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
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
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
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
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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