Monday, June 09, 2008

Money Unmoored by Gold

A stockbroker friend of mine sent me this chart showing the ratio between the Dow Jones Industrial Average (and its equivalent predecessor index) and the price of gold. Notice the greater amplitude of variation in this ratio after Congress established the Federal Reserve Bank in 1913 and severed the connection between gold and money. After 1913, money could be created in arbitrary fashion by the Federal Reserve Bank. Further sundering the connection between gold and money in the 1930s, FDR's New Deal Congress outlawed the private ownership of gold, and clauses in private contracts that called for payment in gold. Finally, Richard Nixon's Congress severed the last vestige of the gold standard in the late 1960s and early 1970s by suspending the U.S. government's promise to pay in gold to settle international claims.

These moves to unmoor the dollar from gold coincided with the stock market swinging to higher highs and lower lows relative to gold. I interpret the chart as showing the effect of monetary inflation in the 1920s, 1960s, and 1990s, and then the impact of recession/Depression in the 1930s and price inflation combined with recession in the 1970s.

When the stock market was relatively high and gold low, in the 1920s, 1960s, and 1990s, the economy genuinely boomed, but that boom was artificially enhanced by easy money. That is why the ratio soared to higher highs than existed in the pre-1913 gold standard era. The result of that monetary inflation was an economic bust, as the dislocations caused by that monetary inflation harmed the economy. Inevitably, the excess money showed up in price inflation, especially evident during the 1970s "stagflation" when both recession and inflation cursed the nation.

Does this chart tell us anything about the future? The author of the chart would have us believe that we are headed for a 1930s or 1970s style economic catastrophe, as shown by the "Target Zone" marked on the chart. Certainly, the precursors for such a catastrophe have been established, and we are seeing the first signs of economic malaise of the 1970s variety. We had monetary inflation in the 1990s and 2000s, which is now manifesting itself in price inflation and incipient recession.

What is your interpretation of the historical meaning of the graph? What do the highs and lows of the various eras mean? Do you agree with my interpretation? What is your thought of the future? Are we headed to a low Dow/high gold ratio that we last saw in the 1930s and 1970s, or will such an economic disaster be averted? In other words, will our economy muddle along for awhile, or must we endure a true economic disaster before the economy improves?

I will offer my opinion later in the comments section.


Burgess Laughlin said...

As a layman (and not a chart-follower), I would wonder: How did the author of the graph determine the "Target Zone"?

There was a 50-year gap between the two previous lows. Why wouldn't the new low, if that is what is being discussed here, be centered around 2030?

Are there other factors involved?

Galileo Blogs said...


The "target zone" that the chart author superimposes cannot be derived from the movements of the lines themselves. You are correct that the future low could just as easily be in 2030 as it could in 2009.

Also, why should the next low be *so* low? It could stop midway as it did in the 1930s. Why should the next low be even lower than it was in the late 1970s?

What is the correct way to forecast the next low or high? That requires identifying the factors that give rise to the movements of the lines in the chart. For example, we know that in the 1920s, government inflated the money supply. In the late 1920s, government also imposed a tough tariff and egregiously raised taxes; these actions led to an economic collapse. During that collapse, government also abandoned the gold standard and unleashed a regulatory assault on business.

"Fast forward" to the 1960s and government again inflated the money supply. Note that the Dow/gold ratio was high in both the 1920s and 1960s. But the 1970s were somewhat different than the 1930s. Both periods had monetary inflation and severe economic malaise, but the 1970s also had the most intense period of price inflation in our history. The presence of that inflation drove the price of gold to unprecedented highs; therefore, the Dow/gold ratio was at its lowest point in the late 1970s.

Fast forward to the present era: In the 1990s and 2000s under the Greenspan Fed, we had significant monetary inflation. Again, the ratio moved to the high side, as it did in earlier "boom" periods. In the past few years, we have begun moving down the scale.

The question becomes, not what do the lines tell us in themselves, but what fundamental factors are in play today that will change the Dow/gold ratio? Like the 1930s and 1970s, we have monetary inflation. We have burgeoning price inflation like the 1970s. Like the 1930s (and I believe the 1970s), we are facing large tax increases when Bush's capital gains, dividend, and inheritance tax cuts expire in a couple years.

Where does all of that leave us? Part of the answer depends on what happens to Bush's tax cuts. If they are allowed to expire, a 1930s or 1970s scenario becomes more likely. If the tax cuts are preserved, and if government spending can be controlled, then there is no reason why the Dow/gold ratio cannot bottom at a level no lower than it is today or even higher. In other words, there is nothing inevitable about the future price trend of the Dow Jones Industrial Average or the price of gold.

Anyone who blindly expects patterns to repeat themselves or simplistically extrapolates trends is likely to lose a lot of money as an investor, or reach wrong conclusions as an economic forecaster.

Instead, he must look at what fundamental factors give rise to the particular phenomenon being studied and then assess its likelihood of occurring in the future.

In sum, the chart illustrates that good government policies that protect property rights, including a gold standard, fosters economic stability. The increasing rate of abandonment of those standards, including but not limited to the abandonment of gold and formation of the Federal Reserve Bank in 1913, have made our economy more unstable. Evidencing this instability is the growing amplitude of variation in the ratio of the Dow Jones Industrial Average and gold.

Paula Hall said...

This is a verrryyyy interesting chart, thanks for posting it.

Galileo Blogs said...

Anytime, Paula.