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 previously mined.
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 anything else.
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 over time.
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 value.
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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