A question from a client this morning, John Harwell of the Mayo Foundation, made me think it would be a good time to give you a refresher course on gold. Even those of you who have been getting this material for decades should find it useful, as I do think we now are heading into the process of relinking to gold. I’ll circulate this to my e-mail list of Democrats and Republicans in Congress, the Bush Administration, the Fed, and the political and financial press.
Jude, there is still something in your gold argument that I find puzzling. The intrinsic value of gold is nowhere near $250 per ounce, much less $350 per ounce. If you added up the industrial and dental uses for gold, there is a huge oversupply of inventory, probably centuries worth. Oils' intrinsic value can be measured in BTUs. Apples' and oranges' values can be measured in calories and MDR vitamin content. All of them have substitutes. I think what people are saying is that the irrationality of the gold price, which has been a myth of religious proportions throughout the centuries, is giving way to a rational evaluation of the intrinsic value of gold. How can it possibly be worth 80x what silver is worth? I agree totally with your thesis that commodity prices in the market represent the best signal to gauge the demand for liquidity and are the best measure of price stability or instability. But gold simply is not rationally priced. It could suffer the same or worse supply shock as oil, if all those hoarders decide to look to its intrinsic value.
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This is a wonderful question, John, asked at exactly the right time. I'll make this as clear as I can and circulate it among our other clients, as it will help everyone get a refresher course:
Gold's value as a monetary commodity is the result of its having so little intrinsic value as an industrial commodity. Wheat or cotton cannot provide the function that gold does as a unit of account because they have such great intrinsic value for mankind. The global economic body does need something real to serve as a guide to the value of government debt, which everywhere serves the monetary function of a circulating medium. When Alan Greenspan was asked several years ago by the House Banking Committee, "Why gold?," he said it was because its stock was so large relative to its flow. There are 130,000 metric tons of gold in existence -- only enough to build the bottom third of the Washington Monument if it were solid gold. And the world's gold mines produce only 2000-to-3000 metric tons per year.
Gold has acquired the monetary attributes it has over the millennia, meaning the world population of 6 billion has learned about gold through custom. There have been competing "monies" in history by which paper certificates or private or government IOUs were valued, but when the US and France dropped silver as a money in 1873, its monetary value declined. Its industrial value finally solidified at a much lower ratio to gold as the emerging photography industry made use of it in coating film. When President Nixon closed the gold window in 1971, the monetarists and Keynesians assumed the same thing would happen to gold as happened to silver. Rep. Henry Reuss of Wisconsin, a Democrat on the Ways&Means committee and a Keynesian, predicted the gold price would fall to $7 an ounce. Milton Friedman, a monetarist, said gold would now have same properties as pork bellies (bacon). Bob Mundell, though, predicted the gold price would rise and lead to a generalized inflation, with oil’s price following gold’s.
Think of it this way: If there were several competing "commodity monies" used by people to determine the value of government debt, then as each one loses out in competition, its monetary value would be subtracted and its price would fall to an industrial level. But when there is only one "commodity money" left for that purpose, it is simply the clear winner and the global electorate uses it and it alone as a monetary guide. It was Karl Marx who actually impressed that on me when he proclaimed that "Gold is the commodity money par excellence." It is as good as it gets. And the world is not going to give it up, no matter what Milton Friedman, the monetarist, or Yale’s James Tobin, the Keynesian, says about it.
Now think of the value of a commodity money at the margin, where change takes place. Let us assume gold and the dollar are in perfect balance for monetary purposes. There is no inflation or deflation working through the economy. The dollar price of gold exactly matches the market's highest value not only for spot transactions, but for time transactions (contracts between debtors and creditors). Let us say that balance exists at precisely $325 per troy ounce. When the government then issues $1 more in paper money than the market wishes, the paper dollar will become a teensy-weensy more abundant than gold, which also pays no interest. That is, gold becomes slightly more scarce than the dollar. The market judges this to be an inflationary error, and gold will be bid up to $325.0001. This also occurs if the government does nothing about the money, but decides to raise tax rates in a way that reduces the economy's need for paper money (cash and bank reserves). If the Fed does not siphon off that non-interest-bearing debt with interest-bearing bonds, gold also becomes scarce relative to the dollar and gold will be bid up to $325.0001, or perhaps $400 if the tax/tariff hike is big enough.
Deflation works in exactly the opposite way. When there is an improvement in the economy's risk/reward structure -- perhaps a cut in marginal income-tax rates or capital gains or elimination of an ergonomics reg -- the market will want more liquidity to serve its purposes in the spot market and in the contract market. If the Fed does not supply it, because it is worried about too many people getting jobs or too much exuberance on Wall Street, the dollar will become scarce relative to gold. The price of dollars will be bid up and the dollar/gold price will fall to $324.9999.... or perhaps to $300 or $258, if there are enough errors by the Fed, large or small, in matching up supply and demand for liquidity with the gold signal.
The fix we are in has come about because of all the good things happening, absent a gold standard. With the end of the Cold War, public finances become much easier to manage. The Reagan tax cuts, followed by the 1997 tax cuts, dramatically have increased the demand for liquidity, but the attendant prosperity has led the Federal Reserve governors to worry about things getting too good too fast. Had Greenspan done what I recommended in late 1996 and begun educating Congress about the deflation potential in a falling gold price, the deflation could have been interrupted when gold hit $350, a place where the interests of debtors and creditors would have been roughly in balance. That would have meant he would have had to persuade the establishment that the fed funds target was inadequate to the task of matching supply with demand for monetary reserves. This, he was unwilling or unable to do. The target today, four years later, might be $325 to maintain a balance of debtors and creditors.
When gold is the target of monetary policy by the Fed, the central bank simply adds liquidity when the price of gold goes from $325 to $324.999. And it withdraws liquidity when the price goes to $325.0001. Actually, the "gold points" could be a bit wider, say $324 and $326, or $324.50 and $325.50. Because the Fed has the absolute monopoly over the ability to turn interest-bearing debt into non-interesting-bearing debt (which is what the term "printing money" means), the market will never challenge the Fed if the Fed persuades the market that it means business, and will not even think of devaluing the dollar for some extraneous reason. A sure way for a speculator to lose his shirt would be to test the Fed by shorting the dollar, only to find that the Fed is perfectly capable to offsetting any market challenge with open-market operations. This is how the private Bank of England kept the sterling price of gold constant over centuries, with brief wartime interludes when gold convertibility was suspended.
In September 1987, when he was Treasury Secretary, James Baker III proposed an international monetary agreement that formally would link exchange rates, with gold as part of a commodity basket that would serve as a reference point. This was a step in the right direction, but it was soon forgotten when the market crashed three weeks later. The “reference point” is needed in order to guide the central banks as they keep their currencies linked, or there will be disputes as to which central bank needs to “tighten” and which do not have to “tighten.” I put quote marks around the “tighten” to indicate there were even then differences of opinion on how to keep your currency in line. In the system I described above, if the dollar gold price begins to rise, as a sign there are too many dollars in circulation, the Fed would have to issue an interest-bearing bond in order to take that surplus dollar off the market. It would have to “contract its balance sheet.”
This is not what most people think of when they think of tightening, and it was not something Baker understood at the time. “Tightening” to most people means raising interest rates. But raising interest rates do not take surplus dollars out of the system. Higher interest rates only serve to weaken the economy, which produces surplus inventories and a declining demand for dollars. There are actually very few “supply siders” who understand this process, as most of the people who were attracted to the Supply-Side Revolution came as tax cutters on fiscal policy and as monetarists on monetary policy.
Does gold only move up and down when the Fed makes a monetary error? No, the Fed need do nothing at all, which is its usual posture, and we see gold moving up and down. These movements occur because of the market’s judgment of the need for dollar liquidity relative to all the other events occurring in the world economy. In the last four years, in fact, the Fed’s errors only were related incidentally to the gold price, as it raised or lowered its interest-rate target for reasons having to do with other theories on how a nation’s money should be managed. That’s why I’ve said the position we are now involves an accumulation of errors large and small, errors that will compound further if there are tax cuts that further increase the demand for liquidity, which the Fed ignores because it is befuddled by what it sees around it.