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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 to go.

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 saw fit.

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 own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

Disclaimer

This letter/article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be -- either implied or otherwise -- investment advice. This letter/article reflects the personal views and opinions of Paul van Eeden and that is all it purports to be. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in this letter/article. The information contained herein is subject to change without notice, may become outdated and will not be updated. Paul van Eeden, entities that he controls, family, friends, employees, associates, and others may have positions in securities mentioned, or discussed, in this letter/article. While every attempt is made to avoid conflicts of interest, such conflicts do arise from time to time. Whenever a conflict of interest arises, every attempt is made to resolve such conflict in the best possible interest of all parties, but you should not assume that your interest would be placed ahead of anyone else’s interest in the event of a conflict of interest. No part of this letter/article may be reproduced, copied, emailed, faxed, or distributed (in any form) without the express written permission of Paul van Eeden. Everything contained herein is subject to international copyright protection.


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