In the previous article in this series I pointed out that even after recent dramatic sell-offs gold prices are still higher than one would expect if one saw them as being driven only by money creation. And this state of affairs has been sustained for a period of years, which suggests that it is not driven by a panic reaction, because panics by definition tend to last for a short period of time.
Gold, Money Creation, and the Monetization of Debt
Having noticed that although gold did fall to the top end of my expected value range using money metrics, I wondered why it did not fall at least to the middle range.
Trying to solve the puzzle, I reasoned that perhaps gold is not just a function of domestic money creation, but of international money creation as well. In other words, gold prices might go up in dollar terms even more than the excess creation of dollars alone would dictate. If other countries also debased their paper currencies, the citizens of those countries would similarly demand gold as a hedge against inflation. And since much of the world seemed to be at least partially following the U.S.’s lead in weakening their currencies, perhaps global gold demand was driving gold even higher than dollar devaluation would suggest.
This is an interesting theory, but there are some problems with this view.
First, the view that global inflation drives domestic gold prices has an obvious theoretical problem. Yes, global inflation would lead to global growth in demand for gold, but it would also lead to growth in global supply. Gold is a commodity with both a demand curve and a supply curve, and if it has both curves it has an equilibrium price and the equilibrium price for gold and dollars is a function of the comparative demand and supply of each of those.
If among the three billion new capitalists around the world there is a certain proportion of gold buyers and consumers, then among those three billion capitalists around the world there is also a certain proportion of gold producers and sellers. As gold goes up in price, the incentives to discover it increase proportionately. That’s how the global economy kept its monetary equilibrium for millennia before the emergence of the global fiat money system.
Second, the biggest problem with the global inflation as driver of domestic gold price theory is that it doesn’t work. If one had used global inflation to try to predict dollar gold prices, or used dollar gold prices to try to predict dollar inflation, one would have had very little success. Global inflation does not seem even to explain the times in which gold prices detach themselves from currency debasement factors.
It seems that gold investors are not just concerned about how much money the Fed has created, nor are they principally concerned about how much money the Fed-wannabes around the world have created; they are worried about something else, and they might have good reason to be. What they are worried about, and what seems to be driving current gold prices, is that public debt levels have risen to the point where the debt will be paid off in highly debased currency. In other words, they’re afraid of what is called ‘debt monetization’.
Debts are monetized when governments decide to use their monetary authorities (in the U.S. context, that is the Fed) to create new money which is then lent to the government. This tends to happen when the government has borrowed up to its capacity and decides to continue borrowing above its credit capacity. When that happens, private lenders are no longer willing to take the chance of lending to an over-indebted government. At that point, governments often attempt to verbally intimidate private lenders, especially banks which are subject to very high levels of government oversight. Sellers of bonds are verbally assaulted as vigilantes and speculators, and in more extreme cases attacked for their ethnicity or religion. Jews have been frequent targets of this type of attack.
In some cases regulators require financial institutions to lend to the government anyway, often for reasons other than the stated ones. For example, recent changes in regulation associated with Dodd-Frank and the Basel Accords purport to act in the interest of financial stability by requiring banks to hold larger proportions of ‘Tier 1 capital’, such as Treasury Bonds, for the purpose of risk reduction. But the problem is that this public Tier 1 capital is in many cases riskier than, for example, the corporate bonds which it replaces. That’s one reason why the European sovereign debt crisis has been so devastating to the private banking system, because earlier versions of risk reduction forced extremely risky public bonds down the throats of the private system. What’s even more maddening is that after suffering through all of that, we still have to sit through political sermonizing about market failure in the banking system.
So, once private lenders have been brow-beaten, and then eventually law-beaten into buying as much public debt as they can possible stand, the rapacious public spending beast’s hunger remains un-slaked. That’s where monetization comes into play. Gigantic piles of money are simply created and then shoveled into the mouth of the Leviathan.
Of course, public spending is not the stated reason for money creation. The Keynesian rationalizations are ceremonially invoked as the beast is fed (by the Fed): “lowering marginal propensity to consume”, intone the priests, “counter-cyclical expansionary fiscal policy” respond the acolytes. The ‘hoarders’ are punished according to their sins. Yet nothing changes except higher levels of inflation and lower levels of real growth, and so the ritual is repeated.
That ritual, it appears, is what gold investors are concerned about, and although they have in the past rung that alarm bell early, for example in the gold price peak in the early 80s which probably underestimated the degree to which Volcker and Reagan would slay the stagflation monster, that doesn’t mean that we don’t have better reason to be concerned now. Gold is a both a store of value against current devaluation and also a hedge against the threat that debt will be monetized and devaluation will get even more out of hand. With net debt standing at roughly 90% of GDP, that doesn’t seem like such a crazy scenario anymore.
Mr. Bowyer is the author of "The Free Market Capitalists Survival Guide," published by HarperCollins, and a columnist for Forbes.com. This article orginally appeared at Forbes.com