Gold Price and Zero Discount Value (ZDV)

Gold $2,000 Based on Banking System Zero Discount Valuation An earlier article introduced the concept of gold’s Zero Discount Value (ZDV). Applied to the central bank whose only asset is gold and whose liabilities are currency and bank reserves, the ZDV is a value for gold such that every outstanding dollar liability in the central bank’s monetary base (currency plus bank reserves) is backed by an equivalent dollar’s worth of gold. It is what the dollar price of gold would be if the central bank’s liabilities were 100 percent backed or covered by gold. To estimate the ZDV in this simple situation, in which no other assets than gold qualify as valuable assets, divide the monetary base by the number of ounces (oz) of gold that the bank holds. If, for example, 200 oz. of gold are held against 400,000 dollars of monetary base, then the ZDV is $400,000/200 oz. = $2,000 an oz. Only if gold is valued at $2,000 an oz. does every dollar that has been issued by the central bank correspond to one dollar’s worth of gold. The market price of gold need not be the ZDV we estimate from central bank data. Gold has sold at a discount to ZDV for many years in the U.S., which is the main reason the term "zero discount" is used. However, there are market and arbitrage forces that move gold’s price toward the ZDV, if they are not thwarted. This statement is a special case of a proposition that applies to any enterprise whatsoever: Market forces tend to make the value of the outstanding liabilities equal the value of the outstanding assets, inasmuch as the cash flows or other returns of the assets are what give value to the liabilities and investors can usually find ways to buy either the assets directly or else buy the securities that represent them. The statement that market value of liabilities equals market value of assets is so widely accepted as true that it is taken for granted. One can invest directly in the real assets of an enterprise (that is, in some replica or close substitute of them) or indirectly by means of the debts and stock that finance them. If the values of these two options are not in line, one invests in the less costly alternative. Possibly one arbitrages by selling or issuing the more costly alternative simultaneously. If the debts and stock have market values that are low compared to the market value of the associated real assets, then the tendency is for the real assets to be avoided or sold and the financial claims on them to be bought. Conversely, if the debts and stock have market values that are high compared to the market value of the real assets, the tendency is to buy the real assets directly and sell the financial claims. These actions align the market values on both sides of the balance sheet. Gold is the real asset of the FED, and currency and reserves comprise its main liability. If the currency value is its face value and the face value is $400,000, then a 200 oz. holding of gold has a ZDV of $2,000 per oz. If the gold sells for less than this, there is a tendency to buy the gold instead of the currency, and vice versa. We observe that gold has in fact sold at a hefty discount to its ZDV for many years. The tendency to buy gold and sell the dollar has been seriously thwarted in the world’s monetary dealings, but not entirely so. Gold has shown a long-term tendency to rise as its ZDV has risen, even if the discount remains large. That tendency has been very far from being a smooth and continuous one. The market price depends on human recognition and action. It depends on many factors, including the actions of authorities, interventions, and sundry political matters. The result is a market price whose many ups and downs depend at times, sometimes long times, on factors other than convergence to ZDV. But still it is my judgment that ZDV exerts a very long-term pull or an attraction for gold’s price. Bank Money and Bank Money Inflation In addition to the central bank, the banking system has as its main component the many ordinary banks that make loans to the public and create bank deposits accordingly. Ordinary banks do not hold gold as an asset. Their loans are their main assets. What is the ZDV when we take these banks into account? When a bank creates a mortgage loan or a business loan, it simultaneously creates a demand deposit or checking account in the name of the borrower, who then spends out of the account to buy a house or perhaps business inventory. Since checking accounts are used as money, the bank creates money when it creates loans. The accounting for this is a debit to a Loan account and a credit to a Deposit account. When loans are repaid, the borrower writes a check to the bank. The bank then credits the Loan account and debits the Deposit account. We use demand deposits as money. We use currency as money. Time deposits are not used in everyday exchange, but yet time deposits are easily converted into demand deposits. If a bank certificate of deposit matures, we can instruct the bank to credit a demand deposit account. When it comes to getting gold’s ZDV, these distinctions among the various kinds of deposits are not relevant. What we want to know is what value of gold it takes to back up all deposits in full. I simply call all deposits bank money to distinguish them from the central bank’s money, which is the monetary base consisting of current plus bank reserves. The backing of deposits is defined as the value of the bank’s assets that can be used to extinguish the deposit liabilities. Good loans are defined as loans that pay off the promised amounts. Good loans back deposits in the sense that when these loans are paid off, they provide their promised amounts of payments by borrowers to the bank. These payments then shrink deposits by the extent of the loans being paid off. Bad loans are loans that fail to provide the full amount of the promised payments. Any losses in value of bad loans below the promised payments mean that borrowers have not collected enough dollars from their customers or jobs to write checks to the banks and reduce deposits. The dollars remain in the system as deposits. How so? If a borrower has bought a house on a mortgage loan that he cannot repay, he has written a check to the house’s owner. That seller then has those funds on deposit in his account. They will only be offset when the borrower pays off the bank loan. If he is unable to do this, then bank deposits or bank money do not shrink. But since the bad loan has reduced or no market worth, we see that bad loans reduce the loan backing of the still outstanding dollar deposits that were created against them. Banks are supposed to write the bad loans off. This requires them to credit the Loan account to reduce it and debit an Equity account, which reduces it. When many loans go bad and reduce Equity drastically, the bank owners and/or managers have to get more equity capital somehow if the bank is to survive. If they do not or cannot, the bank fails and its creditors, the depositors, lose some or, in the worst case, all of their deposits. Deposit insurance is a bank asset and a method to counteract the effect of bad loans. The extent to which it backs deposits is an important element that I discuss below. Until that discussion commences, it is convenient to carry this analysis forward assuming that there is no deposit insurance. Since I conclude later that deposit insurance does not substantially alter the situation, this assumption is warranted. Suppose a bank has a simple balance sheet with $200 of good loans and $200 of deposits. The ratio of the market value of the deposits to the loan assets is 1. This indicates a viable or sound bank, that is, a bank with enough backing for deposits to reduce them when the loans are paid off. Now suppose that $40 of the $200 in loans are a total loss. The ratio of deposits to loans is $200/$160 = 1.25. This signifies that even if the loans are fully liquidated, the bank does not have enough bank money to pay off on its deposits. A bank might have certain off-balance sheet assets to remedy such situations. It might also have off-balance sheet obligations that make the situation even worse. It might have a commitment by its owners to supply capital in such circumstances, or it might have lines of credit with other banks. It might have deposit insurance. I define bank money inflation as an issue of bank money (deposits) not secured by additional assets of equivalent worth. In the preceding instance, there was no inflation when the deposit/asset ratio was 1. There was inflation when the bad loans produced a deposit/asset ratio of 1.25. Sufficient backing to the deposits means the same thing as no bank money inflation. Insufficient backing means inflation. As long as loan values keep pace with deposits, there is no bank money inflation, simply because good loans mean that loans are being repaid and that they are extinguishing the bank deposits and money as they are repaid. If the loan values are overstated, which has certainly happened in the past decade, then there is insufficient backing and there is bank money inflation. Notice that bank money inflation does not refer to inflation of prices in the economy, whether of wholesale goods, consumer goods, stocks, bonds, labor, commodities, interest rates, or real estate. Analyzing how this vast array of prices relates to bank money inflation and to central bank money inflation is another ball of wax. I steer clear of mixing up that analysis with the one at hand. Individual banks within the banking system can always inflate by making bad loans. If the bank’s loans are good loans, it is not inflating money. If the loans are bad loans, then it is inflating money. Critical to bank money inflation occurring is the nature of the loans the banks make. Are they good loans or are they bad loans? That is what determines the extent of bank money inflation. Inflation (of bank money) is not an economy-wide phenomenon unless banks in general are creating loans whose values fail to keep pace with deposit liabilities. This can occur in a central banking and government-influenced system, even when banks compete with one another in making loans. A government might, for example, subsidize or use its powers to encourage the economy-wide expansion of an industry to which banks make loans that ultimately become bad loans due to overbuilding. The FED’s creation of monetary base can influence interest rates and create bank reserves that induce banks to make what turn out to be bad loans. I’ve discussed these issues at length in an earlier article. It seems to me that these kinds of actions are exactly what caused the present credit debacle, and I’ve argued that case in many articles. The government and the FED stimulated bank lending that gave rise to bad loans and the concomitant bank money inflation. Many observers saw this happening while it happened and others predicted it would happen. Warnings filled the air, but the authorities caused the inflation anyway. Zero Discount Value with Bank Money There are two layers involved in the banking system. There is the central bank that produces base money and there are the ordinary banks that produce bank money. Gold backs the monetary base, and loans back the bank money or deposits. If the bank money is fully backed by good loans, does this alter the ZDV? The answer we shall find is that it does not. If the bank money loses value because the banks experience bad loans, does that affect the ZDV? We shall find that it does. In this case, if the deposits are not covered by bank loans, they have to be covered by gold. For purposes of thinking about the price of gold, which is my objective in all of this, I suggest we obtain a ZDV for the total system. I will sketch out how to do this by consolidating the banks and the central bank. I show that the ZDV for the total system cannot be any lower than the ZDV for the central bank alone. A chain is no stronger than its weakest link. Even if the banks make sound loans and produce no bank money inflation, the currency is still subject to the inflation produced by the central bank. This means that sound bank loans cannot lower the ZDV. Second, if the banks make unsound loans and produce bank money inflation, then the total ZDV must be higher than the ZDV of the central bank alone.