The Software Society

How digital technology is changing our culture and economy

Is the US stock market the new gold standard?

The Fed’s policy of “quantitative easing” consists of buying government bonds with money that is simply created from nothing. Historically, simply “printing money” has led to high inflation and economic disaster. Why isn’t that happening today? Is the Fed creating a “money bubble” that must burst?

When the US was on the gold standard, it was difficult to increase the money supply. The US was forced to stop exchanging dollars for gold when other countries began draining our gold reserves by exercising this option. Part of the problem was that the supply of gold grew only slowly, and the world economy grew more quickly, with a valid need for a larger money supply.

Today, the US dollar has no formal backing, no direct equivalent to the gold standard. Nevertheless, the dollar plays a critical role as the world’s “reserve currency.” The US dollar is the reference point for what something is worth, and the value of other currencies is pegged to the dollar through exchange rates. If the dollar is not relatively stable in value, the world economy, not just the US, will suffer. Some countries are collecting gold as a hedge for the dollar’s value becoming unstable, and many countries resent the dollar being the reserve currency, but it is certainly the foundation of the international economy today.

But is there really no backing for the US currency? No equivalent to the gold standard to determine the value of a dollar? No asset where one can redeem one’s dollars?

There is indeed such backing defining the value of a dollar—the US stock market. Like gold, one can buy a share of the stock market if one wants, for example, through a mutual fund that tracks the S&P 500, which represents the capitalization of about three-fourths of traded stocks. The US stock market is “good as gold” because of our government’s protection of property by law; unlike some other countries, there is little prospect of the government arbitrarily confiscating assets. Further, the US stock market is well-regulated, with abuses such as insider trading or fraudulent financial reports punishable by laws that are effectively enforced.

The stock market has many advantages over gold. It represents real assets that generate returns, unlike gold, most of which simply sits in vaults. It can grow in value to match the growth of the economy, so that it can grow as the economy legitimately needs a larger money supply. The stock market is not a perfect representation of the US economy in that it is largely driven by corporate profits rather than the growth in Gross Domestic Product (GDP). However, stock valuations may reflect the overall economy indirectly, as investors try to factor in the prospects for the future growth or decline in profits, reflected in a changing average price-to-earnings (P/E) ratio.

The Fed has recently been buying $25 billion in bonds a month, a drop from $35 billion earlier this year. The total capitalization of traded stocks is about $20 trillion, with the S&P at about $15 trillion. An average growth in stock market value of about 0.23% per month (2.7% a year) can easily absorb a growth in the money supply of $35 billion per month. (The S&P 500 is up about 8.5% so far this year, despite the recent setback.)

There is a direct connection between the Fed actions and the stock market’s value. Low interest rates encourage corporate capital investment that can lead to higher productivity and larger profits. And quarterly corporate profits reflect this effect, up about a factor of 2.5 from their low point in 2008. Overall revenue at the 500 largest-revenue US companies will climb 4.3% in the second quarter this year from the same quarter last year, according to the Wall Street Journal (Aug 4), the largest quarterly percentage gain since 2012’s first quarter. Profits are expected to grow 7.7% in the second quarter. One could reasonably argue that the growth in the money supply is partly driving and being absorbed by an equivalent growth in aggregate company value—avoiding inflation in other areas.

So does this mean that buying the stock market is a sure thing? Of course not—gold fluctuates in value (it’s dropped over 8% in the last year) and so does the stock market. It may be, however, a safer conservative bet than buying gold. Sovereign wealth funds and wealthy individuals in other countries have little motivation to support the price of gold; they have a strong motivation to support the US stock market, the new standard underlying the world’s reserve currency and the safest place to park their money with the prospect of a good return.

The dollar is backed by the US economy, with the stock market a good surrogate. And you can exchange your dollars for a share of that asset.

 

Check out Bill’s recent book:

The Software Society: Cultural and Economic Impact

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