EDITOR'S NOTE: If you ever had any questions about the history of gold, its role as money, how money and currency differ, and what is currently going on in the world in terms of monetary policy and how it affects the value of gold, this detailed explainer from Seeking Alpha is for you. M&T Research Group provides an incredibly in-depth explanation of gold’s role in the world. It starts off with why it is historically important and why it is still just as important today. If you are already invested in gold or want to know why doing so could be a smart move for you now, this piece is a must-read.
- Gold has a solid 5,000 year history of being used as money and is universally accepted.
- The distinction between money and currency must be made in order to thoroughly study the role of gold in the global economy.
- Deconstruction of the reasons behind the decrease in the US dollar's purchasing power can be traced back to the nature of fiat currency.
- Unequal distribution of currency supply within the economy can mask inflation numbers that threaten to normalize gold's worth in dollars to astronomical levels.
- Analyzing the value of everything in the economy in terms of gold can provide insight into their true values and demand.
Gold has been the mainstay of finance and the cornerstone of money for the last 5000 years. It has survived the rise and fall of the greatest and the least of all the empires in history and still is in use today, forming the basis for monetary mechanisms in the global economy. Consistent with the phrase "Whoever has the gold makes the rules," historically investing and stacking gold has been one of the best ways to preserve wealth and secure a financial future for coming generations. In short, gold is a portable, durable, divisible, and fungible unit of account that possesses a consistent store of value. These are the key characteristics that enable it to be classified as money.
Gold as money can be exchanged for various units of local currency across the world. Trends in governments' monetary policy and fiscal attitudes coupled with the behavior of banks stemming from the fallouts of the global pandemic economic crisis, the Global Financial Crisis due to the housing bubble, and the technology bubble have all revived interest in the yellow metal in just the past twenty years. General attitudes towards gold currently classify the precious metal as a "pet rock" and a "useless investment" that does not generate a return on invested capital. However, unlike securities, gold plays a significant role in the financial system that needs to be revisited and rediscovered in order to elucidate its importance in global money flows and the macroeconomic monetary system.
The US dollar has been the world reserve currency since 1944 when the Bretton-Woods agreement was signed. Generally, the signing of the agreement is taken to be the historic moment establishing the US Dollar as the world reserve currency. Post-World War 2, many nations rebuilding from the disasters of war chose to peg their national currencies to the US dollar, hence establishing the world reserve currency system which has continued until the present day. For this article, therefore, reference to the behavior of the US Dollar with respect to gold is useful in generating a benchmark template for how other nations' currencies can be evaluated against gold.
Previous articles such as the Introductory Investment Thesis Parts I & II have glanced over analyses and metrics incorporating broad measures of and developments in gold market fundamentals to contextualize price actions. This article focuses directly on the fundamentals and factors affecting the US dollar's purchasing power in the context of gold as the foundation of money in as much detail as possible. Explanations of the US dollar in the context of gold provides key metrics to evaluate the true value of both the dollar and dollar-denominated assets. In addition, investigating key measures of inflation used to quantify purchasing power allows for comprehensive analysis of the ratio between the total amount of currency circulating within the economy and the total amount of currency within the financial system, circulated and reserved. Through this comprehensive analysis, it is hoped that a broader and precise understanding of the mechanics of gold price action is understood.
Figure 1: Snapshot of usdebtclock.org - a website that tracks the details of the National Debt of the United States and Other Ratios (Seeking Alpha)
Fundamentals of Money and Currency
It is important firstly to distinguish between money and currency such that they may not only be erroneously interchanged but that a concrete definition of each term is established to prevent confusion of the terms being used in this article. General government monetary measures use the terms interchangeably; however, the accepted use of these terms in context is not interchangeable. Money is defined as a portable, divisible, durable, fungible store of value and a unit of account, elucidated as follows:
- Portable - the monetary object must be able to be transported with ease for transaction and accounting purposes
- Divisible - each unit of monetary objects must be able to be divided into many smaller units of the same object in proportion
- Durable - the monetary object must be able to withstand external, unbalanced forces without alteration performed to its physical or chemical composition or constitution.
- Fungible - Each unit of this monetary object must be exactly the same as the same unit of another monetary object of the same elemental, physical, and chemical composition.
- Unit of Account - Drawing on the attribute of divisibility, each specified measure of the monetary object must be divisible and uniform such that it is able to quantify the precise value of a consumable or a commodity in demand.
- Store of Value - Each unit of monetary object must be able to maintain its specific value according to either the weight or the demand for a certain quantity over an extended period of time either by consensus or by resistance to natural elements.
The value of a nation's currency in terms of gold is directly proportional to its perceived market value and, ergo, purchasing power as a function of the total supply circulating within the broader economy. Similarly, the purchasing power of gold as money is directly tied to its supply within the local economy. The transactions conducted for units of consumables or services are dependent on the supply of both the money in use to facilitate the transaction and the goods & services for which money is being spent. Therefore, given an established ratio between goods & services and money in a historical context (which assumes the rate of goods and services supply addition/subtraction is proportional to the rate of money supply addition/subtraction respectively), the price of goods & services will not change. If the money supply increases more than the goods and services available (inflation), it will take more money to buy the same amount of goods and services and vice-versa. This is the key determinant of purchasing power.
Figure 2: M3 Currency Supply for the United States and Gold Fixing Price (10:30 a.m., London Time) in London Bullion Market (Seeking Alpha)
The Purchasing Power of Currency
The purchasing power of a nation's currency, particularly that of the US dollar, can be measured in terms of supply and demand primarily and then in terms of valuations of goods, services, assets, and financial instruments as additional measures of its strength. The broadest measure of currency supply, M3, is useful for encapsulating the true volume of the currency circulating and stagnant within the global economy. According to the Organization for the Economic Co-operation and Development (OECD), M3 includes "[…] currency, deposits with an agreed maturity of up to two years, deposits redeemable at notice of up to three months and repurchase agreements, money market fund shares/units and debt securities up to two years."
Overlaying a chart of M3 for the United States is a historical price chart of gold. As observed, during times of monetary crises, demand for the metal rises such that the price corrects upwards for the increase in money supply and then normalizes around the level of currency supply given a ratio of currency supply to gold reserves. At present, the price of gold is below the M3 supply line and is inevitably due for a correction owing to historical evidence. Further investigations into consumer prices may reveal similar corrective mechanisms during the time the dollar was still pegged to gold. In addition to this measure, interest rates provide an extraordinary insight into the mechanics of currency purchasing power and its relationship to the yellow metal.
The US Debt Clock website provides a ratio of the total amount of US dollar currency units available in the global economy to the total above-ground supply of gold and silver as shown among various other commodities and measures. According to Figure 1 which provides a screenshot of the website containing real-time changes in metrics and key figures, currently the dollar-to-gold ratio sits at just above $21,000/oz., a near-750x increase since 1913 when the dollar-to-gold ratio was calculated to be $29.06/oz. Figures 8 and 9 provide relatively recent indexed inflationary metrics from 1969 that provide a more comprehensive comparison between these stated increases in relation to other liquid funds, balances, and prices.
Figure 3: 10-Year Treasury inflation-Indexed Security with Constant Maturity overlaid with the price of gold at 10:30 am London time at the London Bullion Exchange in U.S. Dollars (Seeking Alpha)
The purchasing power of a currency can be directly measured through interpreting the real yields of a debt instrument. The real yield of a securitized asset or a debt instrument, such as a government-issued bond in this case, is taken as the difference between the calculated rate of inflation and the yield on that securitized asset. One of the main aims of monetary investment is to beat the inflation numbers in order to preserve one's wealth through financial instruments such as securities, high-interest debt, or preservation assets such as gold, silver, and commodities.
If the real yield of a security or an asset is positive, it implies that the interest rate on the principal of the asset is high enough such that the rate of currency inflation is surpassed and wealth in terms of that currency is either being preserved or created in that currency. Conversely, a negative real yield implies that the initial capital being invested into the asset or security is being destroyed. Examining the real yields on a government bond can provide the most comprehensive insight on the effect of the creditworthiness of the government's currency and, therefore, its purchasing power.
Figure 3 shows a chart of the price of gold in US Dollars overlayed on a chart of market yield on 10-year inflation-indexed treasury securities (also known as the TIPS - Treasury Inflation-Protected Security - rate) from January 2003 until the present day. It is visually clear that the correlation between the timing of moves in the price of gold and the TIPS rate is close to -1. However, the magnitudes of the moves at each reversal or acceleration for both the TIPS rate and the price of gold do not perfectly correlate with each other. Summarily, the timing of the moves in real yields can tell of the direction and timing of the moves in the dollar price of gold, but not the magnitude of the move. This can be proven by correlating the recent price action of gold with the behavior of the TIPS rate. A few notable examples of this can be found particularly during the March 2020 gold price crash and the gold price ascent and the yield collapse in the early stages of the Great Recession ('07-'09). Currently, it is observed that real yields are largely inversely mimicking the price action of gold.
Key measures of purchasing power such as the real yield as a direct measure and currency supply as a proxy measure reveal important insights into gold-currency dynamics. The real yield is indicative of both demand and purchasing power. In addition, metrics such as the velocity of money can provide a more comprehensive overview of currency demand. In addition, supply is an interesting measure when Gresham's Law is considered, which states that "bad money drives out good money." This has not only applied to gold throughout history, but to the US dollar particularly within the last century. This forms the basis for the dollar milkshake theory and other theories replying on supply-demand dynamics. Despite the affinity for economic control through currency, however, the luster of gold has shined through the annals of financial history and brought stability in circulation and acceptance.
Denominating Assets & Liabilities in Gold
Examining the price of assets and liabilities denominated in weights of gold is valuable in understanding the trends in purchasing power of the US dollar which was only done in proxy by examining the behavior of government debt real yields. While real yields provide insight into the integrity of the government's financial mechanism structure, pricing assets and liabilities in gold yield insights into demand, supply, and instrument value that must be derived when working with real yields alone. In addition to examining the gold worth of assets and liabilities, a brief glance at the behavior of commodities will provide a more comprehensive insight into how every financial instrument denominated in currency is worth in money.
Figure 4: Dow Jones Industrial Average-to-Gold Ratio from 1981 with Technical Price Levels and Diagrams (Seeking Alpha)
A technical analysis of these price charts is warranted to provide comprehensive insights into the underlying value of the securities and assets being analyzed. Simultaneously, it is important to note that before the dollar-to-gold link was severed in 1971, a direct measure of the worth of assets in terms of gold was evaluated through the dollar as a proxy as the gold standard was still in effect. After Richard Nixon eliminated the gold standard, the link between the dollar and gold was "temporarily" severed, disconnecting prices of dollar-denominated goods, assets, securities, and services from a measure of true value.
While the dollar price of gold then corrected for the increase in currency supply, nominal prices of securities and financial assets, particularly the major market indexes, stagnated for most of the 1970s. This provided the illusion of a "stagflation", where growth slows considerably to where there is an economic contraction but the inflation rate achieves higher highs offsetting the contractions on paper. It is this net percentage difference between real economic performance and currency inflation that needs elimination to understand the real state of the economy and the real value of goods and services.
Shown above in Figure 4 is a chart measuring the Dow Jones Industrial Average DJI-to-gold price ratio from 1981 to the present day - each price level is a measure of the number of ounces of gold one would need to purchase one share of the index. As shown, typically price levels are achieved in pairs and the distance between a set of two price levels is approximately five ounces. Between the two price levels for each pair, the distance between them is approximately 0.77 ounces. An ascending support trendline from the beginning of the timeframe marks a significant deviation to the peak around 2000 and a correction initiated by a rising wedge to levels below the trendline during the commodities bull market until 2011, where a macro-reversal took place.
There are two distinct technical patterns within the price action - a rising wedge building from 1995 and completing in 2002 and a descending channel building from 2017-2018 and completing between 2020-2021. Presently, after the breakout of the price action from the descending channel, the DJI-to-gold ratio has reached levels previously seen in 2018, 2007, and 1996 despite the bullish breakout trend. This is important to understand as this behavior has been exhibited in other forms historically, which resulted in the initiation of a bullish trend or a sharper corrective wave lower depending on the timeframe.
Figure 5: Dow Jones Industrial Average-to-Gold Ratio from 1891 with Technical Price Levels and Diagrams (Seeking Alpha)
A monthly historical price ratio chart from 1891 shown in Figure 5 is provided for reference with three key approximate dates for important gold-related events - the Federal Reserve foundation in Dec. 1913, the dollar devaluation of 1933 through Executive Order 6102, and the erasure of the dollar's gold standard in Aug. 1971. Price level pairs have been expanded to include peaks in the price action. Volatility in the price action markedly increases from the Roaring '20's until the present day with peaks achieving new highs and lows going lower.
It is evident from this chart that despite the continuous achievement of all-time highs (ATHs) in the nominal price level of the Dow Jones Industrial Average, the DJI-to-gold ratio indicates that it is still at levels just above the market peak in 1929 and the late 1960s. In addition, it bears noting that the peak-to-trough pattern is accompanied by a short bounce in the price action before heading to a normalization of the DJI-to-gold ratio at the minimum. Elliot wave analysis and further technical investigation may confirm the fundamental hypothesis that in this inflationary environment, further downside to the ratio and a sudden normalization is highly likely.
Figure 6: West-Texas-Intermediate-Crude-Oil-to-Gold Ratio (Seeking Alpha)
Like the DJI-to-Gold ratio, an Oil-to-Gold ratio shown in Figure 6 can be constructed to determine a real value of crude oil. It is observed that since the 1950's, a near-stable value of crude oil was established by the market, after which the price action descended into an ascending channel despite various breakouts until the price breakdown of 2014, when the Organization of Petroleum Exporting Countries (OPEC) initiated a silent war with the United States shale oil industry and drastically increased production, leading to the bear market of 2014-2016 in the nominal price action. However, a descending channel was established during the period between the end of the 2014-2016 bear market until the present day.
Extrapolating the trendlines, an observation finds three false breakouts which test the upper bound of the ascending channel before the ratio drops into the descending channel. The lower bound, while acting as support for the ratio action, has acted as resistance for historical ratio actions prior to and after a breakthrough in 1991. A hypothesis based on these technical conditions alone could be constructed for the outperformance of oil with respect to gold on a nominal basis - a bullish move in the ratio action implied that the nominal price action of oil is outperforming the nominal price action of gold, and vice-versa. This is true for all assets, liabilities, and securities being analyzed in terms of the price-to-gold ratio.
In fact, by examining the value of the dollar itself, one understands how its gradual devaluation through currency supply inflation and liquidity injection into the system has masked true values of consumables and commodities whose market-determined prices are denominated in dollars. Figure 7 an inversion of the gold nominal price chart in US dollars depicting the path of the value of the US dollar with respect to gold. Two major events are marked on the chart for reference - the implementation of Executive Order 6102 and the withdrawal of the gold standard of the US dollar.
Figure 7: Inverse of US Dollar Price of Gold Interpreted in Negative Territory as a Measure of the US Dollar's Value (Seeking Alpha)
Figure 8 shows a price chart of the worth of the US dollar in terms of grams of gold. Both charts depict the implementation of Executive Order 6102 and the elimination of the US dollar gold standard in 1971. Since the decoupling of the gold standard the value of the US dollar has invariably decreased by well over 95% of its original value in terms of gold weights. This has not, however, been reflected appropriately in the nominal price charts of assets, liabilities, and other securities, consumables, and commodities as nominal prices are no longer reflective of their true value owing to the visibility of the nominal dollar value.
This visible market-driven dollar devaluation over time has masked key developments in the value of securitized assets and other commodities and consumables not mentioned here such that they are perceived to be "inflation-beaters" due to the pace of nominal price increases. However, the nominal US dollar price of gold at times has seen to outpace these items' and securities' nominal price performances to where a net decrease in their true value is observed. As a result, as discussed earlier, the additional performance of their real yields on value suffer owing to the difference between the nominal price performance and the gold price performance. Such a difference is therefore indicative of a real yield wherein the yield on the asset in nominal terms is surpassed by the yield on the capital invested into gold.
It is for this reason that the gold-driven value of everything on the market must be determined, which allows for a short investigation into the measurement of inflation metrics. Determining inflation metrics both by supply and demand means is valuable in understanding the different means of measuring inflation and a quantification of the disconnect between the currency supply circulating on Main Street and the supply circulating between financial institutions on Wall Street.
Figure 8: Worth of the US Dollar in Grams of Gold (Seeking Alpha)
The key question that investigates comprehension of the effect of currency supply increases on the real economy revolves around the construction of inflation metrics. To measure inflation is to measure the amount of currency circulating within the economy given a set of qualitative and quantitative supply and demand figures. A variety of econometrics determined from deriving inflation figures is useful in generating the overall health of the organic economy with respect to the financialized economy.
Since inflation is solely a monetary phenomenon, observing currency flows across different sectors of the economy originating from the Federal Reserve or government-run welfare programs allows for comprehension of the concentrations of money supply in various sectors of the economy. Currency velocity, therefore, as a function of where currency supply is most concentrated in the context of circulation and usage is therefore most suited to understanding inflationary mechanisms as opposed to government statistics. However, inflationary econometrics from government bureaus often serve as good yardsticks for observing how currency supply flows and circulates within certain sectors of the economy on a relative basis, and therefore these are included in the analysis.
Figure 9: Quarterly Measures of Various Econometrics for Inflation Calculations Indexed on Jan 1, 1969, at 100 (Seeking Alpha)
Currently, the generally accepted metric for inflation is taken to be the Consumer Price Index (CPI) which measures consumer prices across a wide variety of consumable products, commodities, and services in order to draw a general numeric visual of the effect of currency supply increases on the real economy. However, other measures of price inflation can be used in order to derive a more comprehensive picture of the effect of currency supply increases, such as asset prices, home valuations, and fixed income instruments such as Social Security and securitized debt.
Tom's inflation calculator aggregates data from different measures of inflation for use in inflation calculations. Key measures of inflation used by the calculator include the Urban CPI (CPI-U) from 1665, the Social Security Wage Index from 1951, the Medical-Care Inflation measure from 1935, Personal Consumption Expenditure (PCE) from 1929, and metrics from ShadowStats from 1969 onwards. Explanations for each of these is provided on the website. In order to measure inflation from an indexed perspective, a nominal dollar amount of $100 indexed in 1969 will provide insights into how different inflation metrics return different results.
In addition to Tom's Inflation Calculator, several other indexed measures of monetary inflation shall be considered. Some of these include the M2 Supply of Currency, the Median Sales Prices of Houses, and the Gross Domestic Product (GDP) among others. Contrasting the expected price of gold and the inferred depreciation of the US dollar between different measures of inflation provide estimates in varying degrees of demand and supply of what actual inflation metrics are presented as in order to comprehend the dynamics of currency supply and demand across the various sectors of society.
Indexed at $100.00 in 1969, the various inflation-adjusted calculations from Tom's Inflation Calculator provide the following data for 2020, the most recent data set:
- Personal Consumption Expenditures - $555.33
- CPI-U (Year-over-Year) - $690.38
- Consumer Price Index (CPI) - $704.01
- Social Security Wage Index - $943.84
- Medical-Care Inflation - $1625.80
- ShadowStats Inflation Data - $4072.78
Figure 10: Snapshot of the Most Recent Quarterly Measures of Various Econometrics for Inflation Calculations Indexed on Jan 1, 1969, at 100 (Seeking Alpha)
In contrast, Figure 9 shows inflation data for the present indexed at $100 in Jan. 1969 based on the provided metrics. As shown, the largest inflation is shown by the Reserves of Depository Institutions in sharp contrast with real GDP figures, which have not increased much on a relative basis despite a larger increase exhibited by the M2 currency supply. Interestingly, ShadowStats data show a marked similarity between its indexed inflation metrics and the indexed performance of gold since 1969. Ranking both sets of data according to their indexed calculations, the following aggregated data list is achieved:
- Real Gross Domestic Product- $395.30
- Real M2 Currency Stock - $477.40
- Personal Consumption Expenditures - $555.33
- CPI-U (Year-over-Year) - $690.38
- Consumer Price Index (CPI) - $704.01
- Social Security Wage Index - $943.84
- Median Sales Price of Houses - $1,574.70
- Medical-Care Inflation - $1,625.80
- Nominal Gross Domestic Product - $2,332.90
- ShadowStats Inflation Data - $4,072.78
- Gold Fixing Price (10:30 a.m.) at LBMA - $4,194.20
- Reserves of Depository Institutions - $14,935.80
There are noteworthy observations within this study that point to a dislocation between the real economy and the financial economy - between Main Street and Wall Street. The inflation experienced by real figures such as real M2 currency supply and real GDP is at least 35x less than that of Depository Institutions' Reserves, which stands at a whopping 148.36% increase since 1969 in contrast to Real GDP's 295.30% and Real M2's 377.40%. Interestingly, as mentioned earlier, the inflation experienced in the price of gold, a whopping 4,094.20%, is similar to the inflation experienced by the consumer according to ShadowStats inflation data, which stands at 3,972.78%.
It is important to note that gold is one of many points of confluence between the real economy and the financial economy where physical gold bullion is held by both parties for various reasons - primarily financial security. Therefore, a glimpse into both the real economy and the financial economy can be made by examining currency and credit flows through the markets and trace their respective origins to determine quantities within the system. This enables a thorough understanding of the distribution of currency supply such that a distinction can be made between the currency supply circulating within certain sections of the real economy and the supply in reserves or held by financial institutions for large-scale transactions.
For over 5,000 years, gold has been the go-to natural resource for financial and monetary uses. It has taken center stage due to its inherent properties that allow it to be classified as money - it is a portable, durable, divisible, fungible unit of account that is an excellent store of value. Gold's usage is nearly universal - one can travel to a foreign land and initiate a transaction with gold despite not having the local currency. Understanding the nature of money itself can initiate a complete comprehension of the modern financial system and why it is destined to implode.
Owing to its unique properties as one of the original forms of money, the purchasing power of gold need not be enforced. However, currency, owing to its fragile nature and the absence of the properties of money, does not share the same behaviors in purchasing power as gold. Therefore, over time, a fiat currency system - one where the currency is merely a piece of paper - implodes owing to a realization of its inability to fully recreate the properties of money in the form of a piece of paper. Furthermore, in addition to what was discussed in the article, the purchasing power of gold is founded by another key ingredient that shapes the global economy - energy.
The nature of gold as money allows for a physical representation of the energy taken to structure gold to a form suitable for making financial transactions. If a currency is not backed by a fixed supply of gold, then inherently it is backed by the amount of energy it takes to mine or construct the currency, which is significantly lower than the amount of energy it takes to mine, refine, and mold gold for monetary uses. It is therefore imperative to analyze the value of assets, consumables, and other ingredients necessary to the full functioning of the economy for analysis in terms of energy consumption. Thus, eliminating the currency denomination represents the asset in terms of the amount of energy consumed to produce or sustain its value using gold as a proxy.
In addition to the inability of currency to inherently mimic the properties of money, the unequal distribution of currency supply between different sectors of the economy, regardless of the origin of this currency supply, lends an unfounded denomination to establishing suitable prices for necessary consumables, goods, and services within the economy. Examining certain indexed econometrics such as the real GDP increases and reserves amounts in depository institutions allows for a comprehensive overview of the destinations and, sometimes, origins of currency supply. Applying these figures in conjunction with analyzing cash flows through exchanges and contracts presents a clearer picture such that true price inflation and the effect on personal savings of a wide array of people can be analyzed.
Presently, however, currency and liquidity issues prevalent within the current structure of the financial system provides a near-ideal setup for unprecedented levels of demand both from large financial institutions and smaller retail investors - bullion deliveries may be demanded from major exchanges when currency liquidity issues become increasingly difficult to deal with owing to the large amount of debt and the mechanism of Exter's pyramid. The confluence of liquidity injections and the decreasing rate of money velocity present the problem of timed inflation - if and when the economy completely reopens, we will see an increase in money velocity, and the sharpness of the increase will be determined by the speed of reopening the economy.
Coupled with recent injections of liquidity, hyperinflation or near-hyperinflation fallouts may occur with the collapse in demand for currency and a significant drop in real yields. As explained in An Introductory investment Thesis for Gold and Silver, Part I, "The coronavirus crisis has revealed cracks in the financial system that have been masked over by excessive money printing via zero-interest rate policy (ZIRP) […] negative-interest rate policy (NIRP) […] and other monetary and fiscal policy efforts that have widened the socio-economic divide and created conditions of instability across many markets, providing ripe conditions for retail investment into gold […]."
Originally posted on Seeking Alpha.