I read Shanmuganathan Nagasundaram’s (SN) article, “Gold Can Help India Set Global Agenda On Monetary Policy”, with great fascination and despair. The article is replete with misconceptions about fiat money, gold, and the role of state in a successful society. Contrary to SN, timeless obsession of Indians with gold has been a weakness through history, not a strength. Indians would do well to shed their irrational fascination for the barbaric relic and embrace financialisation. There lies the path to broad-based economic prosperity.

Fiat Money

What is fiat money? Fiat money is currency that is not backed by any physical commodity (historically this has been gold or silver). Does that mean fiat money is “mere pieces of paper with nothing backing them other than the misplaced confidence of gullible citizens” as SN states? People’s confidence in a currency stems from its network effect — that how many people use it and are willing to accept it as a form of payment, as a unit of account, and as a store of value.

However, there is more backing a fiat money than mere confidence. Fiat money is also legal tender — it must be accepted as a form of payment for financial obligations, including taxes. So, a government’s capacity to tax — which depends on how productive the society is and how effective the government is in collecting taxes — is ultimately what backs fiat currency. Contra SN’s colourful assertion, “A piece of paper printed by US Federal Reserve Chairperson Janet Yellen has pretty much the same intrinsic value as the one printed by Gideon Gono, former central bank governor of Zimbabwe,” thus, the Zimbabwean dollar (which was finally abandoned), with an unproductive economy and dysfunctional government, had little backing and even its own people were unwilling to hold it. On the other hand, the US dollar is backed by the productive capacity of the world’s largest economy with a government which has a 200-year record of collecting taxes efficiently. Unsurprisingly, it is not just accepted by its citizens but by people world over as a safe haven.

SN is careful to add the codicil that, “In the long run, tulips have far greater intrinsic worth than unbacked currencies”. Of course, no country lasts forever, and we can be sure that all fiat currencies will end worthless. But it may last for decades if not centuries — certainly beyond the time frame of most human decisions. So, the endgame, while clear, is not very useful for making decisions here and now.

To complete the circle, while fiat money’s usage stems from its status as legal tender, its ultimate value rests on its network effect, which may transcend its link to the taxing power of the sovereign issuing the currency.

Gold Is Not Money

SN states that “Gold is just money — has always been money — and if I may add, will always be money”. I find the faith in making forecasts about eternity, touching. Leave that aside. Money is a social construct — it exists only because society confers value to it. In that sense, gold’s value derives from the value conferred by society over millennia. However, the government and the laws are also part of society. They do not exist apart from society. Laws as they stand today do not accord gold the legal status of money. It may well change in the future if the gold bugs are right but it will only reinforce the fact that gold’s status as money rests on the legitimacy provided by governments not the other way around.

To those who are not convinced, I will present the contrasting fortunes of gold and silver to drive home my point. Before the 19th century, gold and silver were equally widespread as monetary assets — with many countries on a bimetallic standard. This was reflected in the steady 16:1 price ratio of gold/silver (see chart below). However, beginning in the mid 19th century, western countries started to demonetise silver and switch exclusively to the gold standards.

The United States joined the bandwagon in 1873 and by the early 20th century, silver was not a monetary asset in most countries. The result was dramatic. The ratio of gold to silver price shot up. Although the ratio has fluctuated since then, it has been far above the 16 level that persisted for centuries. (There was a brief period in 1980, when the Hunt Brothers’ efforts to corner the silver market sent the ratio back to 16.) If “gold is money and always has been money,” the same applies for silver too, which has been extensively used in coinage especially in India. So, governments moving away from bimetallism should have had no effect on the long-term price of silver. Yet, silver never regained its former status with respect to gold after “demonetisation” by governments. Thus, the value of gold/silver, at least partly, derives from the monetary status accorded by governments.

One can argue that, with the final abandonment of any link between gold and fiat money in 1973, gold too is no longer a monetary asset. Yet, central banks/governments continue to hold significant amounts of gold in reserves, implicitly according it quasi monetary status. Moreover, in contrast to silver, which was demonetised a century ago, gold’s demonetisation has been recent — many investors have not fully comprehended or adjusted to the new reality.