John Maynard Keynes once famously called gold the “barbarous relic,” suggesting that its usefulness and, hence, it’s value, is antiquated. So the question really is, or should be, is gold useful today? If so, what is its value? And how much should you pay for it?
In July of 2011, US Fed Chairman Ben Bernanke was asked pointedly whether or not gold was money. He said no. Milton Friedman once famously said, “Money is what money does,” meaning if people use it as a medium of exchange, it doesn’t matter what they call it. For instance, convicts often trade cigarettes for goods and services, so in prison, cigarettes are money. Likewise, for most of human history, gold has been a medium of exchange, albeit with numerous iterations and evolutions — until 1971, when Nixon took the world off of the gold standard, proclaiming, “We’re all Keynesians now.” Many people certainly think of gold as money. Interestingly, governments the world over own large amounts of gold and have recently begun increasing their ownership of gold. My question: If it ain’t money, why would they own it all? Mr. Bernanke says “tradition.” Seems like an awfully expensive tradition to maintain. Maybe there’s more to it.
As articulated by a young Alan Greenspan in 1966, gold is the only thing that fulfills all the requirements of money: It is scarce, it cannot be fabricated or produced in large quantities, it is durable, it is homogenous and divisible (so each unit is of comparable quality to the next), and it is widely acceptable as money. Obviously, printed money can’t meet these criteria. Only gold can.
Over time, gold has undergone three major transitions: First, it became the global standard as a medium of exchange; second, an international banking system was developed around it, in which paper money was fully convertible into gold; and third, convertibility into gold ceased in 1971 and a purely fiat money system took its place. Global monetary policy “abandoned” gold, yet it trades today at about $1,600 per troy ounce — about 40x its price in 1971, when the US departed the gold exchange standard. How could this be?
Just because the world switched to a fiat money system, does not mean that the virtues of gold have changed at all in the past 40 years. Quite the contrary, the virtues of gold have remained the same. It is the political climate that has changed. The hardest thing for an investor to wrap his mind around is that the intrinsic value of gold is not a singular price per se. Rather, gold derives its value as a put on government finances. The more egregious the fiscal and monetary policy, the more valuable gold becomes.
The open secret in the financial world is that governments discourage the use of gold as money for its citizens, but in fact they trade in it through their central banks and treasuries. According to the the US Treasury Dept, US Treasury holdings of gold are 261 mm ounces, and the Fed’s holdings were 13.5 mm ounces as of July 2012. Led by governments such as India and China, central banks as a group have been snapping up gold more recently at a staggering pace — increasing their holdings of gold from 156 metric tons to more than 400 metric tons in only 12 months (ending March 31, 2012). Note well, this is a sharp change in behavior from persistent government selling of gold stocks over the past four or five decades. Even the IMF has just reversed a long standing policy of gold liquidation to purchase about 44 metric tons.
Of course, ownership of gold is a global phenomenon. As such, gold prices are affected not only by the US Fed’s monetary policy but also by what other central banks around the world do. It is widely believed that the ECB will have to “print” as their end-game solution to save the euro. If so, then the impact of EU printing will magnify the currency wars already taking place as no country wants a strong currency. Until now, the EU has been very cautious about printing money. Should they become a major participant in the currency wars, then they will only add tinder to the flame — accelerating global money printing and the put value of gold.
Unlike many other assets, gold doesn’t generate any income — or even promise to generate any income at any point in time. So, any return on gold comes strictly from its price movement. All that having been said, now we can focus on what matters: The printing that has occurred, and the printing that will likely occur. To help us examine this relationship between monetary policy and gold, I looked at the monetary base relative to gold prices. Between 1971 and today, both the monetary base and gold prices are up 37.7x and 38.4x respectively. See below:
Sources: St. Louis Fed, Gold.org, CFA Institute.
As you can see in the table, the monetary base has expanded from $69 billion in 1971 to almost $2.7 trillion today. Juxtaposing both gold prices and the monetary base on the same graph is also illuminating. Because of the explosion in debt during the early 2000s, the market was looking through the slowing growth of the monetary base and correctly anticipating that it would need to expand rapidly to cover the bad debts. This is the wisdom of the markets at work.
United States Monetary Base vs. Gold Prices (Five-Year Rolling % Change)
Sources: St. Louis Fed, Gold.org, CFA Institute.
Just as the monetary base expands into a country’s money supply (M1, M2, or M3) through the creation of credit in the banking system, gold is really a hedge against this potential for the monetary base to expand into the money supply. Therefore, looking at the monetary base is a relevant metric for evaluating gold’s potential. Moreover, the central banks have complete control over the monetary base, while they must rely on the banking system and economic growth to produce the money supply (although they certainly have tools to influence credit creation).
As noted in my recent article on government debt, governments of the world are trying to solve a debt crisis by adding more debt. This will only serve to ensure that the next recession is severe. But regarding gold, escalating debt levels and fiscal deficits only increase the burden on central banks to print more money. At present, the world is caught in this circular loop of debt and easy money. When the world appears ready to give up on debt and easy money, then you should give up on gold . . . but not a moment sooner.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.