Alasdair Macleod – 1 December 2010
The chart below shows the relationship between global liquid dollar money, and its multiple of the value of the US government’s declared gold holdings.
Liquid dollar money is taken to be the sum of:
- Total domestic and foreign deposits less time deposits.
- Currency in circulation.
- Excess reserves held at the Fed.
- Savings instant demand deposits.
- Private investors’ Treasury holdings.
All these items are intended to represent sources of cash that individuals and businesses feel are available for them to spend at any time. It is not perfect, merely an approximation, and divided by the value of gold owned by the US government is represented in the chart by the blue line, plotted against the left-hand scale. To complete the illustration, the gold price is shown in red, plotted against the right-hand scale.
There are four distinct phases:
- The early post-war years when the US held between 19,000 and 21,828 tonnes (1948-57) and when the dollar/gold ratio increased from 6.8 to 10.04. Fractional banking ratios of this magnitude have been shown throughout monetary history to be broadly sustainable in normal times, though a ratio of 10 is too high for adverse economic conditions, because there is an enhanced risk that bank customers may demand the return of their gold. The danger of this happening was reflected from 1958 onwards when gold was steadily drawn down by foreign creditors until 1968, when the US’s holding had been reduced to 9,679 tonnes. As a result of this run on the US’s gold reserves, coupled with expanding money supply the ratio climbed to over 46 in 1971.
- The end of all gold convertibility was inevitable as a result of this ratio moving dramatically into dollar insolvency territory. The Fed effectively put the shutters down on all further withdrawals. The market reaction was to reprice gold, leading to the 1970s bull market when the price rose over 24 times to $850. This rise was sufficient to return the dollars-to-gold ratio close to the sustainable levels of the post-war years.
- The gold price entered a twenty-year bear market from 1980, driven by the high interest rate policies of the Volker years, the accompanying gold suppression policy and the rapid increase in bank credit in the late 1990s. The result was the dollar to gold ratio took off to highly dangerous levels, exceeding 78 times by 2001. This set the stage for a gold bull market that should easily exceed the proportions of that of the 1970s, but starting from $250 as opposed to $35.
- The bull market duly commenced to correct the extreme dollar overvaluation, and so far has brought the ratio down to about 40 times, which is still extreme. To get back to a ratio of ten, gold has to move up to $4,500, at which level the dollar is still over-issued on any historic basis. This assumes no further dollar issuance, does not include off-balance sheet issuance (such as to finance military and political objectives in Iraq and Afghanistan), and that the US actually owns the 8,133.4 tonnes it says it has.
The reality is that dollars will continue to be issued in the form of cash and credit, even if the US enjoys a modest economic recovery. The likelihood is that developing financial crises (in the plural) will be addressed by the issuance of more money and credit. A time may come when gold even discounts future dollar issuance if the market wakes up to this trend.
Meanwhile, the dollar-to-gold ratio suggests that gold in real terms is about as cheap as it was in 1968/9, 1972/3 and 1990/91.