GoldMoney Alert
26 November 2003
___________________________________________
Searching for Gold's Value
I am always on the outlook for interesting analyses of the gold market. I am therefore very pleased to present the following paper written by Paul van Eeden of: www.internationalspeculator.com
email address: Paul van Eeden <info@internationalspeculator.com>
Paul offers a comprehensive analysis of the gold price, but I also like this paper because of the historical perspective it provides. I hope that you enjoy it as much as I did.
--------------------------------------------------------------------------------
The Gold Price
By Paul van Eeden
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 US 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 US 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 about 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 thirteen 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 to why it is trading for $325 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 US 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 US 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/M3n-1)(GPn-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 to 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, 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.
"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 Congress declared that a serious emergency exists, I as President, do declare that the national emergency still exists; that the continued private hoarding of gold and silver by subjects of the United States poses a grave threat to the peace, equal justice, and well-being of the United States; and that appropriate measures must be taken immediately to protect the interests of our people." Franklin Roosevelt - March 9, 1933
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 Unites States' gold reserves expanded from 8,998 tons in 1935 to 19,543 tons in 1940, as many foreigners cashed in on the overnight gain that the United States' 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 tons 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 US dollars made the rest of the world realize that thirty five of them just weren't worth an ounce of gold any more. Massive redemptions of dollars, in exchange for gold, depleted the Treasury's gold reserves by 58%, to 8,584 tons by 1972. In 1972 the United States had less gold than in 1935 but it had approximately ten 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. US gold reserves stayed roughly at 20,000 tons 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 tons), peaking in 1952 (20,663 tons) 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 US, 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 onwards 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 onwards are shown in the following chart.
Following is a comparison between the theoretical gold price and the actual gold price, to see how well the model stands up to reality.
Closing the Gold Window
The massive redemption of dollars forced Nixon to close the Gold Window in 1971, in a desperate attempt to retain some gold in the Treasury. When forced to choose between holding gold or his own dollars, Nixon chose gold. That, in and of itself, should tell us something about the value of gold.
Gold was now officially demonetized and since it could no longer be acquired at a price of $35 an ounce, the market was left to determine what the actual price should be. Since we know that gold was worth $35 an ounce in 1947, we can calculate what the price of gold should have been in 1971, and compare it to what actually happened in the market.
Dollar inflation from 1947 to 1971, offset by gold inflation, meant that the gold price should have been $103 an ounce when the Gold Window was closed, almost three times its official price of $35 an ounce. With the gold price at only a third of its value, it just had to go up.
Not only was this upward force at work, but inflation during the 1970s also lit a fire under the gold price. M3 more than doubled from 1971 to 1978. By 1978 the gold price should have been $199 an ounce and, in fact, its average price for that year was $193 an ounce.
It's very reassuring that the theoretical gold price coincides this well with the actual price for 1978: it confirms that the establishment of 1947 as the year during which gold was actually worth $35 an ounce, is most probably right on the mark, and that the model is working.
But if you look at Figure 1 you will notice that the gold price continued to rise far beyond what the model predicts, and remained above the theoretical price until 1984. Why?
1978 - 1984
The gold price's deviation from its fair value between 1978 and 1984 can be explained by looking at what else went on during that time.
In retaliation for the Western world's support of Israel, during the Arab-Israeli War of 1973, Arab members of OPEC took control of the organization, cut oil production and increased the oil price from $3.00 a barrel in October 1973 to $11.65 in January 1974, a 288% increase in just four months. In addition, the United States and the Netherlands were cut off from OPEC oil supply due to their close relationships with Israel.
This did not, however, push the price of gold up. In fact the gold price had reached fair value in 1974, remained essentially flat during 1975 and fell 22% in 1976. By 1978 the gold price had reached fair value again. This market action seems normal and does not indicate any gold price premium as a result of the oil embargo, or the increase in the oil price.
But on the backdrop of this tension between the United States and the Arab World, the Iranian Hostage Crisis in 1979 did cause a dramatic rise in the gold price. When fifty-two Americans were taken hostage by Iranian students in November 1979, at the American Embassy in Tehran, the gold price shot up from an average price of $305 to $615 in 1980, briefly trading over $800 an ounce in January of that year. The hostages were finally released on January 20, 1981, four hundred and forty four days after their capture, and the gold price was on its way down again, to find its theoretical level of $236 an ounce.
From 1980 to 1984 the gold price declined by 41% to $361 an ounce, which differs by only $25, or 7%, from its theoretical price of $336 an ounce.
1984 - 1988
With the oil crisis over, the hostages released, and the status quo of the Cold War casting an eerie calm over the world, not much happened between 1984 and 1988 to upset the gold price. The actual gold price differed, on average, by only 7% from its theoretical price during those four years. This is a remarkable correlation. Especially considering that we started with gold at $20.67 in 1933, and relied only on a logical adaptation of the gold price based on sound economic reasoning, without in any way modifying the results to better "fit" reality.
1988 - 1996
On the surface, the gold market between 1990 and 1996 was about as exciting as watching paint dry, but a lot was happening in the undercurrent.
Notice that the actual gold price started to deviate from its theoretical price in 1998. The reason, this time, may not be so obvious to those not intimately familiar with the gold market.
In 1983 a new financial risk management tool was developed to mitigate the impact of gold price volatility on mining companies: Hedging. Total gold hedging increased from four tons in 1983 to forty five tons in 1986. But from 1987 to 1990 a total of eight hundred and seventy six tons were hedged.
Whether it had anything to do with George Bush Senior's term as President or not, M3 growth increased only 6% between 1989 and 1993. Gold inflation on the other hand was 8% during that period, and so the gold price should have declined by 2% over those four years.
This downward pressure on the gold price, coupled to the expansion of hedging, decreased the actual gold price by 19% between 1987 and 1993. The gold price was now more than 15% below its theoretical value and the upward pressure again began to show.
The vigorous resumption of dollar inflation in 1994, and the already undervalued gold price, exerted strong upward pressure on the Midas metal. Yet in 1996 the gold price began a 30% decline, to $273 an ounce, which it reached in 2001. This occurred despite the increase in M3, which drove up the theoretical gold price to $659 an ounce over the same period.
Before we examine what happened since 1996, it is important to note that even with the advent of hedging between 1984 and 1996, the actual gold price differed, on average, by only 12% from its theoretical price during those years. This is five decades after we began our theoretical calculations and once again validates the concepts on which the theoretical price is based.
The dollar exchange rate
Gold is quoted in US dollars as a remnant of the period between 1944 and 1971, when the US Treasury owned most of the official gold reserves, and an ounce of gold was convertible into 35 dollars.
Prior to 1971 most currencies were pegged against the dollar at fixed exchange rates, so the price of gold in other currencies did not change much between 1944 and 1971 either. After 1971 the exchange rates between most currencies started to fluctuate. Nothing was convertible into gold anymore, so there really wasn't any standard to measure a currency's "value" against.
The dollar was still regarded as one of the most stable currencies in the world as the United States had both the largest economy and the most foreign trade. It was therefore natural to continue to use the dollar as the de facto reserve currency. But as the dollar was now also floating against most other currencies, it was possible for the dollar's exchange rate to increase in response to the demand for dollars, and decrease in response to supply.
continued |
