The Case for Gold

According to the Federal Reserve, M2 (currency in circulation + savings deposits) grew by approximately $730 billion in 2008. However, only 2,500 metric tons of gold were mined In 2008, equaling about 80.4mm ounces (2500 metric tons* 32,150.7 ounces/metric ton). At today’s price of $980/ounce that equates to about $78.8 billion of gold reserves being introduced into the global economy. As such, for every dollar unit of gold being mined, the US is printing $9 of fiat paper currency.

Another way to think about it (though similar conclusion) is that M2 grew by 10% last year ($7.4 trillion in 2007 --> $8.2 trillion in 2008), whereas the supply of gold only increased by 1.5% (2500 metric tons vs. existing stocks of 160,000 metric tons). Under this framework, paper currency is growing nearly 7 times as fast as the supply of gold.

While the functional utility of gold is suspect, when viewed as an inflation hedge these stats provide a pretty compelling case for the yellow metal. Even more alarming is that I am probably underestimating the growth in paper money vs. gold since I am only including the US dollar (including all paper money would most certainly increase this ratio). However, since I am not sure what percent of the world’s paper money is composed of the US dollar, I can’t determine the ratio. With that said, I would guess that ~20% is an appropriate ratio since that equates to the US share of global GDP (perhaps with a bit more research I can determine a more precise answer).

Suffice to say, with the US government expected to run a $1.2 trillion deficit in 2009, coupled with an $800mm billion stimulus package, it is not hard to see why gold has steadily increased in 2009. While I make no predictions as to how high it can soar, it is worth noting that in the last inflationary spell to hit the US, gold topped out at an inflation-adjusted price of over $2100/ounce (see chart).