Prices When Gold Is MoneyNov 8, 2018·Alasdair Macleod
We are getting ahead of ourselves here. Gold does not circulate as money – yet. It might never do so. Perhaps the end of government currency, fiat money imposed on us by government laws, may never be replaced by what for millennia has been the people’s money, gold. Do we even wish it? Given what we have to do to get there, probably not.
It is hard to think of a life without Nanny State giving us her money-tokens to buy our sweets, telling us what to eat and what medicine to take. But Nanny State is getting long in the tooth. When she was younger, she was less controlling. Her constant refusal to allow us, the ordinary people, to do what we want is an increasing source of friction.
Growing numbers of us can see Nanny State should pack her bags. But Nanny State’s favourites are frightened at the prospect of no nanny. Those of us who want a life without Nanny State can’t agree what it should be, and don’t know what happens when she goes.
Above all, there’s a feeling our secure, controlled world is coming to an end. Increasing financial instability and economic uncertainty are our common destination. Nanny State has frittered away all our pocket money, and it turns out the cupboard is now bare.
We can see the state is irretrievably bust. But governments don’t go bust, economists tell us, because they just issue more money to pay the bills. This is wrong: it is going bust by other means, and those of us who don’t see it are driven by wishful thinking. Ultimately, government-issued money will reflect its issuer’s complete bankruptcy. And there’s no point in following up the collapse of one fiat currency with another. The Zimbabwe dollar is followed by the bond note, and Venezuela’s bolivar is being followed by the bolivar soberano. Bust is bust is bust. It is the logical outcome for all national currencies issued by spendthrift governments.
In the entire scope of human history, government money is always ephemeral. It dances above the water for a relative day or two before it is spent and dies. One day in the future, we will turn back to gold, as we always have in the past. Governments, as demonstrated by the Mnangagwa and Maduro regimes, will resist it to the bitter end. Like children robbed of all their pocket-money, the ordinary citizen will be left with nothing. The only exchangeable value will be gold, and probably silver as well.
Those who have gold will escape the poverty of those that don’t. In time it will begin to circulate as the gold haves buy things from the have-nots, and gradually with the wider distribution of gold a sense of normality will return. It matters not if we price things in gold-grammes, or whether a slimmed-down government gives it a name. Sovereigns, eagles, krugerrands. It matters not if we use them electronically, so long as the bullion is readily there, and all credit is repaid in physical gold.
This article explains how prices work in a world that trades using gold as money. It assumes all forms of cash and electronic money is gold in another guise. We assume there is no issuer risk, because there is no fiat money. To explain pricing in gold we must contrive an ideal. It is this ideal we will assume.
The basic role of money
Money’s basic function is to facilitate the exchange of goods and services, its role always being temporary. Both parties in a transaction must have faith that the money is readily accepted by everyone with whom they transact, and that means all those counterparties must have faith that their counterparties will accept it as well. This has always been gold’s strength. It is a considerable disadvantage of fiat money, whose acceptance is confined by national boundaries.
We exchange goods and services because it is infinitely more efficient to buy from others what we cannot provide for ourselves, or that to do so would waste our time unnecessarily. Instead, we specialise in our own production, selling it for money so we can buy all those other things. It means we must keep a small store of money, or at least a facility to access it, in order to satisfy our daily needs and wants. And who sets that amount? Well, we do as transacting individuals.
When we have a temporary surplus of money, such as from the sale of an asset, we reinvest it. Either we buy another asset, or we lend it to someone else (usually through an intermediary) for interest. It matters not whether it is fiat money or gold.
The general level of prices is set by the purchasing power of the money in which it is measured. The two most important variables are the quantity of money in circulation, and the relative average preferences that people have for holding money relative to goods. Of the two, changes in relative preferences have the greatest immediate impact on prices.
If people decide as a whole to reduce their preference for money, then the general level of prices will rise. Indeed, hyperinflation, described as a catastrophic rise in prices, is the visible symptom of a widespread flight out of money. In other words, preferences are to not hold any money at all and to get rid of it as quickly as possible.
Alternatively, if there is an increased preference for holding money, prices will fall. This additional preference for money can be expressed in two ways. It can be held as physical cash, or more commonly people increase their savings. An increase in savings generates a shift in production methods to compensate for the lower prices of consumer goods. The greater supply of capital for investment tends to reduce interest rates and alter the businessman’s calculations in connection with his production.
These are the considerations behind the deployment of money in a community, whether it is fiat money or gold. It is the way economic actors make best use of the money available, and in free markets, which have proved to be the most consistently progressive of systems, production does not need the stimulus of additional money to that already in circulation. That is a neo-Keynesian myth.
Trading with gold as money
People in a community, town, city or even a nation set their own monetary requirements. Let us assume that in doing so, the general price level, that is to say the balance of preferences for or against gold relative to goods, differs from that of a neighbouring population. In that case, an arbitrage will take place, whereby gold will flow to the community with the lower prices to pay for current consumption, so that the purchasing power of the gold in the two communities will tend to equate.
Additionally, gold savings will seek out the higher returns between the two centres and flow the other way from gold seeking lower prices. However, the quantities of gold held as savings are always significantly less than the quantities spent in consumption. In fact, the arbitrage takes place both through the trade of goods and also by the deployment of capital exploiting interest rates differentials, so that a balance in prices and interest rates is achieved.
It is therefore easy to see that in a commercial world with effective transport and communications, whatever the local preferences are for holding money relative to goods, multi-centre arbitrage tends to produce a common price level and a common level for interest rates. These adjustment factors are conducive to trade, not only between communities but between nations. And trade priced and settled in gold is, all else being equal, far more effective than when individual fiat currencies are involved, because with gold as the common money national boundaries are not a barrier and trade is truly global.
Given gold’s ubiquity as money, the effect of localised changes in general preferences for holding gold relative to goods can be regarded as minimal. An additional consideration is an underlying inflation of above-ground stocks of gold through mine supply, but this is broadly offset by population growth.
Technological innovation and improvement in production methods as well as competition all tend in the long run to reduce the general price level of goods and services. So, while there is little change in the general level of prices from the money side, there can be a significant reduction in prices over long periods of time from the goods side. The effect is to enhance the purchasing power of savings, leading to stable, low interest rates and the accumulation of private wealth.
Pricing commodities in fiat
So far, we have considered the purchasing power of gold in the broadest sense. Obviously, within a general level of prices, there are forever fluctuations in individual values, reflecting changes in technology, improvements in production methods and evolving consumer demands. At the commodity level, it is always the evolution of the uses found for them that drives demand. For example, until twenty-five years ago silver was predominantly used in photography, a use which has now almost ceased. Today, the largest silver market is for solar panels, while there are growing electronic and anti-microbial applications. Sources of energy evolve as well, with nuclear, gas, oil and hydro the main sources today. Not so long ago, coal was a major fuel for electricity generation. Now it is being side-lined through environmental considerations.
Under the fiat currency regime, commodity prices have been at times extremely volatile, generally rising over the long term as the purchasing power of fiat currencies has fallen. The underlying trend of, for example, the oil price has been for it to rise, from a few dollars a barrel in the 1960s to over $60 today. In the last ten years, West Texas Intermediary oil has been as high as $140 and as low as $27. Meanwhile, fluctuations in demand have been minor. In the period between the price high in 2008 and the low in 2016, global demand has increased fairly consistently from 85.8 million barrels per day to 96.2, while the oil price fell dramatically.
Analysts readily give us a blow-by-blow analysis of why oil was high and why it was low, but the fact remains that its price volatility has been far greater than supply and demand characteristics suggest. It seems reasonable to conclude that fluctuations in the dollar side of the price are a significant cause of oil price instability. The example above is far from being a one-off. In June 2008 the oil price topped out ahead of the Lehman crisis, and the dollar’s trade weighted index (TWI) bottomed at roughly the same time. The oil price fell 70% by January 2009, while the dollar’s TWI rose by 17%. In choppy markets for the dollar, when it had lost its previous gains on a TWI basis, oil rallied from $42 to $114 between January 2009 and April 2011. Between June 2014 and February 2016, oil fell from $105 to $27, while the dollar’s TWI rose from 80 to 99. There is clearly a strong negative correlation with the dollar, suggesting the oil price is influenced more by changes in the dollar than by demand and supply factors for oil.
The other side of the currency coin is that while the oil price has a marked negative correlation with the dollar’s TWI, the dollar obviously has a negative correlation with the TWI currency components. Price volatility is therefore more evident in the dollar-oil relationship, than in oil priced in the other currencies. They are, if you like, bit players in the fiat to oil price relationship. It is predominantly in the dollar that the price volatility lies.
We see the same pattern in other key commodities, such as copper. When oil peaked in 2008, so did copper. The oil price bottomed in January, so did copper. Copper hit its all-time high in January 2011, oil peaked a few months later. The fit with the oil price is not perfect by any means, but the price cycles for oil and copper show sufficient similarities for us to say they broadly correlate.
You could take the view that it is marginal demand that sets the price of copper. It explains to analysts why the copper price is so sensitive to warehouse stock levels, fluctuations in Chinese demand, and all the other market-related reasons. But essentially, with copper priced in dollars, if you sell copper, you are buying dollars. If you defer your purchase of copper, you are holding on to your dollars. The dollar is always the other side of all commodity and energy trades.
It is the nature of money that you automatically assume all the price movement comes from the commodity side. However, the record of supply and demand for oil and the fluctuations in the dollar price demonstrate the instability is mostly due to the money side of transactions. It also appears to be the case in a range of other commodities, such as copper. Therefore, if the leading representative of the fiat crowd, the dollar, was banished along with all its fiat epigones, commodity price volatility would substantially disappear. The question then arises as to whether the sound money replacement for fiat currencies, gold, would encourage similar fluctuations in price.
We cannot just observe historic prices of commodities measured in gold, because both are priced in dollars. We need to step away from dollars entirely.
Pricing commodities in gold
When gold is money and bank credit is eliminated, trade imbalances cannot arise. That is to say, cross-border purchases cannot be financed by credit, other perhaps than self-extinguishing trade finance specifically for the purpose of trade settlement. Imports, including oil and other commodities, have to be paid for on an aggregated basis by exports. It is for this reason that trade imbalances cannot occur between nations settling their trade with sound money.
The implication is that most commodity speculation in fiat-money economies is eliminated with gold, because speculation, whether it be backed by lines of credit or in futures (which ultimately are backed by credit) becomes severely restricted. Speculation cannot be eliminated entirely, because there is nothing to stop two parties from entering into a wager, without the services of a credit-issuing banker. Therefore, destabilising price trends are less likely to be set in motion.
The demand for risk management through the use of derivatives is likely to recede as well, due to the absence of volatility on the currency side of prices. Protection from fluctuations in commodity prices essentially becomes an insurance function, because without the ability of financial entities to easily tap lines of bank credit, exchanges will be unable to rely on margin calls. If they are to contain counterparty risks, they must require option writers and short-sellers to commit the liquidity and assets to meet all potential obligations.
Commodities priced in gold will therefore be more stable. Destabilising trends set in motion by credit flows disappear. Instead, it is the shifting patterns of genuine demand and their effects on supply that set individual prices for raw materials and the various sources of energy required to propel our lives.
And lastly, an absence of central bank intervention, which ceases with sound money, ends the destabilising credit cycle. It is this that drives fluctuations in the purchasing power of currencies both by increasing the quantity of money and credit and by destabilising our monetary preferences. The price volatility we experience today is almost entirely due to excessive quantities of dollars sloshing around the system. Eliminate that, and you eliminate the single most important source of price volatility.
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