$10,000/oz Gold And The Money Supply

|
 |  Includes: GLD
by: Skyler Greene

With all the advertising from companies offering to trade cash for gold (or sell you gold) and a news headline every other day predicting hyperinflation and the dramatic collapse of the dollar, it's easy to get confused about the future, and how gold will weather it. Many companies in the business of reselling bullion (or "news" websites funded by advertisements from such companies) have a direct financial interest in propagating these untruths.

There are definitely reasons to consider holding physical gold or an ETF like the SPDR Gold Trust (NYSEARCA:GLD), but hedging against inflation is NOT one of them. Since the US canceled convertibility of gold and the dollar, gold's price has not effectively hedged against inflation.

Click to enlarge

Nonetheless, in light of loose monetary policy and the Fed's quantitative easing programs, many seem to believe that gold is destined for a meteoric rise with an estimated end date of... never.

I was inspired when reading an article written by Paulo Santos titled "Is Gold Ever An Investment?" I agreed with his conclusions, and wanted to extend them further by debunking many of the myths surrounding gold and monetary policy. Up first: gold and the money supply.

The Money Supply, As Viewed By Farmer Bob

Most commentators and leaders discussing the debt and inflation fail to understand how the monetary system actually works. That link is a fantastic article on how the US dollar works, but I'm going to provide a simpler analogy below.

A common argument is that "printing more money" (increasing the money supply) devalues money and causes inflation. Well, not exactly. Excess printing of money would lead to inflation, but increasing the money supply does not necessarily cause inflation. (Inflation, as defined by Wikipedia, is the "erosion of purchasing power.")

The term "purchasing power" is key here. Consider the following scenario.

Farmer Bob has ten cows one year. Now, Farmer Joe wants to buy these cows, and he has ten dollars with which to do so. Thus, he buys each cow for a dollar, and goes home happy.

Now, Farmer Bob's cow-breeding operation goes really well the next year. (Economic growth.) So when he meets up with Farmer Joe, he now has 20 cows to sell. But the money supply (number of dollars in our little world) hasn't grown any, so Farmer Joe again only has ten dollars.

Well, Farmer Bob doesn't really have much choice but to sell his 20 cows to Farmer Joe for 10 dollars. One dollar now purchases two cows -- an increase in purchasing power. (AKA, deflation.)

But consider an alternative scenario. The local currency-issuing authority notices that farmers are doing great, so they issue more money -- they double the existing supply. Now Farmer Joe has $20, and he exchanges this $20 to Farmer Bob for 20 cows. In this scenario, the money supply doubled, yet inflation did not occur -- because the money supply was keeping up with the value of economic output. The purchasing power of the dollar is the same as it was (one cow) because even though there are double the dollars going around, there are also double the cows.

In a final scenario, the currency issuer goes hog wild and prints millions and millions of dollars. Now that everyone has millions of dollars, $20 isn't worth so much, and Farmer Bob won't accept $20 for his cows. He wants a lot more -- say, $2 million. Thus, the value of an individual dollar has decreased dramatically. (Hyperinflation, as seen in Zimbabwe.)

Money Supplies and Inflation Not The Same

This is obviously a very simplistic analogy that excludes many factors, but it does go to show why "printing money" does not equal inflation. Printing money (or declining economic output) is a prerequisite for inflation, but it alone is not sufficient for inflation. This is why the money supply grew by 5% annually since 1981, yet inflation was only ~3% -- and why Japan's M1 monetary supply has quintupled since 1986, yet the island has experienced two decades of inflation. Just as my analogy is far too simplistic to possibly accurately model inflation and deflation, so is the assumption that "increase in money supply" = "inflation."

So Where Does Gold Fit In?

The analysis above is why headlines like "money supply explosion will lead to accelerating inflation" and "the path to $10,000/oz gold" are so dangerous. The first article, for example, shows the following chart of the "true money supply":

Money supply Click to enlarge

Looks pretty scary, right? Oh no, hyperinflation!

Regardless of whether the chart is valid or not, it's important to view gold's performance vs the money supply. If, as many suggest, gold is protection against the evils of an increasing money supply, then gold's chart should look pretty good as the money supply has exploded.

Not so. Just look at the chart from 1975 to 1999, a period during which the US experienced (towards the end) literally the greatest economic boom ever.

Now look at the price of gold (below.) Overlay the charts in your mind. From 1975 until 1980, the money supply increased fairly slowly -- yet gold went parabolic. From 1980 on to 1982, the money supply stayed flat, and gold fell. From 194 through 1989, the "true" money supply exploded, going from "$1,000" by the chart's measurement to "$3,000." Yet gold didn't follow along. At all.

Anyway, the article's eventual conclusion is that dramatic hyperinflation is about to happen. In early 2014, gold will be worth literally infinity and the dollar will be worth nothing.

If you're willing to believe a model that -- by the author's own graph -- was absolutely wrong for two decades, then go ahead and buy lots of bullion. But if you think that predicting hyperinflation is about to start when inflation is actually pretty low, at 1.7%, sounds a little sketchy -- you'd be right in thinking twice about piling into gold.

Gold is a fear asset you can utilize to speculate on the market's reactions. I personally think gold will hit a new high in the next few years, but only because everyone believes it will. Gold isn't an "investment" or a hedge against inflation, or as we've seen, the money supply. Gold is a speculation, you'd do well to remember that before putting any significant percentage of your portfolio into it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.