Throughout the ages, gold has captivated societies, and in a post-gold-standard world, many feel that with the instability that occurred in the first decade of the 21st century, some form of the gold standard should be brought back. There were inherent problems with the gold standards implemented in the 19th and 20th centuries, and many people are failing to realize that gold, under the current free market system, is a currency. Gold has often been thought of in relation to the U.S. dollar, mainly because it is usually priced in U.S. dollars, and there is a rough inverse correlation between the USD and gold prices. These factors must be considered when we see that the price of gold is simply an exchange rate: In the same way one could exchange U.S. dollars for Japanese yen, a paper currency can also be exchanged for gold. (Learn more about the origins of currency. Read The History Of Money: Currency Wars.)

Gold Is a Currency

Under a free market system, gold is a currency, although it is not often thought of as one. Gold has a price and that price will fluctuate relative to other forms of exchange, such as the U.S. dollar, the euro or the Japanese yen. Gold can be bought and stored, and while it is not often used as a direct payment method for everyday use, it is highly liquid and can be converted to cash in almost any currency with relative ease.

Gold, therefore, has tendencies like those of a currency. There are times when gold is likely to move higher and times when other currencies or asset classes are likely to outperform. Gold is likely to perform well when confidence in paper currencies is waning, when there is potential for war and/or when there is a lack of confidence in Wall Street-type trading instruments.

Gold can now be traded in multiple ways, including buying physical gold, futures contracts, a gold ETFs, or investors can participate in just the price movements without owning the underlying asset by purchasing a contract for difference (CFD). (To learn more, see The Gold Showdown: ETFs Versus Futures.)

Gold and the U.S. Dollar

Gold and the USD have always had an interesting relationship. Over the long term, a declining dollar has meant rising gold prices. In the short term, this is not always true, and the relationship can be tenuous at best, as the following two-year weekly chart demonstrates. Notice the correlation indicator in Figure 1, which moves from a strong negative correlation to a strong positive correlation and back again.

Figure 1: USD Index vs. Gold Futures (pink) – Percentage Terms

Source: TD Ameritrade

The U.S. dollar's relationship to gold prices can be linked to the Bretton Woods System, where international settlements were made in U.S. dollars and the U.S. government promised to redeem dollars at a fixed gold rate. While the Bretton Woods system was dissolved in 1971, the U.S. remains a global power in 2010; therefore, when gold is discussed, talk of the U.S. dollar usually ensues.

While gold and the U.S. dollar share a relationship, as any major currencies do, it is important to remember that gold and currencies are dynamic and have more than one simple input. Gold, for example, is impacted by far more than just inflation, the U.S. dollar or war. Gold is a global commodity and therefore, gold reflects global sentiment, not simply the sentiment of one economy or group of people.

Problems with the Former Gold Standards

When considering gold as a currency, many people support moving back to an adapted form of the gold standard. There were various problems with the gold standards that were implemented between the 1800s and 1971 (there were gold standards well before this time as well).

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 allow for proper inflow and outflow of gold to bring the exchange rate back to par with trading partners. While many countries followed the rules, several did not - namely France and Belgium. Any system requires the cooperation of the parties involved, and the gold standard was no exception.

A second problem with the gold standard was that while it did maintain average price stability over the long run, there were still short-term price shocks that needed to be absorbed by economies. The California gold discovery of 1848 is a prime price shock example. The gold find increased the money supply, which raised expenditures and price levels, creating a short-run of instability. While this could be counteracted with the proper protocol, it should be noted that economic disruptions did occur during gold standard times, and no attempts to sustain a gold standard have lasted. (For more, see Why Gold Matters.)

Gold as a Currency - Revisited

A post gold-standard free market system basically allows gold to act as a currency. This means gold, often referred to as a "safe haven," is an indicator of uncertainty. Gold allows traders and individuals to invest in a commodity that can often partially shelter them from economic disruptions. As mentioned above, disruptions will occur under any system, even a gold standard. Just as there are times when it pays to cross a border to buy goods in another country because of a favorable exchange rate, gold should also be viewed in this way. There are times when it is favorable to own gold and other times when the overall trend in gold will be benign or negative. Even though the official gold standards now gone, gold continues to be impacted by currencies and global sentiment; therefore, gold must be traded in the same way as a currency is traded.

As for the problem of countries not playing by the rules, this is likely a problem that will not go away under any system. But at least under a free market currency system, over the long run, countries are penalized for not adhering to protocols.

No matter what system is in use, its effectiveness relies on investors' belief in the system. The lure of the gold standard is that it provides the illusion that paper money is backed by something substantial. Yet gold can neither be eaten, nor can one build a house from it, making its value a matter of the mass perception of the global market place. Free markets allow gold to act as a currency for those who wish to use it, while other currencies are backed by those who accept that paper money will pay for goods and services. This belief is reinforced by advertising: An ad not only promotes a product, but by providing a price, it reaffirms the idea that paper money buys goods and services. Gold need not enter the equation, except for those who wish to invest in a commodity/currency during times when it is advantageous to do so.

By purchasing gold, people can shelter themselves from times of global economic uncertainty. Trends and reversals occur in any currency, and this holds true for gold as well. Gold is a proactive investment to hedge against potential threats to paper currency. Once the threat materializes, the advantage gold can offer 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, yen or U.S. dollar. Gold has a long-standing relationship with the U.S. dollar and over the long term, gold will generally move inversely to it. With instability in the market, it is common to hear talk of creating another gold standard, but 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, but people must be aware that gold is forward-looking, and if one waits until disaster strikes, it may not provide an advantage if it has already moved to a price that reflects a slumping economy. (To learn more, check out Getting Into The Gold Market.)