November 12, 2007 – Everyone knows that the dollar is losing purchasing power day after day because of inflation. Consequently, the practice of “inflation adjusting” has become well-known. It is a process that attempts to equate in a consistent way the purchasing power of the dollar at some previous point in time to the current cost of goods and services. The aim is to offset the distortion in prices caused by inflation
For example, on January 21st, 1980, gold closed in New York at $825.50. But we all know that a 1980-dollar had more purchasing power than a 2007-dollar now has because of the intervening twenty-seven years of inflation. So when inflation adjusting for this change in the dollar’s purchasing power, it now takes $2,208 to buy what $825.50 bought in January 1980.
Clearly the dollar is not a consistent measure of purchasing power. This is a tragedy with dire long-term consequences, for reasons so pointedly explained by John Maynard Keynes in his Economic Consequences of the Peace penned in 1920:
“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily and, while the process impoverishes many, it enriches some…Lenin was certainly right. There is no subtler, no surer means of overthrowing the existing order of society than debauching the currency.”
There is no doubt that the dollar is being debauched year after year. However, the true picture is much worse than most people suspect. There are two problems with inflation adjusting overlooked or ignored by nearly everyone.
First of all, the federal government has repeatedly changed the Consumer Price Index so that it no longer accurately measures the actual rate of inflation. The adjustments made to it cause the CPI to significantly understate the real loss of purchasing power in the dollar.
In order to account for this loss, John Williams of www.shadowstats.com calculates the CPI the ‘old’ way, without the federal government’s changes. By his calculation, the rate of inflation today is 10.4%, compared to the 2.8% rate of inflation reported by the federal government. That’s a big difference, and the impact of that difference is magnified when inflation-adjusting over long periods of time.
For example, here are two calculations for the price of gold, which was generally $35 per ounce until President Richard Nixon declared on August 15th, 1971 that the dollar would no longer be defined as a weight of gold. Inflation-adjusting using the federal government’s method, $35 today equates to $179.40. But using the old CPI formula still followed by John Williams, $35 equates to $471.70.
This different result between these two methods of calculating for the loss of purchasing power from inflation is huge, but we should not accept this $471.70 price as the correct measure because inflation-adjusting does not tell the whole story. This incomplete picture is its second problem. There is another form of currency debauchment – called debasement – that is not captured by any inflation-adjusting method. This second problem needs some explanation in order to pinpoint it.
When precious metal coins were used as currency, inflation would result if too many coins were circulated, even if they were gold and silver. There was, for example, a harmful precious metal inflation when the newly discovered riches of the New World were brought back to Spain over a short period of time.
In other words, regardless of the nature of the currency being used, inflation will be the result if too much new currency is introduced, regardless whether it is gold or silver coin in 16th century Spain or paper dollars in the United States today. As I explain above, the CPI attempts to measure this loss of purchasing power from inflation. What the CPI does not measure is ‘clipping coins’, which is the loss of precious metal in a coin said to contain a certain weight of metal.
If a one-ounce coin only has .99% of an ounce of gold, that coin has been ‘debased’. To put it into current-day terms, the coin is circulating with $832.50 of purchasing power (based on Friday’s closing rate of exchange between gold and the dollar), but only has $824.18 of gold content. Debased coinage is a much more subtle form of debauchment than inflation.
Debasement is particularly hard to grasp in today’s world in which currency is paper banknotes or book entries on a bank balance sheet. Fortunately, we can nevertheless measure how badly the dollar has been ‘clipped’ with the Fear Index. Here are the calculations for the Fear Index as of October 31st:
|(US Gold Reserve) * (Gold’s Market Price)|
|———————————————————————-||= Fear Index|
|(261.5 million ounces) * ($790.60 per ounce)|
Thus, for every $100 of M3, which is the total quantity of dollar currency in circulation, the value of $1.65 as of October 31st is derived from the US Gold Reserve. The value of the other $98.35 is derived from the other assets in the Federal Reserve and the banks, namely, loans and government paper they own. The accounting of these components that give the dollar its value is made clear by looking at the dollar’s balance sheet.
Monetary Balance Sheet of the US Dollar as of October 31, 2007
(denominated in billions of units of account called dollars)
|Gold @ $790.60||$206.7||Federal Reserve Notes||$815.8|
|IOU’s Owed to Banks||12,318.6||Bank Deposits||11,709.5|
|Assets Backing the $||$12,525.3||M3||$12,525.3|
Dollars are liabilities of financial institutions. Because they are liabilities, they are only as good as the assets on the balance sheet of those financial institutions. In other words, dollars are not money (i.e., gold); they are only a money substitute that we use in place of gold as a convenience. We also use dollars because legal tender laws force them into circulation, which is the case with most national currencies today.
Both inflation and debasement are made clear by the monetary balance sheet. The total quantity of currency, as reported in M3, determines inflation. The relative percentage weight of gold backing the dollar (which is the Fear Index) measures the dollar’s debasement.
So to get back to the point about ‘clipping’ the dollar, as the Fear Index declines, the dollar is being ‘clipped’. Just like a gold coin loses gold ‘content’ when it is clipped, a dollar loses gold content – which is expressed as ‘backing’ – when the Fear Index declines.
Thus, to compare a 2007-dollar to a 1971-dollar, use the Fear Index, not any inflation-adjusting measure. Because it is based on both the quantity of dollars as well as the weight of gold giving value to the dollar, the Fear Index captures both inflation and debasement. Therefore, the Fear Index is much more useful than any inflation-adjusting method. The Fear Index accurately conveys the true loss in the dollar’s purchasing power.
Here’s an example of how to use the Fear Index to equate the dollar over long periods of time. In September 1971, one month after the $35 rate of exchange between gold and the dollar was abandoned, gold was $42.65, and the Fear Index was 1.65%. Today the Fear Index is again 1.65%, as indicated in the formula calculated on page 1. The conclusion therefore – as difficult as it may be to accept – is that gold on October 31st at $790.60 was essentially of equivalent value to gold at $42.65 in 1971.
Gold closed Friday at $832.50, which is 5.3% above its October 31st price. Therefore, if you bought gold on Friday and want to compare it to the dollar that existed in September 1971, you were basically buying that gold at $44.91.
In other words, even at $832.50, gold is exceptionally good value. We just don’t easily recognize how good a value gold really is because we try to measure its value in terms of dollars, which is a currency that is continually being both inflated and debased. These two ills greatly distort the dollar.
We therefore need the Fear Index to provide a clear picture, which is what the page-1 chart presents. I have put on the chart the dollar price of gold at key points of time. We can clearly see that gold at October 31st, 2007 was the same essential value when its price was $35 in early 1971, just months before the last remnants of the gold standard were abandoned.
So for older readers who remember the 1970s, did you regret by the end of that decade not having bought gold when it was close to $35 per ounce? Or are you a reader too young to have experienced that decade and regret having missed what was a once in a century opportunity? Well, this is a new century, and gold is as cheap today as it was in 1971. ¤