The hierarchy of money and the case for $8000 gold

In the hierarchy of money, gold is superior to fiat money. Historically, recent decades have been characterised by reliance on fiat money, with fiat making up the lion's share of global international reserves. The war between Russia and Ukraine (and by extension West and East), inflation and systemic risks reverse this trend. A long-term gold valuation model, which assumes that gold will make up the bulk of international reserves, suggests that the gold price will exceed $8,000 over the next decade.
 

 
The trend of central banks increasing gold reserves is likely to continue. 
 

The hierarchy of money

Reading Zoltan Pozsar's analyses for a few years, I started reading books and attending lectures by his intellectual mentor Perry Mehrling, professor of international political economy. According to Mehrling, there is a natural hierarchy of money, to be visualised as a pyramid. 
 

Pyramid of the hierarchy of money. 
 
At the top of the pyramid sits the ultimate money, which is scarce, universally accepted and has no counterparty risk because it is nobody's liability: gold. Below gold are national currencies issued by central banks. Then come deposits created by commercial banks. At the bottom are securities, such as bonds and shares.
Since everything below gold can be created out of thin air, the base of the pyramid can easily be widened. Throughout the business cycle, balance sheets (assets and liabilities) expand - credit is created - causing an economic boom. During a recession, balance sheets contract and the shape of the pyramid changes.
Horizontally, the pyramid is all about quantity and leverage. Vertically, the pyramid is about quality: the higher, the better the quality of money.

Mehrling :

In a boom, credit is starting to look like money. Credit forms become much more liquid, they become much more useful to make payments with. And in contraction, you find out that what you have is not money, it is actually credit. In contraction, you find out that gold and currency are not the same thing. That gold is better. You discover that deposits and currency are not the same thing. That currency is better.

 
Now my interpretation...
 

A long-term gold valuation model

What has happened in recent decades, after the gold standard was broken in 1971, is a huge increase in the supply of fiat money, credit and securities. The pyramid is out of shape with a small tip and a fat belly. Global debt to GDP ratio is near its highest point ever in 2020.
Policymakers will not allow debt defaults - a contraction of credit - because the global financial system has become too large and interconnected. One default too many can jeopardise the stability of the entire scheme. The only way to restore the shape of the pyramid is to raise the price of gold.
In an earlier article, we discussed the relationship between the price of gold and equities over the past 100 years. These are dynamics between the top of the pyramid and the bottom. We concluded that the current decline in equity market capitalisation, relative to GDP, signals a new gold bull market.
 

 
In an economic downturn, US equity market capitalisation falls relative to GDP and the dollar is devalued through one of the four money prices (par, interest rates, exchange rates, price level) to stimulate the economy. As a result, the price of dollar-denominated gold rises. 
In today's article, we will use Mehrling's hierarchy of money and examine the relationship between national currencies and gold to get an idea of where the gold price is heading.
Central banks have created so much ‘money’ since 2008 that, from an economic perspective, the relationship with bank deposits has weakened. Measuring the value of official gold reserves versus the monetary base (central bank money) may not be sufficient to predict the future price of gold.
Instead, we will evaluate how much gold central banks are willing to hold relative to foreign national currencies. In other words, the composition of international reserves (foreign exchange and gold), which support their balance sheets. By going through the archives, I was able to come up with a long series of data on gold as a percentage of international reserves from 1880 to the present*.
 

The chart shows the world's official gold reserves as a percentage of official international reserves. 
*For this article, I have excluded special drawing rights, IMF tranche positions and silver from international reserves because of the consistency of the data sets and because they represent only a small proportion of total international reserves. Data from 1880 to 1913 are mainly from Peter Lindert and Timothy Green. Figures include official gold and foreign exchange reserves, not foreign exchange from private banks or gold coins in circulation. Data from the interwar period come from several publications of the League of Nations, the annual reports of the central bank, the World Gold Council and the Federal Reserve. Data since 1950 come from the IMF, the World Gold Council, Metals Focus and the BIS. Data from Robert Triffin are used as a check on my calculations. The numbers from 1880 to 1935 should be considered estimates.
Central banks overall have an unusual level of confidence 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 beginning to lose confidence in the currencies issued by their peers. In 2022, official gold reserves rose by a record 1,136 tonnes, while foreign exchange reserves fell by a record $950 billion. Large purchases by central banks on all continents in recent years indicate how central banks think the system will stabilise, through a rising gold price, confirming that they do not intend to design a new pyramid.
 

Global gold reserves
In light of the war, which caused the US to freeze dollar reserves, inflation and systemic risks from the Russian central bank, the trend of gold increasing its share of total reserves makes sense.
If we continue this trend and assume that gold accounts for a conservative 51% of global international reserves, the price of gold should be $10,000 per troy ounce. Of course, while raising the gold price, central banks increase the weight of their gold and sell foreign exchange, resulting in a lower gold price needed to make up the bulk of total reserves. On the other hand, central banks' balance sheets grow over time and their demand for international reserves also increases, which may lead to an urgent revaluation of gold.
I use central banks as a proxy for the entire economy. The private sector is in a similar boat to central banks: they also have little exposure to gold versus credit assets. It is certainly not just central banks that will drive up the price. Let's say $8,000 per ounce, an average figure, would put gold's share of total reserves above 50%.
 

Click here to view the animated chart! 
 

Conclusion

Over the centuries, the price of gold always rises because the available quantity of physical metal is insufficient to meet humanity's liquidity needs. Devaluing national currencies against gold to increase liquidity is a fact of life.
Previously, coins were depreciated by reducing their precious metal content, resulting in more national currencies. Since the gold standard was abandoned in 1971, fiat money can be created at the push of a button, aimed at stimulating growth or revitalising the base of the pyramid. But the top inevitably follows. The price of gold has to go up to reset the shape of the pyramid. Now - given war, inflation and systemic risks - will be one of those times when the gold price has to adjust.
 

Sources

Bank for International Settlements (BIS), Annual and Monthly Reports.
Banca D’Italia (1987). Gold In the International Financial System.
Bloomfield, A. I. (1963). Short-Term Capital Movements Under the Pre-1914 Gold Standard.
Board of Governors of the Federal Reserve System (1943). Banking and Monetary Statistics 1914-1941. Part 1.
Eichengreen, B. & Flandreau, M. (2009). The rise and fall of the dollar (or when did the dollar replace sterling as the leading reserve currency?)
Green, T. (1999, for the World Gold Council). Central Bank Gold Reserves. An historical perspective since 1845.
International Monetary Fund. International Financial Statistics.
League of Nations, multiple publications.
Lindert, P. H. (1967). Key Currencies and The Gold Exchange Standard, 1900-1913.
Lindert, P. H. (1969). Key Currencies and Gold 1900-1913.
Mehrling, P. (2012). Economics in Money and Banking.
Triffin, R. (1961) Gold and the Dollar Crisis, The Future of Convertibility.
Triffin, R. (1964). The Evolution of the International Monetary System: Historical Reappraisal and Future Perspectives.
World Gold Council, Gold Demand Trends reports and Datahub.
 
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