Gold: The Next Global Reserve Currency

Gold is on a path to become the next global reserve currency.

A macroscopic perspective of our global economy suggests the world’s financial crisis was caused by an inordinate accumulation of debt relative to GDP.

However, the excess debt relative to income was the result of fiat currency regimes.  These regimes are based on the faith and credit of governing institutions, not physical capital reserves, and permit an infinite amount of credit and undercapitalized debt formation.

Well capitalized debt formation is predicated on a stable currency regime that cannot be easily manipulated, one that is partially backed by tangible capital reserves.

Global macroeconomic environment remains highly overleveraged, where total debt (private and public) relative to GDP is still unacceptably high.  Future economic prosperity requires further debt reduction.

A sustainable level of total debt/GDP is roughly 150% – 200%.  During the US depression, this figure reached 260%.  By 2008, it was over 350%.

According to the Bank for International Settlements, total debt/GDP in the advanced economies grew from 167% in 1980 to 314% today.  Further debt reduction is essential to improve the global economy.

Debt accumulation also hindered long term investment.  Both severely undermined the economic multiplier, or monetary velocity.  Monetary velocity is the number of transactions per unit of currency over a given time period, where GDP equals Money Supply multiplied by Monetary Velocity.  Given a stable money supply, income rises as the monetary velocity rises.

From 1980 through 2008, monetary velocity in the US fell over 50% and investment as a percentage of GDP dropped 32%. This level of investment is roughly half the global average of 24% and is a major impediment to long term economic prosperity.

Healthy economies produce a monetary velocity greater than 1.5.  Today, this figure is below 1 for the entire world. Debt reduction and increases in investment are needed for global economic recovery.

Debt reduction and an increase in long term investment require a stable medium of exchange backed by tangible assets, such as gold.

Gold possess unique attributes that mitigate geoeconomic and geopolitical uncertainties.  Therefore, it tends to preserve purchase power parity and wealth over long periods of time and across geographical locations.

Attributes of gold include the following:

1.  Gold production is a proxy for general economic activity in terms of resourceallocation and input productivity (i.e., the cost of labor, capital and raw materials per unit of output).  The cost structure for gold production more accurately reflects that of other essential commodities, thereby preserving purchase power parity more readily.

2.  Gold is a physical product that cannot be manipulated easily, since the marginal cost of production per ounce ranges between $500 and $1,000.

3.  Gold is highly durable and reusable, such that the total supply continuously increases.

4.  Gold possesses economic diversity:  this includes investment, both industrial and financial, and consumption (i.e., 10% industrial, 40% financial, 50% consumption).

5.  Gold serves as a historic medium of exchange.

6.  Annual production of gold increases total supply by approximately 2% per annum.

Some believe the supply of gold may be inadequate to support future economic activity.  This may not be the case for the following reasons:

1.  According to the World Gold Council, known supplies will maintain this rate for the next 25-50 years

2.  Future technological innovations may increase gold supplies.

3.  Should future supplies wane, lower capital reserves provide a better stabilizing force than fiat currencies.

4.  Given a constant supply, price appreciation will protect purchase power parity.

If additional capital reserves are needed, other tangible assets with similar properties can be incorporated..

At this time, gold seems to be the most effective candidate based on its economic diversification.  Silver would be a likely addition in the future.

The demand for gold has been increasing significantly.  Currently, there are significant public and private financial resources available to satisfy this increase in gold demand.  These resources include sovereign currency reserves of nearly $12 trillion and private financial assets of $200 trillion.  Investment in gold represents only 0.2% (2/10ths of 1%) of private financial assets and 10% of sovereign currency reserves.

Future portfolio allocations that provide greater weight in gold seem very likely.  Recently, many governments have made large gold acquisitions, especially China.

The global market value of gold is approximately $8.5 trillion and the global narrow money supply totals approximately $26 trillion.

A stable currency regime using gold as a reserve asset can be achieved if the total value of gold approximates the total value of the narrow money supply.  This implies a three-fold increase in the value of gold, from $8.5 trillion to $26 trillion. Therefore, I anticipate a three-fold increase in the unit price of gold in the future.  Deteriorating global economic conditions, including the Eurozone and elsewhere, place greater pressure on achieving this equilibrium more rapidly.

A decade or two is a plausible and realistic time frame for this to occur.  During this time, I expect the price of gold to reach $4,000 per ounce.

The lack of confidence in undercapitalized fiat currencies is accelerating at a rapid pace.   Stable, long term economic prosperity is predicated on a different global reserve currency.

In my view, gold represents the most likely candidate as the next reserve currency.

Copyright 2012 Barry Elias.  All rights reserved.

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