Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Tuesday, December 24, 2013

In gold we trust?

I've written before that a desirable property of a monetary instrument is for it to hold its value over short periods of time (See: Why Gold and Bitcoin Make Lousy Money).

In other words, a good monetary instrument should have a stable short-run rate of return. If I earn some money today, I don't want to see its value decline by 50% tomorrow. If I spend a dollar today, I don't want to see its value rise by 50% tomorrow. Even if these fluctuations cancelled out in the long run, it would be terribly inconvenient and annoying. I'd rather live in a world where my money lost value at a slow but steady rate. Of course, I would not want to store my wealth in the form of such an instrument. But that's not how we store wealth anyway. To store wealth, we can always sell the money we do not need for transaction purposes and purchase other securities.

Now let's take a look at some data -- the type of data Ron Paul likes to use. Let p(t) denote the price-level at date t (I will use the consumer price index). Then 1/p(t) measures the purchasing power of money. If p(t) rises over time (inflation), the purchasing power of money falls over time. And so we have this familiar picture:


I've written about this before here: Ron Paul's Money Illusion.

Now, we can perform the same sort of exercise for gold. Let q(t) denote the USD price of gold at date t. Then the purchasing power of gold is measured by q(t)/p(t). So, if the price of gold rises as fast as the price level, the purchasing power of gold remains constant. If the former rises faster than the latter, then the purchasing power of gold is rising; and vice-versa.

We know that over very long horizons, the rate of return on gold exceeds that of money. But all this says is that gold is a better store of value than cash over long periods of time. (I discuss here whether gold is a good store of value relative to other assets.). How has the purchasing power of gold held up over the last little while?

Here is the purchasing power of gold vs the USD since the beginning of the year:


OK, so this past year was not a good one for gold. If you had earned your wages in gold at the beginning of the year, that gold would now buy you 25% less bread. That's like a tax. And it was not the Fed doing it to you. In fact, if you had instead held on to your USD over same period of time, you would have experienced a much smaller decline in purchasing power.

What if we look at the past 2 years? Here is the picture:


What we see from the picture above is that the purchasing power of gold held up with that of the USD in 2012, but that its short-run rate of return was more volatile. It's rate of return then fell down a  steep hill in 2013.

Let's go back 3 years now:


Gold can't even beat the rate of return on cash over a three-year horizon? That's pretty sad for a store of value.

The main lesson I take away from this is not that people shouldn't invest in gold. By all means, go ahead and invest in all sorts of stuff, including gold. The main lesson is that commodity prices tend to be highly volatile over short periods of time and that this short-run volatility makes them undesirable as payment instruments. There is a better alternative available, and the United States has it in the form of the Federal Reserve.

Happy 100th birthday, Fed!

And a Merry Christmas to all.

PS. My colleague Christian Zimmermann points me to this potentially interesting paper: The Gold Dilemma by Claude Erb and Campbell Harvey.

11 comments:

  1. I like your rugged good looks and sensible slacks. Keep up the good work, sir.

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  2. Great post! I was making similar point on my blog a week ago (its in Croatian). Did you see Matt Busigin's chart on cumulative returns from 1950s? Its making similar point to what you are writing here...nobody will hold currency for 20 years. Even in gold standard era there were periods of twenty or more years when price level was rising or falling. So basically people had similar problem "forecasting" purchasing power of the dollar/gold in the future. Now they at least know what is the target price level. Other than that, real interest rate was very variable too which didnt make things easier then. *sorry form my bad explanatins in english.

    +I hope internet austrians arent claiming that the rise of purchasing power of dollar in early 30s was a good thing.

    Merry Christmas!

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    1. Petar, I've looked for it, but cannot find it. Do you have a link? Merry Christmas!

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  3. David,
    I'm guessing you wouldn't be a fan of gold-backed bitcoin!

    Alternative currencies fail as a medium of exchange when they are not the medium of account. When they are not the MOA, these currencies only serve as MOE in specific instances (to facilitate payments for illicit activity).

    I was in Argentina in 1987 when the dollar was the MOA. It worked well as the MOE. I was there again in 2006 when the dollar was not so much the MOA, but was still used as the MOE in the "grey" economy (i.e. $ cash was used to pay for houses to mask the transaction from the fiscal authority).

    The case for holding gold as a wealth store is simply that, as a perpetual consumable of inelastic supply, it is an MOA independent of currency issuers. Gold would only be useful for alternative MOE (I am actually thinking a gold-backed bitcoin) should the currency it is replacing have risk of failing as an MOA.

    Of course, gold doesn't act as an MOA most of the time. It acts like any commodity fluctuating in price. These fluctuations are often the result of the "call option premium" of it becoming the MOA in the future rising and falling. The way to look at gold is that the gold price will be seen as steady (i.e. become the denominator) if and when the option is exercisable.

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    1. Diego,

      Are you suggesting that *if* gold or bitcoin were the MOA, then it's short-run rate of return would stabilize?

      Also, note that I am not against gold or bitcoin (or whatever) as a currency. In fact, I think that the threat that they pose as alternate currency can serve as a useful check on a central bank. But if that option is ever exercised, I don't think we have reason to believe that its rate of return would be stable over short periods of time.

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  4. "Stability" is a matter of perception. If gold (or bitcoin) were perceived as the MOA, the dollar would exhibit short-run volatility against it. This is the way Argentines thought about the Austral: it fluctuated, and the dollar remained constant.

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    1. Diego: I have had related (but half-baked) thoughts myself. I like the way you put in terms of comparing MOA and MOE. There may be something profound here and it would be interesting to see the idea formalized. Are you aware of any such work?

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  5. JP Koning sparked some of my thoughts on this, and he is likely aware of the academic literature surrounding it.

    I think the danger of QE is that we don't really know, at this point, what impact it will have on the perception of the MOA in the long term. As an asset swap, QE transfers duration risk from private investors to taxpayers (via the consolidated Fed+Treasury balance sheet). I think there is an unacknowledged link between this duration risk and perception of the stability of the MOA, or at least there was such a link in high inflation Latin countries.

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  6. The Fear Gauge, Volatility, ^VIX, traded by XVZ, has bottomed out at 12.14, and has been rising for seven trading days, confirming that the financial markets have pivoted from a bull market to a bear market

    On Friday, January 17, 2014, The Great Economic Transformation, that is the pivot from liberalism into authoritarianism, was fully established with the failure of fiat wealth.

    Global Financials, IXG, Nation Investment, EFA, and World Stocks, VT, traded lower as currency traders sold the Euro Yen, EUR/JPY, carry trade, and the Australian Dollar Yen, AUD/JPY, carry trade, causing derisking out of Eurozone Stocks, EZU, European Financials, EUFN, and Eurozone Nations, EWI, EWG, EFNL, EWN, EWQ, EIRL, EWP, EWO, PGAL, as well as deleveraging out of Eurozone Debt, EU, and likewise derisking out of Australia, EWA, and Australia Dividends, AUSE. New Zealand, ENZL, traded lower from its rally high.Turkey, TUR, continued lower. Investment trading reflects that the Major World Currencies, DBV traded lower.

    Global Industrial Producer, FXR, leader, General Electric, GE tumbled as Bloomberg reports GE reports after profit-margin forecast trails forecast. And Transportation leader United Parcel Service, UPS, tumbled as Fox reports Shipping giant slashes FY view. Industrial Miners, PICK, traded higher. Crain’s Detroit Business reports Flagstar S&L to cut 700 jobs in restructuring move. Despite the WSJ report that IBM commits $1.2 billion to cloudstack; investing in cloud computing stocks, seen in this Finviz Screener, has peaked out.

    The India Rupe, ICN, traded lower, forcing India’s Banks, HDB, and IBN, India, INP, and India Small Caps, SCIN, lower. The Brazilian Real, BZF, traded lower, forcing Brazil Financials, BRAF, and Brazil, EWZ, lower.

    Chinese Financials, CHIX, traded lowe as Bloomberg reports ICBC won’t repay troubled Chinatrust Product, official says.

    Despite the trade higher in the US Dollar, USD, UUP, to close at strong resistance at 81.40, Gold, GLD, and Silver, SLV, traded higher, taking Gold Miners, GDS, and Silver Miners, SIL, higher. Spot Gold, GOLD, closed at the highest level in five weeks at $1250.

    Needless to say, fiat wealth now being unstable, cannot sustain wealth. In the age of authoritarianism, one should be invested in, and take possession of, and safely store gold bullion and silver bullion, as in the new epoch, the diktat of nannycrats and precious metals will be the only safe form of wealth.

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  7. Gold was hammered in 2013 starting with thejapanese yen dedevaluation that year. It means the carry trade was back on. Seriously, check a chart of USD/YEN vs gold and they are very oppositely correlated. Its like the more abe prints the more gold goes down. And of course the long side of the carry was index equities....put those on your chart too and you will see it. So yen shorts funded equity buys for the last part of bens backstopping pre taper. Equity risk was basically favored to gold, with yen "to the moon" stimulus funding.

    All it proves to me is gold (as is everything) priced in fiat can get whacked...as fiats real backing (debt) becomes increasingly alarming at a soverign level, thus just leaving one relatively floating and managed fiat to war against another similarly floating, ungrounded fiat.

    BOOM.

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