Why Trading Gold for Oil Doesn’t Make Gold Money

If India trades gold for oil, does that make gold money?

No.

OK, it’s more complicated than that, but the short answer is still, “No.”

The long answer has to do with pricing and substitution, which are kind of boring words, and yet they are at the heart of the matter.

You see, while my accountant never fails to remind me that India’s decision to trade gold for oil is a clear example of how gold can and will be used as a form of money, questions do arise, like, “How much gold is a barrel of oil worth?”

Hmmm…

To express the answer, I bet the Indians and Iranians are not delving into the issues of consumption and production. Instead, they’re probably looking to the international spot market and futures market, finding a delivery date and oil grade that matches what they are trading, and then using the price listed… in U.S. dollars… to begin their negotiation.

Then they’re converting the U.S. dollars into ounces of gold, again using some international gold market that expresses prices in… U.S. dollars.

Gee. All of sudden the whole notion of trading gold for oil doesn’t really seem like it gets too far away from the greenback.

Why India Trading Gold for Oil Doesn’t Make Gold Money

To have gold truly perform the function of money, India and Iran would have to express the “price” of oil in ounces or grams of gold, and it would not be dependent on a U.S. dollar equivalent.

Instead, the rate of exchange would be dependent on factors such as how much oil is being produced and demanded in the world, and how much gold is available to exchange for oil versus other goods and services.

After all, that’s how money works, right?

We determine the availability of the product or service in question, and then we determine how much of our store of U.S. dollars, or other currency, we want to use on that product or service.

The exact exchange ratio is determined not just by the transaction in hand (gold for oil), but instead is informed by all of the other transactions going on in the marketplace simultaneously.

Currently gold does not determine the price of the dollar, instead the price of the dollar determines the price of gold. So the precious yellow metal lacks one of the crucial requirements of “money.”

Substitution is the other point that comes to mind when considering this exchange of gold for oil…

The Indians and Iranians made an arrangement that substitutes a commodity for money. Granted, the commodity in question (gold) has been used as money in the past, but it is NOT used in that way today. That is, it is not simultaneously a storehouse of value AND a unit of exchange.

So does the arrangement between these two countries satisfy the “unit of exchange” requirement? It would, if the two parties had not relied on the pricing mechanism I described earlier. Instead, all they’ve done is plug and play.

An example will clearly illustrate the point…

Really, They Could Substitute Anything

If the Iranians want to sell one million barrels of oil, the Indians would presumably look to the international markets and determine that the oil should cost one million barrels times the price per barrel of say, $90, which is obviously $90 million.

From there, the Iranians and Indians agree to substitute gold for U.S. dollars. To arrive at the right amount of gold, they divide the total oil price of $90 million by the current price of gold, say $1,550, to arrive at 58,064.5 ounces.

In this arrangement, the two parties could substitute anything. How about iPads? The $499 version? Instead of $90 million, or 58,064.5 ounces of gold, the oil now “costs” 180,360.7 iPads.

They could substitute wheat, ball point pens, tons of steel, Nikes… even hours of service in a call center. The Iranians could negotiate for a credit of say 18 million hours of call center service (assuming the service is priced at $5/hour), that some Indian company could perform at some time in the future. It could be in response to when Iran takes people into custody for no reason… their relatives could call 1-800-HOSTAGE to see what in the world is going on.

OK, the last part is a bit extreme, but the point is made. Simply substituting a product or service in the place of money does NOT make that product or service the same as money.

So the Iranian/Indian arrangement, as proof that gold can be used as money, fails on two fronts.

But note, we’re clearly stating that gold is not money TODAY. It has been in the past, and it can be tomorrow.

For gold to be money, a national government must recognize it as such, allow national debts to be paid in gold, and also use gold to pay for goods and services. That’s not happening today.

For now, gold remains nothing more than a commodity.


Rodney

 

Ahead of the Curve with Adam O’Dell

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This is not a chart of gold (in U.S. dollars), nor a chart of oil (in U.S. dollars). This is a chart of oil, in gold

 

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Categories: Economy

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.