Throughout the ages, gold has captivated humanity. At the end of the gold standard, there was an increase in financial instability and inflation. During multiple stock market crashes in the first decade of the 21st century, the price of gold began to rise again. The idea of returning to the gold standard became more popular at that time. Admittedly, there were inherent problems with the gold standards implemented in the 19th and 20th centuries.

Many people fail to realize that gold is a currency under the current system. Gold has often been thought of in relation to the U.S. dollar, mainly because it is usually priced in U.S. dollars. There is a long-term negative correlation between the dollar and gold prices. These factors must be considered when we see that the price of gold is simply an exchange rate. Just as one can exchange U.S. dollars for Japanese yen, a paper currency can be exchanged for gold. Gold also played an essential part in the origin of money.

KEY TAKEAWAYS

  • Under a free market system, gold is a currency.
  • Over the long term, a declining dollar meant rising gold prices.
  • By purchasing gold, people can shelter themselves from times of global economic uncertainty.

Gold Is a Currency

Under a free market system, gold is a currency. Gold has a price, and that price will fluctuate relative to other forms of exchange, such as the U.S. dollar, the euro, and the Japanese yen. Gold can be bought and stored, but it is not usually used directly as a method of payment. However, it is highly liquid and can be converted to cash in almost any currency with relative ease.

It follows that gold acts like other currencies in many ways. There are times when gold is likely to move higher and times when other currencies or asset classes usually outperform. We can expect gold to perform well when confidence in paper currencies is waning, during wars, and when stocks suffer significant losses.

Investors can trade gold in multiple ways, including buying physical gold, futures contracts, and gold ETFs. Investors can also participate in the price movements without owning the underlying asset by purchasing a contract for difference (CFD).

Gold and the U.S. Dollar

Gold and the U.S. dollar have always had an interesting relationship. Over the long term, a declining dollar meant rising gold prices. In the short run, the relationship can breakdown.

The U.S. dollar's relationship to gold prices is a result of the Bretton Woods System. International settlements were made in dollars, and the U.S. government promised to redeem them for a fixed amount of gold. While the Bretton Woods system ended in 1971, the U.S. remained a global power. When people discuss gold, talk of the U.S. dollar usually follows.

It is also important to remember that gold and currencies are dynamic and have more than one input. The price of gold is impacted by far more than just inflation, the U.S. dollar, and wars. Gold is a global commodity and therefore reflects global factors, not just sentiment in one economy. For example, the gold price declined in 2000 when the U.K. government sold a large part of its gold reserves.

Problems With Gold Standards

When considering gold as a currency, many people support moving back to some form of the gold standard. There were various problems with earlier gold standards.

One of the main problems was that the systems were ultimately reliant on central banks to play by the rules. The rules required central banks to adjust the discount rate to maintain fixed exchange rates. Fixed exchange rates sometimes resulted in high interest rates, which were politically unpopular. Many countries chose to devalue their currency against gold or the U.S. dollar instead.

A second problem with the gold standard was that there were still short-term price shocks, despite long-run price stability. The California gold discovery of 1848 is an excellent example of a price shock. This gold find increased the money supply, which raised expenditures and price levels, creating short-run economic instability. It should be noted that such economic disruptions did occur under gold standards. Also, every attempt to maintain a gold standard ultimately failed.

Using Gold as a Currency

Without the gold standard, the price of gold fluctuates freely in the market. Gold is seen as a safe haven, and a rising gold price is often an indicator of underlying economic problems. Gold allows traders and individuals to invest in a commodity that can often partially shelter them from financial turmoil. As mentioned above, disruptions will occur under any system, even a gold standard.

There are times when it is favorable to own gold and other times when the overall trend in gold will be unclear or negative. Even though the official gold standards are now gone, gold continues to be impacted by other currencies. Therefore, gold must be traded like other currencies.

Switching to a stronger currency can be the key to preserving wealth. For example, Germans who held gold-backed U.S. dollars during the Weimar Republic hyperinflation in Germany in the 1920s became rich rather than poor. Even when no countries are on a gold standard, investors can still buy gold. When they buy gold, investors exchange their local currency for the currency of many of the most successful nations in history. The Roman Empire of Marcus Aurelius, Victorian England, and George Washington's America were all on the gold standard.

Switching to a stronger currency can be the key to preserving wealth.

By purchasing gold, people can shelter themselves from times of global economic uncertainty. Trends and reversals occur in any currency, and this is true for gold too. Gold is a proactive investment to hedge against potential risks to paper currency. Once the threat materializes, gold’s advantage may have already disappeared. Therefore, gold is forward-looking, and those who trade it must be forward-looking as well.

The Bottom Line

Under a free market system, gold should be viewed as a currency like the euro, the Japanese yen, and the U.S. dollar. Gold has a long-standing relationship with the U.S. dollar, and it generally moves in the opposite direction in the long run. When there is instability in the stock market, it is common to hear talk of creating another gold standard. Unfortunately, a gold standard isn't a flawless system. Viewing gold as a currency and trading it as such can mitigate risks to paper currency and the economy. However, investors should be aware that gold is forward-looking. If one waits until disaster strikes, the gold price may already have risen too high to offer protection.