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What the Price of Gold Means

Posted by
December 19, 2011
in Blog

It’s amazing how so many people don’t get gold. It’s only been 40 years since the dollar was completely severed from it’s once proud golden heritage, yet most finance and econ people are wont to consider gold just another commodity—and a not very “useful” one at that. Thus they speak of “investing” in gold as if it were just another market play alongside pork bellies or frozen orange juice futures.

Sound money people know better. Historically, gold is not just another commodity, but the premier monetary commodity. Through most of US history, the dollar was defined as about 1/20 oz. of gold. Even though the gold weight of the dollar was reduced three times—in 1832, 1934, and then the complete abandonment of gold in 1971—gold continues to be held as a monetary asset, not just by “gold bugs” and conspiracy theorists, but by central banks around the world.

The great Austrian economist and classical liberal thinker Ludwig von Mises was one of the greatest champions of sound money in general and the classical gold standard in particular. Mises noted that, even when gold has been demonetized by national governments (so they can force circulation of unbacked paper money), gold remains a “secondary medium of exchange”–a back up, if you will– in case fiat currency should fail.

In a similar vein, Doug French, president of the Mises Institute, explains that the current economic role of gold is not “investment,” but “insurance.” Therefore it’s not helpful to think of gold in regular investment terms (as most finance guys do) such as “rate of return” or “yield.” Gold does not “yield” an increase, but merely holds its monetary value well over long periods of time—the perfect tool for people desiring to protect their wealth against the ravages of the fiat money economy.

With this view of gold in mind, we can gain a proper understanding of what the current dollar price of gold, and changes in that price, mean. When the dollar price of gold goes up, that doesn’t mean gold is suddenly “performing” well, like a hot stock pick. It simply means that people are becoming more worried about the future of the dollar, and hence turning to alternative monetary asset known to hold its value well over long periods of time. Likewise, should gold drop sharply, that would indicate a return of confidence in the dollar.

By the way—and note that I say this as a big “fan” of the gold standard—I frequently tell my students that I would be very happy to see gold fall through the floor. Why? Wouldn’t this invalidate the gold bugs’ hypotheses? No, it would confirm them. A decline in gold would simply mean that people trusted the future path of US monetary and fiscal policy to be stable and sound enough to cash in some of their insurance (gold) and invest their funds in actual capital—you know, the stuff that actually makes the economy grow and raises living standards. A fall in gold would be most welcome because it would signal confidence in a strong economic future. I’d like to see it happen; I doubt it will anytime soon.

So back to the meaning of gold: to understand the decade-long run-up in gold prices, we need to figure out why people have been getting worried about the future of the dollar in the first place. Here, a picture is worth 1,000 words:

As you can see in the chart, the price of gold correlates strongly with the government deficit (correlation coefficient = .84). Now I know, I know—“correlation does not prove causation.” But in this case I’m pretty confident that the correlation strongly reflects a key causal element.

Rising government deficits are a sign of trouble. Governments that take on too much debt will eventually find themselves unable to raise enough taxes to repay the debt, and will have to endure either default or monetization. Default is too painful, especially in democratic regimes where the formula for political success is to promise and deliver to the key voting blocs as muchof “other peoples’ money” as possible. But as Margaret Thatcher famously said, sooner or later you run out of other people’s money, whether in the form of high taxes on the rich or loans from mercantilist export nations. The options at this point, to put it bluntly, are to default on the debt or monetize it.

Default means “end of the road” for the entitlement spending. Easy living, via the government, at the expense of someone else, simply cannot be sustained. The money simply isn’t there. But the democratic masses will have none of this; they will riot in the streets, a la Greece. Woes betide the party that votes in austerity measures once the dependent classes are entrenched and comprise a sizeable majority of the population.

Thus the pols, and their above-the-fray “technocrat” friends at the central banks, contrive to inflate the debt away through monetization. Monetization is a dangerous narcotic: the first round or two can boost stock markets and make things seem OK for awhile. But if the government doesn’t get its budget in order in the meantime (and why would they, given that the central bank has just made expanding the debt oh so easy?), further rounds of monetization will become a must; yet each will have less of a palliative effect. Larger and larger monetary stimulus—leading to higher inflation—will be in order just to keep things from falling back. Eventually, either the currency is utterly destroyed, or massive depression sets in which allows the economy to “reset” back to a productive path of saving and capital accumulation over several years’ time. In either scenario, holding one’s wealth in the form of real money—gold—is a safe bet for making it through the storm without losing much value.

Thus the logic of gold: gold is like a debt barometer. When debt levels grow fast, so does the price of gold.  This is because the faster the debt rises, and the greater the debt burden grows, the more likely it is that the guilty government will resort to monetization. Monetization tends to produce price inflation; price inflation destroys wealth—liquid savings in particular—hence the increased eagerness to hold “wealth insurance” in the form of gold when debt monetization schemes begin to materialize.

If the raw correlation between gold and the deficit isn’t enough to convince you that monetary/fiscal policies are the driver of the gold price (and that the gold price is simply debt-danger gauge), consider how gold prices reacted to the Fed’s announcement and enactment of QE I and QE II (otherwise known as, um, debt monetization schemes):

So what’s gold telling us now? Gold prices peaked close to $1,900 this summer, and have since fallen a bit, down to about $1,600. This retraction of gold prices, even though slight—is good news. It shows hesitancy on the part of the central bankers to dilute the currency further (or perhaps simply complete disorganization in the European Union regarding a comprehensive Euro-wide debt monetization policy). But alas, I’m afraid the hesitancy will not last, especially given the truly dire straits of the European debt situation. Thus I’ll be watching that gold price like a hawk (an inflation hawk, no less), to get my early weather forecast.

Tyler Watts is an assistant professor of economics at Ball State University.

image from mises.org