The value of gold: some theoretical
considerations
The problem with the back-of-the-envelope
calculation
Robert Wutscher
The Shadow Economist
Feb 11, 2010
The following article discusses some
of the fundamental dynamics of gold as money (circulating currency)
that are likely to assert themselves IF we were to move towards
a form of gold standard. I am not arguing either for or against
such a move, which would require other considerations. I also
show how the dynamics can differ conditional upon an inflationary
or deflationary “death” of the paper currency. From
the way it is written, I seem to favour the deflationary path.
However, this is only because it is the more complex of the two
to account for. The inflationary path is easier to work out and
for that reason does not require nor take up much discussion
in this essay.
"The true value of gold is not
to be crucified on a cross of price."
-Gold meditation mantra
The true value of gold lies not in its
dollar price, but in its role in the monetary system. One which
has been removed from it since 1971. Most readers of this website
are probably more interested in its dollar price - how they can
gain personally from gold or preserve their wealth with it. Many
of those readers would also be interested in seeing its role
restored in the monetary system. But they implicitly assume that
the two goals are linearly compatible. They see no conflict between
the intangible benefits afforded by the restoration of sound
money and the personal gains that can potentially be made from
it in a transition to a gold standard. But there is a snag.
The most basic back-of-the-envelope calculation
for a targeted gold price is to divide some measure of the money
supply by ounces of available above ground gold supply. Jim Sinclair,
purportedly the world's largest gold trader, once wrote on his
website that he used this formula to determine the high in 1980.
Some more conservative pundits apply a percentage of the money
supply and divide by estimated ounces. (1) Other
more aggressive pundits even add total derivative and credit
card debt to arrive at some outlandish targets. But where is
the snag?
If we were to move onto a gold standard,
the snag is to assume that all the dollars you count out there
are for real. You would implicitly be assuming that all debts
can be repaid and rolled over (even through monetary and price
inflation) or monetised. You would also be assuming that asset
(collateral) values are fair or sustainable at whatever level
you lock in the gold price to the currency. You are also expressing
a high degree of faith in the Fed's ability to inflate away our
debt troubles. You are also overlooking the fact that the money
multiplier, which started off at around 8x in 1970 and has been
pushed up into 50x before the 2008 crisis, could unwittingly
go into reverse gear.
Parting with the above implicit assumptions
(and sticking with the back-of-the-envelope formula throughout
this essay), it is my contention that you would need to determine
what the money supply would be on the basis of a sustainable
private debt level first. (2) Only on
the basis of the amount of money left over after deflation would
you be able to derive a “stable” numerator for the
above back-of-the-envelope calculation.
Without the purging of “excess”
private debt there cannot be a recovery. Everyone will only be
working to pay off their debts, which would be money deflationary.
But if debts are paid off with deposits which therefore disappear
from the system, don't we end up with less circulating dollars
in relation to gold than initially calculated?
A more concrete example might make this
clearer. Assume a current house priced at 200,000 dollars based
on how far prices could be pushed under the current fiat money
regime (through debt extension and money multiplier process).
If we could determine a sustainable house price at 50 ounces
(relative to income in ounces), that would mean that gold should
be valued at 4,000 dollars. But what if the house in dollars
were to be overvalued? Let us say that without excess (unsustainable)
debt, the house would only be worth 50,000 dollars. This being
the price that willing buyers would pay willing sellers relative
to their incomes in ounces (and without any consideration of
the fact that the sellers may be unwilling to sell because they
paid 200,000 dollars in the first place). Now gold is only 1,000
dollars.
All this assumes we have not yet transitioned
to a gold standard. If we had, the price at which money is fixed
to gold can have a material impact on general prices and economic
conditions, whether the gold price is set too high or too low.
(3) A transition will always be easier after
excess private debts have been purged, as it is almost impossible
to determine a sustainable debt level before the time (because
there is no constant level, only a comfortable one - below a
sustainable threshold - during different stages of the business
cycle (4)). Until then the value of money will
prove unstable (in terms of goods in general).
The above is of course only a problem
if we assume deflation and - in the specific example above -
that house prices can fall in nominal terms.
If we have not exceeded the sustainable
private debt threshold, then our answer would be different.
Under that scenario, the price of gold would be unbounded to
the upside. It would move up in relation to the increase in money
supply. Private debts would not pose a problem because they can
be eroded away in real terms up until such time that gold gets
locked in and reaches its fair value in relation to general goods
prices. (5) Public debts would effectively get
monetised under this scenario, where the money then flows freely
to the private sector feeding price inflation without any need
for net debt repayments. In fact, if the nominal interest rate
could be maintained low enough, there would be a scramble for
more leverage. Though this may have been written in a somewhat
nonchalant manner, I do not wish to imply that such an inflationary
scenario is not without its (horrendous) costs.
Whereas gold investors might think they
have it easier as they only have to guess at the price that can
make them money, monetary theorists contemplating a return to
gold have a much harder task ahead of them. They have to determine
the price that the market would have determined had gold already
been widely in circulation as currency or a process of how to
get there. Such a price could be vastly different to the speculators'
guesses, which is based on a much narrower market. The mistake
is to assume that a narrow market can serve as a proxy for the
market price of gold as circulating currency. Even worse is to
assume that a leveraged market (such as the Comex) can serve
as a proxy for effective cash demand.
For example, as speculators are working
with all available supply, it seems only logical that any extension
of the market must come from additional demand. But demand for
a commodity as “store of value” (its current role)
is entirely different to demand for “medium of exchange”.
“Store of value” because of hoarding is again different
to its value as true savings (linked to investments in an efficiently
functioning capital economy) where prices are ultimately determined
by future cash flows. Circularity (where gold income can cover
gold expenditures) is required to approximate general equilibrium
conditions for the economy as a whole. Hoarding can easily lead
to much higher prices as supply is effectively removed from the
market. Dishoarding of money (if gold) will always lead to a
drop in its price as it becomes available for circulation (as
medium of exchange) to drive up general goods prices. Unlike
fiat deposit money, it cannot disappear in debt repayment.
“Store of value” will only
equal “medium of exchange” value when savings are
true (i.e. equal to investments without significant hoarding
(6)). “Store of value” will then
increase based on general productivity gains (as opposed to decrease
under the fiat monetary regime because of monetary inflation).
If productivity drops because of economic contraction before
transition, then (current hypothetical) “store of value”
must also drop in order to start off a lower base at wherever
the economy bottoms. “Store of value” (when it is
also medium of exchange) can only store what value there is in
the economy. That ultimately depends on the amount of wealth
there is that can be transferred across time. (7)
Higher goods prices are incompatible
with higher gold prices when gold is money. A contraction in
trade would mean more gold relative to goods and therefore higher
goods prices relative to gold (its inverse). For as long as we
remain on the fiat regime, higher goods prices remain compatible
with higher gold prices. The danger is that investors push gold
prices too far because they do not entertain a bout of deflation
(which arguably may already have been experienced) and have too
much faith in the Fed. The same holds under the inflationary
scenario where the increase in the price of gold should not be
pushed too far ahead of other commodities.
What I have written may prove highly
dissatisfying for the gold investor/speculator as he has no way
of determining whether the current gold price is above or below
its monetary price (at least not on the basis of the above analysis
alone). I hope, however, that it proves insightful for the monetary
theorists on the problem dynamics that need to be addressed in
considerations towards a restoration of a gold standard. However,
I believe that even the astute investor, who is able to read
both the markets and the economy, can draw some insights into
possible price volatility that is likely yet to unfold if we
were to move towards a gold standard. Whether such a move is
at all warranted requires much further debate and analysis.
Notes and references:
1) Perhaps they do so to account
for some continuation of fractional reserves, where banks will
never need to pay out all the gold at any one time to depositors.
2) See my first article “Why
the Fed will fail”
(Dec 22, 2009) where I explain why there is a big difference
between the unsustainability of private as opposed to public
debts for the purposes of determining the effects of inflationary
policies. This condition determines the creditworthiness of borrowers
and is intimately connected with the willingness to borrow and
lend, the linchpin of our current fiat monetary regime.
3) For example, if gold was locked
in at 4,000 dollars, then the house price would rise to 200,000
dollars through a process of price inflation with all its concomitant
effects. In real terms, however, you would be no better off at
the end of the process than if gold was set at 1,000 dollars
as the house is still only worth 50 ounces (but would involve
monetary deflation with its unfavourable effects if the house
price was above 50,000 dollars when you started).
4) Many Austrian economists may
strongly disagree, arguing that money supply growth and elasticity
of money are the prime causes of business cycles and that therefore
a return to gold should help in eliminating it. My contention
is that even under gold standards, we have experienced business
cycles. Elasticity of money is a primary cause, but is one in
the form of a fuel. Fundamental causes of cycles (the spark or
fire, which arguably can be extinguished), I believe are inherent
in nature and by extension in the nature of humans and more specifically
arises out of their interactions with each other (me being Martian
of course).
5) The last phrase is necessary
because if the price of gold is set too high on transition, then
general price inflation will continue until general prices equilibrate
with the high price set for gold. Visa versa if the gold price
was set too low.
6) Under the current fiat money
regime, investments do not equal voluntary savings. The shortfall
of investment funding is obtained from “forced savings”
through a policy of monetary inflation. Prices could even be
stable because of productivity gains matching money supply growth,
but is nonetheless disequilibrating as the economist, von Hayek
has pointed out (Prices
and Production, 1932, Lecture I).
7) It may seem counter-intuitive
that gold should not necessarily rise when one thinks in terms
of the origins of money, i.e., before a commodity becomes money
in an economy that starts off from barter. In this case its value
will increase as the commodity becomes more in demand not just
for its “use” value, but also its “exchange”/liquidity
value. In the current environment we are not starting off from
a position of barter and the value placed upon gold could already
exceed its typical use value. The question is, what is its exchange
value premium and how far away from it are we with current investment
(hoarding) demand?
###
Feb 11, 2010
Robert Wutscher
The Shadow Economist
email: rwutscher@telkomsa.net
The shadow
economist, Robert Wutscher, is a retired financial due diligence
specialist who has taken up the study of economics. His study
has turned to the shadow side of economics: what most economists
ignore, suppress or fail to account for in their models under
the light of mainstream economic consensus methodology. A rich
resource exists in many old economists who have passed away with
insights that do not sit comfortably in today's quantitative
models and with warnings/lessons of the past going unheeded.
The modern consensus methodology is primarily based on quantitative
methods and generally considers only economic aspects and assumptions
that are amenable to quantitative analysis, even if this can
only be done with abstraction of reality or of the mathematics
itself. It ignores other concepts essential to human decision
making, that may be too hard to quantify and that may be hidden
in the shadows of the aggregates and averages that form the edifice
of macroeconomics and econometrics.
The shadow
economist is new on the block and will generally challenge the
conventionally held wisdom even that of the gold bugs. He welcomes
constructive criticism. He can be reached at rwutscher@telkomsa.net
321gold Ltd
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