August 28, 2006 – Gold is one of the world’s most misunderstood assets. There are many reasons for this unfortunate situation, but one stands out. Gold exists in an environment in which there are many powerful forces fiercely hostile to it. Most notable among these are governments and the myriad of vested interests that feed from the public purse or rely upon some government-issued license or privilege.
Governments have confiscated gold, taxed it, propagandized against it and even outlawed it. Gold does not have any powerful sponsor championing its cause. In fact, the opposite prevails. Apologists for central banks as well as government toadies clamoring for continued state control of money have worked hard to discredit gold where possible, for example, by blaming it for things it was not responsible – like the Great Depression – and by denigrating gold as a fondling of speculators or a superstition better suited for primitive economies.
Conventional economic wisdom and monetary thinking is designed to justify the reality of the way today’s monetary system works. It does not undertake a critical review of the system nor look at alternatives such as gold.
Yet despite this hostile environment, gold continues to be valued throughout the world. Stripping away the misinformation and half-truths about gold, it is clear that gold continues to serve an important role. Why is that?
It is because gold is useful, and as a consequence, it therefore has value. And how does gold’s usefulness arise?
Here is a basic primer highlighting the eight most important essential features of gold that everyone should know. By evaluating them, it is possible to determine whether gold’s usefulness could be of value to you, just as it already is of value to countless millions of people around the world.
1) Gold is a special, unique commodity because it is the only commodity produced for accumulation; all other commodities are produced to be consumed. Essentially all of the gold mined throughout history still exists in aboveground stocks. Nevertheless, gold is rare.
The entire aboveground gold stock is only about 155,000 tonnes. If all this gold were put into one lump, its size would be 8,000 cubic meters, the volume of which is equal to the bottom 18% of the Washington Monument or 3¼ Olympic size swimming pools. It is also staggering to note that in one day twenty-times more steel is poured than the total weight of gold mined throughout history.
2) Because it is accumulated and not consumed, gold’s supply is its aboveground stock. This fact changes everything in terms of how to analyze gold.
Gold’s price is still a function of supply and demand, but the supply that matters is not the relatively little amount mined each year, which historically only increases the aboveground stock by a relatively consistent 1.7% per annum. Rather, gold’s supply is the weight accumulated in its aboveground stock for the simple reason that a gram of gold mined today is no different from a gram of gold mined by the Romans two-thousand years ago. In other words, gold in the aboveground stock is perfectly substitutable for newly mined gold.
Supply is not that important in determining gold’s price because in the short-term gold’s supply is relatively unchanged. New mine production cannot be meaningfully increased in the short-term. So gold’s price is principally a function of demand.
While it is common to hear that gold’s price is determined by jewelry demand, that belief is totally misguided. Just like wet streets do not cause rain, the price of gold does not depend upon jewelry demand. The important point is not the form gold takes when it is fabricated, but rather, the use to which it is put. Most jewelry is high-karat gold acquired because of gold’s monetary characteristics, not for reasons of adornment.
Therefore, the price of gold – or more precisely because it is money – gold’s rate of exchange depends upon monetary demand, or what some people mistakenly call its investment demand. It cannot possibly be otherwise, given that gold’s supply is its aboveground stock and that some 80% of this amount is held for monetary reasons, and not for fashion, adornment or other factors.
3) This observation about monetary demand means that gold is money. In other words, gold is hoarded because its greatest usefulness arises from those attributes that make it money.
Gold’s advantages as money are numerous. Perhaps most important in our present age marked by the perennial inflation of national currencies, gold is money that cannot be created ‘out of thin air’ by government fiat. Another important factor in gold’s favor is the mountain of debt and financial derivatives that overhang the world economy. Gold is the only money that is not contingent upon anyone’s promise, an attribute that explains why gold is called “sound money”.
4) The US dollar is in trouble because it is being debased – it is being inflated by newly created dollars that fund the growing federal government budget deficits. This insidious inflation erodes the purchasing power of the dollar month after month. That’s bullish for gold.
It used to be that the dollar was “as good as gold”. The dollar achieved that distinction because it was formally defined as a weight of gold under the rule-based system known as the gold standard. Under that system, which ended 35 years ago this month, gold and dollars were interchangeable and essentially the same. But no more. By some estimates, the dollar has lost more than 90% of its purchasing power since then.
Nevertheless, gold and the dollar remain competitors. In fact, gold is the dollar’s only serious competitor. They compete for holders, which explains the reason for the Federal Reserve’s pro-dollar, anti-gold propaganda. It also explains the importance of dollar interest rates, which need to be raised from time to time to entice people to hold dollars instead of gold.
The Fed has stopped raising rates, at least for now. But even if they start raising rates again, remember that only real (i.e., inflation adjusted) interest rates matter. Nominal interest rates are not important. For example, if dollar interest rates are 10% and the inflation rate is 10%, real interest rates are zero, and low or negative real interest rates are bullish for gold.
5) Gold preserves purchasing power, but there’s another way to describe this essential feature of gold. Don’t view gold’s price to be rising. Rather, recognize that the purchasing power of the dollar is falling. This conclusion can be made clear by looking at the price of goods and services in terms of dollars and also gold.
For example, the price of crude oil from January 1946 to July 2006 has risen from $1.17 per barrel to $74.40, a 64-fold increase in price. A different picture emerges though when crude oil prices are viewed in terms of grams of gold. A barrel of crude oil today costs 3.6 goldgrams, only slightly above the 2.3 goldgrams average price achieved since 1946.
6) It is important to understand that the market gives gold its value, not central banks, though central banks would have you believe otherwise. Central banks tell you what they want you to hear. They would like you to think that they control gold’s price, but the reality is different. The market determines gold’s price, just like it determines the price of a Picasso or a loaf of bread.
Though central banks do not control the gold market, they can influence gold’s price. Importantly, their influence is diminishing. Central banks have been dishoarding much of the gold in their vaults, so they now hold a relatively small part of the aboveground gold stock. After the Second World War, about 90% of the aboveground gold stock was in the vaults of central banks. It’s now probably about 10%. Less gold within their control means that central banks have less influence on its price.
Central banks intervene in the gold market – just like they intervene in many other markets. The reason for their attempts to manage the gold price is simple. By keeping the gold price low, central banks make the dollar look better. With their interventions central banks are trying to make the dollar look worthy of being the world’s reserve currency.
The gold price is a barometer that measures whether a national currency is being managed well (i.e., no inflation). So by trying to keep the gold price low, central banks artificially make the demand for dollars higher than it would otherwise be. It is also consistent with the statist philosophy of governments these days, namely, that they will usurp whatever power they need to try maintaining the status quo in order to preserve the privileged position politicians enjoy at the expense of taxpayers.
But central banks are no longer the factor they once were. Gold is relatively undervalued, and the weight of money moving into gold means that central bank influence on gold is declining. To understand why, you need to know what GATA knows. The Gold Anti-Trust Action Committee has published the combined research of several analysts, including several contributions by me, and it is all available for free at www.gata.org
7) Since 2001 gold is up about 14% per annum on average, but gold is headed higher still. How much higher?
No one of course knows, but in my October 2003 interview in Barron’s I identified $8,000 as my target. I reaffirmed that target in another interview in Barron’s in May 2006. Now before you say that target is outrageous, consider the following.
It takes about $10 today to purchase what $1 purchased in the 1970s, which saw gold rise that decade from $35 to its record high of more than $800 in 1980. I expect history to repeat, taking gold from $350 a couple of years ago to over $8000 in a decade’s time. It is not unreasonable to expect that gold will once again command the purchasing power it once did, particularly given the ongoing inflation of the dollar.
8) It is prudent to buy gold because of the alarming problems facing the dollar and other national currencies. Gold offers a simple means to diversify and therefore hedge risk, but make sure you buy physical metal, not paper. There is a big difference between owning metal and just a promise to pay metal to you.
Examples of physical metal that you can own are coins, bars, high-karat jewelry and the gold offered by my company, GoldMoney, which stores the gold you own in a specialized and insured bullion vault near London, England. Examples of ‘paper gold’ are gold certificates issued by banks and mints, pool accounts, futures accounts and the NYSE listed exchange-traded fund. With these products you own a piece of paper rather than gold itself.
Gold should be viewed as the bedrock asset in your portfolio, so do not take any risks with it. As a consequence, own metal, and not just someone’s promise.