Gold is on its way up again
February 16, 2004
Gold is on its way up again after Greenspan indicated
that he really isn’t in any hurry to raise interest rates.
This caused the dollar to weaken and the gold price to rise. Not
because gold became more attractive, merely because the weaker dollar
translates into more dollars per ounce of gold.
We now understand the relationship between the US
dollar exchange rate and the dollar-gold price, both in theory and
in practice (previous columns), and so it’s time to move on.
Apparently gold has been demonetized. Supposedly it
has lost its value as a store of wealth, and is no longer necessary
in our modern monetary system. To address these issues and figure
out what we should expect from the gold price, which is perhaps
the more pertinent question for some readers, we have to be able
to calculate, somehow, what gold is really worth. And by that I
don’t mean what it is trading for.
Some people believe that a stock, or commodity, is
only worth what it is trading for. In a trading-sense that is correct.
But there is such a thing as intrinsic value and, especially for
investors, if you know what the intrinsic value of an investment
is relative to its stated value (current price), you are in a better
position to determine whether to buy or sell. Finding gold’s
intrinsic value is our next task.
First we need to make an assumption: gold is money.
Its intrinsic value is derived from its role as money and a store
of wealth. Gold has been used as money for millennia and, as I will
show you in due course, it is still being used as a store of wealth.
Even according to the Federal Reserve Board Chairman, it’s
still used as money: “Gold still represents the ultimate form
of payment in the world… Gold is always accepted.” –
Alan Greenspan, May 20, 1999.
We can return to this assumption again later but without
stating it, and having somewhere to start from, we have nowhere
At the start of the twentieth century the world was
officially on a gold standard. England adopted a de facto gold standard
in 1717 after Sir Isaac Newton, then Master of the Royal Mint, undervalued
silver. In 1819 England formally adopted the gold standard. The
United States was on a bi-metallic (gold and silver) standard but
switched to a de facto gold standard in 1834 and an official gold
standard in 1900.
The value of the dollar had been set in 1834: a twenty
dollar gold coin contained 0.9675 ounces of gold. Dividing the face
value of the coin by its gold content gives you the gold price:
$20.67 per ounce. This conversion rate between gold and the dollar
remained in force until 1934.
Evaporation of capital after the stock market crash
in 1929 precipitated a deflationary economic contraction. 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. Nominal GDP fell thirty six percent
from 1929 to 1934.
The government wanted people to spend their money
to stimulate the economy. But how do you get people to spend when
they are saving? Deflation was driving the Depression and it was
clear that money was gaining purchasing power, so it made sense
for people to save. Conversely, it doesn’t take long for people
to figure out that they are better off spending their money during
inflationary times, 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 that was impossible during the
gold standard because gold was currency. If the Government devalued
paper dollars, people would switch their savings to gold without
a net increase in spending.
The government was hamstrung. Creating dollar inflation
meant that gold would have to be removed from circulation and so,
in 1933, President Roosevelt declared private gold ownership illegal.
Now the government was free to print as many paper dollars as it
The very next year Roosevelt increased the gold price
by sixty nine percent, to thirty five dollars an ounce, thereby
instantaneously devaluing the dollar by forty one percent.
From 1934 to 1971 the gold price, officially, remained
thirty five dollars an ounce. However, as we will see, even though
the gold price was stagnant from ’34 to ’71, the gold
market was far from it.
I don’t know where Roosevelt got the number
‘thirty five’ from, but it is unlikely that gold was
worth sixty nine percent more in 1934 than it was in 1933. Therefore,
the last year in which we can be sure that gold was ‘correctly
priced’ is 1933, the last year of the gold standard, the last
year that gold was (officially) currency and because a twenty dollar
coin contained 0.9675 ounces of gold.
Gold was money up to 1933 and we know that the
conversion price of gold into dollars was $20.67 per ounce. So now
that we have a starting point, we can to try and figure out what
the gold price should have been after 1933, and how that compares
to the market price for gold.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
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