The market price for gold
February 27, 2004
First of all, thank you for all the feedback. I do
read all of it. As much as I would love to discuss the points raised
in each comment individually, that is just not possible. I do, however,
plan to address some of them in future columns. In the meantime,
let’s get on with the story.
Gold was $20.67 in 1933, when gold was money and a
$20 gold coin actually contained 0.9675 ounces of gold. Last week
we saw that gold should have been priced at $35 an ounce in 1947.
But President Roosevelt had set the gold price at
$35 an ounce back in 1934, thereby overvaluing gold and undervaluing
the dollar. As a result, the US Treasury’s gold reserves increased
by 117% from 1934 to 1940, as foreigners sold massive quantities
of the metal to the United States (see last week’s column).
From 1940 to 1957 the US Treasury’s gold reserves
remained relatively constant but by 1958 they started falling. Within
three years, by 1960, Treasury gold reserves had declined as much
as twenty two percent. Just as the increase in gold reserves from
1935 to 1940 indicated that gold was overvalued and the dollar was
undervalued, the decline in reserves after 1957 indicated that the
dollar was now overvalued, and gold was undervalued.
It was becoming more and more difficult for the European
and American Reserve Banks to maintain the gold price at $35 an
ounce. In 1961 the situation was severe enough that the United States,
Britain, West Germany, France, Switzerland, Italy, Belgium, the
Netherlands and Luxemburg all agreed to sell gold into the market
to try and prevent the price from exceeding $35 an ounce; and so
the London Gold Pool was created.
The French, who were smart enough to realize that
the London Gold Pool was a loosing proposition, eventually started
selling francs for dollars and sent the dollars back to the United
States in exchange for gold.
By 1968, when the London Gold Pool croaked, US gold
reserves had declined more than fifty two percent from their 1957
levels. In 1971 US gold reserves were 9,070 tonnes, only seventy-two
tonnes more than they had been in 1935. It was clear that thirty-five
dollars were no longer worth an ounce of gold. But what should the
gold price have been?
An increase in the amount of dollars (dollar inflation)
reduces the dollar’s value and hence prices rise. Similarly,
an increase in the amount of gold in the world reduces the value
of gold and causes the gold price to decline. If we knew what the
increase in US money supply was from 1933 to present, and we knew
how much gold had been produced since then, we could theoretically
calculate what the gold price should be at any point in time.
This is not the same as taking the current money supply
(M3 as an example) and dividing it by the total amount of gold held
by the US Treasury, which would give us the gold price in dollars
assuming we were on a 100% gold standard. Rather, this tells us
what the gold price should be if gold were acting like an independent
The Consumer Price Index (CPI) that we used last week
to show that gold should have been worth $35 an ounce in 1947 is
not a direct measure of currency inflation. It indirectly measures
the effect of inflation by gauging the rise, or fall, of prices.
Implicit in the CPI are the effects on prices of an increase in
money supply and an increase in production. More money causes prices
to rise while an increase in production causes prices to fall –
everything else being equal, of course.
Applying a change in the CPI to the gold price assumes
that average worldwide gold production was increasing at more or
less the same rate as the average increase in production of the
basket of goods making up the CPI. This is not an ideal situation,
and I would definitely have preferred to use direct monetary inflation
and actual gold production.
It used to be simple: money was coins and currency.
Today money supply is thought of in terms of monetary aggregates
that include checking accounts and savings accounts, as an example,
in addition to coins and currency in circulation. The broadest measure
of money supply in the United States is M3 (what I prefer to use),
except that M3 data doesn’t exists prior to 1959. The Reserve
Bank of Minneapolis did a study that extrapolated M3 back to 1948,
but that still leaves us with a fifteen-year gap from 1933 to 1948.
Which is why I used CPI data to calculate the gold price from 1933
Since M3 data from 1948 onwards is available we can
now look at the inflation of dollars (increase in M3) relative to
the inflation of above ground gold (that is the total amount of
gold ever mined). Because of its physical properties, essentially
all gold ever mined is still around in some form or another, whether
it is jewelry, coins, bars, or whatever. Gold inflation is therefore
just annual mine production as a percentage of above ground gold.
Starting with a gold price of $35 an ounce in 1947
(last week’s column) it is now possible to calculate the theoretical
gold price for every year since then. In 1971, for instance, when
Nixon closed the Gold Window in a desperate attempt to retain some
gold in the Treasury, the gold price should have been $103 an ounce.
It is therefore no surprise that gold was being bought hand over
fist at thirty five dollars an ounce, and that the gold price began
to increase immediately after it was emancipated.
Still, it would be unreasonable to expect that after
thirty eight years of a fixed, thirty-five dollars an ounce gold
price, the market would immediately trade at the correct level.
But by 1974 it had essentially reached its correct price. The chart
below compares the theoretical gold price with the actual US dollar
gold price between 1971, when Nixon closed the Gold Window and left
it up to the market to establish its price, and 1978.
In 1971 the average gold price was $41.17 and the
theoretical gold price was $102.78, a difference of 60%. That difference
had narrowed to 49% in 1972, 24% in 1973 and 14% in 1974. By 1978
there was only a 3% difference between the actual gold price and
the theoretical gold price. The average difference from 1974 to
1978 (both years included) is only 13%.
The fact that there is, on average, only a thirteen
percent difference between the actual gold price and the theoretical
gold price for the five years from 1974 to 1978, is astonishing.
But not if gold is behaving as money: a currency currently independent
of any government, whose value is market determined.
As you will see, this incredible correlation between
the actual gold price and the theoretical gold price is not a fluke.
The correlation remains strong right up to the present day. The
market has been pricing gold correctly not only since Nixon closed
the gold window in 1971, but even during the Bretton Woods years,
as illustrated by the flow of gold into, and then out of, the US
Next week we’ll start off at 1978.
Paul van Eeden
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