 1971 (more on this later), central banks still held (and indeed still do hold) large stores of gold despite the currencies they issue not being redeemable for gold anymore. Why? Because gold remains a universally accepted store of value. The same can’t always be said for a nation’s currency (see Argentina, Venezuela, Turkey).
Investors too, still behave as though the global financial system should be underpinned by something intrinsically valuable and scarce. They have historically flocked to gold during economically and geopolitically uncertain times or when inflation is persistent. This is because on some level they’ve accepted something that the ancients also came to understand.
The bright yellow metal that’s soft and doesn’t tarnish or corrode, that can be hammered into the finest leaf or stretched into a wire of a hair’s breadth, is desirable for its unique properties, and highly valuable by virtue of its scarcity.
The Gold Standard
From the 1870s to around WWII, the global economy operated on a gold standard in which circulating notes were backed and redeemable for a fixed supply of gold. This regime was adopted by industrial economies in order to address rising inflation due to countries printing more paper money than they could make good on.
The system encouraged trust and trade between parties who subscribed to it, but having a scarce commodity as the backbone of a monetary system inevitably leads to the sorts of issues we saw above. You can’t expand the money supply (your promises to pay) when it’s pegged to gold. And the sad truth is that sometimes you have to.
The Great Wars
For obvious reasons the gold standard was suspended throughout WWI. All the combatants ceased redemption rights and began printing money in order to pay their own citizens for the war effort. An added wrinkle to this story is that the United States took no physical part in most of the conflict, and was exporting goods to Europe in exchange for gold throughout. During WWI, the US tripled the dollar value of its exports and built a trade surplus that surpassed a billion dollars for the first time.
WWII only exacerbated this trend. Again, the US wasn’t on the ground for most of the war and further expanded its trade surplus by exporting goods in return for European gold. By the end of WWII, the US held the majority of the global store of gold, making a gold standard practically impossible.
The Bretton Woods Agreement
This led to the Bretton Woods agreement of July, 1944, where delegates from the 44 Allied nations drafted a new global financial order at a conference held at the Mount Washington Hotel in Bretton Woods. The agreement saw a gold-backed US dollar (redeemable at $35 per ounce) assuming the role of global reserve currency, with other national currencies pegged to it at different fixed rates.
This arrangement placed the United States in the position of being the world’s gold vault, as its own currency was to be fully exchangeable for the yellow metal. Are you starting to detect a theme here? What would you say happens next based on all the above?
The Nixon Shock
Yes, just like the Roman emperors of old who clipped their coins, the US printed more dollars than it could redeem in gold and in 1971, President Nixon was finally forced to close the gold window. ceasing convertibility of the US dollar for gold. This brought the Bretton Woods era to a close.
Below you can see what happened to the price of gold in the wake of the Nixon Shock. This was also the start of the age of freely floating fiat currencies and the forex market as we know it today.
Gold’s Role After Bretton Woods
Some have called fiat currencies the greatest monetary experiment in history. Advocates of sound money argue that the gold standard led to extraordinary periods of prosperity (the industrial revolution took place under a gold standard). And blame humankind’s inability to overcome its baser instincts of greed and war for the repeated failure of the gold standard.
Today gold has been fully inducted into the global financial system. It trades as a commodity rather than a currency and its price dynamics are influenced by a variety of different factors. These include the amounts of new gold mined each year, the seasonal demand for gold jewellery in the Middle-East and Asia, as well as a host of wider factors such as interest rate expectations, fear of inflation, lack of confidence in the economy, concerns over geopolitical turmoil (wars, blockades, tariffs, economic sanctions).
As a fully financialised asset, Gold is no longer as volatile as it once was. Many would argue that it has ceased holding governments to account because its price is easier to manipulate (we’ll return to this in part 3). You can see this reflected in its price following the Nixon Shock. Gold never returned to those levels of volatility despite multiple decade long wars in the Middle East, a dotcom bubble, global financial crisis, and global pandemic.
Gold’s scarcity makes it difficult for gold-backed currencies to expand the money supply. In times of extreme need (such as war) gold standard agreements give way to more pressing concerns.
The US acted as global bank for a period, but eventually also fell upon to need to print more dollars than it could back with its gold reserves.
Gold Trading In The Present Moment
Whether you realise it or not, by providing you with a broader context of the history of gold in parts 1 and 2, you already should be developing an intuitive understanding of gold’s place in the global economy.
Aside from its industrial uses in the manufacture of electronics, or its demand in jewellery and decorative art, gold remains what it has always been, a scarce and highly desirable material whose history and universal acceptance forces states to contend with it, whether they like it or not. Consider this: if our monetary systems haven’t been backed by gold since 1971, then why are central banks still the single largest holders of the stuff?
Gold As Financial Asset
This brings us on to the root of the matter. As a financial asset, most of the gold that is traded on a daily basis is actually paper gold rather than physical. Gold’s price is quoted in US dollars per troy ounce, trading under the ticker XAU/USD. It trades throughout the work week on different markets, giving it a continuous stream of price quotes that go from Sunday evening to Friday evening in New York. This makes the gold trading market a 24/5 market like foreign exchange, on which there’s gold trading live around the clock during the working week.
What’s interesting to note, is that the current price sometimes refers to gold’s spot price, and at other times to a front month COMEX futures contract, depending on the time of day. As you might expect, the gold trading volumes of the COMEX market are larger, which is why gold aficionados say the price no longer reflects the true underlying supply and demand dynamics of the commodity itself.
How is Gold Traded?
The conventional wisdom has it that gold is a safe haven asset that investors go to in times of economic uncertainty, inflation, or when they fear broader political risks. It also tends to be inversely correlated with the US dollar, so a weak economy is thought to be good for gold.
This is why it’s most often regarded as a hedging instrument. Investors hold gold in their portfolios to offset the potential losses from the riskier assets they’re invested in.
It should also be noted that gold is a non-yielding asset. As such, when the economy is growing there’s an opportunity cost associated with holding gold versus a currency or a bond that (normally) offer an interest rate. Even in today’s world of super low (or even negative) rates and relatively low growth, tech stocks are favoured over non-yielding assets due to their promises of future earnings.
When to Buy and Sell Gold?
Gold investors are known for playing a long game. They slowly and steadily accumulate during gold bear markets when the money is chasing other high-beta assets. They know there’s a bubble elsewhere they could be chasing but they knuckle down and hold for the long term. The question of what is gold trading at in the short term is almost irrelevant to them.
The expectation is that ultimately the limited supply of gold versus the ever-increasing monetary supply will eventually lead to a drastic repricing of gold against the dollar as we saw after the Nixon Shock. In many ways it’s a similar mentality to the original ideals behind bitcoin, which is no coincidence as bitcoin’s monetary policy is rooted in the philosophy of sound money.
The Future of Gold Trading?
The question of how to trade gold is a moving target. Its performance since the pandemic is a perfect example of this. We’re seeing multi-decade record inflation prints all over the world and yet gold has barely managed to break beyond its 2011 high.
The events of 2020-2022 have been the perfect storm that should have seen gold catapulting to blue skies. It was the scenario every gold bull is supposedly hedged against.
Instead we’ve seen a stock market buoyed by incessant money printing and bitcoin taking the shine away from gold as an inflation hedge.
Does this mean that gold is dead and bitcoin is the new gold for the digital age? Not so fast. Up until very recently, bitcoin has been an uncorrelated asset from a new asset class that nobody understood or accepted.
Like gold it holds power to account. Unlike gold, it’s not currently on the balance sheet of every major central bank. So while bitcoin may appear as though it has single handedly replaced an asset with thousands of years of history, it’s likely that gold’s story doesn’t end here.
Today gold is an asset at the heart of the global financial system. It is held by all major central banks and trades around the clock on a combination of spot and futures markets.
Gold is held in portfolios in the interests of diversity, and as a hedge against unwanted economic outcomes. It has underperformed despite rising inflation post-pandemic.
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