What is gold, and what is it not?

Two gold bugs and fellow readers, Dave and Fred, have been talking about gold on the comments section from one of my previous posts. I thought it would better to share this on the blog and try to clarify a bit the fuzziness around gold, what it is and what it's not.

Q: Is gold money?
A: Gold is probably the only real money.

Q: Is gold a currency?
A: No, gold is not currently a currency, in any country in the world. If you want to buy something any where on the planet, the price that is going to given is either going to be in the local fiat currency, or in Euro or USD in countries where the official fiat currency is in trouble. Both the Euro and the US dollar are fiat currencies. You can always exchange some goods against some gold, but that would be barter to me.

Q: What is inflation?
A: It's the increase in the supply of money and credit in the current official fiat currency.

Q: What is deflation?
A: It's the decrease in the supply of money and credit in the current official fiat currency.

Q: Does gold do well during inflation?
A: Depending on your definition of inflation, the answer might change. If gold was the official currency, then obviously, and by definition, gold would do poorly during inflation. Given the definition I used above, gold does well during a fiat currency inflation, although historical precedents and empirical results show that it does worse than many other commodities, including base metals and agricultural ones

Q: Does gold do well during deflation?
A: Depending on your definition of deflation, the answer might change. If gold was the official currency, then obviously, and by definition, gold would do well during deflation. Given the definition I used above, gold does loose value during a fiat currency deflation. Why? Because the quantity of gold doesn't change, while the quantity of fiat currency available decreases. This mechanically creates an imbalance that can only be balanced again only if the price of gold decreases.

Q: So why does everybody keep saying that gold does well during deflation?

A: Because the only deflationary period they think about is the Great Depression. But back then, the dollar was backed by gold, so gold was the official currency. Deflation meant a decrease in the quantity of currency and credit, which meant an increase in the value of the dollar and hence of gold.

Please note that during the Great Depression, the USD was devalued by almost 50% (or more). So obviously, gold was doing well in those days!

Q: Why is this time different?

A: This time is not different! Quite the opposite. The value of the US dollar will rise... But it's the very first time in US history while deflation is happening with a US Dollar not backed by gold. So you can't compare pear with apples. What is deflating, is the number of US dollars. Not the quantity of gold. It's a dollar deflation.

Q: Why is gold doing well?

A: For two main reasons. Firstly, people start realising that sovereign default is not a chimera, it's real, and it's likely to happen. So the only way to protect one's wealth is to use the store of value property of gold, which is completely free from any governmental fiat, and liability. Secondly, why are bonds, the dollar, all commodities doing well?

Please note that I own physical gold and that I'm a strong advocate of 100% gold backed currencies and also against central banking and partial reserve lending all of which I consider to be fraud and theft. But it doesn't mean that I have to see gold differently than what it is.