Understanding Gold 7
The Ratio of Two Ratios
The unique properties of gold combined with how the Fed operates determines the dollar price of gold (POG). Similarly, other central banks’ monetary management determines the POG in their currency. Because gold is a monetary proxy with limited industrial use, it is not subject to the normal supply and demand market valuations that govern other commodities, goods, and services. The spot and future prices of all other commodities diverge and converge because of the influence of business cycles and the environment. Gold is the exception. This is why gold is in contango or does not backwardize.
The universally accepted historical properties of gold establish its value as a barometer of geopolitical and monetary uncertainty. Market watchers therefore give the POG exceptional scrutiny. Changes in the POG signal monetary error. Sudden swings in the POG may lead to conjecture that private transactors, gold producers, or governments are manipulating the POG. A better understanding will readily show that manipulation of the world’s monetary Polaris is not possible. If manipulation was possible, mankind would have long ago abandoned gold as the numeraire, the commodity money par excellence.
The orientation for understanding the dollar POG is a ratio of two ratios. In the numerator is the supply of dollars relative to the demand for dollars, and in the denominator is the supply of gold relative to the demand for gold.
Dollar Supply and Demand
The largest influence on the POG is the numerator. The Fed supplies dollar liquidity for a market which at any time demands a required level of dollar liquidity. Dollar supply is 100 percent controlled by the Fed. The Fed creates or extinguishes base money¹ through its operating mechanisms. The Fed can control dollar liquidity down to the penny by creating or extinguishing base money in any amount. It is therefore obvious that the Fed must have an operating model that incorporates a standard of reference for issuing the supply of dollar liquidity. With a gold standard, the reference is a fixed dollar weight of gold.
The Fed has no direct control over dollar demand. The Fed can only indirectly influence dollar demand by its management of base money. The monetary policy lever that controls dollar supply acts in coordination with the separate and independent fiscal policy lever. Fiscal policy influences dollar demand by encouraging or inhibiting economic growth. Demand for the dollar also increases or decreases based on the Fed’s ability to maintain value and faith in the world’s reserve currency.
- Base money is cash and reserves. Base money, dollars, and dollar liquidity are interchangeable in meaning.
Gold Supply and Demand
The least influence on the POG is the denominator, the supply of gold relative to the demand for gold. The supply of gold consists of all gold ever mined throughout history and still held, also termed the stock of gold. The total stock of gold is around 186,700 tonnes. Of the total stock, some 20 percent is held inert by central banks. Annual production that is additive to the total stock is around 2,500 tonnes. Annual production remains consistent around 2 percent whether the POG is high or low. Gold miners are unique in that they shift production to their least rich mines when the POG rises and to their richer mines if the POG falls. Since gold has minimal industrial use and its main utility is as a monetary proxy, the stock of gold is around 85 percent of all gold ever discovered and held above ground. The stock of gold vastly exceeds gold demand.
Demand for gold is also termed the flow of gold. Because the stock of gold vastly exceeds the flow of gold, there is little influence on the ratio from the denominator. Demand for gold is primarily a function of error in the numerator, the supply of dollar liquidity relative to demand. When the supply of dollars exceeds demand, the dollar loses value relative to gold. Demand for gold increases. The opposite occurs if the demand for dollars exceeds supply. Dollars become more valuable relative to gold and the POG falls. Any change in the denominator becomes a function of error in the numerator.
On a gold standard that links the dollar to a fixed weight of gold, the denominator becomes a constant. The dollar is as good as gold and there is no difference in their value. This eliminates demand for gold due to changing value in the numerator. A gold standard makes the value of a fixed weight of gold interchangeable with the value of the dollar.
A conventional belief is that gold sales by central banks influence the POG by acting on the demand for gold relative to supply. For example, in 2013 the U.S. sold 1,280 tonnes of the precious metal to buyers around the world. The amount of 1,280 tonnes is .68% of the total stock of gold. A sale of less than 1.0% over the period of a year will not influence the POG. The movement of a negligible fraction of the total stock of all gold ever mined from one owner to another does not affect the POG. Any change in the POG derives from the numerator, the central banks’ management of supply relative to demand.
If supply and demand for gold determined its price, we would see inflation or deflation across all currencies at the same time. Inflation and deflation are unique to individual currencies. This is because a central bank controls the issuance of a currency’s supply. Venezuela’s current hyperinflation is not a result of demand for gold, but rather error in the creation of bolívar supply relative to its demand. Venezuelan demand for gold is the result of bolívar supply mismanagement.
Reports of gold manipulation is a common refrain. Since gold demand is a function of the Fed’s supply of dollars, the only way to manipulate the POG is to gain control of the supply of gold. Gold’s unique properties comprise certain unalterable facts. The annual production of gold has remained steady at around 2 percent for centuries. Almost all the gold ever discovered is still held. To manipulate the supply of gold by withholding a producer’s output would have negligible effect. Any fraction of annual supply relative to the total stock of gold is insignificant. Even if a manipulator could withhold a portion of annual supply from the market, there are plenty of alternate sources that can step up their sales from inventory, or other miners who can makeup the shortfall from withheld production.
Another often discussed venue of gold manipulation is through the “paper” derivative futures market. Gold watchers theorize that private transactors or government agents dump gold futures, whether through naked shorts or not, to drive the POG down. Every future has an offsetting counterparty. For every seller there is a buyer. The enormous derivative values are a nominal sum that net out. Any downward pressure on the price of gold by selling a large block of Comex gold futures is a short-term event. The futures involved are a tiny fraction of the stock of gold; 12,000 contracts or 34 tonnes of gold dumped on the market is .02 percent of total gold supply. The majority of contracts net out without delivery taken. The main result from this type of action is psychological. Such action may influence those who don’t understand the ratio of two ratios. Watching a declining POG may overwhelm a market participant on the exchange to take bigger discounts, or premia, in order to find a counterparty.
The Ph.D Standard
Since Nixon ended the dollar link to gold in 1971, wild swings in the POG are the norm. A gold standard matches dollar supply with dollar demand at a fixed weight of gold. Without the stable standard of reference of gold, dollar supply has floated untethered to anything real. Jim Grant’s designation of monetary policy based on a Ph.D standard is the sad reality of the Bernanke and Yellen Fed. Coordinated global central bank policy under the Ph.D standard has resulted in negative interest rates, excess reserves, misallocated capital, distorted markets, and unsustainable debt.