This post was inspired by an exchange between Martin Armstrong of Armstrong Economics and one of his readers. In an earlier blog entry Mr. Armstrong wrote: “The wealth of a nation is the total productivity of its people. If I have gold and want you to fix my house, I give you the gold for your labor. Thus, your wealth is your labor, and the gold is merely a medium of exchange. So it does not matter whatever the medium of exchange might be.” One of his readers took exception to this comment and argued that money should be tangible and ideally should be gold or silver.

Mr. Armstrong’s reply is worth reading in full. After giving us an abbreviated history of money through the ages, he sums up as follows:

“Paper money is the medium of exchange between two people where one offers a service or something they manufactured, which is no different than a gold or silver coin requiring CONFIDENCE and an agreed value at that moment of exchange. You can no more eat paper money to survive than you can gold or silver. All require CONFIDENCE of a third party accepting it in exchange. For the medium of exchange to be truly TANGIBLE it must have a practical utilitarian value and that historically is the distinction of a barter system vs. post-Bronze Age REPRESENTATIVE/INTANGIBLE based monetary systems predicated upon CONFIDENCE.”

I agree with Mr. Armstrong’s central point. Many gold advocates assert that gold is “real wealth” and has intrinsic value, which is patently wrong. Value is subjective and will change based on circumstances. For example, you might place a high value on gold in your current circumstances, but if you were stranded alone on an island with no hope of rescue then gold would probably have no value to you. Gold has exactly the same intrinsic value as a Federal Reserve note: zero.

However, he is very wrong when he states: “…it does not matter whatever the medium of exchange might be.” On the contrary, it matters more than almost anything in economics!

The problem with today’s monetary system isn’t that the general medium of exchange (money) has no intrinsic value. As noted above, money also had no intrinsic value when it was gold. The problem with today’s monetary system is that an unholy alliance of banks and government has near-total control of money. Banks have the power to create new money at whim, as does the government via the central bank.

Aside from the comparatively minor problem of causing the purchasing power of money to erode over time, the creation of money out of nothing by commercial banks and central banks distorts the relative-price signals that guide investment. This happens because the money enters the economy in a non-uniform way. In the US over the past several years, for example, most new money entered the economy via Primary Dealers who used it to purchase financial assets from other large speculators. The stock and bond markets were therefore the first and biggest beneficiaries of the new money, which led to an abnormally-large proportion of investment being directed towards strategies designed to profit from rising equity prices and low/falling interest rates. Such investment generally doesn’t add anything to the productive capacity of the economy. In fact, it often results in capital consumption.

Instead of saying “it does not matter whatever the medium of exchange might be”, what Mr. Armstrong should have said was: it does not matter whatever the medium of exchange might be, as long as it is chosen by the free market. Putting it another way, the government should stay out of the money business.

Here’s the wrong way to think about gold supply: “Although gold’s aboveground inventory is huge compared to current production, only a tiny fraction of this gold will usually be available for sale near the current price. Therefore, changes in mine supply can be important influences on the gold price.” I’ll now explain the right way to think about gold supply.

Whenever I point out that the supply side of the gold market consists of the entire aboveground gold inventory, which is probably somewhere between 150K tonnes and 200K tonnes, and that the gold-mining industry does no more than add about 1.5%/year to this inventory, an objection I often get is that only a tiny fraction of the aboveground inventory is available for sale at any time. This is of course true, and nobody who has a correct understanding of gold supply has ever claimed otherwise.

If all, or even most, of the aboveground supply were for sale at the current price then the price would not be able to rise. The price can rise and fall by substantial amounts, however, because there is always a huge range of prices at which the owners of the aboveground supply are prepared to sell. Moreover, this range is constantly changing based on changing personal circumstances and assessments of the market. In addition, some holders of existing aboveground gold will be planning to hold forever. These plans, which are themselves subject to change in response to changing circumstances, also factor into the formation of the gold price, in that a decision to withhold X ounces of supply can have a similar effect to a decision to buy X ounces.

As I write, gold is trading in the $1120s. It is therefore certain that a tiny fraction of the aboveground supply is currently changing hands in the $1120s and that there are plans in place to sell other tiny fractions in the $1130s, the $1140s, the $1150s, and all the way up to some extremely high number. Some people will also have plans to sell gold if the gold price falls below a particular level and there will be millions of people who have no specific selling intentions who will decide to sell in the future for some currently unforeseeable reason. At the same time there will be countless plans in place to buy at certain levels and millions of people with no present intention to buy who will, for reasons that aren’t currently foreseeable, decide to buy in the future.

It is the combination of these myriad plans that determines the price. Furthermore and as mentioned above, over the days ahead many of these plans will change. For example, some gold-buying/selling intentions will change based on what happens to the stock market or the bond market.

How does the gold-mining industry fit into the situation?

The gold-mining industry is not materially different from any other seller except that its plans are not price sensitive. Specifically, every year it will sell an amount that’s equivalent to about 1.5% of the total aboveground supply regardless of price. At this time four years ago it was selling gold in the $1800s and it is now selling roughly the same amount of gold in the $1100s. It is the ultimate price-taker. To put it another way: whatever price arises from the changing plans of gold owners and potential owners, that’s the price at which gold producers will sell.

On a related matter, due to the huge existing aboveground supply of gold there should never be a genuine shortage of physical gold. Obtaining more gold should always be solely a question price. A consequence is that the gold market should never go into “backwardation”, that is, the spot gold price should always be lower than the price for future delivery. Just to be clear: in an abundantly-supplied commodity market the futures price should be higher than the spot price by enough to eliminate the risk-free profit that could otherwise be had by selling the physical and buying the futures. That’s why it would be very significant if the gold market were to make a sustained and sizeable move into backwardation. Such a development would indicate that holders of the aboveground supply were withdrawing their gold from the market en masse and/or that the gold futures market was breaking down due a collapse in trust. Even the small and brief backwardations of the past two years have some significance*, although recent gold backwardation episodes have more to do with near-zero short-term US$ interest rates than gold supply/demand. The point is that gold backwardation is only important because the existing aboveground supply in saleable form dwarfs the rate of annual production.

In summary, the price of gold is where it is because of the range of prices at which existing holders intend to become sellers and the concurrent range of prices at which potential future holders intend to become buyers. These ranges are constantly in flux due to changing perceptions and circumstances.

*Keith Weiner has written extensively about the significance of gold backwardation at https://monetary-metals.com/.

Here is an excerpt from a commentary posted at TSI on 30th August:

During bull-market years and bear-market years, it is not uncommon for the US stock market to experience a quick decline of 10% or more at some point. For example, there was at least one quick decline of 10% or more in 1994, 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2007, 2008, 2009, 2010, 2011 and 2012. In other words, 15 out of the 19 years from 1994 to 2012, inclusive, had quick declines of 10% or more. Only two of these years (2001 and 2008) had declines that could reasonably be called crashes.

The periods from mid-2003 through to early-2007 and late-2012 through to mid-2015 were unusual because they did NOT contain any quick 10%+ declines. In other words, the 12.5% decline in the S&P500 Index (SPX) from its July peak to last Monday’s low was not extraordinary in an historical context, it only seemed extraordinary because the market had gone an unusually long time without experiencing such a decline. That is, it only seemed extraordinary due to “recency bias” (the tendency to think that trends and patterns we observe in the recent past will continue in the future). Furthermore and as noted in the email sent to subscribers late last week, this year’s July-August decline was significantly smaller than the July-August decline that formed part of a bull-market correction in 2011.

In summary, what happened over the past few weeks was not a crash by any reasonable definition of the word and was only extraordinary in the context of the unusually long period of low volatility that preceded it.

That being said, the recent market action could well have longer-term significance. Just as the sudden increase in volatility in 2007 following a multi-year period of exceptionally-low volatility marked the end of a cyclical bull market, the sudden increase in volatility over the past few weeks could be marking the end of a cyclical bull market. In fact, there is a better-than-even-money chance that this is the case.

Also, while the recent quick decline doesn’t meet a reasonable definition of a stock-market crash, it could be part of a developing crash pattern. Recall from previous TSI commentaries that a US stock-market crash pattern involves an initial sharp decline in the 7%-15% range (step 1) followed by a rebound that retraces at least 50% of the initial decline (step 2) and then a drop back to support defined by the low of the initial decline (step 3). A breach of support can then result in a crash. Step 1 of a potential crash pattern is complete and step 2 is now very close to being complete. Note, however, that even if steps 2 and 3 are completed over the next couple of weeks the probability of a crash will still be low, albeit much higher than it was a few weeks ago.

After China’s government announced a small reduction in the Yuan’s foreign exchange (FX) value early last month, US Presidential aspirant Donald Trump immediately leapt onto the nearest available podium and exclaimed:

“They [the Chinese] continuously cut their currency. They devalue their currency. And I have been saying this for years. They have been doing this for years. This isn’t just starting. This was the largest devaluation they have had in two decades. They make it impossible for our businesses, our companies to compete. They think we’re run by a bunch of idiots. And what’s going on with China is unbelievable, the largest devaluation in two decades. It’s honestly…a disgrace.”

The fact is that even after its recent “devaluation”, relative to the US$ the Yuan is up by 8% over the past 5 years and 30% over the past 10 years. Here’s a chart showing the performance (a rising line on this chart indicates a strengthening of the Yuan relative to the US$). Take a look at this chart and then re-read the above Trump comments.

Is Trump really that poorly informed about what’s going on? Perhaps, but probably not. It’s clear that Trump has become the consummate populist — someone who is willing to say anything that he thinks will strike a chord with a large mass of voters, even if he knows that what he is saying is complete nonsense.

In the case of China’s so-called devaluation, however, it isn’t just bombastic billionaires with a lust for political power who have misrepresented the situation. Anyone who has claimed that the Yuan’s devaluation was primarily about boosting exports has a poor understanding.

The reality is that the Yuan is very over-valued and has begun to fall under the weight of this over-valuation. Furthermore, rather than deliberately devaluing the Yuan, as part of its effort to maintain the semblance of stability China’s government has actually been trying to prevent the Yuan from devaluing. This can be deduced from the fact that China’s government has been selling-down its FX reserves (selling reserve-currency (mostly US$) assets and buying the Yuan puts upward pressure on the Yuan’s relative value). However, trying to prop-up the exchange rate via the selling of FX reserves and the simultaneous buying of the local currency is a form of monetary tightening, which, according to the fatally-flawed Keynesian theories that guide policymakers the world over, is the last thing that China’s economy needs right now.

Faced with the choice of keeping the Yuan’s FX value at an unrealistically high level via a form of monetary tightening or allowing the currency to start falling under the weight of its own over-valuation, China’s policymakers opted for the latter. Actually, they didn’t have much of a choice.