To believe that the gold market is influenced by the manipulation of a banking cartel to the extent that the gold price doesn’t reflect the true fundamental drivers it is necessary to have almost no understanding of what those price drivers are and how they should affect the market. There are many fundamental relationships between gold and other markets that I could show in chart form to support this statement, but in this post I’ll focus on a chart that illustrates the relationship between gold, commodities and economic confidence.

The change in the average credit spread, that is, the change in the average difference between yields on relatively high-risk and relatively low-risk bonds, is a good indicator of changes in economic confidence. Specifically, when credit spreads are widening it means that confidence is on the decline and when credit spreads are narrowing it means that confidence is on the rise.

Fortunately, there are a number of easy and accurate ways of determining whether credit spreads are widening or narrowing. One that I like to use is the IEF/HYG ratio. This ratio is the price of an ETF that holds 7-10 year Treasury securities divided by the price of an ETF that holds junk bonds of similar duration. A rising IEF/HYG ratio indicates widening credit spreads (falling economic confidence) and a falling IEF/HYG ratio indicates narrowing credit spreads (rising economic confidence).

Those who understand gold’s role in the financial world would know that the gold price should generally trend upward relative to the prices of most other commodities (as represented by a broad-based commodity index such as GNX) when economic confidence is on the decline and trend downward relative to the prices of most other commodities when economic confidence is on the rise. Absent manipulative forces that prevent gold from behaving in the proper way, what we should therefore see is a positive correlation between the gold/commodity ratio and the IEF/HYG ratio. This is exactly what we do see in the following chart.

All markets are, always have been and always will be manipulated, but this generally doesn’t prevent them from responding in a reasonable way to the genuine fundamentals over multi-month periods.

Most people with a basic grounding in economics know that increasing the supply of money leads to a fall in the purchasing power of money. However, this is usually as far as their understanding goes and explains why monetary inflation is generally not unpopular unless the cost of living happens to be rising rapidly. Monetary inflation would be far more unpopular if its other effects were widely understood.

Here are some of these other effects:

1. A greater wealth gap between rich and poor. For example, monetary inflation is probably a large part of the reason that the percentage of US household wealth owned by the richest 0.1% of Americans has risen from 7% to 23% since the mid-1970s and is now, for the first time since the late-1930s, greater than the percentage US household wealth owned by the bottom 90%. Inflation works this way because asset prices usually respond more quickly than the price of labour to increases in the money supply, and because the richer you are the better-positioned you will generally be to protect yourself from, or profit from, rising prices.

2. Large multi-year swings in the economy (a boom/bust cycle), with the net result over the entire cycle being sub-par economic progress due to the wealth that ends up being consumed during the boom phase.

3. Reduced competitiveness of industry within economies with relatively high monetary inflation rates, due to the combination of rising material costs and distorted price signals. The distortion of price signals caused by monetary inflation is very important because these signals tell the market what/how-much to produce and what to invest in, meaning that there will be a lot of misdirected investment and inefficient use of resources if the signals are misleading.

4. Higher unemployment (an eventual knock-on effect of the misdirection of investment mentioned above).

5. A decline or stagnation in real wages over the course of the inflation-generated boom/bust cycle. I point out, for example, that real median household income in the US was about the same in 2015 as it was in 1998 and that the median weekly real earnings level in the US was about the same in Q3-2016 as it was in Q1-2002.

Real earnings decline or stagnate because during the boom phase of the cycle wages will usually be near the end of the line when it comes to responding to the additional money, whereas during the bust phase the higher unemployment rate (the excess supply of labour) will put downward pressure on wages.

Note that while a lower average real wage will partially offset the decline in industrial competitiveness resulting from distorted price signals, it won’t result in a net competitive advantage. It should be intuitively obvious — although to the Keynesians it apparently isn’t — that an economy could never achieve a net competitive advantage from what amounts to counterfeiting on a grand scale. In any case, what sort of economist would advocate a course of action that firstly made the economy less efficient and secondly tried to make up for the loss of efficiency by reducing living standards (a reduction in real wages equals a reduction in living standards).

6. More speculating and less saving. The greater the monetary inflation, the less sense it will make to save in the traditional way and the more sense it will make to speculate. This is problematic for two main reasons. First, saving is the foundation of long-term economic progress. Second, most people aren’t adept at financial speculation.

7. Weaker balance sheets, because during the initial stages of monetary inflation — the stages that occur before the cost of living and interest rates begin to surge — people will usually be rewarded for using debt-based leverage.

8. Financial crises. Rampant mal-investment, speculation and debt accumulation are the ingredients of a financial crisis such as the one that occurred during 2007-2009.

The above is a sampling of what happens when central bankers try to ‘help’ the economy by creating money out of nothing.

Governments and central banks have invoked the writings of J.M. Keynes to justify the massive increases in government spending and monetary inflation that have occurred over the past 9 years. However, some of Keynes’s apologists have pointed out that the famous British economist would not have agreed with many of the policy responses for which his work has provided the intellectual justification. They point out, for example, that Keynes only advocated temporary increases in government spending as a means of absorbing shocks to the economy, and that he was dead against currency debasement and the creation of structural deficits. The problem, though, isn’t that Keynes’s theory has been applied to an unreasonable extreme; the problem is that the theory is completely wrong.

For starters, the laws of economics always apply, so if greater government deficit-spending really did act to strengthen the economy during recessions then it would also act to strengthen the economy during the good times. On the other hand, if greater government deficit-spending hurt the economy during the good times then it would also hurt the economy during recessions. The point is that there isn’t one set of laws that applies during periods of growth and another set that applies during periods of contraction.

Secondly, the concept that the government can provide a sustainable boost to the economy by increasing its spending is based on the fallacy that increased consumer spending causes the economy to grow. It causes GDP to increase due to the misleading way the GDP calculation is done, but for an increase in consumer spending to be sustainable it must be an effect of real growth; that is, it must follow an increase in production, which, in turn, must follow an increase in saving. Consumer spending is the caboose, not the engine.

Thirdly and as most people realise, the government usually does things much less efficiently than the private sector. The fact is that government spending tends to involve a lot of wastage. This is not an issue for the true Keynesian because he views an increase in spending as an economic plus even if the spending is totally unproductive, but it should be an issue for a good economist.

Fourthly, the government doesn’t generate any real wealth of its own that can be spent in order to offset what’s happening in the private sector. Instead, everything the government spends must first be borrowed or stolen from the private sector. So, how can the private economy possibly be helped by the government increasing the rate at which it steals and borrows from the private sector?

Fifthly, recessions occur because of the widespread mal-investment prompted by the earlier expansions of the supplies of money and unbacked credit brought about by the central bank and the commercial banks. As a result of this mal-investment, the economy’s structure becomes distorted such that it is geared to produce too much of some things and not enough of others. Unfortunately, the Keynesians mislabel the distortion caused by inflation as an “output gap”, which they then cite as justification for more inflation and more government spending. To further explain, recessions are symptoms of the process via which an economy attempts to rid itself of the distortions caused by prior inflation and intervention. And yet, in its role as “economic shock absorber”, the central-planning team comprising the government and the central bank tries to sustain the distortions. How can this possibly be beneficial?

If an economy is strong enough it should be able to recover DESPITE the application of Keynesian remedies designed to smooth-out the transition to the next expansion, which is why the economy usually recovers. However, the economic structure will necessarily be weakened by each successive increase in government spending and each successive monetary-inflation-fueled boom until, eventually, the economy will be in such a weakened state that it will be unable to bounce back in the face of more Keynesian policies. That’s why the US economy’s recovery from the 2007-2009 recession has been ‘surprisingly’ lacklustre and why Japan’s economy now seems incapable of strong growth.

Hyperinflation* and/or a totalitarian state are the inevitable destinations if Keynes’s theories are relentlessly applied over the long term. The reason is that each round of policy mistakes creates the justification for more mistakes, setting in motion a downward spiral that will be inescapable as long as the perceived solution entails more of the same. The only unknown is how long it will take to reach one or both of these destinations.

*Just to be clear and as explained in a previous blog post, I have never been of the view that hyperinflation is an imminent threat to the US economy. The imminent threat is the continuing erosion of freedom as new interventions by the government are justified by the adverse consequences of earlier interventions.

The price of gold is dominated by investment demand* to such an extent that nothing else matters as far as its price performance is concerned. Investment demand is also the most important driver of silver’s price trend, although in silver’s case industrial demand is also a factor to be reckoned with. In addition, changes in mine supply have some effect on the silver market, because unlike the situation in the gold market the annual supply of newly-mined silver is not trivial relative to the existing aboveground supply of the metal.

Given that the change in annual mine supply is irrelevant to the gold price and is not close to being the most important driver of the silver price, why do some analysts argue that the gold/silver ratio should reflect the relative rarities of the two metals in the ground and therefore be 10:1 or lower? I don’t know, but it isn’t a valid argument.

A second way of using relative rarity to come up with a very low gold/silver ratio is to assert that the price ratio should be based on the comparative amounts of aboveground supply. Depending on how the aboveground supplies are calculated, this method could lead to the conclusion that silver should be more expensive than gold. It would also lead to the conclusion that gold should be the cheapest of all the world’s commonly-traded metals, instead of the most expensive. For example, if gold’s relatively-large aboveground supply was a reason for a relatively low gold price then gold should not only be cheaper than silver, but also cheaper than copper.

Another argument is that the gold/silver ratio should be around 16:1 because that’s what it averaged for hundreds of years prior to the last hundred years. This is also not a valid argument, because changes in technology and the monetary system can cause permanent changes to occur in the relative values of different commodities and different investments. For example, when monetary inflation was constrained by the Gold Standard the stock market’s average dividend yield was always higher than the average yield on the longest-dated bonds, but the 1934-1971 phasing-out of the official link to gold permanently altered this relationship. In a world where commercial and central banks can inflate at will, the stock market will always yield less than the bond market (except when the central-bank leadership goes completely ‘off its rocker’ and implements the manipulation known as NIRP). This is because stocks have some built-in protection against inflation. The point is that the ratio of gold and silver prices during an historical period in which both metals were officially “money” does not tell us what the ratio should be now that neither metal is officially money and one of the markets (silver) has a significant industrial demand component.

The global monetary system’s current configuration dates back to the early 1970s, when the last remaining official link between gold and the US$ was severed. This probably means that we can look at how gold and silver have performed relative to each other since the early 1970s to determine what’s normal and what’s possible. With reference to the following chart, here’s a summary of what happened during this period:

a) The gold/silver ratio spent the bulk of the 1970s in the 30-40 range, but broke out of this range to the downside during the second half of 1979 in response to massive accumulation of silver bullion and silver futures by the Hunt brothers.

b) The ratio dropped as low as 16:1 in January of 1980, but then returned to 40 in the ‘blink of an eye’ as rule changes by the commodity exchange created financial problems for the highly-geared Hunts and a commodity-investment bubble began to deflate.

c) During the second half of the 1980s the ratio trended upward as US financial corporations weakened. The ratio peaked at around 100 at the beginning of 1990s in parallel with a full-blown banking crisis that almost resulted in the collapse of some of the largest US banks.

d) The ratio trended lower throughout the 1990s as the banks recovered (with the help of the Fed) and financial assets trended upward.

e) From the late 1990s through to the beginning of 2011 the ratio oscillated between 45 and 80, with 80 being reached near the peaks of financial crises (early-2003 and late-2008) and 45 being reached in response to generally high levels of economic confidence.

f) In February of 2011 the ratio broke below the bottom of its long-term range and rapidly moved down to around 30. The huge price run-up in silver that led to this large/fast decline in the gold/silver ratio was fueled by the overt bullishness of a high-profile/well-heeled speculator (Eric Sprott) and by various rumours, including rumours of silver shortages and the unwinding of a price-suppression scheme led by JP Morgan. There were no silver shortages and there was no price-suppression scheme to be unwound, but as is often the case in the financial markets the facts didn’t get in the way of a good story.

g) The 2010-2011 parabolic rise in the silver price ended the same way that every similar episode in world history ended — with a price collapse.

h) Silver’s Q2-2011 price collapse set in motion a major, multi-year upward trend in the gold/silver ratio. In this case, the upward trend in the ratio was driven by the deflating of a commodity investment bubble and problems in the European banking industry. The ratio rose all the way to the low-80s and is still at an unusually-high level in the 70s.

The gold/silver ratio’s performance over the past five decades suggests that the 45-60 range can now be considered normal, with moves well beyond the top of this range requiring a banking crisis and/or bursting bubble and moves well beyond the bottom of this range requiring rampant speculation focused on silver.

*In this post I’m lumping speculative, safe-haven and savings-related demand together under the term “investment demand”.