Why is RBI giving us the wrong advice on gold?

By Shanmuganathan Nagasundaram

I am a great believer in Darwinism and his theory of evolution based on the principles of self-preservation. Much as one has pondered about other options, this instinct for self-preservation would have to be the most charitable explanation for Reserve Bank of India (RBI) Deputy Governor KC Chakrabarty's recent comments where he advised Indian citizens against buying gold.

A more likely scenario is that he is clueless about the differences between "money" and "currency', as I will shortly explain.

But before embarking on what's as much of a lesson in history as in economics, it's important to clear another all-too-prevalent misconception. Every time gold prices go up, it's reported in the media - and RBI officials and so-called experts confirm this - that people buy gold because of uncertainties in the economic environment.

This is anything but the truth. If you take the top 10 economic research/investment firms in the world that operate in this space, all of them recommend gold because of the certainty of currency debasement. Readers can check out firms like Casey Research, Goldmoney, GATA, Sprott Asset, etc - all of these firms have been recommending to their investors for the last 10-and-odd years that they must keep a substantial portion of their net worth (sometimes going upto even 80 percent) in gold and related instruments.

So it's not uncertainty, but the certainty that central bankers will do a poor job of managing their currencies, that causes investors to buy gold. When a central banker complains about gold prices going up, it's much like a college kid who bunks classes, parties most of the time and does dope and then says that he deserves an "A+" and not an "F".

Gold is the canary that indicates the performance of central bankers isn't exactly pretty. Reuters

Gold is the canary that indicates the performance of central bankers isn't exactly pretty. And it's likely to get substantially worse in the years ahead. As I have written earlier, a five- digit gold price is guaranteed (in dollar terms, that is, in rupee terms it is heading for six digits) given the current currency in circulation (Read: Gold - Ending 100 years of solitude). With the introduction of the QEX series by the US Fed and the more recent proclamation of the "Draghi Put" by the European Central Bank, it's getting increasingly harder to put a ceiling to gold prices, let alone a floor.

Money Vs Currency

The Greek philosopher Aristotle defined money during the 3rd century BC. Based on his observations as to what the free markets had used over the previous 3,000 years, he identified the five properties of any commodity that can be used as money. They are:

Convenient: That's why iron or zinc cannot be money as it would require too much of a quantity to accomplish even an average transaction.

Consistent: That's why real estate cannot be money as each property is unique and not strictly comparable to another one.

Durable: That's why rice, wheat or even rare spices cannot be money as they have a relatively short shelf-life.

Divisible: That's why "art" or cattle cannot be money.

Has value of it's own and cannot be created out of "thin air: That's why "paper" cannot be money.

Based on the above five properties, the free markets standardised on gold (and silver) as money. It's very important to recognise that gold earned its title as money due to its unique properties and not because some king or government fiat declared the same as money.

So then what are currencies? Currencies "used" to be money substitutes due to their convertibility into gold and silver at fixed ratios. Since the closing of the gold window in 1971, that's not been the case and currencies are just floating abstractions, or unbacked liabilities of bankrupt governments. Or, in plain English, just pieces of paper. We laugh at the Romans or Egyptians for their beliefs in Apollo, Zeus, Ra and after-life, but they would have puked their guts out for this modern belief in paper money.

Central banks just print some numbers on pieces of paper and we accept the same as "money". Rather, we are forced to accept these as money through legal tender laws in some countries. So the RBI prints the 1 series (1 followed by as many zeroes as required) and when it's not enough, it prints a 5 series. My guess is that before this decade is out, we'll have at least one more addition to the "5" as well as the "1" series. Or as Jim Rogers would love to say, "we'll run out of trees".

Conclusions

Chakrabarty's statements, in my opinion, are just plainly ridiculous. Had he worked for a private investment firm, somebody would have eventually sued for the enormous damage that he's about to cause in the years ahead for dissuading people from buying gold. And if he is so concerned about the transaction costs and other issues he mentioned, he can contact any average Indian housewife and they would be able to educate him on that.

But what puzzles me is a more serious issue. Either gold is money or it's not. I happen to believe it is. But Chakrabarty is entitled to his opinions. If he thinks gold is money, then his statements reflect a very poor piece of advice. If he thinks gold is just a barbaric relic, then he should encourage the RBI to sell its gold and convert them to dollars or whatever colourful pieces of paper he fancies the most. Why prevent or discourage citizens who want to put their personal finances on a gold standard when the RBI itself is trying to do that for its own finances?

Shanmuganathan "Shan" Nagasundaramis the founding director of Benchmark Advisory Services - an economic consulting firm. He is also the India Economist for the World Money Analyst, a monthly publication of International Man. He can be contacted atshanmuganathan.sundaram@gmail.com