Gold - It's Money not Insurance

Many investors describe holding physical gold, gold in the ground (gold miners), or products with financial exposure to gold, as ‘insurance’ against forms of financial collapse. The ‘gold bug’ investors may hold a set percentage (say 10% or 25%) of their portfolio in gold. Other investors will move in and out of gold as they vacillate between being more and less concerned about financial stability. We wish to see gold (gold coin and gold bills of exchange) circulating in exchange for goods and services. If gold remains stuck in a vault its ability to promote efficient human coordination over time and space is wasted.

The following quote is from a Schroders Insight article. We take up the challenge to rationally explain why gold will provide protection (i.e. short-term wealth) during a financial collapse.

“Buoyant gold prices and similarly ebullient valuations of gold stocks suggest many share some discomfort on the sustainability of the current manipulated asset price utopia and yearn for some insurance against potential unsustainability.  The inability to rationally explain why a chunk of yellow metal, or better yet, an exchange traded financial exposure to it, should provide such protection, should remind us of the behavioural aspects which will continue to thwart those looking to fit human behaviour into a discounted cash flow or GDP growth outcome.” Schroders, Shoot first, ask questions later, 8 March 2017, Martin Conlon.

Firstly, we need to debunk that gold is a form of ‘insurance’ against financial collapse. A proper definition of insurance is a form of cover that provides indemnity for a mutualisable risk event over time and space. Much of what today is described as insurance, such as ‘mortgage protection insurance’ or ‘lifetime annuities’, is a misnomer. Instead it is a directional gamble made by an insurance company which is often only exposed on the occurrence of the insured event - as we saw with AIG on its credit default swap obligations.

We cannot envisage how gold could be held such that it provides ‘insurance’ against financial collapse. For example, if gold was held in a pool what mutualisable event could it cover? If it was to be paid out on a ‘financial collapse’ event, such as a severe decline in the purchasing power of the dollar, wouldn’t everyone in the pool in that situation want back their contribution to the pool? Simply, a financial collapse is not a mutualisable risk over time and space.

With respect to a financial collapse those holding gold, including the ‘gold bugs’, may have more wealth than others, but relative wealth is not a form of indemnity. It is just that they may have maintained their wealth better than others. For many, wealth destruction will occur before the financial collapse, but this may only be recognised during the financial collapse. Many consider assets to have ‘intrinsic value’, or ‘objective value’, remote from human subjective value. This error in thought would be exposed in the situation of a financial collapse. This includes the error of not allowing for sufficient depreciation allowance when valuing an asset.

We can conclude that the ownership of gold is not a form of insurance. It is just a form of short-term wealth. Wealth is only good for its capacity of exchange into income, where income is conceived as a steady flow of goods and services. Income is perishable. Income is the hairdresser cutting the hair of a client. Income is the milk produced by the dairy. Income is the goods and services that people use. If an asset cannot be exchanged over time and space for income, it is not wealth. Typically, gold can be exchanged for income over time and space. It is the most marketable good, in particular when gold is in the form of gold coin, as it can be counted by tale. At any specific time and place in the future, there is no guarantee that gold will be able to be exchanged for income. For example, gold may be banned or confiscated by government(s). If not, the next most marketable good will take its place. After gold, over time and space, silver has established itself as the next most marketable good. That is why both gold and silver are known as the monetary metals. Gold and silver each exhibit larger stocks to flow ratios, quite different to other commodities. They exhibit the smallest decline in marginal utility, such that it is near constant, with increased quantity of the good. The good(s) with the smallest decline in marginal utility – the most marketable good - is money.

Most investors consider money to be government fiat. They are wrong. In all cases in the past, government fiat has shown itself to be a poor form of wealth. At best, it has steadily lost its ability to purchase goods and services over time and space. At worst, it has fully lost its ability to purchase goods and services over time and space.

Most investors denominate their asset valuations in government fiat. They are confused. Instead, assets should be denominated in terms of money (gold).

We concur that “an exchange traded financial exposure to it [gold]” may provide not protection to investors. If the exchange traded financial exposure to gold is settled in government fiat, the investor may have much government fiat, but still no gold. With gold in permanent backwardation (i.e. not offered against fiat), that may not provide any protection.

In conclusion, we believe a “chunk of yellow metal” is likely to provide protection in a period of financial collapse as it is likely to be exchangeable into goods and services in any location, before, during and after the financial collapse. That much can’t be said for government fiat.