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
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 currency.
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 to 1947.
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
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
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 Treasury.
Next week we’ll start off at 1978.
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.
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