Has Gold Peaked?

Includes: GDX, GLD, IAU
by: Greg Blonder

Over the last decade, it was hard to lose money on gold. Gold prices, and related precious metal stocks and funds, averaged around 20% a year returns, sailing through the economic downturn. So, naturally, many people are wondering - will this extraordinary run continue, or has gold peaked?

Most observers, myself included, agree that fear and speculation are the main drivers behind the rise in gold. Its future prospects are debated ad infinitum, with partisans on every side and in between. A tiny minority of economists and politicians hope to return their country's currency to a "gold standard", despite the very serious flaws and dangers this blast from the past would engender (see comment below). But, what if we took their proposal seriously? After all, their concerns are moving the market. Would this perspective shine light on the future of gold prices?

If gold were to underpin all currencies, it would have to meet two basic, plausible economic criteria. First, is there enough gold in the world to more or less back all the paper currency in circulation? And more importantly, do gold prices rise in parallel to economic growth, as befits any well-behaved currency? It turns out the answer to both questions is "yes".

Over human history, most analysts agree around 5 billion troy oz. of gold have been mined- perhaps 4 billion are available to back currency prices. At $1,400/troy oz., the total gold supply comes to $5.6 trillion dollars. This glistening pool of gold should be compared to the number of US dollars in circulation ($1T until recently, now around $2T. Plus depository receipts, etc. Perhaps $6 T in all). Given that the US is about 1/3rd of the world's economy then, in fact, gold is a plausibly a currency replacement. Trillions for trillions - it's in the ballpark.

Secondly, does gold track GDP? This behavior is critical - if a country doubles its GDP while holding a fixed stockpile of gold, each ounce must be worth twice as much when expressed in dollar terms. To check, I've plotted gold's price versus world gross domestic product, normalized to 1967 when gold first floated free of the dollar:

goldvs gross world product

logarithmic plot of Gold price compared to Gross World Product GWP (both in current dollars)
normalized to 1967 (sources:
World Bank, National Mining Assoc).

While gold prices hardly rise smoothly (consistent with a "fear and awe" driven commodity), they do more or less parallel the rise in gross world domestic product. The last decade's rapid rise in gold prices have brought this precious metal more or less in sync with GWP. By this metric, its rise is necessary, not unexpected.

Based on this analysis, gold is more or less fully priced. In the future, I'd expect returns to drop in half - slowing to match GWP - or around 8-10% a year.

At least that's my two cent's worth.

An aside: why is gold a poor choice as a fundamental currency?

As a physical token, gold is a serviceable form of currency. Unlike paper bills, gold is inert and will not corrode or decay. More importantly, gold is impossible to counterfeit- a gold atom cannot be transmuted from a cheaper metal by criminals (Fraud, yes. Counterfeit, no). And it's quite dense, so a large gold value may be easily stored or transported.

Beyond these enviable physical attributes as a coin of the realm, gold is an utter disaster as a currency standard. Small government, ultra-fiscal-conservatives embrace the idea of a gold standard to limit the size and reach of the federal government. With a paper standard, the government can fund its programs by simply printing more dollars. With a gold standard, the only way the government can expand is when political leaders authorize new taxes, taking gold directly out of the pockets of its citizens. If you don't trust your elected leaders, then gold is seen as a brake on their economic reach. Printing money is viewed as taxation without representation.

But the mere existence of a gold standard turns out to be a very weak barrier. At the end of the day, we elect a government and they can temporarily interfere with the gold standard at will - as they have done multiple times in the past. Gold is no more than a baby blanket, providing comfort at night but no real protection against the cold reality of day.

The remaining gold standard proponents are the paranoid - fearing a world government takeover, or a global plague, or a societal breakdown because gays can marry. Unfortunately, zombies want payment in brains, not bullion.

But the main problem with a gold standard is one of fairness and flexibility.

Imagine some country - one we dislike, suddenly discovers a new vein of gold and and can increase world supplies by 25%. That reduces the value of our houses and savings by the same amount- for no good reason other than the expansion in the gold supply. It's as bad as printing money, but potentially worse in that a US competitor might be advantaged.

Even without a major new vein to tap, the gold standard is hardly a stable foundation for a world currency standard. Continued gold mining increases world gold reserves by about 1.5% a year. If you are not a gold mining country, this is equivalent to a yearly inflation rate of 1.5% eating away at the value of your gold-backed currency. Which means your currency declines in value by half in 45 years. Which is both silly and corrosive - why should we suffer inflation merely because there are more gold atoms around?

Globally, the problem is even more divisive. Again, imagine there are two countries separated by a wide ocean. The first is more advanced than the other, with a strong economy and a large gold holding. The other is young, eager but still developing and with few gold reserves. This second country grows internally, raising its standard of living to match the first. But now trade is impossible - the identical good in the first country costs more than in the second, by the ratio of its gold holdings. Although this inequity might balance out slowly over years of trading, it represents an onerous tax few developing countries are willingly pay.

The world economy is one hundred times larger than its currency holdings. This key insight, recognizing that physical money has no intrinsic value except as a token for the strength of the overall economy, is one of the greatest inventions of all mankind.

It's an enormous source of wealth and prosperity that a gold standard would diminish.

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