The devaluation of gold
July 15, 2005
Last week’s comment that the increase in gold
supply since 1900 has, in effect, devalued gold by an average of
1.73% per year resulted in a flurry of emails. So I thought I would
follow up this week and continue to look at gold’s value.
Before we get to that, let’s get some things
out of the way. One comment I received claimed that monetary inflation
only occurs when the supply of money exceeds the increase in real
gross national product. That is incorrect. Inflation occurs when
the supply of money increases. Price increases occur when the rate
of inflation exceeds the rate of increase in real gross national
product. An increase in prices is not the same as inflation; it
is the result of monetary inflation.
Another comment was that gold is removed from supply
when it is fabricated into jewelry. It all depends on how you look
at jewelry. Many of us view jewelry purely as items of adornment.
But during times of trouble jewelry quickly becomes a source of
currency and in some countries jewelry is widely accepted as a store
of wealth. In my opinion gold jewelry is no different than coins
or bars of gold. It has a higher manufactured component to it that
could become a loss to the owner, but it will always have at least
its intrinsic weight-value of gold (less smelting costs).
Here is a recap for those who did not read last week’s
commentary. If we view gold as money then the supply of gold consists
of all the gold that has ever been mined, since practically all
of it is still with us in one form or another, mostly as bars, coins
and jewelry. Annual mine production of gold increases the supply
of gold (the total of all the gold previously mined) and can therefore
be thought of as inflation of the gold supply. The inflation rate
of gold is annual mine production as a percentage of all the gold
Since 1900 the supply of gold has increased, due to
mining, by an average annual compound rate of 1.73%. As the supply
of money increases, the value of each unit of that money decreases.
The value of each ounce of gold has therefore decreased by an average
of 1.73% per year since 1900 in absolute terms, not relative to
By comparison, the US money supply (as measured by
M3) has been increasing by an average compound rate of 7.8% since
1959. While gold devalues at the rate of 1.73% per year, the dollar
devalues more rapidly. The value of gold in US dollars has therefore
increased at an average rate of 6.07% since 1959. Note that I did
not say “the price of gold” in the previous sentence.
We all know that gold was under-priced at $35 an ounce in 1959.
According to work I have done, I estimate that the gold price should
have been about $51.22 an ounce in 1959 and, if you assume that
that is more or less correct, you can calculate what the gold price
should be today. Compounding $51.22 at 6.07% for 46 years results
in a current value for gold of $770 an ounce.
The gold price today would be about $770 an ounce
were it not for the surge in the US dollar exchange rate during
the 1990s. The fact that gold is not trading at around $770 an ounce
today is due solely to the strength in the dollar; it has nothing
to do with market manipulation or a conspiracy against gold. In
due course I believe that the US dollar will decline sufficiently
for the gold price to reach its fair value again, but that will
be nothing other than a bear market in the dollar. In the long run,
the percentage increase in the price of gold in US dollars is equal
the difference between the inflation rate of gold and the inflation
rate of the dollar. The same is true for the price of gold in any
other currency. In the short-term, however, the gold price can deviate
from its fair value due to exchange rate volatility and capital
flows (see last week’s commentary).
Exchange rates cannot be ignored. The moment you define
the gold price in terms of a currency, any currency, you have linked
it to the exchange rate of that currency. To talk about the price
of gold is meaningless: we have to specify in which currency we
are pricing gold. Consequently, the price of gold in US dollars
is subject to changes in the US dollar exchange rate, the price
of gold in euros is subject to the euro exchange rate and the price
of gold in yen is subject to the yen exchange rate.
We can also attempt to value gold in other terms.
We could measure gold against a basket of goods and services. Or
we could measure gold against the world’s population.
Gold’s value relative to goods and services
is a not a useful indicator. The value of gold will decrease against
goods and services that become scarcer with time and increase with
respect to goods and services that become more abundant. This is
again a relative game, so we have to consider the relative changes
in the goods and services. Not to mention the difficulty of trying
to come up with goods or services that are uniform and constant
According to the United Nations the global population
in 1950 was 2,519,470,000 and it is 6,464,750,000 now. That is an
average annual compound increase of 1.73% and by coincidence the
same rate as gold inflation -- I didn’t make this up. Because
the increase in population is the same as the increase in the supply
of gold, the value of gold remains constant relative to people.
Because the inflation rate of gold and the increase
in population are similar we should find that the value of gold
remains constant relative to labor. The biggest problem (other than
a lack of data) is that labor costs change dramatically depending
on the skills, experience and level of education of the labor force.
While it may be difficult to come up with an international labor
cost index against which to measure gold the mere fact that population
growth and gold inflation occur at similar rates would suggest that
gold should retain its value relative to labor, and labor is perhaps
the most basic measure of value.
Comparing gold’s inflation rate to changes in
a country’s gross domestic product could give us an idea of
how gold’s value changes in relation to goods and services
in that particular country. But there are so many uncertainties
when it comes to gross domestic product, such as the deflator that
is used and, in the case of the US, hedonic adjustments, that I
do not think we will find it to be a reliable measure of gold’s
Regardless of what we use to gauge the value of gold,
we should keep in mind that gold is simply a store of wealth, an
independent form of money that cannot be created at will and therefore
retains its value better than anything else.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
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