The Gold Shadow Price

TL;DR: The shadow price is a theoretical framework for how gold might be valued if certain historical monetary conditions were restored. It is not a price forecast; it is a conceptual tool for measuring the gap between today's world and a scenario in which gold regains a more central role as a monetary anchor.

* nanx.io computes the shadow price and the spot/shadow ratio in real time (both discussed below).

Gold coin of Eucratides I (171–145 BC), a Greco-Bactrian king. Unearthed at Ai-Khanoum, in today's Afghanistan, it is the largest known gold coin minted in antiquity.

Gold: Investment or Money?

In a market economy, gold occupies a unique position. Unlike stocks, bonds, and other financial assets, gold is not an investment; it is a monetary asset. That means the classic valuation methods, based on discounting future cash flows as we would with a stock or a bond, simply do not apply. Gold pays no yield and no dividends; it produces no cash flows over time. This is why well-known investors such as Warren Buffett and Charlie Munger have questioned its role as an "investment."

Buffett, for one, sorts assets into three categories:

1. Currency-based investments: Treasury bonds, corporate bonds, and the like.
2. Assets that produce nothing and are bought only in the hope that someone will pay more for them later. Gold sits here.
3. Productive assets, whose value lies in their ability to generate returns, such as stocks that produce profits and dividends.

But writing gold off as an inert asset, or a purely speculative bet, rests on an erroneous premise: that gold is an investment. Gold is not an investment; it is a monetary asset. It is money, and as such it has historically performed the three classic functions of money:

1. Medium of exchange: facilitating the trade of goods and services.
2. Unit of account: serving as the market's common measure of value.
3. Store of value: allowing wealth to be stored and transferred across space and time.

So if cash-flow valuation does not apply, how do we anchor a price for gold? We need a different frame of reference: the relationship between a central bank's gold reserves and the monetary base it issues. In this post, we will look at the Fed's gold reserves against M0, the monetary base in dollars issued by the Federal Reserve.

Gold as Currency Throughout History

Gold has served as money across civilizations since about 600 BC, when the Lydians minted the first coins, made of electrum, a naturally occurring gold-silver alloy. For centuries thereafter, the gold standard anchored the value of most national currencies, until 1971, when President Nixon suspended the dollar's convertibility into gold. That was a turning point: the world began to operate without any formal link to the metal, ushering in the era of fully fiat currencies.

The decoupling was completed at the end of the 20th century, when Switzerland, considered the last major currency still partially backed by gold, also removed its official link to the metal. Even so, the historical record stands: for over 2,600 years, gold worked as money. Today, by contrast, we live in what amounts to an unprecedented monetary experiment, with no formal linkage to gold at all.

Despite the official separation, central banks still treat gold as money. They keep accumulating reserves, which they hold on their balance sheets much like a "foreign currency." Although these reserves no longer officially back the currency issued, they provide stability and credibility, acting as an anchor of value in times of inflationary crisis or lost confidence. Some of today's largest official gold holders:

Country	Reserves (tonnes)
United States of America	8,133.46
Germany	3,351.53
IMF	2,814.03
Italy	2,451.84
France	2,436.94
Russia	2,332.74
China	2,264.32
Switzerland	1,039.94

The weight of these reserves relative to the currency in circulation has fallen over time, especially after the Bretton Woods system collapsed in 1971. Even so, the metal remains an important part of central bank strategy, even if its proportional weight is no longer what it was under the classical gold standard.

Valuation Methodology: The Shadow Price of Gold

Since gold is money rather than an investment, we can ask: what price would gold need to have to keep a meaningful historical relationship with the currency in circulation?

The shadow price of gold comes from comparing the gold reserves held by a central bank with the monetary base (M0) it issues: the total of physical currency in circulation plus the reserves commercial banks hold at the central bank. Historically, that relationship was far more stable than it is today. Focusing on the U.S. dollar and looking back at the gold-standard era, we find that the value of gold reserves averaged about 25% of the monetary base. In other words, at key moments in history, the gold in the vault was worth roughly one-quarter of all the currency issued.

The idea behind the shadow price is this: in a severe inflationary crisis, if the Federal Reserve wanted to restore gold backing to that historical 25% of the currency in circulation (to shore up confidence in the monetary system), the price of gold would have to adjust upward.

That adjustment could happen in several ways:

• Central banks buy more gold for their reserves, and the extra demand pushes the price higher.
• The currency depreciates (inflation), raising gold's price in dollar terms because the dollar itself is worth less.

We can express the shadow price as:

$$\text{shadow price} = \frac{0.25 \times \text{monetary base (M0)}}{\text{gold reserves (troy ounces)}}$$

Here is the current arithmetic for the U.S. dollar:

$$M0 \approx 5{,}567.2\ \text{billion USD}$$ $$\text{Fed's gold reserves} = 261.5\ \text{million troy ounces}$$

Working in millions (5,567.2 billion equals 5,567,200 million), we get:

$$\text{shadow price} = \frac{0.25 \times 5{,}567{,}200}{261.5} \approx 5{,}322\ \text{USD per troy ounce}$$

That yields a shadow price of roughly 5,322 USD per troy ounce. In other words, it shows where gold would need to trade for the Fed, or the market, to restore the historical ratio of 25% gold backing relative to the currency in circulation.

The Spot/Shadow Ratio: Overvalued or Undervalued Gold?

The spot/shadow ratio compares two gold prices: the current market price (the spot price) and the shadow price defined above:

$$\text{ratio} = \frac{\text{spot price}}{\text{shadow price}}$$

With, for example, a spot price of around 2,600 USD and a shadow price of 5,322 USD:

$$\frac{2{,}600}{5{,}322} \approx 0.5$$

A ratio below 1 means gold is undervalued relative to the historical 25% target: restoring that proportion would take roughly a doubling of the price. The U.S. spot/shadow ratio has averaged about 1 since 1959, which suggests that for long stretches of history gold tracked that 25% threshold quite closely.

The all-time high, 5.81, came on January 21, 1980: the peak of the 1970s inflation crisis, just before Paul Volcker's tight monetary policy began to break inflation. That marked an extreme moment, with the market pricing gold far above what 25% backing would justify.

Spot/Shadow ratio from 1964 to 2024. Source: nanx.io

Summary

The shadow price is a conceptual tool, not a price forecast. It frames how gold might be valued if certain historical monetary conditions were restored, and it measures the gap between today's world and a scenario in which gold regains a more central role as a monetary anchor.

This methodology does not claim that gold will reach its shadow price. What it does show is gold's latent potential as a store of value in a world of expanding monetary bases and inflationary uncertainty.

Sources

• World Gold Council: historical gold reserves data by country.
• gold-api.com: spot gold price.
• Federal Reserve Bank of St. Louis: historical data for the U.S. monetary base (M0).
• International Monetary Fund: information on the Federal Reserve's gold reserves.