Sunday, December 14, 2008

Why Should Currency Standards Be *Gold* Standards?

A more updated version of this article can be found at one of my other blogs, The Late Enlightenment.

My question is not whether or not we should be on any kind of standard at all, but rather why it should be gold. So, fiat currency exorcists, please spare me your arguments about the evils thereof. There isn't a single currency based on gold today so in any event your work is cut out for you, and I concede that this is an academic exercise. Still, it's a question that's interested me for a while, and it's curious that there seems to be no solid, rational answer to the question of "why gold?"

The traditional arguments in favor of gold as the most rational exchange medium are invariably a combination of some or all of the following, all of which are undone by modern technology or empirical data:

1) It's easily divisible.

2) It's identifiable (and elemental - it can't be created ab initio).

3) It's durable.

4) It's rare.

5) It's useful.

Gold certainly qualifies for these categories, but today, so do most of the other transition metals. Let's dispense with 1, 2, and 3 immediately since they're no longer unique features of gold. Modern technology lets us work with and machine and divide into coins all metals - and identify them as well (we now have better techniques than color, oxidation and specific gravity). No, this technology wasn't available to past governments, but it's available to us, and we're talking about why would gold still be the standard now, not historically - or at least why it would be the fall-back.

In terms of durability, although gold is more resistant to oxidation than other metals, once mined and refined, metals are stored under contolled conditions (like vaults or pockets) that make the durability question moot. Pure gold nicks and bends easily too; many other metals do not.

So I ask again: why gold? In terms of usefulness, gold does have industrial and medical applications, but in that regard it's sure no uranium or silicon, and in any event it would be hard to quantify the innate industrial value of an element. That leaves us with only one physical attribute to be the source of gold's central role in human economics.


I had always assumed that value correlated with rarity, but realized I'd never seen data on this. Therefore, to determine which metal would be the best value reserve, I looked at the value to rarity ratio by comparing the relative abundance of metallic elements in the Earth's crust and their modern values; most values came from the Los Alamos periodic table pages, or from current commodities markets for those metals that are commonly traded. For practical purposes, we can rule out as a potential value reserve for humans any elemental metals which are unstable or unhealthy to handle at room temperature. For example: radium is radioactive, tellurium stinks, cesium explodes, and francium exists only momentarily and as part of a nuclear decay path (which means it's both radioactive and becomes cesium, which explodes).

Ruling out the intolerables, we find that osmium and iridium are both rarer and more expensive than gold. Before you start celebrating the inherent rationality of the human valuation of metals, a) iridium is rarer yet cheaper, and b) please find me someone advocating an osmium standard for a currency, or a single currency or economy that has ever been based on either osmium or iridium. By the reasons given for gold as the basic commodity metal, currencies should be based on osmium, at least now that we can collect and refine it. Then again, maybe two centuries from now the foolish age of fiat currencies will have passed and the world economy will be on an iridium standard and I will be hailed as a visionary. (Use the right side of my profile on coins, please.) Of course, I'm not making coin-portrait appointments yet, because on further investigation, any semblance of economic logic breaks down:

Platinum has the same value as gold (or historically, often higher) even though it's substantially less rare in the Earth's crust. It bears mentioning that for some reason platinum has never been the basis for any economies either. Palladium is about twice as common than gold. Rhenium is slightly rarer than gold but about a third the value. Rhodium is about 4x rarer than gold but only about 15% more valuable. Ruthenium is about three times rarer than gold but has similar value, even though it's more industrially useful, even if still obscure. Even so, you don't see it being traded in Chicago, and there have never been currencies based on it, or to my knowledge even the suggestion thereof.

One objection to my theory is that a commodity that's too rare is useless as a basis for wealth, and that there is a rarity "sweet spot" for precious metals. While self-evidently true, this really doesn't tell us anything since it's a circular argument. That is to say, by this argument gold has "just the right level of rareness", which we know because it's what people use, so it must be just right. No dice. I might concede that iridium, which is almost 9 times rarer than even gold, wouldn't be a great choice for a standard, but why not palladium or rhenium? They're both of similar abundance to gold, and they're both industrially useful too.

You might object that just because an element is in the Earth's crust, it's not jumping out of the ground, and that production is a measure of said element's availability to human activities. So I ordered elements by global production as well:

There's a slight trend here, but it's still not the ordering you might expect to see. One thing I noticed was that (not surprisingly) gold was produced far out of proportion to its crustal abundance, which suggests that economic value isn't just a function of ease of extraction. So I also ordered the elements in terms of the ratio of production to abundance. Without showing you the scatterplot, the first ten most "overproduced" relative to their natural abundance were, in decreasing order, carbon, nitrogen, gold, lead, antimony, bismuth, tellurium, phosphorus, sulfur, and mercury. Gold is in there with some rather economically indistinguished elements.

Oddly enough, copper is 20,000x more common in the Earth's crust than gold, and yet it has been used as currency, as has silver. What's going on? There are three things going on: oxidation potentials, animal behavior, and habituation.

A Behavioral Explanation

I added this paragraph after the fact, because of the timely eruption of a tailor-made scandal driving home my point: if you don't think irrational grouppthink psychology plays a major role in human economic behavior, how did the Japan Enten scandal happen? I added this later because it was tailor-made for this article. If you're still not convinced, take the time to read MacKay's Extraordinary Popular Delusions and the Madness of Crowds.

First, gold, silver and copper are the only metals likely to be found at the Earth's surface that have negative oxidation potentials for the transition from pure to oxidized metal (meaning they can be found in nature in their unoxidized forms). Okay; so one day a few thousand years ago, someone was wading up a creek, and found gold nuggets glinting under the water. So what? Why was he interested in the physical properties of shiny gold nuggets any more than wood or rock or water?

It bears constant repeating that when we talk about economics, we're talking about the behavior of a specific animal. Economists concede today that Homo sapiens is not the perfectly rationally self-interested and profit-maximizing animal it was sometimes previously thought to be. Having said that, in asking "why gold?", it seems to me the principle factor that's overlooked is entirely irrational and human-dependent, and it best explains why modern humans might be predisposed to maintain gold as a store of value. That factor is that we're monkeys, and we like shiny things.

I mean that to be taken literally and seriously. Though gold does have industrial applications, we still use it primarily for decoration. On the other hand, I've never seen a palladium necklace at Tiffany's. My wife is a monkey who likes shiny things, and I'm a monkey who likes her, so I went to Tiffany's to get her shiny things. So does everyone else. So gold is valuable.

Now add several thousand years on top of our initial monkey-fascination with gold (which keeps it from being like, say, tulips) and you have considerable historical inertia. By this I mean many (but not all) civilizations independently adopted gold as their exchange standard and store of value, and now that billions of us are all trading, it would be even more impossible to change. To do so, you'd somehow have to simultaneously convince all humans who now recognize gold as inherently more valuable than most other metals (the majority of humans, including wives) that another medium was more valuable; this would be true even if there were no other reasons to use gold as a standard. Even the effective removal of monetary gold from circulation in the U.S. in the 1930s had little impact. It would be very difficult to convince people to switch to a different metal, because everyone already is programmed by history to value gold, and would you trust your neighbor to stop considering it valuable at the same moment you do? It's for this same reason that Ithaca hours, among other quirky currencies, have largely died out. When people in your town take Ithaca hours and American dollars, and no one in the town next door takes Ithaca hours, you get pretty nervous about, say, opening your 401K in Ithaca dollars.

One frequent objection is that if the use of gold were really just an economic legacy system or in game theoretic terms a massive and long-running coordination game, then there should have been economies that assigned higher values to shiny metals other than gold. And of course there were. For centuries China valued silver more highly than gold (whether you can say they were on a silver standard is another question). Isaac Newton even wrote on the topic for the British government, and illustrated his concern over the trade imbalances that would result for the two ends of the Old World if economies on opposite sides of Eurasia used different standards. Note that he didn't state that one was better than the other, just that having two value systems operating simultaneously was unhealthy. Today the gold/silver price ratio in China is the same as in the rest of the world. China's system was Betamax to Europe and the Middle East's VHS; I make this analogy to stress that, like Newton, I don't think that gold is necessarily better either, just that more people were using gold, and those people happened to colonize the rest of the world, so it was a matter of time before China's commodity valuations would have to adjust if they were to keep trading with everyone else.


I'm no commodities expert which is why I took advantage of a friend's recent visit to pick his brain. He does trade commodities, and works as a geologist for a major U.S. government contractor. When I asked him "why gold", he made the usual jokes about going on a selenium standard, and then said, "I don't know. Historical reasons I guess."

I'm not interested in convincing anybody to stop using gold. If you're going to use a precious metal as a store of value, everybody should use the same one, and gold is the one that humans have settled on at this point in history; it's still a kind of stable value reserve, even if it doesn't anchor currencies anymore. Some economists have predicted that it will eventually lose its value, as matter becomes smarter and labor continues to get more valuable, but we'll see. I asked the question "why gold" purely out of curiosity, but it's interesting to note that no anti-fiat-currency websites have begun calling for a rhodium standard, and that no one has provided an argument that explains the tenacity of gold as well as primate inertia.


Mark Herpel said...

Silver functions great as a local currency. Digital gold currency (DGC) works fantastic for global digital transactions because the accounts are denominated by weight. If you are trading with Africa, Italy and the UK, a gram is a gram is a gram, no currency conversion costs or risk.

Thomas Paine Jr. said...

Posting this on behalf of a reader who emailed me (okay, it's my geologist friend who I asked about gold standards):

Another fun currency thought:
Some alternative local currencies work due to narrow and sharply targeted purposes. While the issue of homeless people, the mentally ill, etc. is its own very long discussion, there remains the practical issue of how to help them, if one is so inclined.

Nobody likes the idea of giving them money, knowing full well they may immediately head to the liquor store, etc. Quite a few U.S. cities have instituted systems of alternative currency that trade at 1-to-1 with U.S. Dollars, but are redeemable only at certain places or for certain things (mostly, just food or basic clothing). This retains the ability of the donor to determine to whom to give the value (beggar got in your face? No soup for him! That one asked nicely, and you've got some to spare, knock yourself out). Of course, narrow currency systems are prone to bad management and abuse, too. Care for a Company Store, anyone?

One could argue that these systems are so narrowly set, food stamps for example, that they're not really currencies. After all, if
the system of exchange is so prescribed then it's expressly not a currency, which is supposed to be good for anything anywhere. But, it's still an interesting example. Pure currencies are only theoretical constructs, too, as they all have their limits at some point. You can't truly, purely trade any currency for anything, anytime, anywhere. Even the biggest piles of the most powerful currencies have things they can't
buy. The key however is not to have a currency so universally useful that you could do anything, but that your currency is useful enough to accomplish what a society or nation needed and wanted functionally.

Other systems are set so openly, that they're not currency precisely because they basically become barter economies. Frank Zappa's "ass, grass, or cash, nobody rides for free" line comes to mind. I'm betting you could devise a spectrum from pure barter, through currencies, to pure prescriptivist trade for every possible transaction (e.g. you can only get a chicken if you offer one kg of wheat flour). It would probably be one of the weirdest x-axes ever. And good luck determining what the units would be.

To which I responded:

I'm glad to see this engendered less academic discussions (i.e. like homelessness). Berkeley has a homeless voucher system, and participates in the Joint Winter Shelter using the Oakland Army Base (which has sleep and shower areas). This still doesn't get everyone off the street. Some people are genuinely sick and have no support network, and some people are just con artists or fleeing the law and want to stay on the street.

RE food stamps and currency, I'm sure there's a black market in food stamps as currency. That's a thesis waiting to happen if it hasn't already. At Burning Man, there's in theory supposed to be no currency - you're supposed to barter art objects for everything -but in my experience people did use money (for drugs and food), and it's not like there's much of a central authority to enforce the "rules". As I recall in 2000 there was actually somebody who'd manufactured tons of pretty little wooden disks with the express purpose of trying to get people to use them as currency but it didn't seem to work, and no currency has emerged (so it really is ass grass and cash for wheat flour and chickens). Problem is that it only lasts a week and people bring in whatever they plan on using or consuming, so not much of an incentive to trade in the first place. The irony is that Burning Man wants to encourage interaction and discourage on-looking, but one of the functions that cashless barter and bargaining had in pre-industrial societies (even with standardized units like bushels of wheat or dimebags) was to promote social ties.