To understand gold requires first recognizing its proper orientation. Gold is unlike any other commodity, good, or service. Its value does not change. Its overwhelming purpose is as a monetary proxy. When viewing the monetary world, gold is at the center. It acts as a monetary standard of reference. Everything else revolves around gold. Once one understands this orientation, clarity arrives in the monetary realm.
The market does not set the price of gold (POG). This is axiomatic since gold’s value does not change. It is the value of the floating fiat dollar that constantly changes. The POG is an inverse reflection of the value of the dollar. The Fed controls the value of the dollar by adjusting base money supply. If the Fed supplies more dollars than economic actors demand, the dollar loses value. If the Fed supplies less, the dollar gains value. The POG reflects a change in dollar value. The market determines the value of the dollar based on the Fed’s maintenance of the supply of dollars relative to demand.
Ignoring a few minor changes, the price of gold was $20.67 per ounce from 1792 until 1933. The market did not set the POG for 141 years at $20.67/oz. The value of gold does not change. The market set the value of the dollar at $20.67/oz over that 141-year span because the gold standard linked the dollar to gold at $20.67/oz. As long as the gold standard was properly maintained, the dollar remained “as good as gold” while fixed at $20.67/oz.
There are two prices of gold. There is the spot POG that reflects daily changes in the value of the floating dollar. There is also an optimum POG where creditors and debtors are in balance. When in balance, neither creditors nor debtors are advantaged over the term of a contract because the value of the currency remains stable. Earnings and savings retain their value since inflation and deflation are negligible. The economy operates at peak monetary efficiency. On a gold standard, the optimum and spot POG converge to the same price. Once their price is the same, they remain the same as long as the gold standard is maintained.
When Nixon ended Bretton Woods in 1971, he ushered in our floating fiat system. The POG remained roughly at $35/oz during the Bretton Woods years. After Nixon severed the dollar link to gold, the spot POG began to rise reflecting the excess supply of dollars untethered to anything real. The spot POG changed daily as the value of the floating dollar changed. In January 1980, the spot POG reached $850/oz. By June 1982, the spot POG had fallen to $296/oz. This was extreme monetary chaos that whipsawed the economy. While the spot POG fluctuates in inverse relation to the value of the dollar, long-term contracts govern the value of the optimum POG. During the Bretton Woods years, market participants entered mortgage, bond, CD, wage, and trade contracts based on an optimum POG of $35/oz. In the chaos of the floating fiat system, these contracts had to unwind before the optimum POG could reflect the new value of the dollar. This is a slow process based on the term length of various contracts. This adjustment of the optimum POG is the duration of debt. Duration of debt is how long it takes for the optimum POG to adjust to a new spot POG. The more stable a currency is then the longer the duration of debt.
Greenspan entered the Fed Chair with an understanding of gold and stabilized the value of the dollar around $350/oz during his terms. The optimum POG eventually caught up and stabilized with the spot POG at $350/oz. The price level adjusted up by a factor of 10–from $35/oz to $350/oz. A $2000 VW in the ‘60s now cost $20,000 in the late ‘80s, etc. Greenspan’s stabilization of the dollar at $350/oz is now termed the “Great Moderation.” Economists can’t explain the Great Moderation because they ignore gold as a reference. The spot and optimum POG held in the $350/oz area—though Greenspan allowed gold to fall to $250/oz and created a harmful deflation from 1997-2001—until Bernanke’s term. Bernanke—who thinks gold is held out of “tradition”—began a new era of dollar devaluation. The POG rose to $1900/oz in September 2011 and today is at $1270/oz.
The happy coincidence is that the optimum POG began adjusting up from $350/oz in 2003, and 15 years later is now coincident with the spot POG at $1270/oz. (Everyday the optimum price of gold continues to adjust upward based on past history of the spot POG.) This occurred for reasons completely unrelated to Fed policy. It is a freak monetary accident, but it provides the foundation for a seamless return to a gold standard without the normal destabilizing disruption of having to force alignment of the spot POG with the optimum POG. Error in aligning two disparate prices between spot and optimum could cause a return to a gold standard to collapse before it stabilizes. This is what happened when Great Britain attempted to return to a gold standard in 1925 at the pre-WWI gold parity price after the optimum POG had adjusted up with the spot POG. Great Britain abandoned the gold standard when the deflationary adjustment proved too economically disruptive.
There is a lot more involved today in returning to a gold standard than just linking the dollar to gold at $1270/oz. Even with the beneficial coincidence that the spot and optimum POG are now aligned, there remain huge global monetary distortions. The creation of post-2008 financial crisis excess liquidity is not compatible with a gold standard. Global central banks would need to remove excess liquidity to return to a functioning gold standard. That is the central tenet of a gold standard. A currency manager must create or extinguish currency supply such that it maintains the parity price with gold. In the Fed’s case, the supply of dollars is a residual effect of maintaining a parity price on a gold standard. It is not a means to manipulate the value of the dollar for perceived economic goals. It is impossible to maintain excess liquidity and properly operate a gold standard.
EXCELLENT INFORMATION AND COMMENTARY.