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Gold Isn't Expensive, Instead the Dollar Is Cheap

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John Tamny
September 22, 2010

Gold has been surging of late, and yesterday it hit an all-time high of roughly $1,280/ounce. Supply/demand theory would likely say that demand for the yellow metal is outstripping supply, but this would be mistaken thinking.

Instead, gold is expensive right now because the dollar is cheap.

Unique among commodities, nearly every ounce of gold ever mined is still with us today. In numerical terms, there are roughly 148,000 metric tons of gold on earth, and the supply of newly recovered gold usually works out to 2,000 metric tons each year.

The above-mentioned stock/flow disparity explains neatly why gold has been used as a money measure for thousands of years. Lacking any major industrial purposes that lead to its consumption (as compared to oil for instance), gold discoveries are merely additive to the global stock, and with new, annual discoveries very small relative to the total supply, the price of gold is enormously stable in real terms.

To put it more simply: when the price of gold fluctuates, it's a signal of dollar (the currency in which it's priced) instability, as opposed to a gyrating price of the metal itself. And with gold presently more expensive in dollars that it's ever been in history, the most monetary of all metals is signaling that the dollar is the weakest it's ever been.

The culprit for the dollar's decline is pretty basic. Despite the fact that the Federal Reserve issues dollars, it's the US Treasury that is the dollar's mouthpiece, and, just last week, Treasury Secretary Tim Geithner signaled his and the Obama administration's preference for a weaker greenback.

Or, as Geithner put it, "We are concerned, as are many of China's trading partners, that the pace of appreciation [of the yuan] has been too slow." And to show that China-bashing is right now a bipartisan exercise, Alabama Senator Richard Shelby asked, "Why is the administration protecting China by refusing to designate it as a currency manipulator?"

Basically both sides of the aisle want the Chinese to strengthen their currency, but the true signal Treasury and Congress are sending to the markets is that Washington would prefer a weaker dollar, and markets are complying. Indeed, as we learned in the ‘80s when protectionist politicians reared their ugly heads with regard to Japan and its falsely weak yen, the call for a stronger yen led to a falling dollar, and on October 19, 1987, a stock-market crash the day after Treasury Secretary James A. Baker talked the dollar down on national television.

Japanese monetary authorities, of course, gave in to the baseless demands of mercantilist politicians on the way to a tripling of the price of the yen versus gold, and a deflationary recession from which it has yet to recover. Understandably, Chinese authorities are reluctant to follow Japan's lead, but assuming a similar revaluation to the one Japan gave into, have any of today's politicians stopped to consider the negative economic and geopolitical implications of China's still impoverished population suffering its own "lost decade"?

In Geithner's defense, he has to fend off 100 Congressmen who seek harsh action of the tariff variety absent a Chinese revaluation, while Senator Charles Schumer claims "China's currency manipulation is like a boot on the throat of our recovery." To show yet again how very bipartisan the crackup over China is, Republican Senator Jim Bunning has accused Geithner of having "violated the law" for failing to designate China a "currency manipulator" in his most recent report.

Naiveté when it comes to currency matters is neither the preserve of the Democrats nor Republicans. Both sides don't have a clue, and we all suffer.

Indeed, a growing cadre of politicians in Washington believes that the yuan's fixed link to the dollar (more than 50 other countries have such a peg) is the driver of our economic hardship. Nothing could be further from the truth, and with the yuan soft only insofar as the currency that it's pegged to (the dollar) is weak, our hardship is a function of internal policies from Treasury in favor of a debased dollar.

All jobs and company growth are funded by investment, but with policy stateside in favor of a weak dollar, investors are understandably shying away from committing capital to new and existing ventures given the certain knowledge that any investment returns will be eroded by the dollar's devaluation.

The solution coming from Washington is a stronger yuan vis-à-vis the dollar. If we ignore that the same individuals who decry currency manipulation want the Chinese to manipulate theirs on an upward trajectory, a stronger yuan will do nothing to fix our problems here – which are related to weak investment rooted in the weak-dollar policies that our politicians are embracing, and that will strangle jobs growth even more.

As for China, for Geithner et al to suggest that a stronger yuan will make Chinese goods less competitive on the world stage (thus supposedly making ours more desirable) is the equivalent of a restaurant chef arguing that a shorter minute would reduce the amount of time necessary to cook a soufflé. In truth, money is only a veil, and if the yuan rises even more against the dollar, Chinese goods will continue to arrive here (thankfully) en masse just as Japanese goods did after 1971 when the yen began a 20-year climb against the dollar.

While goods priced in yuan will be more expensive in dollar terms, the costs of goods necessary to manufacture Chinese products will by definition decline. In yuan terms, everything will become cheaper for Chinese manufacturers, which means any yuan strength will be mitigated by reduced costs of production.

Even better for China, a revaluation upward would be dynamite for an economy suffering from a devaluation authored in the US. The seen here is China's growing economic clout, but the unseen is how much greater China's growth would be if its currency weren't pegged to an inflationary dollar which, on the margin, is making investment in China more of a challenge too.

Absent a yuan revaluation upward, it's possible that Congress will start a trade war that history says will prove unfortunate for stocks. Assuming a revaluation, a cascading dollar promises much the same.

Whatever the end result, gold is only expensive insofar as the dollar is very cheap. And for those wondering why the job market is presently limp, they need look no further than the sagging dollar signaled by gold's spike. Washington is playing with currency fire right now, and sadly there's no good outcome to hope for short of another currency crisis that leads to voter demand for a unit of account that is actually credible.

John Tamny is editor of RealClearMarkets, a senior economic adviser to H.C. Wainwright Economics, and a senior economic adviser to Toreador Research and Trading.

Article originally published on September 21, 2010 at realclearmarkets.com. John Tamny, RealClearMarkets, H.C.Wainwright and Toreador Research and Trading are not affiliated with Euro Pacific Capital, Inc. Euro Pacific Capital does not guarantee the accuracy and completeness of third-party authored content.