The past 30 years is the first period in history when no major currency was linked in any way to a commodity, which makes the current situation unprecedented. The levels of indebtedness we now see could never occur if there was any real (physical) backing to the major currencies. However, the US now finds itself in a position which is extraordinary even in today's world of confidence-backed money. High money supply growth rates, large current account deficits and extreme debt levels coexist with minimal price inflation, a surging stock market, a healthy bond market and an appreciating currency.

I have discussed the impact of high money supply growth rates in previous articles. Money is exchanged for goods, services and assets. If the total amount of money in the economy increases at a greater rate than the supply of the things for which this money is exchanged, then the average amount of money which is needed for each exchange must increase. The real rate of inflation in the economy can therefore be determined by subtracting the rate of economic growth (the increase in economic output) from the rate of increase in the total supply of money. For example, between 1969 and 1979 the average yearly rate of growth in the US money supply was 9% and the average level of price inflation was 7%, with the approximate difference representing the average rate of economic growth (2.8%).

Unlike the supply of dollars, the total above ground supply of gold grows at a fairly constant rate of around 1.75% per annum. This means that the variable which determines the gold price is demand, and the fact that the yearly usage of gold for non-monetary purposes is very small in comparison with the total above ground stock of gold means that the major component of demand is investment, or monetary, demand. Monetary demand for gold is linked to confidence in fiat currencies, especially the US dollar. As confidence in the US dollar rises, the price of gold in US dollars will fall, and vice versa.

Investment tends to cycle between stocks, bonds, real estate and commodities, depending on the prevailing level of confidence in the government and its currency. For the past few years we have witnessed high money supply growth rates fuel an incredible bull market in stocks, a situation which has been made possible by soaring confidence in the US dollar. The high level of confidence in the US dollar has been supported by a seemingly insatiable foreign appetite for dollars which has, in turn, allowed the US to enjoy the benefits of a large current account deficit (cheap imported products) without suffering the usual ill effects (a depreciating currency and higher interest rates).

The thing about cycles is that they do, by definition, alternate between peaks and troughs. The nature of investment cycles is that investment alternates between different asset classes, such that strengthening demand for financial assets (stocks and bonds) will often occur in parallel with weakening demand for commodities. Gold, which is both a commodity and a form of money, will naturally suffer the most during a period when the demand for financial assets is accelerating towards a peak. Similarly, gold will benefit the most once confidence in financial assets has peaked and a new investment cycle has begun. For example, in 1982 the Dow traded below its 1966 peak, that is, we had a 16 year period during which the US share market suffered a massive loss in real terms. During that same period the price of gold increased by over 1,000%. In the 16 year period from 1982 until 1998 we have seen the Dow increase by over 1,000% whilst the gold price has dropped substantially. The 1970s bull market in gold reached its climax when confidence in the US government and its currency completely collapsed in 1979/1980, and the current bull market in stocks and bonds will peak when confidence reaches its maximum level .

A complete picture of the depth of the bear market in gold cannot be appreciated by looking at price alone. From the beginning of 1997 until now, the US dollar gold price has dropped by around 19%. However, simply considering the change in price does not take into account the fact that during this period the total supply of US dollars increased at a much greater rate than the total above ground stock of gold. A more appropriate way of viewing the change in the relative valuations of US dollars and gold over this 15 month period is to compare the change in the number of ounces of gold which could be purchased by the US money supply (M3) in January 1997 versus March 1998. At the start of January 1997 the gold price was $370 per ounce and M3 was $4,904 billion, meaning that 13.2 billion ounces of gold could be purchased by M3 at that time. Currently, with the gold price around $300 and M3 at $5,528 billion, 18.4 billion ounces of gold can be purchased by M3. In other words, the US money supply can purchase 39% more gold today than it could in January 1997. Approximately 2% of this appreciation of the dollar relative to gold can be attributed to the increase in the above ground stock of gold over this period. The remaining 37% is due to a weakening in investment demand for gold relative to the dollar.

During the past 15 months, whilst gold was undergoing a 37% devaluation versus the US dollar, the US share market has increased in value by over 30%. Such a dramatic divergence is indicative of the final blow-off in confidence in financial assets and the final collapse in demand for the ultimate safe haven investment. We have now reached the point when almost everyone is convinced that the current investment trend will last forever, therefore the turning point must be close at hand. When a new cycle does commence it will not immediately be recognised as such . In the initial stages of the new cycle in which declining confidence in governments and their currencies will lead to reduced demand for financial assets and increased demand for gold (and other physical assets), each dip in the prices of stocks and bonds will be considered a buying opportunity.

During gold's bear market there has been a large increase in gold lending/borrowing (often called gold leasing). This lending of gold has been given as one of the reasons for the continuing down trend in the price of gold. However, increased gold lending is not a cause of the gold bear market, it is a result. This is because an increase in the amount of gold which is lent into the market is only made possible by an increase in the borrowing demand for gold, and the borrowing of gold is only feasible (profitable) if the future price of gold is likely to be the same as, or below, the current price. In a market where the price of gold is trending upwards, repayment becomes more costly and eliminates any advantage which may be gained by the relatively low gold interest rates (often called lease rates).

A substantial increase in the amount of gold which is lent/borrowed is one consequence of gold's extended bear market. Another consequence, and one which is directly related to the growth in gold loans, is the massive short position which has been built up over the years (reportedly around 8,000 tonnes). Once a new trend is established, this short position will have to be covered in a hurry to avoid potentially devastating losses.

No discussion about gold can really be complete without mentioning central banks (CBs). Some observers have postulated that governments and their CBs try to manipulate the gold price lower in order to maintain confidence in the financial systems. This is a misconception. Confidence in the financial system is not maintained because the gold price is low, the gold price is low because confidence in the financial system is high. What we have experienced since the early 1980s is a shift in investment from physical assets into financial assets. The current low price of gold is a result of the popularity of financial assets, not a cause of that popularity. However, it is clear that the fear of CB disposals of their gold reserves has added to the bearish sentiment surrounding gold. CB selling should be considered as part of the demand side of the gold supply/demand equation since a CB gold sale does not change the total above ground supply of gold. CBs are affected by the same influences which affect the actions of private investors. Consequently, the US dollar bull market has caused some CBs to adjust their currency reserves in the same way that private investors have been induced into shifting capital from the physical to the financial. It should also be noted that central bankers are not immune to acting with only short-term financial gain in mind, particularly as they often operate under the influence of politicians. In summary, the selling of gold by some CBs in recent years can be attributed to short term financial considerations and a belief in the greater benefit of holding US dollars, compared to gold, as a reserve asset.

Milhouse

1 April 1998

The reader is invited to respond to Milhouse's wisdom via email: sas@hk.gin.net

Also by Milhouse:

Confidence Is Everything

Understanding Buffett's Silver Play

What Is Greenspan Really Saying?

Currency Turmoil In 1998

Japanese Monetary Problems

Gold Versus The Dollar

European Monetary Union

US Money Supply and the Demand For Gold

US / Japan Trade - Reality Versus Perception

Is Gold Still a Store of Value ?

Central Banks and Their Gold

The Intrinsic Value of Gold

Gold & Disintegration of U.S. Economic Influence

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