continued from last post
To determine the price of gold in any other currency one would still just multiply the dollar denominated gold price by the relevant exchange rate. The difference is that the gold price now fluctuates in dollar terms (due to dollar inflation and gold inflation), and the dollar itself fluctuates against other currencies. So the gold price in Japanese yen, for example, would behave quite differently than the gold price in dollars - as we will see later.
From 1988 to 1992 the dollar exchange rate was relatively stable. But it has not been so since 1992.
Currency crises
Recall that the upward pressure on the gold price predicted by the model since 1994, due to increased M3, was not reflected in the actual gold price, and that from 1996 to 2001 the gold price actually declined. The reason lies in the phenomenal increase in the demand for dollars following a series of currency crises, each one compounding the demand further, tightening the supply, and strengthening the dollar against almost all other currencies.
During a currency crisis capital, seeking a safe haven, typically flows out of the troubled country. Between 1992 and 1994 the Brazilian real lost essentially all its value. The capital flight from Brazil created demand for dollars and some of it found a home in the United States. In response, the dollar increased by about 10% against a Gross Domestic Product (GDP) -weighted index of thirty five currencies we monitor.
From 1994 to 1995 the Mexican peso declined by over 50% against the dollar, the worst financial crisis in Mexico since the Revolution. More capital moved into the United States and this further increased demand for dollars.
The Japanese yen lost 24% against the dollar from 1995 to 1996, and still more capital fled to the United States, but the "Big One"- the South East Asian Crisis - didn't hit until 1996.
From 1996 to 1998 the Indonesian rupiah lost 76% of its value against the dollar, setting off a domino effect that dragged the South Korean won down 56%, the Malaysian ringgit down 40% and the Philippine peso down by 40%. A truly massive flight of capital ensued, most of it destined for the United States, and increased the dollar by almost 30% against our GDP-weighted index.
In 1998 Russia defaulted on its foreign debt, sending the ruble down over 70% in 1998 alone. The euro's launch in 1999 was also the beginning of its 28% decline against the dollar. Back in 1998 the "new" Brazilian real collapsed again, the Turkish lira fell in 2000 and the Argentine peso followed in 2002… you get the picture.
In all these cases capital fled to the United States. As a result, the dollar increased by more than 120% from 1990 to 2002 against our GDP-weighted index currencies.
Regardless of what the gold price is doing in other currencies, the gold price in dollars is inversely related to the dollar exchange rate. Just like any other import, if the dollar gets stronger the price goes lower. There is an almost perfect correlation between the decline in the gold price, between 1996 and 1998, and the increase in the dollar exchange rate as a result of capital influx from abroad.
This explains the deviation from gold's theoretical price up to 1998, but it does not explain why the actual gold price stabilized between 1998 and 2001, and then commenced a 30% increase in 2002, while the dollar exchange rate did not decline.
The consolidation in the actual gold price from 1998 to 2001, and the ensuing increase in 2002, is a result of the raging, worldwide, bull market in gold that is finally affecting its price in dollars.
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 US 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 US 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 $325 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 Figure 1 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.
Trade deficits
The influx of capital into the United States had a broader impact on America's economy than just increasing the dollar's exchange rate. This was discussed in the February 2003 issue, so suffice it to say here that the Trade Deficit is directly related to the strengthening of the dollar because it made imports cheaper and exports more expensive, during an economic boom that was itself propagated by the influx of capital from abroad.
Barry Eichengreen, from the University of California at Berkeley, has shown using historical data that First World countries can in fact eliminate large Trade Deficits. The good news is that the Trade Deficit can be eliminated quite rapidly. The bad news is that it almost always requires a major, and prolonged, recession. Given the size of the United State's Trade Deficit, it is unlikely that we will have a mere recession - a depression is more likely.
However deep, or prolonged, the economic downturn is going to be, it is impossible to imagine that the United States will continue to attract in excess of $400 billion dollars' worth of foreign capital every year. And when the foreigners stop sending their saving to America so that we can finance our consumption habits, the dollar will decline.
The euro
I do not particularly like the euro, as it is the ultimate fiat currency, but it does offer the world an alternative reserve currency to the dollar. If it weren't for the fact that dollars are being created at the rate of about 600 billion a year, I probably wouldn't have given the euro a second thought.
But the inflation of the dollar, the debunking of the American economic miracle, the arrogance of American Foreign Policy and, perhaps most importantly, the detrimental impact that the War on Terrorism is bound to have on American liberty - not to mention the misallocation of capital and increase in debt that go hand-in-hand with war - are all virtual guarantees that the dollar is going to lose some of its super hero status.
There were two reasons why the dollar became the reserve currency of the world. One, it was convertible into gold - which is no longer true. Two, the dollar was in demand to settle international transactions, as the United States became the world's largest economy and trading nation.
The introduction of the euro has created a viable alternative to the dollar. Neither currency is backed by gold, so the one is just as bad as the other, and the aggregate economy of the European Union is similar in size to the United States'. But Europe has one big advantage over the United States: it has a Trade Surplus. We still have to work off our Trade Deficit, and we know that is going to hurt.
The euro is also likely to get a booster shot from US Foreign Policy. Backlash at American imperialism has already caused several countries to convert massive amounts of dollar reserves to euro reserves.
The real clincher will be the expansion of the European Union though. As more and more countries join the Union, the demand for euros will increase, and the need for dollars will decrease.
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 South East 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 US dollars - but the US 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 South East 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.
Conclusion
Our model demonstrates beyond any doubt that the gold price is ultimately defined by the inflation of the dollar relative to the inflation of gold. Any deviation from this theoretical gold price can be adequately explained, and is temporary.
What is important for us in 2003, is that the gold price is either going to increase to $700 an ounce, or more; or the US money supply has to decrease by 50%. This is not the same as saying that the inflation rate has to decline by 50% - this is saying that we need a 50% decrease in the amount of dollars outstanding, which is a practical impossibility. Therefore, the only conclusion is that the gold price is going up.
Buying gold now is the lowest risk investment you can make. And the upside is a once-in-a-lifetime opportunity.
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Published by GoldMoney
Edited by James Turk, alert@goldmoney.com |
