Growing debt problems and perpetual monetary stimulus have created heavily distorted financial markets. Moving forward a loss of confidence in central banker’s ability to foster growth could lead to a currency crisis. Gold (GLD) would stand to increase substantially in such an event as it may regain its monetary premium.
Money, as a general subject, is likely the most important concept one must understand when entering the discipline of economics. Much of its function and purpose can easily be seen within any economy, dating back as far as civilization itself. Today, there is virtually no individual who is not, to some extent, familiar with money and its role. It would thus seem trivial to pose the question “What is money, and what is its purpose?”. As simple as it may appear, upon further inspection one will find that the question is in its nature extremely difficult.
As a student studying economics this question or some form of it appeared repeatedly. It is taught that money is used to serve three vital roles: a store of value, a medium of exchange, and a unit of account. From a historical perspective it is taught that the progression of money generally begins with barter, next adopting a commodity based form of money, before eventually graduating to the pinnacle of financial innovation, the fiat currency. These principles, taught as if fundamental fact instead of theory, made intuitive sense. I felt generally no desire to question them, or the current systems implementation of them.
It thus came as a great surprise to find that some of these concepts had fundamental flaws. While money’s three functions can generally be agreed upon, its history within society has often been greatly distorted. For one, there is no substantial evidence that barter ever served as a primary means of transaction. Hunter/ gatherer tribes of yesterday, and even some governments today, used barter for simple transactions, but outside of that it had no wide spread use. Commodity based currency typically served as the main form of money for most, but not all, of recorded history. This brings up a second point; fiat currencies are not relatively new. In fact, the first fiat currency dates back to 10th century AD China.
It would thus seem that studying these concepts from a historical perspective would serve one well, as these concepts and their practical uses have been around for quite some time. While it is true that no global fiat currency system has ever been implemented such as the one today, it does not mean historical study provides no benefit. Take for example army generals who would site and studied history’s greatest generals such as Julius Caesar, Napoleon Bonaparte, or Alexander the Great. It would be easy for a general to claim, that the vast change in warfare has left historical study irrelevant, this is a fatal mistake. Studying history provides insights into human behaviour under different circumstances. Although particulars may change, fundamental parallels can still be drawn that provide useful insight into human nature. This is useful when analyzing today’s established systems, be it political, social, or economic.
Both in theory and in practice however, it seems that this is generally not the case. The current economic field is so heavily dependent upon a hand full of theories and practices that it seems to have no concern for other concepts, or wider historical study. Fiscal and monetary policies implemented under these premises have begun to show structural faults that will likely have severe consequences. If these issues are to persist, as it seems they will, gold could once again begin trading as a monetary asset (money) instead of a commodity that provides inflation hedge. This would require a substantial increase in gold prices, as current valuations are drastically to low if the yellow metal were to regain monetary premium.
Economic Theories of Present Day
Of the prevailing theories today, the New Keynesian school of thought is arguably the most prominent. The theory evolved from John Maynard Keynes and his post war work on macroeconomics. The theory has adjusted over time from Keynes original work, but the fundamental premises still hold. The proponents of the theory claim that imperfect completion can lead to prices and wages becoming “sticky”, essentially meaning they have an inability to adjust to changes in economic circumstances in a timely manner. This leads to the assumption that government intervention, through fiscal and monetary policy measures, can assist the economy in reaching its full output potential.
Another prevailing school of thought, and the second most prevalent in today’s economy, is the Monetarist theory, made famous by Milton Friedman. The theory differs from Keynesian thinking by focusing more heavily on the monetary aspect for economic growth in favour of the fiscal approach. The theory centralizes around the notion that control of the money supply can be used to promote economic stability by growing at the same rate as potential output.
Both theories in practice have many nuances and implications that are outside of the scope of this article. The main premise to draw from the brief descriptions provided is that both theories promote government intervention as the optimal path for achieving desired economic results. Theoretically the models come across as logical, where they fall sort however is in there practical application.
Individuals in charge of policy are not fully capable of accurately accessing economic conditions due to the natural complexity of economic markets. Equilibrium models, which serve a purpose in the field of economics, are inadequate justification for massive policy measures like those seen following the great recession. Economies can be more properly understood through complexity theory, a field largely ignored by high level policy makers. Worse yet the theories greatly overlook the importance of behavioural economics from the view point of political actors.
It is becoming increasingly evident that politicians, from all parties, are willing to sacrifice long term economic stability for short term benefits. Alternatively it may be that these are the only politicians who can actually get elected, regardless the fiscal irresponsibility continues. Peace time prosperity under a welfare state system can bring about ever greater demand for government financial aid. This can be seen in the growing fiscal deficits, and perpetual monetary stimulus. The long term consequences of recent policies may prove ultimately profitable for those holding gold, to understand why, a brief historical recap is in order.
End of Bretton Woods and the Emergence of the King Dollar
The early origins of our current economy can be traced back to the late 1960’s. Still under the Bretton Woods System, the United States began to run into issues due to the growing debt generated under Johnson, Nixon, and Ford, in part to fund the increasing conflict in Vietnam.
Federal Surplus or Deficit
(Source: Federal Reserve Bank of St. Louis)
Foreign central banks began to stock pile US dollars, and worry set in that the US did not have enough gold to fulfill its exchange rate of $35/ oz set under the Agreement. Many speculators assumed that Nixon would be forced to devalue the US dollar, and thus increase the relative value of gold. This caused a partial run on the US gold reserves that exacerbated the problem. Nixon assured foreign diplomats that the US would make full on its obligation to convert US Dollars to gold. This calmed foreign central banks enough to allow them to continue to stock pile US Dollars, which began to set in place the US Dollar as the global reserve currency.
When Nixon abandoned in Bretton Woods agreement in 1973 it almost, but not quite, solidified the King Dollar regime, as many foreign central banks stuck holding US Dollar had generally no alternative liquid enough to take its place. It should be noted here, that the United States decision to abandon the gold standard should be viewed as a default. Its failure to fulfill its obligation set under the agreement, meets the technical definition of a default. Individuals, who claim the United States treasuries are risk free, would be wise to more closely examine 20th century history, by definition; the United States has defaulted twice on its obligations within the past century.
In the mid to late 1970’s inflation began increasing at an unsettling pace in part due to the fiscal, and more importantly, monetary policies of the recent past. These policies allowed for an excessive growth of the money supply, leading to increased prices.
Consumer Price Index
(Source: Federal Reserve Bank of St. Louis)
The increasing inflation began to create a crisis for the United States, and many foreign countries as well. The Federal Reserve, then under Chairman Paul Volcker, began to focus more directly on combating inflation. The Fed implemented policies aimed at reducing the aggregate money supply, including sharp spikes in the interest rate. The policies were able to curb inflation, but the serve nature of the tightening policies led to recessions in the early 1980s. These monetary policies cemented the US Dollar as the global reserve currency, as it saw a strong increase in relative value. This allowed, even encouraged, complete fiscal irresponsibility as the global demand for US Dollar, and with it US Treasuries, grew substantially.
The Consequences of Monetary and Fiscal Manipulation
Following the emergence from the Bretton Woods Agreement and the heavy handed monetary policies of the 1980s, debt levels from sovereigns to corporate entities and individuals alike has increased substantially. Whether it is political actors implementing greater and greater budget deficits as a means to foster short term economic growth, corporations levering up their balance sheets to buy back shares, or households utilizing larger and cheaper means of credit for consumption, all debt levels are nearing unsustainable levels that seem to have no end in sight.
The monetary policies implemented to date have assisted in this ravenous sensation with debt, but these measures are running out. Ever growing money supply and unnaturally low levels of interest rates have the potential to create serious long term inefficiencies that will likely be to severe to fix with further use of cheap credit.
From the 1980s onward central banks and the Federal Reserve in particular have followed plays out of the same playbook. Cutting interest rates to combat downturns is not a new phenomenon and had been used in many decades past, however the trend from the last 30-40 years has become overly stimulus and has created a positive feedback loop in which growth seems now to be dependent upon further stimulus. It can be seen that these policies have had a direct hand in creating a ever more violent boom and bust cycle within a number of markets, as asset bubbles inflated by these policies meet there inevitable demise.
S&P vs Fed Funds Rate
(Source: Value Walk)
The reaction to the dot com crash of the late 90s and earl 2000s cemented in place an ideal that policy makers are willing to prop up financial markets regardless of the necessity. As the dot com crash can only be described as pure lunacy, the need for monetary stimulus was completely unnecessary. The economy as a whole was performing relatively well at the time, and speculators who had pushed the dot com stocks to completely unjustified levels should have been left to the fate deserving of their actions. The reaction of policies makers however, instead of allowing markets to cleanse themselves of malinvestment, began to inflate another bubble in place of the one that had just crashed.
The great recession of 2008 showed just how short sighted policy makers have become, trapped within echo chambers reverberating the same economic theories while failing to see the wider ramifications. The crash in housing prices showed how dangerous using the wealth effect as a means of promoting consumption can be. For an attempt to grow asset prices through the use of the money supply and interest rates will inevitably lead to asset bubbles. In addition the use of credit and derivatives had created more complex financial markets in which a failure in any number of particular instances would send shock waves throw the entire system. Dangers which are still very present today and have the same, if not a greater, potential to create economic devastation.
Globally OTC Derivatives Outstanding Notional Value
(Source: Bank of International Settlement)
Many critics of policy makers claim that the 2008 recession would have been best handled by doing next to nothing, allowing those who created the financial mess left to deal with its fall out. This viewpoint is largely guided by emotion rather than reason, as the ramifications of the housing collapse clearly required policy measures to avoid complete catastrophe. The measures taken however were far too short sighted and failed to comprehend the potential for long term structural created in their wake.
Ben Bernanke’s implementation of Quantitative Easing, which can be more accurately described as debt monetization, has the potential for devastating long term consequences. Those who claim the policy measures to have been a success are looking at the issue from to short of time frame. Inflation has the potential to reach unmanageable levels if the US Dollar were begin losing its place as the global reserve currency, something that is not immediately likely, but could manifest over a longer period. Many foreign nations strongly oppose the current reserve currency system as it largely benefits the United States at the expense of others. If confidence in the US Dollar began to fade, and nations no longer opted to renew their expiring treasuries, and instead dumped them onto the market, the consequences would be severe.
Federal Reserve Total Assets
(Source: Federal Reserve Bank of St. Louis)
Interest rates serve a vital role within any well functioning economy, as the price for credit they represent one of the three main price signals, the other two being the price for labour, and consumer and producer goods and services. Manipulating interest rates can have unintended consequences throughout the economy as other connected areas become distorted by artificially priced credit. Looking at various levels of debt from governments to corporations and individual households, it can be seen that these policies meant to foster growth are doing so at the steady deterioration of financial health throughout the economy.
The culmination of these growing inefficiencies has the potential to create a severe and long lasting depression that may catch many completely unprepared. The likely response from policy makers in both central banks and sovereign entities is at this point almost fully predictable. The further expansion of central bank balance sheets and once again near zero interest rates will likely not have the intended effects, as economies cannot borrower and consume their way to prosperity. The fallout from a failed attempt to reinflate this bubble economy would be devastating, as central bankers could lose the principle component to their success to date, investor confidence. If investors begin to believe that central bankers have painted themselves into a corner, and run out of options to attempt in fostering growth, a currency crisis could materialize. If this scenario plays out, and it is quite possible, gold would stand to see great advances in value as it may once again be viewed as asset with monetary value.
Conclusion & Valuation
Gold generally serves few purposes as a commodity, as it has become labelled in decades past. With very limited industrial use, the yellow metal through most of recorded history has served as a monetary asset. A great divergence has emerged in the past decade, as gold prices have fallen greatly even as money supply rapidly increased. This divergence has left gold prices far too low to serve as a monetary medium, and thus would need to see increases if this were to once again take hold.
Based on the aggregate money supply from the leading global powers it can be seen that gold prices could have the potential to trade closer to prices north of $2000/ oz. This figured is derived by using an approximately gold backing of 20% of the global money supply. As this has been the typical range used in gold standards of the past it makes logical sense to use in attempting to draw conclusions of gold prices moving forward, if it were to regain its monetary premium. It can also be seen however, that the 20% backing is not a necessity for a gold long position to be profitable. As at current levels gold only represents a 5.38% backing of the total money supply. Any hint of gold regaining its monetary premium would require this percentage to be higher; meaning even at levels approaching 10% backing gold would provide solid returns.
M1 Money Supply (USD) vs. Gold Supply
|Gold Supply (metric tonnes)||33,000|
|M1 European Union||$9.558|
Gold Prices as % of M1 Money Supply
|$1280/ oz||$2423/ oz||$3634/ oz||$4846/ oz|
(Source: CEIC Data)
Many strong proponents of gold call for a reinstatement of gold standards of the past, as the one and only cure for the problems prevalent in today’s economy. This article does not attempt to draw any such conclusions, nor does it necessarily attempt to make bold predictions of future economic events. Macroeconomic forecasting is an extremely difficult process filled with many potential pitfalls. The highly complex nature of financial markets makes accurate predictions highly unlikely, this does not imply however that profitable trading strategies are impossible to formulate. By assessing the current economic condition against historical case studies, one may be able to use fundamental analysis to draw conclusions in regards to over and undervalued assets in an array of time periods. Given the great divergence in gold prices from the aggregate money supply, and the prevailing levels of debt throughout the global economy, there is a fairly probable chance that gold prices could see sustained upward price movements, proving very profitable for those willing to take a contrarian stance.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.