Warren Buffett on gold, and a response

“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
– Warren Buffett

In response, LargoWinch applies the same logic to fiat currency: “It comes in abundance from trees with little to no efforts, we print as many as we want and assign whatever “value” to it, but we make certain that it contains official looking faces and logos so that we can pay people (yes, with “it”) to stand around guarding it.”

And unlike Buffett’s preferred investment, stocks, the accounting for gold is much simpler: you weigh it with a scale. Gold won’t go up forever, and there will be a time to sell, but it’s a heck of a hedge against dishonest companies who are cooking the books and dishonest politicians who are debasing the currency through inflation.

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18 Responses to Warren Buffett on gold, and a response

  1. pdb says:

    Money is a commodity, just like gold. It’s only property is that people can readily exchange it for goods and services. If I’ve got a bunch of PVC pipe and need some milk, I’d have a hard time finding someone that needs pipe and has milk. But I can easily find someone with cash who needs pipe, and the guy with the milk is more likely to take cash than PVC pipe!

    Also like other commodities, money’s value changes according to the laws of supply and demand. If there’s ‘too much’ money, we have inflation, and so on.

    Unfortunately, the only difference paper money has with commodity currencies like gold, oil futures or McDonald’s gift certificates is that it’s value is controlled via political processes and not market processes!

    The best thing a gold based currency has going for it is that the magic money lever of the fed gets taken away from politicians. This is also why politicians will never give up fiat money.

  2. Steve says:

    Lots of things people do would look strange to people from Mars.

    The reason people have naturally accepted gold as money is that, because it is a naturally limited resource, they know that it will hold its value. On the other hand, every government that has resorted to fiat money has ended up destroying it through inflation.

    pdb is right. The government absolutely depends on fiat money to support the warfare/welfare state.

    Steve´s last blog post..Decentralized Governments

  3. Yu-Ain Gonnano says:

    There are lots of things that are naturally limited resources. Salt, shells, teeth, grain… Many of which were used as money at one point in time.

    But you don’t see anyone advocating for the salt standard today though.

    The truth is that nothing has intrinsic value. Things only have value because we pretty much agree they do. And thus the basis of value for gold and fiat currency are exactly the same.

    What makes a hundred dollars of gold worth $100? Because people will give you $100 worth of stuff for it.
    What makes a hundred dollars of fiat currency worth $100? Because people will give you $100 worth of stuff for it.

    But gold is a zero sum game. When I take a plank of wood and hunk of iron and turn them into an axe, I created wealth as the axe is worth more than the sum of it’s parts. But I didn’t create any more gold. And so there is more “wealth” than there is gold. This can either be solved by debasing the gold (the evil gov’t inflation monster) or by adding another commodity to the money supply, say silver.

    But once you do that, what’s to stop you from adding yet another commodity, and another, and another until the security for the currency is essentially the entirity of the society itself? Which is, by definition, fiat currency. The money is backed by society itself. It has value because we say it does.

    So you get inflation either way, because wealth can be created, but commodities cannot.

    By ceding control of your money supply from the gov’t to the market, you put the stability of your currency in the hands of foreign mining companies. You think foreign governments owns too much of U.S. debt today, do you really want to give them *direct control* of our money supply?

  4. Les Jones says:

    “There are lots of things that are naturally limited resources. Salt, shells, teeth, grainÖ Many of which were used as money at one point in time.”

    They were used here and there from time to time, but gold was used as a store of wealth and medium of exchange continuously from ancient times through the 1970s, when Nixon closed the gold window. Some currencies are still partially backed by gold. If gold isn’t useful why do central banks hold it?

    “What makes a hundred dollars of gold worth $100? Because people will give you $100 worth of stuff for it. What makes a hundred dollars of fiat currency worth $100? Because people will give you $100 worth of stuff for it.”

    True, but the amount of stuff that they’ll give you for that $100 of paper money is constantly declining due to inflation.

    I’ll put $100 worth of gold into a vault. You put in $100 worth of paper money into a vault. In 10 years which do you think will retain more buying power? The cost of many things increases with time for paper money, but stays relatively constant measured in ounces of gold.

    “But gold is a zero sum game.”

    That’s true. So is money, until it’s inflated. Gold’s value is as a store of wealth and medium of exchange. (So are stocks, the way most people use them.)

    You’re mixing up a few concepts here. You’re alternately talking about investment, production, wealth, and currency as it helps your argument.

    Gold can be a good investment when it’s undervalued. However, its main functions are as a store of wealth and a medium of exchange. It is uncorruptable, divisible (unlike, say, a building or a Picaso), easy to store and transport because of its monetary density, and is readily exchanged for goods or currency with minimal frictional costs.

  5. Yu-Ain Gonnano says:

    Thatís true. So is money, until itís inflated.

    Not at all. From the example, the axe added to the total amount of value. Yet, the amount of gold didn’t increase to match. Thus gold suffers from deflation.

    If gold isnít useful why do central banks hold it? Because people value it and it’s convenient. Same reason central banks hold dollars as well.

    The cost of many things increases with time for paper money, but stays relatively constant measured in ounces of gold.

    Actually, if we had stayed on the gold standard, they would have gone down. At current prices the sum total of all the gold in the world is only about 4.5 Trillion Dollars. This would be inadequate to service the U.S. economy, much less the world. If we were to revert to the gold standard the price of gold would have to skyrocket or the dollar debased to compensate.

    And thus we see the problem with the gold standard. An economy on the gold standard can grow no faster than gold is mined. If it were to grow faster, you’d be better off to hold onto the gold as deflation will make goods cheaper tomorrow, but cheaper still the next day, and the next, and the next ad infinitum. Thus commerce slows down as no one wants to trade an appreciating asset (gold) for a depreciating one (everything else). Thus your economy is dependent only on your ability to mine gold. Talk about putting your eggs all in one basket. When it runs out, you’re done. No more growth.

    And then, if another country finds a large cache of it, you become instantly poorer as the money supply increases. In effect, inflation becomes not a problem of your own gov’t printing money, but instead is a problem of some other gov’t printing money.

  6. Yu-Ain Gonnano says:

    Sorry, the edit feature timed out.

    Thatís true. So is money, until itís inflated.

    Not at all. From the example, the axe added to the total amount of value. Yet, the amount of gold didnít increase to match. Thus the gold standard suffers from deflation. In order to preserve the ratio of value to money so that you get neither inflation nor deflation you have to print money.

    For another example, let’s say there are only 5 houses (worth $100k each) and 5 families. Introduce a couple of children and in a few decades there are 6 families, but only 5 houses. Everyone’s house just increased in price (say to $125k) as demand is greater than supply. You still have rising prices and now your gold doesn’t buy as much house anymore.

    It’s the evil inflation monster and you didn’t even have to print money to do it.

  7. Les Jones says:

    Again, you’re bouncing around when it’s convenient.

    You’re saying an ax has more utility than gold. OK, but gold is a better store of value and a better medium of exchange.

    You talk about gold not being wealth, but you offer no definition of wealth.

    “Not at all. From the example, the axe added to the total amount of value. Yet, the amount of gold didnít increase to match. Thus gold suffers from deflation.”

    This is a bizarre way to define deflation. And anyway while that axe was created a hundred others were being worn down or were rusting in basements. Gold doesn’t rust.

    Incidentally, nowhere above did I advocate a return to the gold standard. I have mixed feelings about it, FWIW. I don’t think we’ll ever see a return to a 1 to 1 dollar to gold standard. However, I can imagine a partial backing, the way the Swiss Franc is 1/6th backed by gold. Without some backing it’s inflation now and inflation forever.

    Anyway, you don’t need to wait for a return to the gold standard. You can buy gold yourself right now.

  8. Brian says:

    “I created wealth as the axe is worth more than the sum of itís parts.”

    While I agree with the substance of most of your argument, the quoted sentence is not entirely true. You only created wealth if there is a demand for axes right now. If there is not you might have reduced total wealth because you have taken two objects that have many uses (a bock of iron and a length of wood) and altered it into an object that has fewer uses.

  9. Yu-Ain Gonnano says:

    Again, youíre bouncing around when itís convenient.

    I don’t see it that way. Wealth, money, store of value, medium of exchange, investment, production. They’re all about value and how you use it.

    I wasn’t saying that the axe was a good medium of exchange. That’s a bad use for it. What I am saying is that the axe does have value but that on a finite monetary standard this value is lost as it cannot be accounted for.

    When the gold runs out, one is then forced to use the axe as a medium of exchange because you have no other option. This is the reason for barter economies. There’s more value available (wealth is the sum total of value available to you) than there is gold to exchange for it.

    This is a bizarre way to define deflation
    Inflation and deflation are relative terms. Inflation occurs when the relative price of goods go up and deflation when the relative price of goods go down relative to the currency.

    The cost of comodity X has gone up relative to the dollar therefore the dollar suffers from inflation.
    The cost of comodity X would go down relative to gold (if the commodity is produced faster than gold is mined) therefore gold suffers from deflation.

    For example, from wikipedia, US gold reserves are 8,133 tonnes. At roughly $950/oz, this gives the US about $260billion in gold. Since the U.S. economy is about $8Trillion the price of gold would have to raise 32 fold to bring us back into equilibrium. That is to say, your nearly $1000/oz gold would suddenly become $32,000/oz.

    Thus, if inflation is when you need more dollars to buy the same stuff, needing a heck of a lot less gold to buy the same stuff is deflation.

    Either that, or we have to create a secondary medium of exchange: stocks, silver, oil, or direct bartering.

    However, I can imagine a partial backing, the way the Swiss Franc is 1/6th backed by gold.

    Until the Swiss decide to make it only 1/7th backed by gold, then 1/8th, then…

    The entire reason for fractional backing is that there isn’t enough gold to support the economy. So if the economy grows and gold reserves don’t, you have to change the fraction again. Yay :-|

    I’ll finish like I started. The issue all revolves around the concept of value. Money, whether fiat, commodity, or representative, is just a proxy.

    Brian,
    Very true, but even that supports my point. Wealth is created and destroyed all the time. In order to keep a currency stable the sum total of value for the currency must match the sum total of value in the society.

  10. Les Jones says:

    You’re doing it again. :-) Trying to make arguments against gold all at once by changing the terms.

    Go here. Buy a 1 oz. gold double eagle. That’s a store of value. No need to wait for the government to go to a gold standard.

    As a store of value, that double eagle does well against inflation over long periods of time and does especially well during times of extreme inflation.

    Can you cut down a tree with it? Of course not. For that you need an ax. Can you live inside it? No, for that you want a house? Can it transport you from point A to point B? No, for that you want a car.

    Axes, cars, and houses are all forms of wealth that offer utility. They’re good things to have. But once you have an ax, a car, and a house, and you have excess wealth you want to store for the future – a rainy day, your children’s college tuition, your retirement – you need a way to store that excess wealth.

    Gold is one way to store excess wealth. It’s certainly not the only one. Stocks, bonds, t-bills, and lots of other things can be good, depending on the market. But it’s an option that’s very attractive now with inflation ahead. Click the inflation tag on this post to see past posts that might convince you we’re headed into an era of high inflation.

    And unlike axes, I can buy gold in my 401K retirement account. :-) I currently own GLD, CEF, and GTU.

    I’m looking into buying some commodities, particularly oil, which is sure to go back up in a big way. Heck, I’m considering buying some oil ETFs or stocks outside of my 401K (which I never do) as a hedge against rising gas prices. $2/gallon gas isn’t going to last long. I wouldn’t mind taking some of the money we’re saving on gas now, invest it into some oil-related equities, and cash them out later when they go up along with the price of gas.

  11. Brian says:

    “Very true, but even that supports my point. Wealth is created and destroyed all the time. In order to keep a currency stable the sum total of value for the currency must match the sum total of value in the society.”

    But you are speaking as though wealth is a systemic phenomenon…i.e. creating an ax adds to the grand total of wealth everywhere in the world, whereas wealth is entirely relative to the individual. If I already have 30 axes, the creation of an ax is more or less valueless to me (unless we started using axes as a symbol of value like gold or shells). This is why in neoclassical economics value is entirely a function of the price of an object on an open market, and why prices vary from location to location. An ax is probably less useful in the middle of New York City than it is in the wilderness of northern Canada.

  12. Yu-Ain Gonnano says:

    i.e. creating an ax adds to the grand total of wealth everywhere in the world,

    No. Given your clarification earlier, I’m saying that creation of an ax changes wealth. It may be large, or small, positive or negative.

    Youíre doing it again.

    But of course I am. I already said that all of those things are based on the concept of value and as such can be spoken of in those terms. The only difference is in how that value can be efficiently used.

    Thatís [gold] a store of value
    So what? So is diamond, but we don’t see anyone wanting to base a currency on it.

    I don’t dispute that gold has value. Just that it is inadequate to the task of currency. There just isn’t enough of the stuff. According to Forbes the 14 richest Americans could own 100% of the gold in the US. What exactly would the rest of us use?

  13. Les Jones says:

    Thatís [gold] a store of value
    “So what? So is diamond, but we don’t see anyone wanting to base a currency on it.”

    Good grief. Enough with the currency argument. Gold as a store of value and gold as a currency are two separate issues.

  14. Tom says:

    Look at the long term record of stocks with retained earnings compared to gold which earns nothing. Gold has been flat over time adjusted for inflation while stocks have earned a return several percentage points higher than inflation.

  15. Les Jones says:

    It totally depends on the time scale. Since 2000 gold has gone from 250 to 950 an ounce, which outpaced the hell out of inflation.

    Gold is not an anytime anywhere investment. It is an excellent investment in times of war, inflation, and questionable currency value. All three apply right now and in the near future.

  16. Nate says:

    I know I’m late to the party, but I’ll chime in anyway….

    Gold’s biggest problem is that the “value” you assign to it is 100% subjective. It is no different from fiat money in that respect.

    If there were no commodities markets constatnly publishing the trade price of gold, you’d have no idea what it was worth. You can’t look at a hunk of gold and determine its value. Someone else has to tell you what it’s worth. A corporation, on the other hand, can be valued in the absence of published market prices. I can look at the revenues, the cash on hand, the liabilities, the capital assets, etc, etc… and I can put a reasonable price on that company.

    Gold’s value is purely a PERCEIVED value. If tomorrow, the collective world decided that gold was worthless, your investment would go “poof”. There’s no tangible inputs to support the price. It’s purely perception.

    Gold is so often cited as a doomsday investment (although, admittedly not by our author). But why? If my concerns are food, water, shelter, and protection, explain to me how gold is going to satisfy any of those concerns. When Mad Max comes wandering up to offer me a hunk of gold in exchange for my gallon of water, I’m gonna tell him to pound sand. I’ve never understood the logic.

    The whole concept of gold as a store of value is ludicrous. Sure it stores value. So does everything else in the world. Irrational investors can assign any price to any asset at any time. Just because it happens, doesn’t mean it’s justified or that it will continue to be that way. If public perception ever shifts, gold could be worthless. After all, there was a time when the public perceived Lucent Technologies to be worth $80+ a share. Lucent never cooked the books, nor did they fudge the numbers. Rather, irrational investors simply PERCEIVED the value to be much greater than the tanigible inputs justified. Explain to me how gold is any different.

  17. Les Jones says:

    “The whole concept of gold as a store of value is ludicrous. Sure it stores value. So does everything else in the world”

    Not really. Cash, for instance, has lost 90+% percent of its purchasing power over the last century due to inflation. (And that’s in the U.S. Other countries have had currency exchanges and official devaluations that have wiped out most of their value. It happened just this year in North Korea.)

    Gold has lots of good properties:
    - It requires minimal storage space.
    - It’s highly portable.
    - It requires no maintenance other than being locked up and possibly insured. You don’t have to feed it or paint it or pay property taxes or slip fees. You can neglect it and it won’t even rust.
    - It’s divisible. You can’t readily sell part of your Picaso to pay this month’s rent; and if you can you can usually only do it once (by pawning it, for instance). You can readily sell a few of your gold coins or even shave off part of your gold bars. Need more money next month? Repeat as necessary.
    - Unlike stocks or bonds its value can’t go to zero.
    - Unlike stocks or bonds there’s no counter-party risk. The value of your gold can’t get wiped out because someone else went bankrupt.

    Gold isn’t perfect, and it isn’t the solution to all problems at all times, but it’s got some mighty fine properties.

    I love having it now as a hedge against inflation and currency collapse. That it’s been up going up make it even nicer.

    I expect gold to climb. At some point it will be time to sell. When it gets cheap again years from now I hope I have the money and the wisdom to buy it again.

  18. LChang says:

    Yu-Ain,
    Thanks for your very insightful commentaries and examples. They made total sense to me. Now, I have a much better idea on how to think about this subject, especially in light of Ron Paul’s push to go back to the gold standard.
    People like Les Jones, which there are many, like to view the world in very simplistic terms. If it’s too complicated, then it must be wrong. Valuation is a complex subject, so I thank you for breaking it down and giving it the deep analysis that it deserves.