Golden Weight on the Market

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November 17, 2008

For the last century, the United States ' Keynesian economy has exhibited a peculiar but predictable pattern. In economic boom times, the historical dollar price of the stock market (as measured by its blue-chip index, the DJIA) in relation to the dollar price of gold has been high. Each and every peak in this ratio has been followed by a commensurately deep trough that correlates with economic recession or depression. A graph of this relationship can be found here.

From an Austrian economics viewpoint, the fluctuations in the Dow-to-gold ratio make sense. It shows that Keynesian interventions in the natural, organic, market cannot succeed and can only have the effect of delaying the inevitable pain that results when decades of dislocated labor and capital searches for employment. For Austrians, a rising Dow-to-gold ratio illustrates inflationary Keynesian centralized social planning. The subsequent, inevitable and unavoidable drops in the ratio illustrate gold laughing at Keynesian plans. Artificial values caused by Keynesian 'stimuli' can delay, but cannot escape, the reality of real value as reflected in history's best measure of real value'gold. Just like a ball thrown into the air must come back down, a currency (together with its fiat-denominated market) can only temporarily escape the bonds of real value.


Three truths support this analysis: (1) gold is history's most consistent measure of real value; (2) central bank, fiat, paper notes are man-made, artificial substitutes for real money and have no intrinsic value; (3) the world stock markets and all of their indices and averages are denominated in artificial money substitutes, not gold.

Although gold itself can be inflated when, like in 15th century Spain , new gold is discovered and mined, history shows that gold has held its value better than any other medium of exchange. In the first century, an ounce of gold bought a good suit and will buy a good suit today. 100 ounces of gold also bought an average house in the first century. Although this is not true everywhere at the moment (in urban bubbles), it is becoming more and more true every day. Soon 100 ounces of gold will buy an average house'when it does we will be at or near the bottom of the real estate market.

Before going forward, a brief Austrian proof is necessary for those unfamiliar with gold or Austrian economics. Prior to 1971, Austrians and Friedmanites (supply side Keynesian monetarists and followers of Milton Friedman) argued over the relevance of gold and whether it was nature's most consistent store of value. Austrians took the position that gold was nature's most consistent store of value and that decoupling the Keynesian U.S. dollar from gold in 1971 would lead to an increase in the dollar cost of gold (due to past Fed inflation of dollar) and that future Fed inflationary policies would further devalue the dollar in relation to gold. Friedmanites argued that gold was a 'historical relic' that was no different than any other industrial metal and argued that decoupling would not affect the dollar price of gold at all. Some Friedmanites even argued that the dollar cost of gold would go down. Since 1971, the market has shown that the Austrians were right'the dollar cost of gold has gone from $35 an ounce to $750 an ounce and, despite significant government attempts to intervene and control the gold market, has roughly tracked Federal Reserve inflationary policies.

Because the Dow Jones Industrial Average itself is a bit of a contrived 'average' and the world supply of gold changes, the relationship between the dollar price of one unit of the Dow and the dollar price of one ounce of gold only is an imperfect measure of stock market value. The relationship, however, shows a very clear correlation with inflationary Keynesian plans followed by market corrections. 1920's Fed loose money policy intended to stop the collapse of the British pound and stem the tide of loss of British gold led to the crash of the 1930s; 1950s empire building, Johnson's 'Great Society' and an inflationary war in Viet Nam led to the deep collapse of the 1970s and early 1980s. The current rise in the ratio began with Reagan's defense deficits in the 1980s. The ratio was headed down hard in 1999 and 2000 but has been held aloft for eight years by unabated transfer payments and a two-front war which Keynesian economists supported with their 'broken window' fallacy.

At the inception of the Keynesian Federal Reserve system, the Dow-to-gold ratio was approximately 3:1. This means that one unit of the Dow was 3 times as valuable as an ounce of gold'one unit of Dow could buy three ounces of gold. At the height of the roaring '20s, the Dow-to-gold ratio ballooned to 18.4:1. This means that one unit of the Dow could buy 18.4 ounces of gold. After the stock market collapse in 1929, in 1931 the Dow-to-gold ratio reached a bottom of 2:1'one unit of $41 Dow would purchase two ounces of $20.67 gold. In 1963, at the next apex of the Dow-to-gold ratio, one unit of $760 Dow purchased nearly 30 ounces of $27-an-ounce gold. In 1980, the next bottom of the ratio, one unit of $800 Dow purchased one ounce of $800 gold. In 1999 the ratio reached a new height'one unit of $11,000 Dow purchased 42 ounces of $260-an-ounce gold. The Dow-to-gold ratio has, with slight aberrations, remained on a steady course up or down after it moves 20% off its peak or trough. History also shows that highs have gotten higher (ranging from 18:1 in the 1920s to 42:1 in 1999) and the subsequent lows have gotten lower (2:1 in 1931 and 1:1 in 1980). The ratio has been falling steadily since 1999. One year ago, one unit of Dow purchased 18 ounces of gold; today one unit of $8500 Dow purchases 11 ounces of $772-an-ounce gold. The ratio is falling fast.

Assuming that the dollar-denominated US stock market survives the inevitable crash, history would suggest that the bottom of the market will be when the Dow-to-gold ratio is 1:1 or perhaps even lower because, as indicated above, highs in the ratio have trended higher and lows in the ratio have trended lower. A $4,000 Dow and $4,000 gold would be consistent with historical ratios; a $4,000 Dow and $5,000 gold, although it sounds ridiculous at the moment, is also supported by the historical trends.


Unfortunately, because Keynesians on the left and right know no bounds in their willingness to use the power of the state to delay painful reality, it is impossible to predict Dow-to-gold ratio tops or to predict 'when' the ratio will hit its bottom.

Keynesians of all stripes preach the omnipotence of humans and the infallibility of social planners. Keynesians, by definition, are positivists who cannot foresee negative consequences of government actions and interventions. Austrian economists, on the other hand, are Natural Law theorists who believe that something akin to Newton 's Third Law of motion (for every physical action there is an equal an opposite physical reaction) applies to the ethical free will decisions of men. This is particularly true of the decisions of central social planners and their effect on the free market. The Keynesian-Austrian dichotomy boils down to a difference between a short term and long term view. In the short term, Austrians recognize that Keynesians can always attempt to artificially prop up a faltering economy with monetary inflation (artificially low interest rates) and fiscal stimuli (transfer payments and war). In the long term, however, Austrians also recognize that these ultimately moral decisions must necessarily have moral consequences. Keynes' infamous and cynical reply to this argument: 'in the long term, we are all dead.'

Keynesians thus have what economists refer to as 'high time preference,' meaning they like instant gratification and reject the real-world importance of delaying gratification. While the mature mind understands that the key to real growth and development lies in delaying gratification, avoiding unnecessary pain and expediting inevitable pain (doing hard work first), the Keynesian social planners expedite gratification, attempt to forever delay inevitable pain and as a result cause much unnecessary pain.

When Keynesians decide to artificially stimulate an economy by spending fiat dollars to artificially increase consumption, they see only where the money goes''make-work' projects to build or unnecessarily improve schools, bridges, transfer payments, inflationary $5.00-per cup coffee, etc. They fail to see where that money does not go. The world has finite labor and resources. Keynesians fail to recognize that when the government 'creates' a job, it means that some private business somewhere has lost an employee. Because government can simply print the inflationary dollars necessary to hire the employee, it also has a tremendously unfair advantage over free-market businesses. While Keynesian construction of a school, bridge or other physical improvement looks good and makes people feel good and temporarily employs people, it really represents a theft from the free market. The workers employed to build the school (which may be obsolete in a decade or two) would, for example, otherwise have been employed by a free market entrepreneur to rehab and resell foreclosed homes. Because the free market is patient and prudent and Keynesians are not, Keynesians do not allow this to occur.

President-elect Obama has the power and stated will to initiate new and unnecessary public works programs that will simultaneously employ hundreds of thousands of Democrat voters and temporarily prop up the market. He can also strong-arm the nine big banks that have just received $850 billion in capital injections to make new, irrational loans in blue states, particularly states that have just joined the blue team, like Pennsylvania . He can, like Argentinean president Kirchner, seize private retirement accounts. If none of this works he can, like Hugo Chavez and FDR, nationalize industries. Finally, he can instigate war. While all of these tools will help him retain his job for eight years rather than four, they will cause further unnecessary harm to the free market by dislocating more labor and capital. The historical Dow-to-gold ratio shows that none of these impatient tools will be successful in permanently postponing reality.


Reality will come, it is just a matter of time. Keynes was wrong when he said 'in the long run, we are all dead.' In the long run, Keynes is dead and the rest of us suffer in a world based on his false philosophy.

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Bill Butler's picture
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Bill Butler is a Minneapolis attorney whose practice is devoted to protecting liberty and property interests.  His website is Libertas Lex.