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What Could Happen With Gold if the Dollar Collapses?

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Here are the assumptions, the chart, and the math.

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On numerous occasions, my firm has gone back in our commentaries to the year 1971 and US President Richard Nixon's decision to cut off the ties between the greenback and gold. Today, we revisit the topic once more and check what kind of implications it has for the price of the yellow metal.

Prior to 1971, the most prominent world currencies had been regulated by the Bretton Woods system. Under this agreement, the US agreed to link the dollar to gold. This meant that any amount of dollars handed over by a foreign government or central bank would be exchanged for gold at $35 per ounce. Such an arrangement had a particularly important consequence for money creation. Namely, the US government shouldn't issue more paper money than it had physical gold to back this money up. In practice, it was rather improbable that all the dollars would have to be exchanged for gold at once, so the US government in fact issued more money than it could have paid for with gold, but the main restriction was in place: Debt numbers couldn't be inflated to unsustainable levels.

When the Bretton Woods system was introduced in 1944, the relation of US debt to the official Treasury gold reserves stood at $319.90 per ounce of gold. This meant that there was $319.90 of borrowed money for every ounce of gold the US had. With the price of gold at $35, a quick calculation shows that the US gold reserves could have paid for about 10.9% of its debt. At first, it might seem that there was a lot of debt compared to gold assets. On the other hand, however, such a ratio was similar to reserves required from commercial banks by the regulator. In a way, the US operated like a bank (with a lot of differences, of course).

By 1970, partly due to the Vietnam War, the US began running consistent deficits. The government printed more dollars to meet its obligations and the amount of debt per ounce of gold surged to $1,172.56. The coverage of debt in gold went down to 3.1%. The ability of the US to keep up to the promise to exchange dollars for gold was put into question. Nixon, fearing a situation in which foreign central banks would make a collective bank run on Fort Knox, decided to cease to exchange the dollar for gold and directly break the Bretton Woods agreement.

From that moment on, the dollar has been a fiat currency, which means it is a currency not backed by a physical asset, just by a promise of the government to accept payments (taxes) in it. But, as we've just seen, promises can be broken and right now the ability of the US to pay its debts off in the future is also being put into question. To see why, take a look at the chart below.



Since 1970, US debt has gone up from $370.9 billion to $16.1595 trillion , which is a more than 41-fold increase. Since 2000, gold has appreciated along with the ever sharper increase in debt. A similar chart was discussed in our commentary on gold as insurance.

Our next chart shows the rates of change (ROC) of both the US debt and the average annual price of gold between 1920 and 2012.



The annual ROC of US debt was in a general downtrend in the 1983-2000 period, which was accompanied by poor performance of gold. Since 2000, the ROC of US debt has been increasing again, which means that debt has been growing increasingly rapidly. This coincided with gold's extraordinary performance during the last 10 years.

The US Federal Reserve, led by Ben Bernanke, initiated three substantial rounds of what it calls quantitative easing (QE). In short, QE is a process in which the Fed buys government bonds and other assets from secondary markets with newly created dollars. Its (official) purpose is not to finance government deficits but rather to bring the US economy back on the growth trajectory. Nonetheless, the effects of QE can be compared to those of printing enormous amounts of money. Just to give you an idea of how much debt the consecutive rounds of QE have so far created (approximate amounts):
  • QE1 (November 2008 – March 2010): $1.65 trillion
  • QE2 (November 2010 – June 2011): $600 billion
  • QE3 (September 2012 – ?): $40 billion per month.
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No positions in stocks mentioned.
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