Guest Post: The Rise And Fall Of US Confidence, Or Why The Fair Value Of Gold In Phase Space Is $6,000-$12,000

Submitted by The World Complex

The Rise And Fall Of US Confidence

Today we look at a graph of confidence in the US system. The US confidence ratio represents the ratio of outstanding US Federal debt to the dollar value of US gold holdings (as reported*). No corrections for inflation should be necessary, as both terms are valued in the same depreciating dollars. We use the term confidence as the ability of the US to stretch this ratio to (by our thinking) absurd multiples was a reflection of the world's confidence in the United States--which differs from the ability to actually repay debts.

For post-1971 I used the assumed holdings of 250 million ounces multiplied by the average annual price (from Kitco). There are those who suggest the true holdings are substantially less than 250 million ounces. That may be so, but the picture is already bad enough if we accept the official numbers.

Confidence level sank throughout the Depression up until the beginning of WWII, after which ascendant American power was reflected in a climbing confidence ratio up to the oil crisis in the early 1970s. Confidence sank as the US withdrew from Viet Nam and inflation rose until the price of gold rose sufficiently to restore confidence in American solvency.

From 1980 to 2001 was a golden age for the US. In this time, both stock and bond markets were strong, the US currency was strong, and the only credible opposition to US hegemony disintegrated. But every bubble meets its pin, and ever since the planes hit the towers, the US power and prestige has gone into decline. This decline is marked by a rapid decline in the confidence index. How low will it go?

There is a provocative looking left shoulder and head, suggesting a drop to the neckline somewhere around 2020, after which there may be something of a resurgence in American confidence. The anticipated completion of the bankruptcy head-and-shoulders formation promises to be a hair-raising event.

Actually, though, what appears to be happening is the blowing of bubbles. A bubble is blown, but can only expand so far before confidence fails and the bubble deflates. Then another, in this case larger, bubble is blown. If the bubble is able to deflate without society collapsing, perhaps it will be possible to blow another. Or perhaps we will be wise enough to act in ways that prevent the bubble from being blown in the first place.

At the World Complex we are of the opinion that bubbles are bad--but we recognize they can be a lot of fun. Sort of like going on a bender. The US has been on a bender since 1980. Soon the weekend will be over and it will have to be back at work. Although the new boss may be of the Asian persuasion.

For the bubble to deflate, the debt must disappear, or the gold price must rise. Assuming no change in debt levels, the gold price would have to rise about ten-fold for the confidence ratio to fall to historical values. Unfortunately, a considerable rise in US debt appears to be baked into the cake at this point, so we would foresee gold to eventually reach breathtaking prices.

The 2-d reconstructed phase space of the confidence ratio appears below:

On this chart we don't dare suggest anything other than a fall towards the origin of the graph. If the ratio falls to 10, then gold has to rise to about $6,000 per ounce at today's level of debt. If the ratio falls to 5 (the last low in 1980), then gold would have to be about $12,000 per ounce (again, only at the present debt level). The numbers could be quite astronomical once the deficits in Medicare and Social Security start being realized.

Comments

[Demandrel]

Regardless of your opinion on the price of gold in the future, this analysis is ridiculous if you consider the implied cause and effect.  In order to back the amount of debt held by the US government, they are arguing that the price of gold has to rise.

Can we translate this theory into something that's a bit easier to understand?  Well, we could look at the US like a traditional borrower.  We are then looking at the ratio of debt to the fair market value of the immediately realizable assets of the borrower.  It's not surprising, as a result, that as the cashflow of the borrower improved over time, the amount of debt supported by the cashflow of the borrower, rather than supported by the realizable assets of the borrower, also increased over time.

Now, the analysis essentially says that the ratio should return to a historical level.  And this should happen, it argues, because the fair market value of the underlying realizable assets should increase.  Does this make sense at all?  If the cashflow of the borrower is questionable, then the supportable debt should decline (so perhaps the FMV of the debt would decline to a level that is reasonable if repayment became questionable), but there is absolutely no reason to argue that the underlying realizable assets should increase in price.  

You can argue that the price of gold should increase because of inflation and the devaluation of the dollar.  Fair enough.  And you could perhaps argue that massive growth in US debt could cause excess inflation if that debt was supported by excessively accomodative monetary policy.  But there is no reason to argue that the price of the underlying realizable asset should increase to a level that supports the debt.  That does not make any sense.  No one is going to bid up gold to a price that makes the US solvent.  They may bid down US debt to a price that makes the US solvent based on the fair market value of realizable assets, or some multiple thereof, but they are not going to bid up the price of the underlying asset to that level.  

[mickeyman]

Your point is good, but what you are overlooking is that the US dollar is like a share in the US economy. As the economy of the US weakens, what may get bid down is the dollar. The rising US dollar gold price then reflects bidding down the dollar, not bidding up the gold.

[Demandrel]

The US dollar should fall as a result of inflation in the United States (long-term currency movements should reflect a move towards purchasing-power-parity).  So yes, you are right that the price of gold, in US dollars, could increase as a result of devaluation, but that is not really a direct cause and effect witht he amount of debt held by the US, but rather, as I said, an issue of inflation.  

[jmcadg]

Mike Maloney reckons if gold stocks were to replace physical currencies right now gold would need to be $203,000/oz

[gdgenius]

Estimated M3: $15T

World supply of gold (above ground, in ounces): ~4B

$15T / 4B = ~$3600/Oz.

[Financial Newbie]

"If the ratio falls to 10, then gold has to rise to about $6,000 per ounce at today's level of debt"

What if debt is destroyed (i.e. default)?
Wouldn't a reduction of debt mean a lower price (than the stated $6k per ounce) of gold, as fewer dollars would exist in the system and thus fewer dollars would be chasing gold?

I guess I'm just a crazy deflationist :|
- FN

[mickeyman]

You are correct--but it is difficult to forecast a price in such an event.

TPTB seem to want to avoid this--whether they can or not still needs to be seen.

When I say in the article that I am assuming everything holds together--that assumption is probably more likely through a gradual change rather than sudden change, which I think sovereign default would be.

[shacai]

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