Hollow Treasures

Hollow Treasures

              The price of any commodity is determined primarily by the opportunity cost a rational investor must incur to purchase that commodity.  In other words, what a buyer must forgo to buy your product will determine the price of that product.  This is due to a series of economic realities such as, what you as a seller will get for something depends on the demand for that product, the relative scarcity of that product and the price and scarcity of competing products that can offer the same satisfaction to a buyer.  Regarding investments, that last point is particularly poignant.  For example, if a government or corporation is selling debt instruments such as bonds, the face value and interest rate for that bond will be determined by the board of directors but the board knows that to raise capital they will have to compete against other debt instruments that the market has access to and will have to adjust the carrying value accordingly.  If the average interest rate is 12% and the government or corporation is offering bonds with an interest rate at 10% than a discount from the face value must be given to the buyer to narrow the gap between the two competing investments thus eliminating the opportunity cost or the next best option given up by the buyer. 

             It is important to extend this logic to the price of gold.  The price of gold has oscillated considerably in the last 75 years, particularly since 1971.  Many people blame Richard Nixon severing the dollar from gold that year for gold’s vertiginous rise in price.  If we track the nominal price of gold, it is easy to see why this notion has been the pervading theme for decades.   However, in terms of inflation adjusted dollars and purchasing price parity (PPP) gold has been expensive before and it has been cheap since then as well.  See Chart 1:1 and 1:2 below.[1]

Non-Inflation Adjusted Gold Prices or Nominal Price (1900-2024)

                        Chart 1:1

Inflation Adjusted Gold Prices (1900-2024)

                        Chart 1:2

            When adjusted for inflation the price of gold’s trajectory takes a less predictable path.  The notion that by severing the dollar’s peg to gold the Fed was able to become a money printing machine and thus subsequently led to massive inflation reduces the complexity of monetary policy and its effect on commodities.  When people think of inflation they think of the rising cost of goods, which is correct but will assume that the Fed printing money causes this price hike.  This is not always the case.  The economy grows in terms of aggregate indicators such as GDP and a currency that is pegged to a limited good such as gold has an innate deflationary affect.  According to the World Gold Council, the best estimates currently available suggest that around 212,582 tons of gold has been mined throughout history, of which around two-thirds have been mined since 1950.[2]  Gold is a perennial metal so we can assume that all or a majority that has been mined is still available.  Borrowing our logic from before regarding opportunity cost, the size of the U.S. and world economy has grown immensely.  Looking at the charts below we can see that around 1945, a year after the Bretton Woods System was established, global GDP was around $10 trillion.  Today’s global GDP is around $127 trillion, that is an approximately 12-fold increase in the size of the global economy in real terms.  See Chart 2:1 below.[3]

Global GDP Growth (0-2022)

            Chart 2:1

     This reality started to be felt around the end of the 1960s, as the U.S. economy along with other economies around the world started to grow at meteoric rates, the fear that countries that benefitted from the Marshal Plan such as France, Germany and Japan were going to start trading in their dollars for a limited supply of gold and realize that there wasn’t enough to go around and thus destabilize a newly minted global financial system that had achieved so much in the past 25 years was palpable.  Nixon and his allies understood that to decisively severe the link from the U.S. dollar from gold would free the U.S from this threat.

            Thus, returning to the criticism of the U.S.’s monetary policy there is conflicting data regarding this notion of “money printing” alone that is responsible for causing gold prices to rise.  If we look at several of the graphs provided below, we see that even after 1971, three major economic indicators related to inflationary monetary policy seem rather stable before and after 1971, they being the monetary base, M1 and reserve balance.  The monetary base according to economist Daniel L. Thorton is “related to the size of the Fed’s balance sheet; specifically, it is currency in circulation plus the deposit balances that depository institutions hold with the Federal Reserve. The Fed has essentially complete control over the size of the monetary base.”  That brings us to M1 which is all liquid currency in the economy including commercial bank deposits.  Thirdly, reserve balances are cash balances that depository institutions such as commercial banks have on the federal reserves balance sheet.  This is done through market operations such as buying and selling treasury securities.  If the Fed wants to expand the monetary base it will buy treasury securities from these banks and thus put cash in their reserves, they sell to these institutions securities if they want to do the opposite, however, reserves do not add to inflation, the individual banks can decide what to do with these reserves.  They can lend them out which would add to the money supply or choose not to.  Regarding the latter option banks are required to have a certain number of reserves relative to the money they are lending out as an insurance policy to maintain solvency, this is called the reserve ratio.  See Chart 3:1, 3:2 and 3:3 below.[4]

Monetary Base (1960-1924)

Chart 3:1

M1 Liquid Money Supply (1960-2024)

Chart 3:2

Reserve Balances (1960-2024)

Chart 3:3

            As stated above, none of these indicators has a very noticeable, let alone meteoric rise after 1971.  However, 2008 and 2020 are different stories.  After 1971 though, they inclined a little bit and then grew steadily from there, but so did the global economy.  The average salaried worker, if relegated to a commodity, did not have as much demand for their work as other commodities including gold.  This is because the pool of viable workers grew exponentially with globalization and the amount of mined gold only grew by 2/3rds as stated above.  Even with these economic realities being in gold’s favor, the precious metal has had until recently a mediocre performance as a commodity.  In October early of 1980 gold was trading for around $660.25 per ounce.  In inflation adjusted dollars that is equal to $2,450.85, sound familiar?  Nostalgia is one hell of a drug.

            In the final analysis gold is a limited good relative to other commodities including labor.  Monetary policy has changed over the decades, but most importantly salaried wage workers have become widely available globally while gold’s availability has grown mildly.  With most people associating gold with stability rather than the stock market, even though the stock market has historically been a way better investment than gold, we can expect to see a greater demand for a limited good thus giving rise to its price.  If the economy and political landscape become more stable in the coming years, we can see an exodus of capital from gold investments into other investment opportunities that are more rewarding thus stabilizing the cost of gold.  However, because of its limited availability and more and more people globally becoming middle class and thus having the ability to purchase gold it is unlikely that the precious metal will ever be “affordable” again regardless of Fed policy.

Resources:

[1] Macrotrends LLC . (2024). Gold prices - 100 Year Historical Chart. MacroTrends. https://www.macrotrends.net/1333/historical-gold-prices-100-year-chart

[2] World Gold Council. (2024, February 1). How much gold has been mined? World Gold Council. https://www.gold.org/goldhub/data/how-much-gold

[3] World Bank . (2023). Global GDP over the Long Run. Our World in Data. https://ourworldindata.org/grapher/global-gdp-over-the-long-run

[4] Federal Reserve Bank of St. Louis. (2024, September 24). Monetary base: Reserve balances and M1. FRED. https://fred.stlouisfed.org/series/BOGMBBM