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Gold in a New Era of Fixed Exchange Rates

Judy Shelton, currently an economic advisor to the Trump transition team, has just published an important article in the Wall Street Journal that provides insight into the possibility of monetary policy changes in the new administration.  Her arguments will likely have a profound effect on the price of gold, its volatility, and investments in gold mining companies.

My previous articles have examined the importance of money as a unit of account.  The markets use the price of gold to measure money whether or not central banks choose to adopt a gold standard system.  Markets never abandon gold as the best means to predict price stability, inflation, or deflation.  Of course, each of these have their unique impact on the price of equities, bonds, and commodities.

Shelton’s article illustrates the obvious: trade agreements cannot be considered either free or fair if signatories can simultaneously engineer a decline of their monetary standard.   One party would gain an advantage by interfering with price signals that influence flows of capital.  This is really the dirty secret about the brouhaha surrounding NAFTA and, specifically, trade between Mexico and the United States.  Since the inception of the treaty in 1994, Mexico has devalued its currency almost 90%, an amount that is 20% more than the depreciated dollar.  (Frankly, often following the bad advice of the United States Treasury).  The ensuing inflation hurt Mexican workers by reducing the purchasing power of their wages and by pushing them into higher unindexed tax brackets. The dynamic advantaged the cross-border manufacturers who delayed price increases for their products because wages adjust only gradually with the devaluation.

Shelton suggests that Trump’s trade antics are really a maneuver to get the developed nations to fix the currency chaos.  The suggestion is less of a Louvre Accord and more of a Bretton Woods Agreement.  If so, classicists know that any system that joins currencies to specific exchange values must have a reference point or anchor to which they are tethered.  One cannot simply charge that the ‘dollar is strong’ or the ‘yuan is weak’ without having a neutral gauge by which to make such assertions.  The only useful reference or anchor is gold. And, although not explicitly mentioned, given Shelton’s classical monetary policy background, she must know it.

A perspective of currencies through the prism of gold suggests that this is actually a good time to fix exchange rates.  The grid below illustrates annual increases in the price of gold for each currency after the collapse of Bretton Woods in 1971 and after the decision to float it in 1973.  I use the peak price of gold in each currency in the early ‘eighties because it represents the worst condition of devaluation in the beginning quarter of the floating currency regime.  Note that only two currencies, the much maligned yen and the iconic Swiss franc, are the only major currencies that lost little or no ground in gold terms.

 

 

Annual Appreciation of Gold

 

 

Currency

Year

              80’s Peak

1999

2003

 

Dollar

1.80%

10.60%

9.39%

 

Euro

2.51%

9.41%

9.51%

 

Yen

-0.20%

8.93%

8.44%

 

Yuan

6.12%

6.68%

7.26%

 

Swiss Franc

0.32%

6.01%

6.64%

 

Average

 

2.11%

8.33%

8.25%

 

I list 1999 because the entirety of the post Bretton Woods adjustments likely expired by then.  Also, the Euro was introduced that year at 1.17 dollars to the Euro.  Regrettably, Alan Greenspan’s mismanagement of the dollar resulted in a fairly severe deflation from 1999 through 2003.  Gold fell from its optimum price of $350 to a low of $200 in that timeframe.  That is one reason why the dollar shows the highest level of depreciation since 1999.  2003 is represented in the chart because it is the year where the dollar regains its optimum price of $350, an average price of gold that held from roughly 1982 through 2003. The point is that whether one wants to measure all currencies price action from 1999 or 2003, they have roughly depreciated at the same rate.  Some a bit higher some a bit lower. 

I make two assumptions to determine the optimum gold prices in the non-dollar currencies.  First, as explained in previous articles, the optimum price of dollar gold is assumed to be $1200.  Second, because the dollar remains the reserve currency, other currencies should adjust their levels of depreciation to match the dollar. This way the dollar gains no advantage.  If we make these adjustments today, then euro gold would be assumed to have an optimum level of 1140 and the euro exchange rate at 1.05; yen gold’s optimum would be 160,000 and a yen exchange rate of 130; yuan gold’s optimum at 10,500 and a yuan exchange rate of 8.75; and Swiss franc’s optimum at 1750 and a Swiss franc exchange rate at 1.45.

With this scenario, only euro gold would be expected to decline very slightly.  However, one would hope and expect that the price of gold in the other major trading currencies should actually rise to create a price equilibrium that matches the fourteen year dollar devaluation.  It may very well be that the Swiss would choose to avoid a devaluation of some 40% or some other percentage and would accept a lower exchange rate.  Same with the Chinese. The exercise illuminates the process and purpose of creating a new currency regime that relies upon fixed exchange rates and how it uses gold a reference point in the event that one or more currencies fall out of line. 

What Shelton does not explicitly say, but what history teaches, is that this type of fixed currency regime will unleash enormous economic activity, catapult real wages, and increase the level of capital available to all nations by a magnitude of what exists today.  The consternation about debt in Japan and China will disappear.  The stagnation and threats of ‘exits’ in Europe will subside.  Equities will boom.  And so will the gold mining stocks, which can triple from here just from multiple expansion. All occurs because the market has reliable prices whose authenticity is anchored in gold.

By Stephen W. Shipman, CFA

 

 

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
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