David R. Kotok
April 19, 2013




Gold made the headlines with a rapid plunge, some possible basing, and then another plunge. Let’s talk about gold for a minute.

Central bankers prefer to have the public, the investor class, and the holders of institutional wealth believe in the credibility of their central banking skills and their ability to manage their respective currencies. But central bankers miss a critical point.

When it comes to gold, the gold bugs argue that gold is money. Simply put, that is not exactly correct. Gold was money 150-200 years, and even centuries, ago. In the US, if you wanted to buy something, you could pay for it with a gold coin.

Those days are long gone. I repeat, those days are long gone. But gold still maintains one important characteristic out of the three that we attribute to a functional currency.

So let us get to this question of whether or not gold is money. To be money, you have to have the ability to exchange easily in transactions. When you go to the store and pay for something in dollars, those dollars function as money. You can pay in paper currency, write a check, transfer it electronically, or pre-purchase the electronic entry on a piece of plastic that is carried and use it for payment. Money is a way in which payments are conducted. You cannot easily buy something with a bag or bar of gold, not even with a gold coin. There are not many people in the world who will take gold for payment. The payment mechanism of money is conducted in the currencies managed by the central banks, regardless of whether the currency is the dollar, pound, yen, euro, franc, krona, dinar, yuan, peso, or something else.

The second characteristic of money is to act as a unit of account, a method of measurement. Open up the income statement of your favorite company. It shows how much revenue, expenses, profits, assets, and liabilities they have in dollars as a unit of account or way of measurement. The same is true all over the world. We use these measurement tools constantly, so money has to provide easy, secure ways of measurement.

The problem with money substitutes that fail these two initial tests is that they become subject to volatilities that disrupt their use. Gold is such an item. Bitcoin is another one. Pay for something with bitcoin and how do you know how much you are paying in comparison to the rest of your daily transactions?

The third characteristic of money is that it is a “store of value.” It supplies an answer to the question, “Where can I safely place my accumulation of wealth, the result of my work effort, the gathering of my savings, –and have it hold its value?” Store of value is very important to gold.

Historically, gold, as well as silver and other precious items like diamonds to a lesser extent, has been seen as a place to store value. Gold worked in this regard: it was fungible, it was measurable by weight, and it was the same worldwide; and so it remained for many centuries the traditional place to store value.

In the beginning, central banks traded gold and used it as a reserve because it was such a successful store of value. The central banks still retain their attachment to gold, even when they do not want to admit it.

Now let us get to the wild volatilities of the gold market in the last few days and weeks. In Europe we have a crisis. The crisis involves Cyprus and its ability to pay. Cyprus is broke. It owes more than it has and more than it can earn. And it is beset by a banking collapse in the midst of all this. Cyprus uses the euro for money like the all other Eurozone members. With the euro, the monetary characteristics needed for transactions and pricing still apply, and so Cyprus now has to lock up part of its money because capital controls have been imposed. Furthermore, Cypriots have been restricted in their ability to take their euros and convert them to another currency such as dollars, yen, or pounds. Lastly, Cyprus has some gold, as do most other countries around the world.

The Eurozone colleagues of Cyprus are proposing that Cyprus sell some of its gold. They are very public about it. And the government of Cyprus may have to engage in some negotiation over that gold due to the pressure from its European colleagues. If it does not continue to receive Eurozone assistance, it will not be able to obtain money and make the payments it owes.

The Central Bank of Cyprus does not want to sell the gold. It knows it will not get it back. It also knows that if it holds the gold, it will maintain this mystical store of value that is associated with gold. But if it sells the gold, it will not have that store of value. The central bank resists the sale of gold for two reasons: (1) It has a historical basis on which to maintain the reserve of gold, and (2) It knows that it cannot replace its position if it sells.

In pressing Cyprus to sell, Europeans have announced to the world that there may be a large seller of gold. World traders in gold and other commodities will quickly jump on that trade. They know that if Cyprus breaks loose with the sale of its gold, countries like Greece, Portugal, and Slovenia may be next. They cannot see buying gold, thereby raising gold’s US-dollar-denominated price, in such a circumstance; but they can see selling it short, or otherwise trading it to the downside.

Result: gold plummets and there is massive selling. That terrifies the ETF holders and the retail buyers of gold. They pile on the trade, and gold gaps down to an unexpectedly low price.

What happens next?

First, the European drama around gold has to run its course. That is going to take a while.

Second, the terrified retail investors who panicked and sold have to become exhausted sellers. That is happening very quickly, though it is not over. The notion that gold can no longer be trusted as a store of value was clubbed into investors without any preparation. They saw the consistently upward movement of gold prices as confirmation that gold would continue to increase in value. They failed to see that volatilities could be very high in a market that is relatively thin worldwide. Now, disillusioned, they are reacting out of panic.

What happens after the retail investors are exhausted and the curtain is drawn on the European gold drama?

We believe there will emerge a new set of buyers of gold. They will be emerging-market institutions including central banks whose gold holdings are much lower as a proportion of total reserves than the Europeans have maintained. There will also be some larger purchasers of gold.

Here we are going to propose that the Japanese view gold as a new addition to their reserves. Japan has already said it is going to up its reserves. It has already said that it’s going to implement highly stimulative monetary policies. It has already launched that program in a very substantial way. Japan is printing yen and buying assets. Simply put, that raises the price of all assets.

Now Japan has a problem. It has to negotiate its policy change in a world in which colleagues in other major countries do not like this rapid weakening of the yen against their own currencies. And they do not want the Japanese to directly buy sovereign debt in other countries by converting newly printed yen into another currency and using that currency to buy the government debt of the country in which they have made the conversion.

But there is another option for Japan. Japan can print yen and buy gold. If it buys metal instead of a bond issued by a sovereign country, it will raise the price of the metal. It will exchange yen for currencies and diversify its exposure among all of the currencies. It will not be able to be accused of direct interference with the bond markets of other sovereign countries. Nor will Japan be able to be accused of interfering with the Federal Reserve’s present policy of buying US dollar-denominated, government-backed debt, or with the policies of the Eurozone’s central banks or those of the Bank of England. Furthermore, with central banks and other institutions in Germany, France, the US, India, Russia, and elsewhere continuing to buy gold, Japan is in a position to ask, “Why can’t we buy gold, too?”

Other emerging-market countries also have gold-buying programs. In our view, we are now likely to see more of them.

Our conclusion about gold is this. It is not money in the traditional sense of a currency in which transactions can be made. It does not facilitate payments. It is not a unit of account. We do not print financial statements in terms of ounces or tons of gold. Instead, we use currencies to measure our financial status.

Gold does have a historical store of value characteristic. It is held by central banks and institutions as a reserve. They do not want to sell it. On the contrary, many of them want to buy and accumulate it. Therefore, gold’s characteristic role with regard to sovereign reserves is still intact, even amid the fascinating evolution of central banking and institutional finance we witness today.

Our view about gold as an investment is slightly different from that of a trader. Gold is a long-term investment. We think it should constitute a small portion of a portfolio and be maintained on a continuing basis. It should be a relatively passive investment. Think of it as a type of insurance policy. So we would recommend gold acquisition, for those who are inclined to pursue it, on a very modest level, utilizing a dollar-cost averaging method. Buy a little gold and put it away. Forget the price. Come back again, buy a little more, add to your hoard, and forget the price. Look at gold as an insurance policy that you hope you never need to use. We do believe that abandoning gold completely and disparaging it as a barbarous relic is too extreme.

David R. Kotok, Chairman and Chief Investment Officer, Cumberland
Twitter: @CumberlandADV

Category: Gold & Precious Metals, Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

11 Responses to “Kotok on Gold”

  1. BenE says:

    In my opinion, this is a completely stupid way to see gold. However, it is true that gold’s value spawns out of nothing when enough people see it that way. If gold is an investment in something, it’s an investment in people’s misguided beliefs. I guess if you can reliably predict there are going to be enough stupid people around when you want to sell it, it can be an ok investment.

    One particularly misguided idea in this post is that “money [...] is a “store of value.” It supplies an answer to the question, “Where can I safely place my accumulation of wealth, the result of my work effort, the gathering of my savings, –and have it hold its value?”

    Money only works well as a means of transaction. When people start using it as a means of saving you get all sorts of volatility and market distortions since it is a form of savings backed by nothing real. It’s one of the main issue when hitting the liquidity trap, people start hoarding it.

    Centrally controlled money is designed to gradually lose value so that it isn’t used as savings. Someone once told me that Sparta used to mint his coins in iron, so that buried coins would not last years and rust to dust. If that is in fact true, Sparta was a smart guy who understood the optimal way to design currencies. Gold is not very good in that respect and it’s value is thus subject to huge unpredictable swings.

    Gold is not ‘insurance’. It will be at its lowest value at precisely the apocalyptic times you will want to sell it for food. If you really believe these times are coming, keep 6 months rolling stockpile of food and supplies in your basement. That will have real value if the system collapses.

  2. mad97123 says:

    Central Banks are proving once again that they are the “greater fools”. Gold has no fundamental value, no intrinsic worth. Gold is not, and can never be, an investment. It has no true intrinsic value, no cash flow, no earnings, no coupon. no yield.

  3. Excellent article! I’d like to make two comments. First, “Gold was money 150-200 years, and even centuries, ago. In the US, if you wanted to buy something, you could pay for it with a gold coin.”

    Actually, gold was money as recently as 1970 or so. The dollar/gold exchange rate was officially fixed and carefully managed, so either was a valid unit of account. That was validated by the fact that if you weren’t happy with your dollar bills, you could officially exchange them for gold. Similarly for silver, and in fact U.S. coins had real silver content until 1964 or so. The claim that precious metals haven’t been money since 150 years ago is just wrong.

    That leads to the second comment about gold being money or not: regarding the statement in the article that “It is not money in the traditional sense of a currency in which transactions can be made. It does not facilitate payments. It is not a unit of account. We do not print financial statements in terms of ounces or tons of gold. Instead, we use currencies to measure our financial status.”

    I disagree here. The functions above are simply social conventions. As with 1970 or so, to switch from the dollar back to gold would be a simple matter of changing units on the accounting statements. Either the dollar could be re-linked to gold, or bank accounts could be redenominated in gold units. Then credit cards and everything else used in the modern digital-credit economy could be used to make payments in gold-credits just as we currently use dollar-credits.

    Indeed there’s no reason you can’t actually manage your investments using gold as the unit of account instead of the dollar. You can price markets in gold and chart everything on that basis. ( makes this particularly easy since you can chart price ratios.) You can use the gold ETFs as the equivalent of money-market funds. And looking at things that way, if you think in terms of gold-as-money, then the recent drop in the dollar-price of gold could be seen as a rise in the gold-price of all other assets! Furthermore, on those terms, which arguably is how all charts prior to 1970 are rightfully viewed, and perhaps how all charts since 1970 *should* be viewed (given the continuous inflationary decline in the value of the dollar)… the secular bear in stocks still hasn’t been overcome.

  4. b_thunder says:

    “Japan is printing yen and buying assets…. Japan is in a position to ask, “Why can’t we buy gold, too?””

    What if this is exactly what’s about to happen? How many of the “12 (Misguided) Commandments of Gold Bugs” would then become valid statements? Mr. Kotok may just have made the “goldbugs’ principal case for owning gold” for them!
    A case of a major Central Bank that doubles its monetary base and at the same time buys any substantial amount of gold – isn’t that what the goldbugs’ worldview is all about?

  5. CSF says:

    An excellent, balanced article, devoid of the ideological rhetoric that shapes so many views of gold. One point about currencies as an exchange medium: to buy a pizza in the United States you first convert your yen or rubles into greenbacks at the going exchange rate. The same is true of gold.

  6. Clem Stone says:

    I have a one ounce gold coin that looks like real money to me. It says it’s worth U.S. $50 right there on its face.

  7. Syd says:

    Thanks for this analysis. If central banks like to hold and accumulate gold, and creditors are pressuring an insolvent Cyprus to hand over its gold, it’s clear that gold has value as an investment, as a small allocation in a long term portfolio. But as with other types of assets, it’s hard to know when it’s “cheap”, so utilizing dollar-cost averaging and periodic re-balancing is a good approach.

    As a commodity investment, one nice thing about gold is it’s relatively practical to buy and store the physical gold, and not have to rely on derivatives such as commodity futures (that you bought from MF Global, for instance). Also, perhaps unlike investing in oil and food ETFs, buying gold doesn’t add to the price volatility of consumer staples.

  8. Diablo says:

    Only problem with your argument is that for 10+ years (1998-2008) central banks were net SELLERS of gold….and yet gold almost quadrupled in price in that time.
    They turned to net buyers the last 3-4 years.
    Seems to me that central banks a pretty good contrarian indicator.

  9. ElSid says:

    “..amid the fascinating evolution of central banking and institutional finance we witness today…We do believe that abandoning gold completely and disparaging it as a barbarous relic is too extreme.”

    Yet BR does just that. And in addition, he disparages those who hold gold as a bunch of backwards idiots.

    • IN your amorous relationship, you overlook this reality: I am agnostic on Gold.

      I am not, however, agnostic on the price action of Gold, which has been porr for 2 years and awful for a week. I don’t care if its Gold, AAPL, Nasdaq in 2000, homebuilders in 2005, banks in 2006, brokers in 2007. Bad price action is the collective intelligence of the market. It

      Goldbugs dont respect price action & THATS FATAL in my business

  10. DeDude says:

    A small amount as a balance to other assets is about right as far as I can see.