Debt and the Price of Gold
by Michael S. Rozeff
by Michael S. Rozeff
Why have prices of the goods we buy risen over the past century? Why has the purchasing power of the dollar fallen?
The better we understand why this has happened, the better we can understand changes in the price of gold. The long run course of wages, rents, and consumer prices is reasonably understandable. The long-run change in gold's price is reasonably understandable. The causes of "short-term" variations in gold's price — some running for many years — are not as understandable. Gold is traded in a speculative market. For this reason, its price movements can never be fully understood. Speculative prices are typically forward-looking. They depend on what people expect. These expectations are unknown and changeable.
Our understanding of gold's price movements will always be partial. Because our understanding is limited, looking at alternative answers to the difficult question of price movement causation can be useful.
One answer is inflation: the FED has created too many dollars compared to the goods Americans have produced. Hence, prices rose. This is the quantity theory of money stated very simply. This theory has some worth in the long run, which is 50 years or more. The price of gold and the prices of many other goods and services have risen over many decades along with increases in the monetary base.
In an earlier article, I applied that theory. I estimated that if gold's price rose at the same rate as the monetary base had since 1932, the price of gold would be $1,099. The time between 1932 and 2006, that article's date, is 74 years. If a theory doesn't work given that long a time span, it probably is of questionable worth. Gold at that time was $635. Its price still hasn't reached $1,099, although it got to $1,025. The monetary base has now doubled since that article. The corresponding price of gold is $2,198. Maybe it will get there and maybe it won't. Maybe it will go even higher. The monetary base can shrink as well as rise. The large and extraordinary rise may prove temporary. It can also rise even more swiftly. Markets can do some very surprising things.
It is clear from this example alone that over shorter periods of time, fluctuations (or the lack of them) in gold prices occur that have no obvious or direct connection to changes in the monetary base. In the long-run, the theory gets us into the ballpark, but the ballpark is quite large. The speculative market for gold is not closely heeding my crude application of the quantity theory. The correspondence is loose. Maybe someone else can create a closer fit. Furthermore, it was not clear then and it is not clear now what measure of money to choose. The suggested price of gold using M1 in 2006 was $656, and that using M2 was $3,121. The ballpark is very large indeed.
Another answer than quantity theory is that the security behind the FED's dollars has fallen. This is the backing theory of money, which is less familiar. Professor Michael Sproul first brought this to my attention. This theory is useful because it focuses attention on the FED's balance sheet. The variables on the balance sheet are measurable. We do not face the ambiguities of the quantity theory. We face different ambiguities. At various places in past articles, I've mentioned the backing and how it has deteriorated. The rest of this article goes in a somewhat different direction.
The FED's notes, which are the currency we use daily, are its liabilities. They are only as good as the assets backing them. Those assets are securities in which the FED has invested and a certain amount of gold. Up until recently, the securities held by the FED have primarily been bills and bonds issued by the U.S. government.
Let us suppose that the FED's assets are mainly U.S. government bills and bonds. This means that the FED has made loans to the government. The government, financially speaking, is a subsidiary of the American people. Americans pay taxes and the taxes secure the government's debts. The taxes come out of the product of Americans, that is, what Americans produce.
The U.S. government has not defaulted on its debts. Why then have the FED's notes fallen in price (which is also asking why the prices of goods, including gold, have risen)? I propose that the reason for this is that the security behind the government debts that the FED carries as assets has fallen.
We can get at this in two complementary ways. One is to use the government's balance sheet, and the other is to use the balance sheet of all Americans. Take the government's balance sheet. If its debts have risen relative to its assets, then the security behind those debts has fallen. The backing theory thus leads us to look at the ratio of government debt to its assets. The government's main asset is the flow of taxes it gets from the product of Americans. Since the source of taxes is product, a measure of the quality (or security) of the government debt is the ratio of its debt to Gross Domestic Product (GDP.) However, this ratio does not get at the fact that Americans are indebted on their private account. That encumbers the GDP, since those debt payments have GDP as their source. We need to consolidate the balance sheet of all Americans with their subsidiary, which is the government. We need to look at the total debt of Americans.
The backing theory, as I see it, implies that if the ratio of total debt to GDP rises, then the value of the dollar should fall. The prices of goods and services should rise. Gold should rise in terms of dollars. The FED issues dollars as its notes, secured by government and other debts (and some gold.) As the debt to GDP ratio rises, the security behind those notes worsens, the dollar falls, and the price of gold rises in terms of dollars.
A graph of total American debt as a percent of national income (which is correlated with GDP) is here. That ratio has been on the rise for a long time. The ratio has risen from about 1.87 in 1957 to 4.75 in 2007. The result of this is that there is 5.6 times as much debt per person in real terms. The cost of living has gone up by a factor of 7.38 over the same period. Again we have a crude application of a theory, this time the backing theory, that gets us into the ballpark.
There are many difficulties in applying any theory. Measuring total debt is difficult. The annual value of American product is typically measured by GDP. That has difficulties. It also gives no role for intermediate products, and they are financed by debt. We can use GDP to measure product over time in relation to debt only if we make the gross assumption that intermediate products and their debt financing do not change their relation to GDP. A more accurate analysis should not ignore intermediate products and debt financing for them.
It is difficult to distinguish the quantity theory and the backing theory using modern data because as the money aggregates have changed, so have the debt and the backing behind the currency. Perhaps other times and places with different monetary arrangements will provide further information.
Gold is a speculative market. Price can go "too low" or "too high" compared with whatever theoretical notions we may have about what prices should be. If gold rises too fast compared to the rise of debt/GDP, then it may be overpriced. If it rises too slowly compared to debt/GDP's rise, it may be underpriced.
When gold rose sharply in 1980, the ratio of debt to income (or GDP) was already rising. Gold's price rise anticipated an even sharper rise that occurred under Reagan. Gold overshot in some sense, because it fell back and stagnated for many years. The gold price since 2001 is coincident with another sharp acceleration in the ratio of debt to income. That acceleration has not ended yet. Government debt is rising even more swiftly than under Bush. The bank credit of commercial banks is growing more slowly than in a few years, but it is still growing.
In trying to understand where the price of gold might go next, we need to recognize that gold is traded in a speculative market subject to swings that are virtually impossible to understand. Sometimes they last for a long time. Then there are supply and demand factors that I have not mentioned here at all, such as the demand for gold jewelry and the production by miners. They provide a third way of thinking about the price of gold. The two theories I mentioned are the well-known quantity theory and the backing theory. The quantity theory suggests that we pay attention to the monetary base or other monetary aggregates. The backing theory suggests that we look at indicators of the security behind government bonds, such as the ratio of total debt to GDP.
February 19, 2009
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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