Tuesday, October 12, 2010

A View from the "Gold Perspective"

A reader of Crossing Wall Street blog responds to Eddy's gold model post (which I looked into here) and puts everything in terms of gold, rather than dollars. Note that this is just a portion of that response and I recommend readers take the time to read the whole thing and think about it as it puts everything in a very different perspective. That response:

First, the dollar derives its value from its relationship to gold. So instead of the dollar price of an ounce of gold, it should be thought of as the gold price of a single dollar. (For instance, the current of gold price of single US dollar is presently about 1/1345th of an ounce of gold)

Second, on this basis, the relationship is somewhat clearer: when the purchasing power of an ounce of gold rises (i.e., when an ounce of gold commands more dollars) interest rates will be low; and, when the purchasing power of a an ounce of gold falls (i.e., when gold commands fewer dollars the interest rate will be high).
In other words... gold doesn't rise in dollar terms when real interest rates are low (or negative), but rather interest rates are low because their is no demand for the dollar in gold terms.

A View from the "Gold Perspective"

Under the assumption that Gold IS the only real currency (it has the huge benefit that it cannot be depreciated - an ounce of gold in year 1 is an ounce of gold in year 2, year 3, ... year 100), then the recent run up in gold is not appreciation relative to the dollar, but rather the US dollar has seen a severe depreciation relative to real currency (i.e. gold).

But, if the dollar is collapsing, then why aren't prices of goods and services jumping?

Perhaps (bear with me, this perspective is new to me) we happen to be in a severe deflationary environment in real currency (i.e. gold) terms, offset (intentionally?) by a devaluation of our fiat currency to prevent a collapse in the price level of goods in $$ terms. This devaluation may be saving the economy from falling into a deflationary spiral if not pursued (our economy has a lot of hard assets that are used as collateral for dollar loans. A drop in the assets value would be extremely destructive as the value of these loans would fall if the price of the collateral was allowed to fall, which would cause asset prices to fall further... rinse - repeat).

The Great Depression was a deflationary environment as the dollar was backed by gold. Today, rather than deflation in dollar and gold terms, we have a disconnect between the dollar (slight inflation) and gold (massive deflation) in terms of goods / services.

Below is a chart of headline CPI (i.e. purchasing power of the dollar) vs. gold CPI (purchasing power in gold terms). Since the consumer price index began in 1947, goods / services cost ~900% more whereas goods / services cost 70%+ less in gold terms.

And a year by year comparison of CPI in dollar terms and gold terms shows the economy went "gold deflationary" during the telecom / Internet induced recession early last decade.

Still getting my head around this, but any comments are more than appreciated...

Source: Measuring Worth / BLS