Is gold any good as a currency?

With governments across the world producing paper currencies at a rapid rate, some investors have voiced a desire to return to some kind of gold standard. The early 20th century gold standard essentially fixed the ratio of bank notes in circulation to the stock of gold held by the issuing central bank. If gold were once again to form the basis of the world's money, then governments would not produce money at will.
The amount of money in circulation in an economy would only be able to increase if the amount of gold owned by the relevant central bank increased, and thus (so the argument goes) the value of money is preserved. So is there any validity to a gold standard as a currency benchmark? There is a critical problem with the idea of gold forming some kind of central role in the modern foreign exchange system: There is not enough of it.
More accurately, the supply of gold is not growing fast enough. A gold based currency system would condemn the world to global deflation. Gold would be an absolutely terrible reserve currency.
A reserve currency is demanded primarily to facilitate global trade. The more economies trade, the more reserve currency they will need to effect their transactions. Therefore the growth in the supply of a reserve currency needs to be approximately the same as the growth in global trade. This is the fatal flaw for those seeking a return to a gold standard.
Let us assume that globalization holds steady, with global trade averaging around 20 percent of the world's GDP. Under these circumstances, the value of global trade will rise in step with the rise in the value of global GDP. If the world economy has a trend nominal rate of growth of around 6 percent to 6.5 percent (perfectly realistic in the current climate), then the supply of reserve currency to the world economy needs in order to conduct international trade has to rise by around 6 percent to 6.5 percent.
The problem that the world faces is that the supply of gold is rising at around 1.5 percent per year, thus there is too little gold to facilitate the trade in international goods and services. There are only two possible outcomes that can be generated by this situation.
The first is that globalization goes into reverse (so that trade becomes a declining share of the world economy, and trade grows at around 1.5 percent while the economy growth at around 6.5 percent). Reducing the role of international trade in the world economy would make the world economy less efficient. That means that people would have a lower standard of living than they could otherwise achieve.
Alternatively, the world could experience deflationary pressures. If the world economy is experiencing deflation, with prices falling at 2 percent every year, it would grow at around 1.5 percent per year in nominal terms. That could give a nominal trend rate of growth for exports of around 1.5 percent per year, in line with the growth in gold supply.
However, a world economy with repeated bouts of deflation is hardly healthy - as Japan in recent years or the US in the 1930s demonstrated. Deflation imposes a heavy burden on borrowers. That can serve as a disincentive to investment and entrepreneurship.
As if the lack of supply were not a big enough problem, we also have to recognize that gold is demanded for other reasons. Jewellery demand, even industrial demand for gold will absorb some supply.
These are not necessarily stable sources of demand. A good monsoon season in India could lead to an increase in income for Indian farmers, who chose to purchase gold jewellery, absorbing an increased proportion of the world's gold supply.
Under a gold standard, the money supply of America, the inflation rate of China or the growth of German trade could be affected by how much rain falls in Mumbai. This is hardly desirable for the modern world economy.
If gold is so unsuitable as a currency, how did the gold standard work in the past? The first point is that the gold standard in the late 19th and early 20th century did not in fact last very long. The US only adopted the gold standard in 1900, for instance, and the system collapsed under the strain of international conflict in 1914.
Second, the supply of gold under the gold standard benefited from new gold discoveries and (to some extent) more efficient mining techniques. This meant that gold supply could grow more rapidly than it can today, and mitigate the deflationary impacts. Even with this, the late 19th century still experienced some notable deflation episodes.
The fundamental fact is that gold supply today can not keep up with the growth in the world economy. Unless someone can successfully unlock the secrets of alchemy and find a way of turning base metal into gold, gold has no serious role as a currency.