The Relative Value of Gold to USD

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This perspective posting presents a simplified analysis of the relationship between the value of gold and the US dollar (USD), and speculates on the direction of the relative value of each, over the medium term.
A number of generally familiar concepts were pieced together for this analysis. The links scattered throughout the posting provide more information on these concepts. Although the analysis is confined to gold versus USD, a similar analysis can be performed on the relative value between gold and other currencies, such as the EUR and GBP.


A Brief Primer:

In order for an economy to function properly, whether at a local or international level, it is important for it to have a medium of exchange for goods and services. The alternative to having a medium of exchange is the barter system whereby individuals and entities exchange specific goods and services for one another, which is impractical beyond a very limited scale, and is generally a suboptimal way for economies of any size to conduct transactions.
An acceptable medium of exchange for goods and services is known as currency or money. This need not be restricted to the paper variety (cash), as shown throughout history with the use of gold and silver coins as currency. An acceptable form of currency has to have certain properties in order for it to be used as a reliable medium of exchange. These properties include the ability to value common assets, constant utility, low cost of preservation (durability), transportability, divisibility, high market value in relation to volume and weight, recognisability, and resistance to counterfeiting. As an important aside, the digital currency era is certain to transform the requisite properties of currency. For example, where the medium of exchange is an electronic wire transfer or debit transaction digitally moving from one account to another, there is an altered notion of durability, transportability, divisibility, recognisability, and resistance to counterfeiting.
For thousands of years, gold and silver have met these criteria for use as currency or money. The biblical and historical records are strewn with overwhelming evidence of these and other metal commodities, such as copper and bronze, being used as currency. In 1787, the authors of the U.S. constitution were sufficiently moved by the concept of precious metals as currency, that they included a section in the constitution, mandating for the use of gold or silver as legal tender. The U.S. had largely stuck to a gold-backed currency concept since the founding days until 1971. In more recent history, following world war II, the Bretton-Woods accord represented a final expression of using a gold standard for currency, with a central theme of the value of the USD tied to the value of gold, and other currencies in turn tied to the value of the USD. In 1971, the U.S., under President Nixon, officially decoupled the USD from gold which by extension led to the decoupling of all other currencies from gold, since they were all fixed to the value of the USD. Since that time, all reserve currencies have become what are referred to as fiat currencies; that is, currencies not backed by anything of tangible or tradable value, other than faith in government laws and regulations.


Analysis:

One of the most relevant implications of decoupling paper (or digital) currency from gold has been the removal of constraints on the growth of USDs available in the economy. Prior to 1971, the global supply of gold and, more importantly perhaps, the growth rate in supply from year to year had constrained, to an extent, the rate at which the supply of USD and other currencies could grow. In many ways, restricting the growth of money supply would have also restricted the rate of debt expansion. Controlling the growth of currency (or money) supply is, by most economic standards, a central mechanism to control inflation in the broader economy. After 1971, with the USD no longer tied to gold or the amount of gold reserves the U.S. had held, and with global trade largely conducted in USD, the constraints were removed on how many USDs the U.S. could issue (or rather the Federal Reserve (Fed) could print on the U.S. Treasury’s behalf) into domestic and global circulation. By extension, the implicit constraints on debt expansion would have also been removed, since it was now possible to print as many USDs as needed to create as much debt as the economy was willing to absorb.
In many respects, the concept of value is relative as opposed to absolute. The value of currency is largely a function of one’s faith in the ability to derive utility from the currency held or accepted, whether it is gold, paper, or digital USDs being exchanged for goods or services. As such, the value of gold and USD are best analyzed in terms of each others’ relative utility, regardless of the fact that the USD is used as the global currency standard for trading gold and other commodities, as is the case today.
Since 1971, gold has risen in USD terms by 4,400%. A useful way to understand what happened to the value of the USD over the same period is to look at what has happened to its purchasing power. Over the same period, the consumer price index (including food and energy) rose by nearly 500%. As a useful proxy, it is possible also to look at the trend in the USD against a basket of currencies or against a currency such as the Swiss Franc (CHF). Against a basket of currencies that includes the Euro, Sterling, and Japanese Yen, the USD has fallen since 1971 by nearly 40%. Over the same period, the USD has fallen against the CHF by approximately 80%.
From nearly any perspective one may take, the decoupling of the USD from gold appears to have led to a sharp deterioration in the expected utility of the USD and a sharp rise in that of gold. The reasons are reasonably straightforward. Gold cannot be printed into existence; it has to be mined and refined. The amount of gold coming to market every year rises in a relatively gradual manner. The USD, however, can be printed into existence as it has been with somewhat reckless abandon over the past decade. One of the properties of currency (medium of exchange) is that it be generally available but in finite quantities or gradually increasing at a similar pace to the growth of the economy. With USDs being printed at such a scale under the Fed’s quantitative easing (QE) programs, the question may one day arise as to the extent to which the USD continues to exhibit the properties of ‘currency’, as previously defined.
A state of imbalance in the supply of USDs as a medium of exchange appears to have grown since 1971 with the end of gold as a standard for money issuance. Over the past decade and a half, the Fed’s easy money, QE programs, and general monetary policy appear to have materially exacerbated this imbalance and continue to do so. The U.S.’s fiscal policy (annual budget deficit of $1.5 trillion, $15 trillion in federal debt, and $115 trillion in unfunded liabilities) is contributing further to this imbalance in the supply of USDs against the supply of gold. Unless there is a dramatic reversal in U.S. monetary and fiscal policies, this imbalance is likely to grow further, punctuated by dramatic adjustments in the value of gold in relation to the USD in order to restore a semblance of equilibrium between these two media of exchange.
With a perceived risk of the U.S. falling back into recession, U.S. fiscal and monetary policies appear likely to stay the current paths. On the monetary side, the Fed recently indicated that it will maintain a policy of low interest rates for 2 more years, which is the opposite of what is required (higher interest rates) in order to reduce the supply of USDs that is available to the economy. On the fiscal side, there appears to be little to no political will to adjust expensive policies such as military spending and social programs, which instead continue to grow well beyond the rate of growth of the economy.
As mentioned, the issue of whether the U.S. reverts back to a gold standard is secondary to understanding the relative value of gold to USD. In any economy that is free from artificial barriers (often government imposed), it would seem intuitive to expect the relative value of competing media of exchange to converge to some form of equilibrium. Any medium of exchange that reaches a state of imbalance in relation to other available media would either have to come back into relative balance, or lose its ability to function as an acceptable medium of exchange.
The U.S. has approximately 260 million ounces of gold, more than any other country by a wide margin. The total of gold reserves held by all countries is approximately 1 billion ounces. On the currency side of the equation, there are several measures of USD money supply, known as M, M1, M2 and M3. M3 is the broadest measure of the total amount of money (USDs) available in the economy. It is noteworthy that in 2006, the Fed made a decision to discontinue publication of M3. The latest figures available from the Fed show M1 and M2 at approximately $2 trillion and $9.5 trillion, respectively.
At a current market price of $1,800 per ounce of gold, the U.S.’s gold reserves are worth $468 billion (260 X $1,800). Gold reserves held by central banks around the world are currently worth $1.8 trillion. There appears to be just over 4 times more USDs (based on a narrow measure of money supply, M1) in the economy than there is gold held by the Fed (M1: $2 trillion; U.S. Gold: $468 billion). Based on the broadest measure available of money supply, M2, there are just over 20 times more USDs in the economy than there is gold (M2: $9.5 trillion; U.S. Gold $468 billion).
In theory, if world governments were to unite and pledge all of their gold reserves to the U.S., based on current market prices, there would still be a deficit of gold to support the amount of USDs in the economy, based even on a narrow measure of money supply (M1: $2 trillion; World Gold: $1.8 trillion). Based on a broader measure of money supply, M2, there would be just over 5 times more USDs in the economy than gold reserves held by all central banks combined (M2: $9.5 trillion; World Gold: $1.8 trillion).
The imbalance in the value of USDs in the economy versus the value of gold reserves strongly suggests that the relative valuations are far from equilibrium. As simplifying assumptions, the value of each of these exchange media would be expected to reach a state of equilibrium at a 1 to 1 ratio (the value of gold reserves equals the value of USDs in the economy), and only gold reserves, as opposed to other precious metal reserves are considered for the purpose of supporting USD issuance. Equilibrium is likely to be reached as a combination of several outcomes as follows: a) reduction in the supply of USDs (decrease in the money supply) through higher interest rates, b) reduction in the value (devaluation) of USDs supplied to the economy relative to gold (price higher), and c) increase in gold reserves (limited by the rate of annual production).
Gold versus paper moneyBased on the value of gold reserves and measures of money supply, it would appear that the value of USDs in the economy would have to drop dramatically to line up with the value of gold in the economy. Based on a narrow measure of money supply, M1 ($2 Trillion), and U.S. gold reserves ($468 billion), and assuming no material changes in current fiscal and monetary policies, a state of equilibrium between the two media of exchange would be restored at a gold price of approximately $7,800 per ounce (an increase of over 330% from the current price of $1,800). The results are even more dramatic based on M2, the broadest measure available of USDs in the economy. Based on M2, equilibrium would be restored at a price of gold of approximately $37,000 per ounce. This extreme condition is thought as unlikely to be reached, as a more likely scenario would entail a sudden drop in the value of the USD versus gold (outcome ‘b’ as described in the previous paragraph), prompting the Fed to raise interest rates (outcome ‘a’) to stem the rapid loss of value in the USD, well before gold has reached this price level.
As an additional hypothetical exercise, based on world gold reserves ($1.8 trillion) and M1, the current price of gold would be considered near equilibrium. Based on M2 and global gold reserves, equilibrium is reached at $9,500 per ounce of gold. There is no compelling reason to expect the world to give up its gold reserves to the U.S. This exercise is meant only to add to the perspective of gold versus USD valuation.
If one believes that the market value of competing media of exchange in an economy necessarily must line up to one another within reason, then under any of the scenarios offered, the price of gold has tremendous upside potential over the foreseeable future, barring any artificial fiscal policy barriers that could emerge under difficult economic circumstances. By natural extension, the value or purchasing power of the USD is likely to keep falling dramatically over the same time frame. Based on the simplified analysis presented, calls by market analysts for gold at $10,000 per ounce appear possible and may in fact represent the lower end of the range of possibilities. The results of the analysis presented here, based on a broad measure of U.S. money supply and gold reserves, suggest a range of $15,000-$20,000 per ounce of gold over the medium term. It is highly likely that metals such as silver, platinum, and other precious metal commodities would rise dramatically in a correlated manner to gold price changes.
Greg HajjarThe Relative Value of Gold to USD