Gold – the story of the 20^th century

 Paul van Eedan    

      I believe a historic rise in the gold price has already commenced. Here's why.

      The price of gold is inversely correlated to the dollar. I know that sounds simplistic and obvious, but when I first stated that simple and obvious fact in January 1998, explaining why the gold price would not sustain a rally until the U.S. dollar's ascent on foreign currency markets subsides, no one took it seriously. Today you will hardly ever hear a serious precious metals analyst talk about the gold price without a reference to the U.S. dollar in the same paragraph.

      I have spent the better part of a decade analyzing the gold price, studying not how the gold price changed, but why. It is this understanding of why things happen that allows some investors to flourish while others perish. What you are about to read concerning the gold price is original research that, as far as I know, has never been published before.

 

      Gold is an enigma to most financial analysts, which is one reason why gold investments are scorned. Very few people understand enough about this reclusive metal and yet, using only first principles, it is possible to explain why the gold price averaged $378.04 an ounce for 13 years from 1984 to 1996; why the gold price declined from 1996 to 2001; and why the gold price spiked from 1979 to 1980 - but crashed again from 1980 to 1982.

      Based on the same principles, you will see why the gold price is going to at least double in the next few years, and possibly triple within five.

      It might surprise you to see how simple the methodology really is. But then, most complex problems can be broken up into simple, easy-to-understand components. It is most often those who don't understand what they are talking about that resort to complex theories that don't make sense or unquantifiable forces such as conspiracies.

      My intention is not to bore you into a comatose state with mundane history, but it is really important that we synchronize our thoughts. Let's start at the gold standard, since we know what an ounce of gold was worth then, and continue on to why it is trading for $397 an ounce today, and why I think it will be over $700 an ounce in the near future.

Floating Currencies

      During the gold standard, gold's value was determined by its purchasing power and the value of paper currencies, when they existed, was measured against gold. As a result of paper currency inflation to finance both World Wars, all countries abandoned the gold standard, and gold lost its role as currency.

      The Bretton Woods Accord of 1944 briefly assured stability for a world without hard money by making the U.S. dollar convertible into gold at a fixed rate, and then using the dollar as the world's reserve currency, against which all other currencies were measured. The deficiency embedded in the Bretton Woods Accord was that it allowed the United States to inflate the dollar without recourse, since the ratio between it and gold was fixed, and set by decree. Therefore, from 1934 to 1971 gold was "worth" $35 an ounce only because Franklin Roosevelt decreed that it be so, in 1934.

      The fallacy that the United States could create reserve currency (dollars) at will, without impacting the dollar's value, while the rest of the world had to produce goods and services to earn dollars, came to an end in 1971 when Richard Nixon was forced to abandon the fixed exchange rate between the dollar and gold.

      So what is an ounce of gold "worth" today? Because most currencies in the world are floating, meaning their exchange rates relative to each other are determined by market forces, as opposed to declared by governments, you have to specify in which currency you want to measure the gold price. For our purposes we will restrict ourselves to the U.S. dollar. The question therefore becomes, what is an ounce of gold worth in dollars today?

      Two factors always influence the relative value of gold in any currency. The first is the increase in the amount of currency (inflation of dollars), and the second is the increase in the amount of gold (inflation of gold).

      When the amount of dollars increases (inflation), the dollar loses buying power, and that typically shows up as an increase in the prices of goods and services. It stands to reason that as the dollar is inflated, it also increases the price of gold, in dollars, even though gold's inherent worth (buying power) is not affected.

      Similarly, if the amount of gold increases, the value of gold will decrease. Due to its physical properties, almost all of the gold ever mined is still around in one form or another, which is one of the reasons why gold is so suitable to be money in the first place. The amount of gold mined on an annual basis is nothing other than inflation of the total amount of gold ever mined. The inflation rate of gold is thus new mine production as a percentage of above ground gold stock, which in turn is equal to the total amount of gold mined since the beginning of time.

      Consequently, the change in the gold price, in dollars, over time will be in proportion to the inflation of the dollar and inversely proportional to the inflation of gold. We can calculate the theoretical gold price (Aun) as follows: Aun = Aun-1(M3n/M3 n-1)(GP n-1 /GPn) [Au = gold price; M3 = money supply; GP = gold production]

      But for this to work we need to establish a time at which gold was priced correctly. This means we have to go back to the gold standard and work forward from there.

Reserve Currencies

      World War I destroyed both physical property and, through inflation, the European currencies as well. After the war most countries were up to their eyeballs in debt with little or no hope of ever repaying it.

      Prior to World War I the gold-backed British pound was the world's primary reserve currency because London was the largest financial center and Britain the largest trading nation in the world. But monetary expansion to finance World War I forced most countries, including Britain, to abandon the gold standard temporarily.

      In 1923 Britain announced that it would honor all war debts in an attempt to restore confidence in the British economy and the pound. To accomplish this Britain had to raise taxes, and that only hurt its already crippled economy.

      In a second attempt at trying to boost confidence, Britain reinstated the gold standard in 1925, at prewar parity. At the same time many other nations devalued their currencies in an effort to reduce the burden of war debts and stimulate their economies. Britain's return to the gold standard therefore pushed up the relative value of the pound, diminishing British exports while promoting imports and led to further erosion of its economy. By 1931 Britain was forced to abandon the gold standard again.

      As opposed to Britain, the United States returned to the gold standard in 1919. That, and its increasing importance in global trade, put the dollar in a position to replace the British pound as the world's reserve currency.

The End of the Gold Standard

      The crash of 1929 precipitated a deflationary economic contraction. The combination of a series of bank and brokerage failures, losses on Wall Street, increased unemployment and decreased confidence in the economy led to an increase in the savings rate as people attempted to preserve their capital. Because they were saving, they were not spending, thus resulting in a reduction in demand for goods and services and leading to reduced economic activity: the Great Depression.

      The government needed increased spending to stimulate the economy, but how do you get people to spend if they are saving? People tend to spend more during inflationary times because their paper money is losing value relative to goods. So they are better off spending it as soon as possible, before it devalues any further. Hence, the government wanted to create inflation.

      To create inflation and stimulate spending, the government needed to devalue the dollar. But it couldn't just print more paper dollars because gold was also a component of the monetary system. If the government devalued paper dollars by printing more of them, people would switch their savings to gold without a net increase in spending. Individuals were already hoarding gold, and savings in the banking system tied up gold too, since banks had to maintain reserves, which were mostly in the form of gold.

      As long as gold was money, devaluation of the dollar would not necessarily lead to an increase in spending. To resolve this dilemma, Roosevelt declared private gold ownership illegal in 1933, freeing him to print as many paper dollars as he saw fit.

      Roosevelt said, "By virtue of the authority vested in me by Section 5(b) of the Act of October 6, 1917, as amended by Section 2 of the Act of March 9, 1933...in which amendatory Act Congress declared that a serious emergency exists, I, Franklin D. Roosevelt, President of the United States of America, do declare that said national emergency still continues to exist.... That the continued private hoarding of gold and silver by subjects of the United States poses a grave threat to peace, equal justice, and well-being of the United States; and that appropriate measures must be taken immediately to protect the interest of our people."

      This did not affect the dollar's status as an international reserve currency, as foreigners could still convert their dollars into gold at a fixed rate.

      In 1933 a $20 gold coin contained 0.9675 ounces of gold. So the gold price was $20.67 ($20/0.9675) an ounce by definition, as it had been since 1879, when the United States joined the gold standard. The Executive Order of March 9, 1933, forced citizens (in their own best interest, of course) to exchange their gold for paper dollars at the rate of $20.67 per ounce.

      The very next year Roosevelt increased the gold price by 69% to $35 an ounce, thereby instantaneously devaluing these same paper dollars by 41%  - in the best interest of the people, of course.

Dollars for Gold

      Back in 1933, when gold was money, an ounce of it was worth $20.67. Therefore, we can safely say that gold was overpriced the following year when Roosevelt arbitrarily set it at $35 an ounce. But if gold was overpriced at $35 an ounce in 1934, at what time was it actually worth $35 an ounce? We can get an answer by looking at the movement of physical gold into and out of the United States Treasury and the purchasing power of the dollar.

      Because the gold price was arbitrarily raised to $35 an ounce in 1934, which meant it was significantly overpriced at the time, and due to the demand for dollars as reserve currency, the United States' gold reserves expanded from 8,998 tonnes in 1935 to 19,543 tonnes in 1940, as many foreigners cashed in on the overnight gain that the U.S. government handed them. Gold was happily sold to the Treasury in exchange for dollars, which could then be converted into local currency abroad for a 69% windfall, less transaction costs of course.

      By 1952 gold reserves had reached 20,663 tonnes, and the United States owned approximately 33% of all the gold in the world and more than 65% of the official gold reserves, i.e. gold owned by governments.

      But after 1952 the incessant inflation of the U.S. dollar made the rest of the world realize that 35 of them just weren't worth an ounce of gold anymore. Massive redemptions of dollars, in exchange for gold, depleted the Treasury's gold reserves by 58%, to 8,584 tonnes by 1972. In 1972 the United States had less gold than in 1935, but it had approximately 10 times more dollars outstanding as measured by the change in M1 (currency held by the public plus demand deposits, checkable deposits, and travelers' checks).

      We know that gold was overvalued at least up to 1940 because the world was converting gold into dollars as fast as it could. We also know that gold was undervalued after 1952 because dollars were now being redeemed for gold at a rapid pace. U.S. gold reserves stayed roughly at 20,000 tonnes from 1940, when gold was overvalued, to 1952, when it was undervalued. So somewhere between 1940 and 1952 one would expect gold to have been "worth" $35 an ounce.

      Changes in the Consumer Price Index (CPI) give us a measure of how the dollar's inflation impacts its purchasing power. That means we can determine when gold was really worth $35 an ounce by looking at how the CPI (Reserve Bank of Minneapolis) changed since 1933, when we know gold was correctly priced at $20.67. From 1933 to 1947 there was a 69% increase in the CPI, so $20.67 in 1933 would have been worth $35 in 1947.

      This coincides with the flow of gold into the Treasury up to 1950 (20,279 tonnes), peaking in 1952 (20,663 tonnes), and then declining rapidly as the realization that inflation had caught up with the gold price led to the redemption of dollars. That gold was worth $35 an ounce in 1947 is thus plausible, as judged by the flow of gold, and validated by the change in the dollar's purchasing power, as measured by the CPI. We can therefore conclude that gold was actually worth $35 an ounce in 1947.

      We did not consider gold inflation between 1933 and 1947, as the implied assumption is that gold production was in line with general economic growth in the United States, and thus the increase of goods and services implicitly accounted for by the CPI also accommodated the increase in gold. This is obviously not ideal. Unfortunately, M3 data only goes back to 1959, although we did find a study that extrapolated M3 to 1948. The CPI we used goes back to 1913.

      From 1947 onward, however, M3 (dollar inflation) and mine production (gold inflation) were used to calculate what the gold price should have been (theoretical gold price) according to the formula given earlier. The results from 1971 onward are shown on the chart on page 12.

      Following is a comparison between the theoretical gold price and the actual gold price, to see how well the model stands up to reality.

Gold in Other Currencies

      We can calculate the gold price in any currency by multiplying the dollar gold price by the currency's exchange rate. If we do this for all 35 currencies in our GDP-weighted index, we can actually calculate the weighted average gold price in the world, excluding the U.S. dollar. The currencies are weighted by GDP so as not to give too much influence to small, volatile currencies.

      Doing exactly that, the astonishing fact that gold has been in a bull market for more than five years is blatantly apparent. On average the gold price worldwide has increased by more than 70%, and no one knows it, because most people are too fixated by the U.S. dollar-denominated gold price.

The Theoretical Gold Price

      Our model shows that, given the increase in M3 and gold inflation since 1947, gold is worth $700 an ounce as of 2002. The gold price is currently $397 an ounce. What is this telling us?

      Just as the actual gold price did not deviate from its theoretical price for very long after the Iranian hostage crisis, the current gold price cannot remain below its theoretical price for much longer.

      In fact, were it not for the dollar exchange rate's tremendous increase over the past decade, the actual gold price would differ by less than 10% from its theoretical price. This can be shown by going back to 1990 and backing out the dollar exchange rate from the actual gold price; in other words, essentially keeping the dollar constant.

      You can see the result of this exercise represented in the chart on page 12 by the modified gold price line. Notice how well it tracks the theoretical gold price, and keep in mind that these two lines were derived independently of each other. The theoretical price is based on gold being $20.67 in 1933 and adjusting for inflation. The adjusted gold price is merely backing out the exchange rate from the actual gold price since 1990. The undeniable correlation is no coincidence and begs the question whether the dollar can sustain its current exchange rate.

Gold, the Savior of Capital

      Most people would expect a monetary crisis to cause the gold price to increase; especially one that rocks the globe like the Southeast Asian crisis. Some believe that gold failed to protect capital during that crisis, but here are the facts.

      The gold price did not increase in U.S. dollars - but the United States was not in crisis. The gold price in Japanese yen, however, increased by 34% between 1995 and 1996. The next year the gold price jumped more than 40% in both Philippine pesos and Malaysian ringgit, and 67% in Korean won. Indonesia suffered the most during the Southeast Asian crisis, and the gold price accordingly increased more than 400% in rupiah.

      The next currency crisis may well be the almighty dollar. Gold will once again fulfill its role as a store of wealth and protector of capital. The question is just whether or not you own any.

      The dollar is likely to fall approximately 50% from its current level. That would free the dollar-denominated gold price to find its way back towards its true value of $699 an ounce (as of 2002). Given the mounting pressure on the dollar, there is virtually no chance that it will not collapse.