Monday, July 18, 2011

Popping the Gold Bubble by Selling US Gold Reserves

In earlier posts, I've discussed the topic of backing a nation's currency with something of universal & measurable value, such as electricity. However, nearly every week there are calls for a return to the gold standard (and even Congressional hearing by Rep. Ron Paul on the subject.) Gold does not have a universal value. While I respect the calls to move away from a fiat money supply, returning back to the gold standard would be artificial and potentially dangerous. Here's the problem: gold has very little value in our society, besides as jewelry.

Buying gold and hoping that it will gain value is much like the bubbles we're seen in the past. Examples of bubbles in the past were: the Dutch tulip bubble in 1637, the South Sea Company bubble of 1720, and the housing bubble of pre-2008, to name just a few.

I don't want to speculate on future bubbles, but I want to point out that I think that buying gold and hoping that the price of gold will increase is a very bad idea. Why? I'll take a few sentences to explain the problem of treating gold as an investment.

The US stores on the order of 300 million troy oz of gold in its two main depositories, roughly 140 million troy oz in Fort Knox, and roughly 160 million troy oz near Manhattan. This is roughly 6 years worth of production of gold, given that the world produces ~50 million troy oz of gold each year. And 300 million troy oz is roughly 2.5% of the total world's gold that has already been mined. Using a current estimate of the price of gold of $1600 $/troy oz, this means the the US is storing roughly $480 billion in gold. Some of the stored gold is for other countries or organization, so let's estimate that the US has $400 billion in gold stored at Fort Knox and below Manhattan. Considering that the US currently spends over $2 trillion each year and is over $14 trillion in debt, even if the US were to sell all of its gold reserves, it would barely help the current deficit, let alone help the debt. However, if the US were to sell its reserves, then the price of gold would most likely start plummeting. And here's why.

When broken down by area, gold is used in the world roughly 50% for jewelry, 40% for investments, and 10% for industry. This means that roughly half of the gold produced each year goes just into storage as an investment. This is the definition of a bubble: mass investing into a product that has a zero or a negative rate of return on work invested. All you have going for you is wishful thinking, as opposed to investing into a company that produces electricity. When you invest in such a company, you can expect to make a positive rate of return on investment because the power plant (if it's economically viable) has a positive rate of return on work (kW-hr) invested into the plant.

I've suggested previously that the US could sell a significant portion of its gold and silver reserves in order to ease the transition to an electricity-backed (zero-inflation) currency. Right now, the US Federal Reserve prints money and inflates the currency. The printing of money is in part so that legislators don't have to increase taxes, all other things staying the same. For example, the yearly US GDP is on the order of $14 trillion (also currently the same size as the total federal debt.) Let's assume that the value of the dollar were to stay the same from year to year if the Fed Reserve didn't print money. This is a good assumption because we are consuming roughly the same amount of fuels and producing roughly the same amount of electricity each year for roughly the same price. Now let's assume that the US Federal Reserve were to print money such that the inflation rate is 3% per year (rather than the ~0%/yr if the Federal Reserve weren't to print money.) This means that the Federal Reserve could print roughly $420 billion during that year and the purchasing power of the dollar would have decreased by 3% in that year.

This means that the US could afford the first year of moving to an electricity-backed currency by selling its gold reserves. What I'm saying here is that the US could afford to not inflate its currency by 3% for one year if it sold all of its gold reserves (which if sold at today's prices is roughly 3% of yearly GDP.) This would have no overall change to the overall debt or deficit. (But we will have avoided inflation for one year, and that is an accomplishment because inflation is the unspoken tax that the Federal Reserve imposes on us all. The effect of a zero percent inflation currency compared to a +3% inflation currency is like having your taxes lowered by 3%.)

In the second year of a zero-inflation currency, we would have to sell other assets if we wanted to maintain the same level of deficit, with all other things staying the same. [We would still have a ~$1 trillion/yr deficit and a >$14 trillion debt.] You can see that we would need to sell a lot of assets in order to actually make a dent into the debt. $14 trillion is a lot of money, and the only options are:  selling assets, cutting spending, raising taxes or printing money. [Note: I placed these items in my order of preference. But also note that only roughly 28% of our federal debt is owned by foreign countries. The rest is debt owned by people or agencies inside of the U.S.]

Of course if we decided to go with the selling assets option, we would want to space out of the selling of our assets because if we were to sell all of the, let's say, gold at once, then the price will plummet and we wouldn't be able to obtain as much money from the gold we have stored. If 50% of the world's gold is just for investment, once a large organization starts selling gold, the price will plummet. And this gets me back to the point of this article. I would not recommend buying gold as an investment. (Why? Because I will be a consist, vocal advocate of the US selling its gold reserves, and if the US does sell a significant portion of its gold reserve, then the price will plummet and you will have essentially given the US a lot of money by deciding to invest in gold.) Worse, what if all of the countries in the world started to sell their gold and silver reserves? There's an advantage to selling the gold first because the people who try to sell after the price plummets will not be able to make as much money per oz of gold. This is why I suggest that the US should sell its gold reserves and then move to a zero-percent inflation currency.
Once the economy starts growing (i.e. a real increase in GDP), then the Federal Reserve can start printing money again in order prevent deflation. I personally have no problem if the Federal Reserve prints money to prevent deflation and maintain a zero-percent inflation currency. My problem with the Federal Reserve right now is that they were printing money (via the Bureau of Engraving and Printing) while the inflation rate was positive, i.e. while gasoline prices and the commodity price index were rapidly increasing. Basically, our representatives were afraid of taxing us to pay for the Wall Street, State Government and Auto bailouts, so they decided (through the Federal Reserve's actions) to tax us indirectly via inflation. But a tax is still a tax even if you don't call it a tax. I consider printing money (when there isn't deflation) to be a tax. So, when you pay your taxes each year, remember that you are really being taxes an extra roughly 3% of your salary each year due to the printing of money.

In conclusion, there are two main points I've like to emphasize: 1) investing in gold is dangerous because there's always the chance that world organizations will start selling their reserves of gold once they realize that we will never go back to a gold-backed currency; and  2) I suggest that the US should move to a zero-percent inflation currency, such as an electricity-backed currency. Since the government is used to printing money at roughly 3% of GDP per year, we could pay for one year of going to a zero-percent inflation currency by selling our gold reserves.

As a post note: when I did the calculations above regarding how much money the Fed can order to be printed and its effect on inflation, I was making an assumption that the "velocity" at which money is exchanged in the economy, a.k.a. the velocity of money, was a constant. It is not a constant and a future blog, I'll discuss the relationship between GDP, velocity of money, and the money supply.  The relationship between these variables is easier to see in a zero-inflation currency, such as an electricity-backed currency. A discussion of the velocity of money and the money supply can be found here.


  1. Your calculation of $ value of gold is incorrect.. the gold value is in excess of 100 Trillion

  2. ???
    I think that we are discussing different things. I'm just talking about the gold that is stored in Fort Knox & under Manhattan, i.e. the gold that the US could sell because it's doing nothing but sitting there. This gold can't help feed people, fuel our cars, or power our buildings.

    Here's the calculation again to show you that the numbers are correct.
    The price of gold is ~$1600/oz
    The US stores 300 million oz of gold, which makes ~ $480 billions of worth, of which the US owns ~ $400 billion.
    This number can be verified by going to the US Treasury department's website, and has been recently verified by an independent audit of Fort Knox and the vaults near Manhattan.