Gold as a Currency

If you cannot eat it, drink it, or use it (for economic purpose), it ain't really an commodity. Although gold is traded on commodity exchanges and regarded by many as a commodity, it's both historically and intrinsically a currency. The distinction is important when it comes to invest in gold.

The main use of commodities, such as oil or cotton, is for production, not for store of value. Buyers and sellers are mainly individuals and organizations that take them as input or output in the production process. Profit and loss are results of production marginal costs and prevailing market prices. A few low-cost, efficient producers make the most profit.

On the other hand, the marginal cost of currencies is negligible comparing with its market price, i.e. the face value. Currencies are instruments to store value. They don't have any intrinsic value without considering the amount of economic goods and services they may use to exchange. The purpose would be undermined if vastly more currencies are created than the actual goods and services. We know that as the threat of inflation.

Theoretically, anything can be used as currency as long as it people put their faith behind it. And such faith is instilled in government's paper money. When faith runs out of on a particular paper currency, people flee to another government's paper money, traditionally the hard currency like the US dollar. What if people lose faith in all government papers? They turn to the currency has the highest marginal cost of production - gold, because government cannot simply print gold, rather they have to dig it out of the ground.

So when it comes to invest in gold, we should think of it as making a currency trade rather than buying a cash-generating asset. The subtlety lies in the nature of relative-value and zero-sum in currency trade. In other words, even if you made the right decision, you only made money in your base currency, and in nominal terms. It does not necessarily mean that you can now effort more goods and services. It's likely that the goods and services now cost more as your base currency depreciates. That's often a puzzling aspect in currency trading.

As government around the world create paper money at a fanatic pace in an attempt to inflate the economy out of the current slump, hedge funds and big money managers around the world are piling into gold, essentially a bet that all paper currencies are losing value relative to gold. Again, even if they are right, they are merely preserving the purchase power of their money, though they might have a good profit in their base currency. Personally, I am not quite sure about that. When governments and central banks outside the US really face cash crunch, they are more likely to sell their hard currency reserve, such as gold, to finance import purchases, therefore depressing gold prices, at least in the short-to-medium term. Physical commodities and commodity producers, despite the lower demand from the economic recession, seem to be a better place to invest, given that they actually create value through the production process.