As I am writing this column, the price of gold is $1247 and the price of silver is $18.28. A ratio of 1:68, which means that one ounce of gold is the equivalent of just over 68 ounces of silver. Does this relation determine the actual value of the two metals? Is the 68-times higher value of gold really objective?
The ratio in the past
Paper money dates back to the 6th century, but it did not become a fixture in contemporary monetary systems until rather recently (the first European paper bill was printed in Sweden in the 17th century and the precious metal standard was abandoned just over a hundred years ago). So what was used to determine the value of gold or silver when there were no bills? What was used to set their prices when the precious metals themselves were being used as money?
The rule is simple. Both in the past and today, price reflects the mutual relation between two products. Today, the price of everything – e.g. a tonne of coal – reflects its relation towards paper money. The more coal there is, the lower its price. The more bills there are, the lower their value. Or, if you prefer, the higher the price of coal. The same goes for food, cars, houses, as well as gold and silver. The contemporary bill is the common denominator facilitating price comparison. But it was not there in the past. So what was used to valuate e.g. gold or silver, which served as money?
A “counter” metal. Let’s use the British gold guinea as an example. In 1663, when the guinea was launched, its nominal value corresponded to 20 silver shillings. The method used to convert the yellow coins into the white ones in the past was based on their quantitative relation. When there was ten times more gold, its price was approximately ten times higher than that of silver. Easy enough. Pretty much obvious.
But how does this apply today when there is about 10-15 times more silver but the price of gold is almost 70 times higher? Where is the logic here?
And what about things like the American Eagle, which has the nominal ratio of 1:20 because the face value of the silver ounce is $1 and of the gold ounce is $20? And there are still more inconsistencies. A gold ounce with face value of $20 cannot be bought with 20 paper dollars or even with 20 silver ones. What’s this all about?
Evolution of anomalies
In 1789, Alexander Hamilton was appointed to United States Secretary of the Treasury, which made him responsible for drafting new monetary standards for a country that had just drafted and adopted its constitution. The discussed legal tender options included gold, silver, and both. Ultimately, a bimetallic system was adopted, which permitted both gold and silver dollars. Another problem concerned establishment of the weight of the gold dollar and the silver dollar. Since Hamilton adopted the 1:15 ratio taken from the market, the gold dollar contained 1.6038 g of pure gold and the silver dollar logically had 15 times more, i.e. 24.06 g of silver.
Hamilton’s inspiration was nothing more than the market ratio, the indicator depicting how many ounces of silver could be purchased with an ounce of gold on the free market. The relation between the yellow and white metal in the coins produced by the Philadelphia Mint (the first mint in the United States) may have been modelled after the market ratio, but it was called the mint ratio. They were identical for quite some time, because the free market proportion of the metals was similar to that of American coins.
While there is nothing wrong in taking after the free market, assigning permanent values to anything – e.g. money – is a crucial error. The supply of the metals shifted a few years later. Consequentially, the free market started to set the price of a gold ounce at 15.5 ounces of silver, which meant that a reasonable person with a gold ounce would not give it to the mint in exchange for 15 silver ounces in coins under the official ratio but would rather sell it on the free market for 15.5 raw silver ounces. In accordance with Copernicus’/Gresham’s law, people with the option to make payment in either silver or gold would choose the former. Why? Because it had a lower value in the coins they used. And this is how gold disappeared from circulation.
The contemporary ratio is based on free market valuation. But said valuation is subject to endless changes and has certain dynamics, which means that all attempts to “turn” it into coins are naive. Unfortunately, politicians rarely do their history homework and they made the same mistake in the 1830s. This time the victim was silver. Under the so-called Coinage Act of 1834, the weight of the gold dollar was reduced to 1.50 g while the weight of the silver dollar remained the same, 24.06 g, making the mint ratio 1:16. In contrast, the free market valuated metals under the 1:15.6 ratio and everyone in possession of a gold ounce wanted to exchange it for a silver ounce coin because – even though it had only one-15.6th the value – it could be used to make payments as if it were worth 16 times more. And another thing: the coins were being melted. When a Smith had a silver dollar, according to the mint ratio it was worth 1.50 g of gold. However, with the free market’s proportion of 1:15.6, 24.06 g of silver – i.e. $1 – could buy 1.54 g of gold or 2.5% times more. And so Americans started to melt their coins and use the obtained material on the commodity market.
Naturally, the silver coin was forced out of circulation. Citizens had lost the money they had been using in small everyday transactions. And it was all because of politicians, who decided to assign a rigid value to something that should have never had one in the first place. They may have had good intentions, to a certain extent, but ultimately no subsequent laws and acts were able to maintain healthy bimetallism. The desire to keep a fixed ratio between the prices of gold and silver can be compared to a desire to maintain a fixed relation between the price of fuel and gas. It’s simply impossible.
The gold rush emerged a decade and a half later and gold was now flowing into the mints. The yellow metal started to dominate and was unofficially turned into the absolute foundation of the monetary system. Since a certain group of politicians wanted to return silver coins to favour, more regulations were introduced under the Act of 1853. They reduced the content of silver in the dollar to 22.39 g, which brought the ratio of the two metals to 1:14.89. It really complicated things, because the official exchange rate – i.e. the mint ratio – remained at 1:16 while the market ratio established the proportion of 1:15.4. And so, in reality, there were three conversion rates. Why?
To keep silver coins in circulation since they were quickly disappearing because of their current value. A silver dollar deprived of a higher value would not be suitable as a speculation tool. With reduction of its real value, it was no longer an attractive option to melt it into so-called bullion.
The events of 1853 hold the “mystery” of inconsistency between the face and real value of the coin. The silver dollar, which initially had 24.06 g of silver, was, as previously discussed, “cut down” to 22.39 g, but its face value remained the same. $1 was no longer worth $1. This was the initial concept. It was a monetary mess as the change of the value of $1 was made to only some of the coins. Specifically, coins with face value of $1 were left unchanged, i.e. with 24.06 g of silver. The devaluation covered 50-cent, 20-cent, and 10-cent (dime) coins. The purpose of this operation was to keep silver money in circulation for everyday retail transactions. In reality, $1 was now worth more than two 50-cent coins or ten dimes. Where is the logic?
There is none. There was obviously no way that all the political meddling would produce permanent and positive effects. With time, the “cheating” took various forms and it continues to this day. The Silver Eagle from the US mint is a good example. It may still weigh one Troy ounce and has face value of $1, but it costs over $18! As you can see, the free market never lets itself be cheated. There is always a way to value a precious metal in a more objective manner.
This summary shows that the gold/silver ratio has taken on various forms in the past. Any attempts as “tinkering” with it will produce specific results. Since economic systems are dynamic, the attempts to stabilise many of their aspects can never end well. When it came to gold and silver, it was ensured that silver would no longer serve as money in small steps.
The 1860s saw the start of the Civil War, which produced the so-called greenbacks. The paper bills with an unprecedented wartime stability squeezed metals out of circulation completely until the 1870s. As chance would have it, gold became more available thanks to the newly discovered deposits. Numerous countries were in favour of this metal and the gold standard was ultimately accepted in many places worldwide.
This was the critical moment, because silver, which had become more expensive than gold, much more expensive, was pushed to the side. First, the German Empire stopped buying silver and using it to make coins. Then the United States did the same. Other European countries were also experiencing the aforementioned problems. The world was turning to gold, which was understandable. And politicians made gold important. This is how the demand for silver had declined and how its price had dropped.
Historical sources suggest something very interesting. As long as both metals constituted money, their mutual price value was generally similar to their quantitative proportions. When silver was sentenced to monetary banishment, its value in relation to gold turned almost unpredictable.
This may lead to the conclusion that the price of silver will never be stable as long as silver does not regain a monetary function.
And what about our contemporary free market ratio? How is it determined?
Contemporary gold silver ratio
By the supply of paper money, of course. Not by wars, not by earthquakes, and definitely not by bankruptcies, crashes, and statements made by politicians. The prices of metals react to the inflow of capital into the gold and silver markets and only said inflow can be motivated by political, economic, etc. events. Why would some attack influence the price of gold, as certain analysts often claim? Let’s take the events in Paris as an example. While they did raise panic, why would the death of a few dozen people raise the price of gold? Thousands of people die every day from hunger and epidemics in Africa and there is no effect on gold whatsoever. Why would there be any from death of Europeans? Why would gold react in any way to something that has no direct impact on the supply of money and metals?
Attacks and geopolitical or economic twists raise short-term panic, which causes increased capital inflow to the market of our two ores. Since emotions quickly fade, the capital relatively quickly flows away and the price drops. Its growth does not last long. This is nothing more than a manifestation of the law of supply and demand.
However, it should be noted that, due to our inflation system, the capital volume does not drop below a certain minimum. Furthermore, said minimum is permanently growing. Consequentially, despite price fluctuations, the chart bottoms keep rising. And this is the foundation of a long-term growth trend.
Today, even though there is only 10-15 times more of gold, the capital value of the gold market is much higher than that of the silver market. If some of the capital invested in the yellow metal were to be moved to the white one, a two- or three-digit growth would be nothing out of the ordinary.
Therefore, the contemporary gold/silver ratio expresses the product of several factors: supply of money associated with gold; supply of money associated with silver; available gold quantity; available silver quantity. The first two are determined by demand, i.e. the people and entities that actually BUY rather than express the desire to buy. The power of demand is reflected in the volume, i.e. the quantity of the capital exchanged for ores. Taking all of the available money into consideration is the wrong approach, because only some of it ends up on the metals market, which is very important information.
