Monday, December 10, 2012

$42.22: Not quite the meaning of life, but a number worth remembering

One of the more archaic features of the US monetary system is that the price of gold continues to be set at $42.22. Ever wondered why that is? This post will work through some monetary history to show why, unlike most countries, the US doesn't mark the gold price to the market price of $1750 or so. I'll give a quick hint. Marking the gold price to market wouldn't be a mere cosmetic change—rather, it would require the Federal Reserve to hand over hundreds of billions of free money to the President. Here's how it all works.

The Fed currently holds 261 million ounces of gold. At the archaic price of $42/oz, this stash is valued at a mere $11 billion. With modern day gold trading at $1750, the market value of 261 million oz is actually $457 billion. Doesn't that mean that the Fed would show a huge mark-to-market gain if gold were revalued?

No. If you read the fine print, the Fed doesn't actually own gold ounces. Rather, it owns gold certificates that have been issued to it by the Treasury. There is a long history behind this. At the end of 1933, the Fed owned some 195 million ounces comprised entirely of physical gold. Valued at the then official price of $20.67, this stash would have been worth around $4 billion. The Gold Reserve Act, passed on January 30, 1934, required the Fed to transfer all of this gold to the Treasury in return for $4 billion worth of gold certificates.

Here's the kicker. Unlike most gold certificates, the ones issued by the Treasury to the Fed were not payable in a fixed quantity of physical gold. Rather, a $10,000 gold certificates simply promised to pay to the bearer $10,000 worth of gold.

Let's trace what happened the very next day. On January 31, 1934 the official price of gold was increased by the authorities from $20.67 to $35 per ounce. The Fed's certificates, which the day before had provided a claim to $4 billion worth of gold held at the Treasury, still provided the same $4 billion claim. But with gold having been revalued, $4 billion worth of gold certificates was now the equivalent of a mere 115 million ounces, far less than the day before when these same certificates could lay claim to 195 million ounces.

So by tweaking the gold price, the Treasury had "transferred" itself some 80 million ounces (195m less 115m) from the Fed. Valued at $35/oz, this 80m oz amounted to $2.8 billion. Using its newly-acquired 80 million ounces as collateral, the Treasury printed up fresh gold certificates, brought these certificates to the Fed, and had the Fed issue it $2.8 billion in newly printed currency.

Back in 1934, $2.8 billion was a lot of money. The Treasury would go on to use these funds to create the Exchange Stabilization Fund (ESF), a reserve fund that the Treasury uses to this day to circumvent congressional oversight over spending.

Let's zoom forward in time. The US revalued gold from $35 to $38 in May 1972, and again in February 1973 to $42.22. This is the price which stands today.

Just as in 1934, the benefits of a modern revaluation would accrue entirely to the Treasury. At the official price of $42.22, the Fed’s $11 billion worth of gold certificates currently lay claim to 261 million ounces of gold ($11b divided by $42.22). Say the official gold price was increased to $1750. The Fed’s certificates would still be worth $11 billion in gold, but these certificates would now represent a claim on a measly 6.3 million ounces of gold, far less than the current 261 million ounces.

After our hypothetical revaluation, around 255 million ounces (261m less 6.3m) sitting in Treasury vaults would be free and unencumbered. The Treasury might choose to just sit on its new treasure trove. But most likely it would proceed directly to the Fed without passing go, deposit $450 billion worth of gold certificates (255m oz. x $1750), and receive in return a massive $450 billion stash of Federal Reserve notes or deposits.

This odd result has created what I think is one of the more amusing equilibriums in monetary politics. Hard money types would like nothing more than to see their favorite asset, gold, revalued. But they don't actively pursue the idea because of the expansionary effects a revaluation would have on the Fed's balance sheet. Easy money types would like nothing more than to see the government get billions in free cash, but don't like the idea of the barbaric metal getting a leg up. The upshot is that gold stays valued at its archaic price of $42.22.

The always tedious US debt ceiling season is upon us, so don't expect this blog to be the only one to point to gold revaluation or other various loopholes as a way to hack the limit. The folks at MMR, I see, have come up with an odd trillion dollar platinum coin idea. In any case, by drawing attention to either of these loopholes don't assume that I'm recommending them.


  1. JP,

    Great Post.

    You've been awarded the first beowulf award, "which is awarded for investigation into highly obscure legal areas which could end up having a profound effect on our monetary system and economy."

    Love the blog here - only time constraints have kept me from writing longish responses to several of your prior posts. They demand longer than a few words in response.

    Mike from MR

    1. Thanks Mike, a pleasure to have you drop by. I've been reading MR for about a year now, and though I don't comment often, I'm always around.

      For readers, I left a link on Mike's blog to an old paper that describes in detail how the 1972 and 1973 gold revaluations helped out the Treasury.

  2. JP this is fantastic. Where are you getting this history? I.e. if I wanted to read more about the 1933-34 stuff in particular, where did you get that?

    1. Hi Bob, the best way is to go to FRASER and slog through the old Federal Reserve monthly bulletins.

      Also the Fed's 1934 Annual Report.

      FRASER in general is an excellent resource, there are probably personal memos and meetings that would talk about this period that have been documented and digitized.

  3. I'm not so sure "On January 31, 1934 the official price of gold was increased by the authorities from $20.67 to $35 per ounce."
    The price was not raised from 20.67 to 35 USD in 1 day. It took a few months.


    2. Roosevelt's buying plan steadily pushed the *market price* price higher in 1933. But it was only on January 31 that the *official* price was increased.

  4. Have you noticed that when the gold price went from $38 to $42.22..., it went from $380/10 to $380/9?