Real money? Or barbarous relic?


The last time, we saw how the modern financial system came to be, and the role of central banks and the reserve currency. This time, we’ll discuss the role of Gold- the original reserve currency.

Primitive tribal societies used conches, rocks and furs for barter. As societies grew from tribal bands to cities and civilizations, all of them transitioned to gold as real money.

What is money? It is several things at once- a store of value, and a medium of exchange. It lets you store and transfer the results of labor- both physical and intellectual. In fungible numerical units, it lets you value different things relative to each other. Its standardization makes it far better than barter- where you may not be able to agree on an equivalent exchange.

How do you create money?

Gold - Wikipedia

-For something that is used as money, it has to be rare, or it will not remain a store of value. If you use rocks, anyone can come up with more money very easily. Gold is much harder to mine and extract from the ore. For each ton of excavated ore, you get only a few grams of gold.

-It must also be easy to carry around. Paper notes and coins are great. Rocks, not so much.

-It must be relatively easy to work with the material to shape it into coins and stamp them. Gold has a relatively low melting point, as does silver, compared to other materials like Iron or Copper.

-Finally, it should be hard or impossible to counterfeit. In the old days, without the new kinds of ink and manufacturing, notes could be copied easily, but gold could not be faked.

Gold is rare, cannot be easily faked, is easy to carry around and work with. All of which make it ideal as a currency. The rarity made it unsuitable for small transactions, so silver, copper coins filled that role.

Credit and Banking

Apart from old functions of money- as a store of value and means of exchange, another function emerged with the rise of banking- credit creation. Banks began in late medieval ages, when it was inefficient to move gold over long distances. A banker would take possession of the gold, and hand out a receipt. This receipt was safe to carry around, since no one but the depositor would be able to claim it. At the receiver’s town, the receipt was verified, and equivalent gold returned to the depositor from its own stock, minus a small fee.

Over time, the custodians realized they didn’t need all the gold at any given time. Only a fraction of it would be required by depositors at a given time. The rest would remain in vaults. The receipts themselves could be traded and were as good as gold. So they started loaning out some of that gold for extra return. This formed the basis for modern banking. This enabled ‘creation’ of more money than the amount of gold that existed, and provided a strong boost to economic growth.

Being able to create credit is now a vital part of the modern economy. Before the Industrial Revolution, agriculture was the biggest part of an economy. The surplus it generated drove everything else. To boost output, more land had to be cultivated. After the Industrial Revolution, innovation boosted output without increase in land. Innovating required money- provided through credit. The increased output was used to payback the loan and everyone was better off.

Being able to create credit under a gold backed currency still had its limits. It was constrained by the amount of gold available, and if the gold went underground, credit creation froze. It could neither be expanded when needed, nor contracted on demand. This cycle of ebb and flow of credit created the business cycle. A period of growth, then a recession as the economy contracted. Businesses failed, jobs were lost, wealth was destroyed. Then after a while, the growth resumed.

One way to create more currency than you have gold for, is to revalue the price of gold in that currency. In 1934, the US government confiscated all private gold, and compensated gold owners at a rate of $20/oz. After it was all bought, the rate was re-pegged at $35/oz. This allowed almost doubling the amount of money that could be made available for the same amount of gold. But this policy isn’t without costs. In a system where all currencies are pegged to gold, this revaluation is equivalent to devaluing your currency against all foreign currencies.

A gold standard currency which allows countries to regularly readjust the value of their currency’s exchange rate to gold is not really a gold standard at all!

Fiat currencies

Since 1971, the world has moved to floating rate Fiat currencies- currencies not backed by a hard physical asset. It is inaccurate to call this a currency backed by ‘nothing’. It is backed by several factors- the power of the government to collect tax revenue, its military power, its markets, the trust that its currency will not be printed to infinity, and most importantly- the productivity of the people of the country.

In a fiat currency regime, the inherent value of a currency is the extent of ‘trust in the system’. A country like Japan, with its high productivity, robust institutions, free markets, gives investors a lot of confidence in its ability to pay back its liabilities in other currencies. It is expected to be capable of earning that foreign exchange through net exports. Japan is poor in natural resources too, so the Yen’s value depends almost entirely on the Japanese being competitive in the world market.

A fiat currency is controlled by its central bank, and credit creation is controlled indirectly by the central bank through the interest rates it controls. If it hikes rates substantially, banks are better off hoarding their money and keeping it at the central bank than lending. This in turn slows the economy and reduces money circulating. A rate cut does the reverse and boosts the economy. Having fiat gives the government and central bank a lot of ways to pull the economy out of a slowdown. This is a big change away from a gold backed currency that constrains what the government can do in a recession.

In the Great Depression of 1929, all major economies contracted sharply. Unemployment spiked to over 25%. GDP tanked over 20%. The Dow Jones index dropped 90%. All of this was devastating to the public, and the gold standard tied the government’s hands. Contrast this with the response to the 2008 crash. The US Fed printed trillions of dollars needed, established swap lines with other central banks, intervened directly in markets to lower rates, and worst of it was over in just over a year. It took a World War and over a decade to recover from the 1929 depression!

The flip side of fiat, is the risk of unconstrained money creation. If too much is created through persistent low rates and borrowing, it leads to more money chasing fewer goods, thus creating inflation. Has this actually happened? Of course! We have Weimar Germany from the 1920s, and Zimbabwe from 2008. In both cases, inflation went completely out of control, destroying the currency and bringing the economy to collapse.

How is all this related to gold? You cant print gold. In all these episodes, gold retained its value, by going up when priced in the inflating currency. If you hold cash, it becomes worthless, but when converted to gold, it retains its value. Of course, gold wasn’t the only thing to retain its value- real estate, art, most physical goods also retained value. But you can’t move your house around. Your Picasso painting is too expensive to be used to buy bread. How many people even have Picassos? Can’t sell your car either, you need it to get around. But gold? You can carry it around, can use it for payments, and accepted anywhere. Unlike crypto currency, it doesn’t need any electricity, internet, or any computational resources either, and cannot be tracked.

Gold is very valuable in these cases-

  1. There is a financial system collapse, money in banks is inaccessible, and no other liquid assets are available other than barter.

  2. A bout of sustained moderate to high inflation, or severe hyperinflation and currency collapse.

  3. In a world of negative interest rates like in Europe, gold’s zero yield becomes higher than a bond yielding less than zero.

In a collapse, gold is a concentrated store of value that you can carry around easily. Physical gold is the only useful form of gold here, as ETFs/futures and other digital forms will also be inaccessible.

In high inflation- any form of gold will do, but physical will cost more to store and secure, while futures and ETFs will be very easy to buy and sell instantly.

In negative rates, such as Europe, you want to maximize your return, while having minimal or no risk of default. Government bonds will yield negative and have no default risk. Gold has zero yield and no default risk! Negative rates happen when there is deflation, so zero yield is effectively increasing purchasing power. Gold becomes an asset with positive real yield!

How do you hold gold?

-Buy physical gold. Bars, coins, or jewellery.

Physical gold is the least risky, since you have possession. But storage and transport is a risk. If you keep it in a bank locker, or your house, it remains at risk of theft or break ins. But in a crisis, you can take it with you easily. Jewellery can be used regularly, so has some utility regularly.

-Buy and store remotely with 3rd party, in a vault

A 3rd party vault would be very safe, and keep the gold out of reach of any local governmental authorities or others, but make it hard to get to. Also requires trust in the 3rd party and the government where it is located.

-Buy gold ETFs on an exchange or futures

ETFs/futures give you the same price exposure, can be sold and bought instantly, and don’t need to be stored or transported. In case of shortage of physical gold, the ETF is not worth the full price, since it doesn’t have all the gold that it should.

-Sovereign Gold bonds ( India only)

SGBs offer gold price + 2.5% interest. This handily beats inflation, and the capital gains tax on redemption is zero! The risks are same as that for ETFs, but returns are even better than an ETF. This is by far the best option for a digital exposure.

Gold as an asset class

Specific to India, the red line marks the percentage change in Nifty 50 large cap index since 1995, its inception, and the blue line is the gold price percentage change in Rupees. Even over a span of 25 years, gold has done as good as Nifty, and with smaller drawdowns in the interim!

India has historically been a high inflation economy. The only time gold took a pause, is from 2014-2019. As oil prices collapsed in 2014, it sent inflation lower for several years. Fiscal spending came down, and the currency stabilized. Since most gold in India is imported, the price rise and demand is an interdependent cycle. Price rise leads to more demand, which in turn contributes to weakening currency due to excessive imports, which causes a further rise in price.

On average, both have generated ~10% per year, but the Nifty has been far more volatile, dropping 40%+ in 2008 and 2020. A combined portfolio of both would have generated the same returns, but smoothed out the returns.

Why not to have gold

  • It doesn’t pay any dividends

    It is not meant to. Gold is meant to be insurance, not generate an income. Cash in your wallet doesn’t pay any interest either.

  • You can’t do anything with it, it is just a rock.

    You can use (some) for jewellery. Otherwise it is going to sit idle. Tradeoff of security for loss of utility. In an emergency, it can be pledged as collateral used to get a loan.

  • In a bull market, stocks do far better

    Absolutely. It is not meant to be a replacement for stocks. A stock represents a piece of a real business. Comparing gold to stocks is like comparing the US dollar to Apple’s stock. One is a currency, the other is a business.

  • Crypto is better, easy to transfer, cant be counterfeited, hard to steal from a cold wallet

    Both crypto and gold have their tradeoffs. In a stable system, crypto is cheaper for cross border transactions, and faster. It is safer to store offline in cold wallets for larger amounts. Where gold has an edge is the edge cases- your internet goes down, or governments block crypto traffic, the electricity goes out, or crypto is declared illegal by regulation, and you are stuck holding crypto that cannot be converted into local currency that you can actually use. Unless the real world is actively using crypto, holding it in crypto will leave it at risk.

    Crypto is also too small to absorb serious money flow into it. Its total market cap is tiny. Liquidity in gold is far higher, as well as capacity to absorb more inflows.


There are a whole host of reasons why gold has been the preferred ‘money’ across continents, and cultures. It is not an outdated relic of a bygone era. It is likely to remain just as valuable in future. It is not meant to be a replacement for stocks, but simply a hedge against inflation and systemic risk. As the price chart shows, it has done quite spectacularly even in the long run vs a diversified equity index. All of which makes a strong case to own gold. There is no single answer to how much, and in what form. That depends on your circumstances and outlook- on inflation, on systemic risk.

There is no reason to be ONLY in gold, crypto, or exclude them entirely. All of them have their tradeoffs, and have a place in your portfolio. Evaluate the tradeoffs, risks, and make the most of it with the right allocation.

In the next post, we’ll cover India’s growth story- what we got right and wrong from 1950 to now, the major changes in the past few years, and where we are headed in this decade. If you have questions or comments, you can leave them below / write to, or on Twitter. If you liked what you read, share it with friends. Have a great weekend!

-Prathamesh Godbole