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    Thursday, June 1

    The Hierarchy of Money: How the War between Russia and Ukraine, Inflation, and Systemic Risks are Driving the Price of Gold to $8,000+

    Gold is the ultimate money and is superior to fiat money, according to Professor of International Political Economy Perry Mehrling. Mehrling visualizes a hierarchy of money as a pyramid with gold at the top, followed by national currencies issued by central banks, bank deposits, and securities at the bottom. The pyramid’s base can be easily widened as everything beneath gold can be created out of thin air. Throughout the business cycle, balance sheets are extended, causing an economic boom, and contracted during recessions. Gold is a better form of money in contraction than credit.

    The pyramid is out of shape due to a massive increase in supply of fiat money, credit, and securities after severing the gold standard in 1971. The global debt to GDP is near an all-time high established in 2020, and policy makers cannot allow the debt to default because it could risk the stability of the entire financial system, which has grown too big and intertwined. The only way to restore the shape of the pyramid is by increasing the price of gold.

    The current decline of the equity market capitalization, relative to GDP, signals a new gold bull market. The relationship between national currencies and gold is examined to get a sense of where the price of gold is headed. Central banks have created so much “money” since 2008 that the relation with bank deposits has weakened. Measuring the value of official gold reserves versus the monetary base may not predict the future price of gold. Instead, we will evaluate how much gold central banks are willing to hold relative to foreign national currencies, which underpin their balance sheets.

    Central banks have an unusual faith in foreign exchange, as gold’s percentage of total reserves accounted for 16% in 2022 against a historical average of 59%. However, these central banks are starting to lose confidence in the currencies issued by their peers. In 2022, official gold reserves went up by a record 1,136 tonnes, while foreign exchange reserves went down by a record $950 billion. Large purchases by central banks on all continents in recent years indicate how central banks think the system will stabilize by a rising gold price, confirming they have no intention of designing a new pyramid.

    In light of the war between Russia and Ukraine, inflation, and systemic risks, the trend of gold increasing its share of total reserves is logical. Should gold make up a conservative 51% of global international reserves, the price of gold would need to be $10,000 per troy ounce. In the process of raising the gold price, central banks would increase the weight of their gold and sell foreign exchange, resulting in a lower price of gold required to make up the majority of total reserves. Over time, central bank balance sheets grow, and so does their demand for international reserves, possibly revaluing gold in urgency.

    Central banks are used as a proxy for the entire economy. The private sector is in a similar boat as central banks, as they have little exposure to gold versus credit assets. It is not just central banks that will drive up the price. A ballpark figure of $8,000 per ounce would make gold’s share of total reserves exceed 50%. Throughout the ages, the price of gold always rises as the amount of physical metal available is insufficient to meet mankind’s liquidity needs. National currencies devalue against gold to increase.

    Throughout history, gold has proven to be a valuable commodity, with its price increasing over time due to a limited supply unable to keep up with liquidity demands. It is a well-known fact that national currencies are prone to devaluation against gold in order to increase liquidity.

    Traditionally, coins were debased by lowering their bullion content, which resulted in an increase in the number of units of national currency. Since the gold standard was abandoned in 1971, fiat money can be created with ease, allowing for increased growth and economic stability. However, this practice can lead to inflation and systemic risk, ultimately resulting in the need for the price of gold to rise in order to reset the economic pyramid.

    Given the current global environment of war, inflation, and systemic risk, it is likely that the gold price will adjust in the near future. This will provide a unique opportunity for investors to capitalize on the current economic climate and potentially benefit from a rise in the value of gold. As always, it is essential to approach any investment decision with caution and to seek professional financial advice before making any major investment decisions.

    Top points:

    • There is a hierarchy of money, with gold being the ultimate money, followed by national currencies, deposits, and securities.
    • The massive increase in supply of fiat money, credit, and securities has made the pyramid out of shape, with a tiny tip and a fat debt belly.
    • To restore the shape of the pyramid, there needs to be an increase in the price of gold, as policymakers won’t allow the debt to default, risking the stability of the global financial system.
    • Central banks have an unusual faith in foreign exchange, but they are starting to lose confidence in currencies issued by their peers. In 2022, official gold reserves went up by a record 1,136 tonnes, while foreign exchange reserves went down by a record $950 billion.
    • The trend of gold increasing its share of total reserves is logical due to the war, inflation, and systemic risks. Should we assume gold to make up a conservative 51% of global international reserves, the price of gold would need to be $10,000 per troy ounce. A ballpark figure of $8,000 per ounce would make gold’s share of total reserves exceed 50%.

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