Economic Relationships

# Follow Up To Question of Gold Being Overvalued

In your Nov. 19, 2010 Chart In Focus article about gold versus the dollar, you focused only on the dollar.  What about gold’s relationship to the other currencies?  Maybe the supply of all currencies around the world should be added and compared to the quantity of gold.

This is a good question, I'd like to offer a ridiculous oversimplification which will hopefully be nevertheless enlightening.

Imagine a world where all of the people die of some unknown disease, but somehow an airplane with 200 people crashes safely on an island in the South Pacific.  The 200 people are all adults, with an amazingly serendipitous 100 men and 100 women.  In order to set about repopulating the planet in an orderly fashion, the leaders of the survivors decree monogamy.  In economic terms the leaders have established a fixed exchange rate, 1 man for 1 woman.  No problem so far.

Now suppose that among the planeload of survivors is a genetics expert, who sets up his own lab and starts cloning only women.  Let's call him "Gene" Bernanke.  Before long, there are now 100 men and 200 women on the island.  With this new reality, thanks to "Gene's" work, the 1 man to 1 woman exchange rate just will not work any more.  The new "exchange rate" is 1 man for 2 women.  Sorry ladies, I'm telling this story, so I get to skew the numbers as I wish.

Now imagine that one of the men on the island is observed to have collected 10 wives instead of the 2 wives that the math would seem to dictate.  We might say that this man is "overvalued".  If coupling made sense, then the "husband to wives" exchange rate would equal the men to women ratio.  So if you see episodes when the ratio becomes skewed compared to the baseline, you can make conclusions about what that might mean for adjustments in the future.

The actual Bernanke made a similar point, using an alchemist instead of a gene splicer, in his famous "Helicopter Ben" speech.

The reader asks about gold versus all of the currencies instead of just gold versus the dollar.  But gold is a currency just like any other.  So comparing gold's exchange rate in dollars to what it has been in the past should not be any different than comparing the total number of dollars in existence to the total number of euros, or sheckels, or simoleans, or any other measure.

Suppose that the dollar and the euro were at parity at some point.  \$100 equals 100 euros.  Now suppose that the Fed prints a bunch of dollars, doubling the number of dollars in circulation, but the ECB keeps the number of euros constant.  Logically, the exchange rate should go from 1:1 to 2:1.  If there are twice as many dollars as before, but the same number of euros, then the "value" of the dollar should be cut in half.  But if we notice that the market does not make that adjustment to a 2:1 exchange rate, then there is a mismatch which we can perhaps use to our advantage.  There may be a condition of the dollar being either overvalued or undervalued versus the euro if it does not adjust to that exact 2:1 ratio.  The reason for the mismatch does not matter,  What matters is the math, and the presumption that the market will eventually adjust to where it needs to go to get into equilibrium again.

It is true that an investor somewhere in the world has the choice of holding his own currency, holding some dollars, or holding some gold (which is the same as another currency).  What this investor decides to do will affect the exchange rates.  If gold were stable and the dollar were stable, but simoleans were suddenly devalued, the investors would adjust the exchange rates of both dollars to simoleans and simoleans to ounces of gold.  For somebody who only cares about dollars and gold, the actions of the central bank of Simolea don't matter.

Wow!  I've got plane crashes, disease, genetic manipulation, polygamy, and fictitious countries all woven into one explanation.  Talk about putting one's metaphors into the Osterizer and pressing the "puree" button.  Hopefully the explanation will help with understanding of the point.  My math shows that gold is overvalued compared to the precise expansion of the money supply, adjusted for expansion of the gold supply.  That does not necessarily mean that the market has to adjust immediately to correct this overvaluation condition.