Gold is a type of money, just like Dollars, Euros, Pounds and Yen. Unlike these other forms of money, gold has been around for thousands of years, while many fiat systems have come and gone. Because the amount of gold in the world cannot be increased without finding and mining more of it, its value is fairly constant. This is in stark contrast to the fiat monies which can be created on command by governments and central banks.
When someone talks about the price of gold in some currency like US Dollars, they are talking about the exchange rate between two currencies – gold and dollars. It makes just as much sense to talk about the price of the dollar in gold as it does to talk about the price of gold in dollars. It all depends on which currency is central to your thinking. For most of my life, I've lived in the United States, and used US Dollars to purchase groceries, keep my accounts, and so on. But when I lived in England, I used Pounds to buy my groceries, and keep my accounts. When building a boat in New Zealand, I had accounts in NZ Dollars, paid for the boat's construction in NZ Dollars and paid bills and expenses in NZ Dollars while visiting there. Same for my visits to Japan, Germany, Mexico, Tahiti, and so on. Still, as I traveled, I always related the value of the local currency back to my "home currency", the US Dollar. "How much is that in dollars?", I would ask myself. When I had the answer, I could assess the price and decide "Wow, cheese is a real bargain!" or "Sheesh! Gasoline is really expensive here!".
But to think of the US Dollar as "the center of the monetary universe" with all other currencies circling around it is silly. When friends of mine from England visit the US, they are doing just the opposite of what I did when visiting them – they are relating all the US Dollar prices they see back to their "home currency", the Pound Sterling.
I have now come to realize that we are all travelers… moving through space around the globe and through time as well. As we move to new places and new times we find people using new forms of local money. Sometimes these moneys have the same name, but very different values. Dollars in the US or New Zealand or Hong Kong or Australia or Zimbabwe do not have the same value as one another. And one US Dollar in 2008 does not have the same value that one US Dollar had in 2003.
Gold is a money that is recognized around the world, throughout all of history, and changes value very gradually over time. To my mind, this makes it the perfect money in which to value all the others. The perfect "home currency" to relate local prices back to, to determine whether things are cheap or dear.
In today's world of "floating exchange rates", the market sets the price of one currency in terms of another. Traders buying Japanese Yen with US Dollars, selling New Zealand Dollars for British Pounds, buying Swiss Francs with Euros, and so on, agree on how much they will pay for each transaction made. These transactions are posted electronically and become the bid and ask prices that guide other buyers and sellers, and are called the "spot prices" of currencies. Traders are also buying and selling currencies for delivery in the future, months or even years from now. The prices they set are based on the spot price, but also figure in estimates of future changes in value due to inflation, interest rates, expected demand and other factors.
Bonds are another form of currency exchange – you will be getting your principal back 2, 5, 10, 20 or more years in the future, and receiving a fixed "rental" (the interest) every so often until then. Although the currency lent and repaid have the same name, they are really two different currencies because of the intervening time. For example you might buy the bond with 2008 US Dollars, receive an interest payment in 2010 US Dollars and finally be repaid the principal in 2018 US Dollars. Although bonds are said to have no "exchange risk", many of the other factors that drive currency futures prices also drive bond prices… especially interest rates and inflation expectations. No one will pay $1000 for a bond earning 3% if a new bond with the same maturity and risk profile can be purchased for $1000 that will pay 12%. And if one expects the money returned at maturity to be worth less than the money being used to buy the bond (due to inflation) then one will insist on a higher interest rate… or pay less up front than will be returned at maturity. If a new issue is priced too high (by setting its interest rate too low) there will be no buyers. So traders also set the price of bonds, which is another way to say that they set interest rates.
Of course, the expected future value of a currency can be higher as well as lower. When people expect their money to buy more in the future, they tend to put off purchases because they expect a better deal to come along later. This activity is called saving. The monetary effect is called deflation, because the amount of money chasing after the goods available is declining, making each unit of money more valuable as time goes by.
As I write this, the "Credit Crisis" and recession being experienced around the world is making the US Dollar more valuable. Banks, hedge funds, traders, investors, governments, home owners (in fact, nearly everyone) have borrowed large sums of money to leverage their investments and increase their rate of return. Although this practice is very profitable in good times, it quickly reverses its effect and multiplies the magnitude of losses when the value of the underlying assets declines. When losses get large enough, they can cause individuals and firms to go bankrupt, leading to still more losses for those who were doing business with them. In attempting to reduce this leverage, and thus reduce the rate of losses, firms and individuals are scrambling to get dollars to repay those loans. They sell whatever they can to raise the money. This selling of assets and buying of dollars pushes the value of the dollar higher with respect to almost everything – stocks, real estate, oil, gasoline, steel, copper, even gold.
In investing, it is common to borrow an asset, like a shares of a stock or a large amount of a commodity like copper or silver, and then sell it, anticipating that the price of the asset will fall, and it can be bought back cheaper in the future when it needs to be returned to the original owner. This is called "short selling". It is legal, and can be quite profitable. It improves functioning of markets by making available commodities that would otherwise site idle in warehouses, and enables more accurate pricing of stocks and commodities.
When a large number of traders have short positions in an asset, and the price of the asset goes up too much, those traders are looking at large losses, and some will decide to exit their positions by buying back the asset they had sold, paying a higher price, and taking the loss. This buying pushes the price even higher, causing more traders to decide to buy back the lent asset, and this can become a vicious circle, shooting the value up much higher than is warranted on fundamentals alone. This is called a "short squeeze". Eventually, the sellers who must get out have completed their buying, and the "gravity" of fundamental value reasserts itself. The asset price that spiked higher so rapidly now falls back, often just as fast or even faster than it rose during the squeeze.
If one thinks of money as a commodity, it makes sense that buying a stock (or a house) using leverage is a form of dollar short selling. Just like the silver trader who borrows silver and sells it for US Dollars is "short silver" (he is also "long the dollar" since he lots of that in his account) a house buyer with a mortgage has borrowed US Dollars and traded them for a house; she is "short the dollar" and "long real estate". The same can be said of stocks bought on margin – the trader is short the dollar and long stocks.
And just like any other commodity, the dollar is subject to short squeezes. When, let's say, stocks begin falling in value and many players in the market are short dollars and long stocks, they will be experiencing losses, and if those losses get large enough, they will need to "cover their short" by selling other assets to buy back the borrowed dollars. Note that this has nothing to do with the fundamentals of the dollar as a currency – how sound it is, how large the trade and current account deficits are, how fast the printing presses are running, nor does it matter how sound the assets they are selling are. The dollar short sellers need to get out NOW, and they will do whatever it takes to get out. It should also be clear that lending them more dollars is not an answer to their problem… they have already borrowed too much. They need to reduce, not increase, the size of their dollar short position.
And like all short squeezes, at some point the players who need to repay their dollars have done so, or have gone bankrupt trying. Now fundamentals reassert themselves, and the "overbought" dollar falls while the "oversold" stocks and commodities rise, each according to it's underlying value. Prices oscillate around for a while until balance is restored and the next cycle can begin.
Of course in the real world, there are many other processes going on at the same time. Uncertainty about true asset values, uncertainty about the soundness of trading partners, outright fraud, changes in production and demand, government and central bank policy changes and so on all play a role in determining the evolution of the overall economy.
How can we tell a dollar short squeeze during an inflationary period from a true deflation?
In both cases, the purchasing power of dollars is increasing, but the psychology is very different. In inflationary times, people look at a falling price and think, "Wow! I better scoop up that bargain now; it probably won't last long." In deflationary times they think, "No point in buying today, I'll wait until I really need it; it will probably be cheaper then."
I just experienced this at the local gas station. US gas prices in dollars have been falling since July, and are now about one half what they were then. In gold, they peaked in September, but have also fallen sharply. As I was driving by the station I saw a new lower price at the pump. My tank was half-full. In a deflationary mind-set, I would have reasoned that as I still had half a tank, I might as well wait for a few days to fill up, since the price would probably be lower than it is now, and by hanging on to the money I would be earning interest on it and gaining value. But that was not my reasoning… my reaction was to rush in and fill up quick at this great price while I still could. That is inflationary thinking.
True deflationary thinking takes time to develop. People have to experience falling prices for so long, that future low prices become their expectation. For almost 70 years prices have generally trended up as more and more money has been created.
Will the current "crisis" keep prices falling long enough to reverse that thinking?
It is hard to say for sure, but the fundamentals do not seem to be changing; if anything, they are deteriorating. Bailouts and stimulus programs are ballooning deficits and central banks are doing everything in their power to flood the system with liquidity. Let's look at what that means: the central banks (like the Federal Reserve) are selling dollars to the traders and banking houses who are desperate to reduce their dollar short positions. They are buying all sorts of assets, much of it the "financial toxic waste" that got the investment banks and hedge funds into this bad position in the first place. So now the Fed is shorting the dollar on a massive scale, taking the other side of the de-leveraging trade. But they have a huge advantage over other traders in the marketplace: they can never run out of dollars. No matter how big their losses get, they can always stay in the game. Or can they?
Where do they get the dollars they are supplying to the market? Most of them are borrowed from foreign governments that run trade surpluses, but ultimately, they will create them out of thin air if that's what it takes. And foreign governments and other large lenders will be increasingly nervous as they look at the central bank's balance sheet and see dwindling tax receipts and mostly junk bonds, non-performing mortgages, stock of failing or failed companies, and so on, as the primary source of future repayment. Of course they will get their money back eventually, but if the central bank just prints it up, its purchasing power in 5, 10 or 30 years will be only a small fraction of the value they are lending now. When they truly realize that, the game is over. When the central banks can no longer borrow, they will begin to print money in earnest. Then, it will be like the cartoon coyote running off the cliff: everything is going fine until he looks down and sees nothing but the canyon floor, far below him, and suddenly everything is not fine, gravity reasserts itself, and he is falling out of control, to eventually disappear in a puff of dust as he hits the ground. In economics, this is known as hyper-inflation. Think of Zimbabwe. Think of million-dollar bills, printed on one side only because it's too costly to print on both sides. Think of needing a wad of these to buy a single gallon of gas, or a gallon of milk, or a burger and fries.
But it will still take about the same amount of gold to buy a gallon of gas, or a meal, as it does today. Perhaps, if there is a massive flight to the safety of gold, gold's price may be pushed up compared to most other things, and it may take even less gold to buy a gallon of gas then it has historically, at least for a time, until things settle down again.
At the moment, it is quite profitable to speculate by buying and holding dollars and other fiat currencies. No one knows how high they will go, or how long it will take before they begin to fall again. But it is a speculation in a highly volatile commodity that has terrible fundamentals and is undergoing a powerful short squeeze. It is playing with fire, and it will take both luck and skill to make a profit and keep it.
Gold on the other hand is just a sound money. Holding it will not make you rich, but will keep you from getting poor. It will not build anything, employ anyone, or pay any interest. But it will retain its value. It is true cash that can be traded for enough local currency to buy what you need any place at any time.
If you have experienced large paper losses in your securities portfolio, be sure to evaluate those losses in terms of gold. Remember that the rising dollar may make your losses look bigger than they really are. Be sure to honor your stops: exit positions to preserve your capital, don't go on hoping they will recover. Look at each position and ask, "If I had the cash, would I buy this today, knowing everything I know about the security, the economy, and my own risk preferences?" If the answer is "yes", then keep the position; otherwise close it out, whether at a loss or a profit.
Take advantage of the dollar's rise to accumulate solid assets like gold (your cash position) and stock in the world's best companies, to buy debt-free real estate and to diversify yourself internationally. Invest in yourself. Learn a new skill or a new language. Travel. Improve your health. Exercise. Meditate. Start a business that can be profitable on a small scale without needing to take on debt, one that can exploit the market gaps that will be left as large old-line companies burdened with debt and union contracts go under. Or start an information publishing business to share what you've learned with others and help them weather the storm, prosper and become happier and healthier.
The bottom line is that health and happiness come first. Spend time with your family! Time is a tricky asset… as we grow older, we have less and less of it, and each second becomes more precious. Spend it wisely. Never confuse happiness with financial success. And never confuse your dollar net worth with your true wealth as measured in gold.