Why gold is better than cash

October 15, 2003

Rightly or wrongly, investing in gold is often compared to investing in cash. This is in part because gold has been used as money for thousands of years and often it trades like a currency although it also has some of the traits of a commodity.

Regardless of how you choose to categorize it, gold is often considered a currency. The summary below clears up some common misperceptions about gold, relative to cash, and shows that, when the concerns of the average persons with respect to cash are taken into account, well …. Gold comes out on top!

Defining Gold versus Cash

When gold is compared to cash, most people don't realize that there are two main different ways of holding gold bullion in a bank account: (1) allocated gold and (2) unallocated gold. Using this terminology, cash on deposit at a bank is technically "Unallocated Cash". Therefore, one should compare unallocated gold to cash on deposit. However, I am going to compare Allocated Gold to Cash on Deposit as most people who think of gold, think of it sitting in a vault, not being lent out and therefore not collecting a return.

Allocated gold is not lent out

One of the main reasons you keep money in the bank is that it (hopefully) pays a rate of return, the interest rate. Modern finance theory tells us that in simple terms, the greater the risk, the higher the return should be. Cash on deposit earns a rate of return because the bank lends out your cash - in effect you have loaned the bank your own cash. That is why you earn interest on it. The bank lends out this money at some multiple (in excess of 10 times) greater than its total deposits. You have just taken a risk on (1) the banks credit worthiness and (2) that the bank has made a good decision to lend out this money. The more money the bank lends out, or the higher the credit risk of the person/institution to whom the bank has lent the money, then the more risk you have taken on by depositing cash at the bank. The only control you have over this risk is by not keeping your cash on deposit with the bank. This is similar to unallocated gold: it is lent out to a 3rd party, often to a multiple of what is actually on deposit, and it earns a rate of return which is called the lease rate.

By comparison, allocated gold is not lent out, does not carry any credit risk on the bank or a 3rd party, and therefore does not earn any income. Indeed, allocated gold may bear a holding charge to cover the costs of storage and insurance.

The bank owns your cash

If you deposit allocated gold with an institution, you own the gold. You can turn up to the bank and demand your gold to be delivered to you. It is like holding it in your own safety deposit box.

Cash on deposit, on the other hand, is not owned by you. It is owned by the bank and therefore if your bank went into bankruptcy, then all cash on deposit with the bank would be shared amongst its creditors (unless it is bailed out by the government or through insurance). Having cash on deposit means that you rank as an unsecured creditor of the bank. Furthermore, if everyone demanded all their cash from the bank at the same time, there would not be enough cash to pay people. In small amounts, you can usually demand your cash, however even in modest amounts, cash cannot be paid on demand.

Gold is always accepted

Provided that gold has its authentication verified, gold has always been accepted. It has been used as a store of wealth and as a currency for many thousand years. And as Alan Greenspan said in May 1999:

"Gold still represents the ultimate form of payment in the world …..

Gold is always accepted."

In contrast, cash is not always accepted. The other day I withdrew £100 in 5 £20 notes from a banking machine. I then walked to the store to buy a sandwich for lunch. When I went to pay for my lunch I was told that the first £20 note I took from my wallet was not acceptable - I didn't know that it was an "old note"! A note which I had withdrawn from the bank five minutes earlier had not been accepted…. Yet gold is still used as a currency today. Gold is gold.

Gold is also accepted anywhere in the world. It can be a currency without borders. Cash has borders and this is most pronounced when the government is unstable, the currency is not liquid or the government is printing too much money. Upon reflection, I thought that none of these applied to the British Government yet my £20 note was still not accepted.

Gold is relatively scarce

Without getting too deep into the debate as to whether gold has scarcity value, it is worth pointing out that Gold Fields Minerals Services (GFMS) estimate that only about 150,000 tonnes of gold has ever been mined. At a gold price of US$370/oz, this values the total world gold stock at US$1.7 trillion. To put this in context, the total cash stock (M1 money - being cash & checkable deposits) in the United States is approximately US$1.3 trillion. Knowing that money exists in every country and how that money is multiplied, I would suggest that gold is scarce, relative to cash.

Gold is produced, money is printed

Gold forces discipline; gold's production process from exploration through to the minting of gold bars can take as long as 30 years, but let's say that it generally takes 10 years. Compare this to cash, which can be printed at will by each of the world's governments. On this subject, consider the famous remarks by Governor Ben S. Bernanke (of the Federal Reserve Board), before the National Economists Club, Washington, D.C., November 21, 2002:

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services."

Gold is subject to price risk, but so is cash

Unfortunately most people remember the years between 1980 and 2000 when gold fell from a daily high of US$800/oz to lows of US$250/oz. Gold has price risk but it can also appreciate.

People often forget that cash also has price risk. A currency's value (say the US$) is relative to other currencies or what the US$ can buy in terms of goods and services. Currently, the value of the US$ is falling against other currencies, making its value to international investors less attractive and making goods and services for US citizens more expensive. Cash has price risk too.

Gold is more secure

Investors holding gold in an allocated gold account are provided with the exact identification numbers of each gold bar they own: manufacturer, purity, and bar number. This gold is physically segregated from other gold in the vault and this gold can be insured.

Cash on deposit is not physically segregated. Your cash is mixed with other people's cash and you rely on the bank's accounting system to record details of your cash balance correctly. You are not provided with individual serial numbers of every note held on deposit for you and often the cash is not insured - do you insure your cash in the bank? Have you asked for proof (identification numbers) of your cash on deposit? And have asked the bank manager to keep your cash physically separated in an individual safety deposit box?

Below is an example of allocated gold. The photo shows a picture of actual gold bars held for an account at a major bullion bank and the table above it shows the bar identification numbers given to the customer.

Conclusion

It is not surprising that gold has been accepted as a form of payment for thousands of years: gold is indestructible, fungible, easy to store, liquid and secure. More importantly, gold is better than cash.

Nik Bienkowski CFA

Head of Institutional Investment

Gold Bullion Limited

www.goldbullion.com

October 15, 2003

Disclaimer

This information does not constitute financial advice. You should obtain your own independent financial, taxation and legal advice before making any decisions about investing in gold. This information is not an offer for investment in gold and should not be used as the basis for any investment decision.

A one-ounce gold nugget is rarer than a five-carat diamond.