• Over the course of the last century, the gold price has experienced numerous extended bull and bear markets. These market cycles tend to persist for many years at a time. In this week’s post we will examine the one key factor that drives these bull and bear markets.

• While there are many theories regarding the factors that influence the price of gold in the short term, there is one common denominator that can explain each of these major gold price cycles. The gold price rises as confidence in society’s long-term economic future deteriorates. Conversely, the gold price falls as confidence in society’s long-term economic future improves.

• The level of confidence in the long-term future of society tends to move in long cycles that last many years. The gold price follows these cycles, although the gold price moves inversely to the level of confidence.

• Gold is leveraged to the misfortune of fiat money. When confidence regarding society’s long-term economic future improves, the value of fiat money finds support and gold becomes less appealing. Conversely, if economic confidence is eroded, the value of fiat money falls and the gold price rises.

• Indeed, a long-term chart of the USD gold price tells the story of optimism and pessimism in the future of the United States.

• In the early 1930s, the gold price soared (the US government was forced to devalue the USD against gold) as the depression took hold and people became much more pessimistic about the United States. The gold price was stable through the 1950s and early 1960s as the post WWII boom fueled confidence in the future of the United States. The 1970s, a period in which the gold price soared, saw the return of pessimism as the costs of the Cold War mounted and as the Vietnam War challenged America’s sense of self-confidence.

• In contrast, the 1980s and 1990s marked a period of increasing confidence, peaking in the late 1990s with the technology boom, the same point at which gold bottomed. However, as cracks began to appear in the US economic story in the 2000s, the price of gold rose sharply. Over the last several years, confidence in the long-term outlook for the US has picked up markedly and the gold price has fallen. The question today is whether that confidence is justified.

• In summary, the gold price is a vote of no confidence in the long-term economic prospects of society. Our primary objective in this week’s post is to explain why this is the case. In order to do this, we will discuss why gold has value, why fiat money has value and the intimate relationship that exists between gold and fiat money.

Why Does a “Pet Rock” Have Value?

Before we begin, it is worth noting that the question of whether gold has any role or value in a modern society is a divisive one. Indeed, a discussion regarding the value of gold can quickly deteriorate into a debate that seems almost religious in nature. On one side of the argument are those that believe that “everyone must own some gold”, “gold is the only true money” and that “fiat money is a government conspiracy”. On the other side of the debate are those that believe that “gold is little more than catastrophe insurance”, “gold is a relic” and “gold is a pet rock”.

Debates about gold tend to be contentious for two reasons.

First, gold and fiat money are both poorly understood. Topics that are poorly understood make for chaotic debates. The view of The Money Enigma is that a sensible debate about the price of gold is impossible without a solid understanding of (a) why gold has value, (b) why fiat money has value, and (c) the complex and competitive relationship that exists between gold and fiat money.

Second, for reasons that we shall discuss, gold is a barometer for pessimism regarding the long-term economic prospects of society. A debate regarding the long-term prospects of society is, in and of itself, a divisive one. Optimists tend to feel that pessimists are “ignoring the march of progress” and underestimate that power of innovation, while pessimists tend to feel that optimists “just don’t get it” and that “this time isn’t different”.

Amidst all this debate, the primary goal of this week’s post is to develop a simple and objective framework that can help the reader think about what drives the price of gold, or at least what drives the major bull and bear market cycles in the gold price. Hopefully, both “gold bugs” and “gold bears” can use this framework, not only to challenge each other, but also to challenge their own views.

So, let’s begin this process by asking a simple question: “Why does gold have value?”

Gold is a real asset and derives its value from its physical properties. In other words, gold’s physical or tangible properties make it “useful”.

But what is so “useful” about gold? After all, we can’t eat it, we can’t drink it and we can’t grow crops with it. As gold’s critics point out, we don’t consume gold. Most commodities (wheat, oil, iron ore) are “consumed” in the sense that they are either eaten, or used for energy, or transformed into useful secondary goods.

In contrast, gold isn’t consumed: it just sits around.

Ironically, this is part of what makes gold so valuable. The fact that gold is rare and that we don’t consume gold, means that the stock of gold is relatively stable over time. Moreover, the growth in the stock of gold is slow and relatively predictable.

Why does this make gold valuable?

In simple terms, gold acts a constant. Gold is as close as we come to a “constant” in an economic world that is dominated by “variables”.

While most people never think about it, the property of “invariability” is remarkably rare in nature. It is so rare that most, if not all, of the “standard units” that we use to measure physical properties are invented. Feet, inches, kilometers per hour, kilograms are all standard units of measure. They are standard units in the sense that they are invariable in the property that they measure (for example, an inch is invariable in the property of length). None of these standard units occur in nature. Rather, we had to make them all up.

Gold is not invariable in the property of market value and therefore is not a standard unit for the measurement of market value in a technical sense. However, in a practical sense, the relative lack of variability in the stock of gold encouraged people to treat gold as the standard unit for trade. In a world full of variables, gold was the closest thing we could find to a constant.

It needs to be remembered that the economic life of pre-modern human society was far from stable. Most of human history, until relatively recently, has been characterized by war, disease and famine. Commodities that were in abundance one day might be scarce the next, and visa versa.

As a participant in a pre-modern economy, this creates an obvious dilemma. What goods do you accept in exchange for the goods that you produce? Ideally, you want a good where there isn’t a scarcity one day and an abundant oversupply the next.

In a sea of variability, gold became attractive as a pseudo-constant. One could accept gold in trade knowing that the broader economic community wasn’t going to grow lots more of it, build lots more of it or dig up a lot more of it next year. This quality became particularly valuable as trade extended over great distances and across cultures.

In short, gold’s physical properties make it valuable. The rarity of gold and, ironically, its lack of apparent usefulness make it “useful” in the conduct of economic life. More specifically, the relative invariability in the stock of gold makes it an excellent form of money in the sense that it is a useful medium of exchange, a good unit of account and acts as reliable store of value over very long periods of time.

However, in modern times, gold faces competition. Ironically, that competition comes from a form of money that was born of gold: fiat money.

The Competitive Relationship between Gold and Fiat Money

If gold was the father of money, then fiat money is the prodigal son.

The relationship between gold and fiat money is, like most relationships between father and son, “complex”. There is a competitive tension between gold and fiat, but fiat probably wouldn’t have come into existence without the help of gold and gold is always there to welcome fiat home if it gets into trouble, although not necessarily on fiat’s terms.

Gold and fiat money are in a war for hearts and minds. Those who might believe that fiat money has won the battle and that gold is a relic need to remember that, viewed from a historical perspective, fiat money is still in its infancy.

Gold has served as money for thousands of years. Representative money, paper money that is backed by gold, has served as money for centuries. But fiat money has occupied a primary place in world affairs for less than a century. Viewed in this historical context, fiat money is still a child that remains relatively untested.

Nevertheless, the early success of the prodigal son has chipped away at the importance and, arguably, the value of gold. Moreover, if the experiment with fiat money continues to be successful, then this will gradually debase the value of gold over the decades to come.

Every time fiat money proves it worth, the attractiveness of gold as a form of money declines, if ever so marginally. Conversely, every time a fiat currency stumbles, people are reminded of the extraordinary properties of gold.

In this sense, gold is a leveraged “anti-fiat” asset.

A rise in the value of fiat money has a negative “double whammy” impact on the price of gold.

First, if the market value of a fiat currency rises, then, all else remaining equal, the price of all goods in terms of that fiat currency will fall, including the price of gold. Second, as the value of fiat money rises, or even as the value of fiat money remains constant for a prolonged period of time, fiat money chips away at the relative attractiveness of gold.

Conversely, a rapid fall in the value of fiat money has two positive impacts on the price of gold.

First, as the value of a fiat currency falls, all else remaining equal, the price of all goods as expressed in terms of that fiat currency terms will rise, including the price of gold. Second, a sudden fall in the value of fiat money reminds people of the fact that fiat currency is always vulnerable to a sudden decline in long-term economic confidence, a unfortunate property which gold does not share. As people become nervous about the economic future of their society, demand for an asset that does not rely on this metric improves.

This last point highlights an important difference between gold and fiat money.

Fiat money is only as good as the society that issues it. While gold derives value from the relative invariability of its stock, fiat money derives its value from the expected economic prosperity of society.

In order to understand why the value of fiat money depends upon long-term economic confidence, we need step back and think about the evolution of “paper money”.

Why Does “Paper Money” Have Value?

In order to answer the question “why does paper money have value?” we first need to answer a more fundamental question: “why does any asset have value?”

The view of The Money Enigma is that assets can only derive their value in one of two ways: either they derive their value from their physical properties or they derive their value from their contractual properties.

In simple terms, if something doesn’t derive any value from its natural or intrinsic properties, then the only way it can derive value is if it creates an obligation on a third party to deliver something of value.

This paradigm is so fundamental that it is used as the basis of classification of assets for accounting purposes. For accounting purposes, every asset must be classified as either a “real asset” or a “financial instrument”.

Real assets derive their value from their physical properties, whereas financial instruments derive their value from their contractual properties.

In nearly every society, the first form of money used was “commodity money”. Gold is a perfect example of commodity money. Commodity money is, by definition, a real asset that derives its value from its physical properties.

The problem with commodity money is that it restricted the capability of governments to finance wars and other public expenditures. After all, you can’t pay your armies in gold coin if you run out of gold.

This problem led to the invention of the first paper money, otherwise known as “representative money”. Rather than paying the armies in gold, the ancient kings and emperors decided to pay soldiers by issuing pieces of paper that were promises to deliver gold on request. This first paper money was an explicit legal contract that promised, on request, the delivery of a certain amount of gold or silver from the treasury of the king.

This first form of paper money, “representative money”, was a financial instrument and, in common with all financial instruments, it derived its value from its contractual properties. Representative money had value solely because it represented a claim on a real asset (gold).

While the use of representative money did provide government with more flexibility in the way it could finance its operations, it still restricted the amount of paper money that government could issue.

The ingenious solution to this problem was to remove the gold convertibility feature, thereby effectively cancelling the explicit contract that governed paper money.

This is the point that representative money became fiat money.

The question that mainstream economic fails to provide a good answer for is why did paper money maintain any value once the explicit contract that governed representative money was rendered null and void. After all, paper money was originally accepted only because it was “as good as gold”.

So, why did paper money maintain any value?

The view of The Money Enigma is that the explicit contract that governed representative money was replaced by an implied-in-fact contract that still governs fiat money to this day.

Fiat money is not a real asset and does not derive its value from its physical properties. Therefore, prima facie, fiat money is a financial instrument and must derive its value from its contractual properties, even if that contract is implied rather than explicit

The view of The Money Enigma is that fiat money is a financial instrument and derives its value solely from the nature of the liability that it represents. Fiat money is an asset to one party because it is a liability to another. More specifically, fiat money is a liability of society (the ultimate issuer of money) and represents a proportional claim on the future output of society.

In more technical terms, fiat money is a long-duration, special-form equity instrument and a proportional claim on the future output of society (“Proportional Claim Theory”).

The notion that money is a proportional claim on the future output of society is a complex idea that we have discussed extensively in recent posts. For those that are new to The Money Enigma, I would highly recommend reading “What Factors Influence the Value of Fiat Money?” and “A New Theory of Fiat Money”. Readers with a financial background may also be interested in reading “Money as the Equity of Society”, a post which compares fiat money with shares of common stock.

So, what does this theory imply about the value of fiat money? 

In simple terms, if fiat money (the monetary base) is a proportional claim on the future output of society, then the value of fiat money primarily depends upon expectations regarding the long-term economic prospects of society.

More specifically, the value of fiat money is positively correlated with expected long-term real output growth and negatively correlated with expected long-term monetary base growth.

If this still seems a bit complicated, then think of it this way.

The value of fiat money is a slice of cake that we hope to eat at some point in the distant future. The cake is “expected future output” and the number of slices we must cut the cake into depends on the “expected size of the monetary base”.

As each slice of our cake gets smaller, the value of fiat money falls.

The expected size of each slice of future output cake can shrink (the value of fiat money can fall) either because (a) the expected size of the cake shrinks (expectations for future output growth fall), or (b) we expect that the cake will need to be cut up into more slices (expectations for future monetary base growth rise).

In the most basic terms, we can say that fiat money is only as good as the society that issues it. If people are optimistic about the economic prospects for a society, then the value of fiat money issued by that society should be well supported. However, if people become more pessimistic about the future path of the economy, then the value of fiat money will start to decline.

The Gold Price and Economic Confidence

Now we have all the pieces of the puzzle, we can bring them together to think about what drives extended bull and bear market cycles in the gold price.

If gold is a leveraged “anti-fiat” asset and the value of fiat money is positively correlated with the perceived long-term economic prospects of society, then the gold price is a barometer of pessimism regarding the long-term economic future of society.

In the context of the United States, the gold price, as measured in US Dollar terms, rises if confidence regarding the long-term economic future of the United States deteriorates. Conversely, the gold price falls as market confidence in America’s long-term future improves.

It is important to note that the gold price is not a measure of confidence regarding current economic conditions. People can feel bad about the “here and now” and the gold price can still fall. Rather, gold is a proxy for pessimism about the long-term (30-40 year+) future of the United States.

While confidence about current conditions is rather volatile, confidence regarding the long-term future of a society tends to move in extended cycles. These cycles often last for years, if not a decade or more.

People’s expectations about the long-term prospects of their society tend to be slow to adjust. Most of us don’t wake up one morning and completely change our view on the 30-year economic prospects for the country we live in. Rather, our view tends to be changed slowly by the accumulation of data points, both positive and negative.

It is these extended cycles of rising and falling long-term confidence that create the extended bear and bull market cycles that we see in gold.

What does this mean for gold investors today?

In simple terms, if you believe that markets are generally too pessimistic about the long-term future of the United States and other major global economies, then you should expect the gold price to continue to fall. Conversely, if you believe that markets are too optimistic about the long-term economic future of the US, then you might reasonably expect the gold price to rise.

It seems reasonable to believe that confidence in the long-term future of the West peaked in 1999/2000 when it seemed that advances in technology would drive a permanently higher level of productivity growth. Not surprisingly, this point also marked the low point in the price of gold.

Confidence slowly deteriorated over the course of the next ten years and hit a nadir in August 2011 when S&P downgraded the credit rating of the United States. Again, this was the point at which the gold market turned and a bear market began.

Since then, confidence regarding the long-term future of the United States has improved markedly and the bear market in gold has continued. However, the view of The Money Enigma is that much of this improvement in confidence has been driven by a monetary experiment called quantitative easing. Whether this improvement in confidence turns out to be permanent in nature is far from certain, but the odds are against it.

Those readers who are interested in my view regarding the challenges associated with quantitative easing might want to read “The Case for Unwinding QE” and “Monetary Base Expansion: The Seven Stages of Addiction”.

Author: Gervaise Heddle