September 22, 1997 – In recent weeks as the Gold price slid to test support around $320, the bears have come out with newer and lower targets. Some say Gold is headed for $300. Some have set their price target to be $282, which is the 1985 low. These may or may not be reasonable targets.
I never take exception to anyone’s price forecast. Only time will prove their forecast or mine or anyone else’s for that matter, to be right – or wrong. However, I do take exception to those price forecasts that confuse or ignore the difference between Gold’s price and its value. Both of these words are used to communicate any marketable product’s worth, and both are often used interchangeably. However, they have different meanings.
Consequently, anyone who looks only at the Gold price without also giving due attention and consideration to Gold’s value is doing so at their financial peril.
To explain this difference between price and value consider those forecasts that are targeting the 1985 low at $282 to be the area at which Gold is headed and will in time reach. While Gold is presently still some $40 above that 1985 price, it is already better value today than it was back then, an important fact ignored in many of these bearish price forecasts. The reason for this different result between price and value is the Dollar, which is the numeraire used in these long-term comparisons. The Dollar does effectively communicate price, but its use in comparisons ofvalue over the long-term can be misleading.
Because of the Dollar’s on-going and relentless debasement, the unit of measurement denoted by a Dollar in 1985 is very different from the size of the measurement unit denoted by a Dollar in 1997. Though the term Dollar remains unchanged, the amount of wealth measured by a Dollar changes considerably over time because the purchasing power of a Dollar is constantly eroding. In other words, 282 1985-Dollars are not the same as 282 1997-Dollars because they measure very different quantities of purchasing power.
Consequently, the Dollar label attached to an ounce of Gold at its low in 1985 (i.e., $282 per ounce) means something very different from that same label today. That 1985 price label denominated in terms of Dollars measures a different amount of wealth than 282 1997-Dollars measure today. If all price comparisons of Gold were made in terms of purchasing power instead of Dollars, Gold’s exceptional value at current levels would be more readily recognized and understood.
For example, if we use the Consumer Price Index to measure the debasement of the Dollar, we can determine that one 1997-$ purchases only 48% of what one 1985-$ purchased. Therefore, it takes 429 ’97-$’s to equal the purchasing power of 282 ’85-$’s. Consequently, in terms of value (i.e., purchasing power), Gold at today’s price of $321 is already 25% below its 1985 low when measured in adjusted Dollar terms (recognizing that 429 ’97-$’s have the equivalent purchasing power of 282 ’85-$’s). But even this comparison understates the true value of Gold today.
One further adjustment to the Dollar is necessary because the monetary relationship between Gold and the Dollar has changed. This change results from the fractional reserve nature of the banking system that creates Dollar currency.
To explain this point, it is necessary to begin with the recognition that Dollar currency is a liability of the Federal Reserve (which issues cash currency) and also of the nation’s banks (each one of which issues deposit currency, e.g., the Dollars on deposit in checking accounts). Consequently, Dollars only have value as currency because the monetary institutions issuing Dollars have assets of value.
Though these assets are quite diverse and numerous, they can be grouped within two categories describing their essential nature – tangible and intangible assets. There is only one tangible asset, and it is on the balance sheet of the Federal Reserve – 261.7 million ounces of Gold. The intangible assets are debt obligations, i.e., the money loaned out by and therefore owed to banks and the Federal Reserve.
This relationship of monetary assets to currency liabilities can be illustrated by examining the nature of Dollar currency for what it really is – bookkeeping units of account. To do this, I use a construction I call the “monetary balance sheet”.
Monetary Balance Sheet of the US Dollar as of August 31, 1997
(denominated in billions of units of account called Dollars)
|[email protected]$324.75||$85.0||Federal Reserve Notes||$436.6|
|IOUs Owed to Banks||5,107.5||Bank Deposits||4,755.9|
M3, a broad definition of the total quantity of Dollars in circulation, equaled $5,192.5 billion as of August 31st. These Dollars were accepted as currency because the monetary institutions issuing this currency had assets of equivalent value.
As the value of the intangible assets in these monetary institutions falls (for example, because problem loans increase, or interest rates rise causing the market value of fixed rate loans to decline, etc.), the value of Gold rises. In other words, monetary problems weaken confidence in the Dollar currency system, which in turn causes more people to hold Gold as a monetary alternative. In short, rising fearfulness about the value of Dollar currency causes people to value Gold more highly.
Some perceptive readers will note that I have just described the process of monetary change that highlights the usefulness of the Fear Index, which measures these important changes in Dollar confidence. The Fear Index is calculated as follows:
|(US Gold Reserve) * (Gold’s Market Price)|
|———————————————————————-||= Fear Index|
|(261.7 million ounces) * ($324.75 per ounce)|
Presently, confidence in the Dollar currency system is very high, with the result that the Fear Index is near record lows (only in 1971 – when few questioned the federal government’s commitment to keep the Dollar on a Gold Standard – has confidence in the Dollar currency system been this high). But the level of confidence about the Dollar currency system is constantly changing. Therefore, in order to get a true measure of Gold’s value, these changes in the level of confidence must be taken into account, which is an adjustment that can be made by using the Fear Index.
In February 1985 when Gold was $282 per ounce, the Fear Index stood at 2.50%. Today, with Gold at $321, the Fear Index is 1.64%. Therefore, because of the prevailing but unusually high confidence in the Dollar currency system, the intangible assets of the monetary institutions that create Dollar currency are now being valued higher so that Gold has 34% less value today than it did in February 1985. This difference in Gold’s usefulness vis-a-vis the Dollar must be taken into account in order to completely turn 1997-Dollars into the exact equivalent of 1985-Dollars. This adjustment, which must be captured in order to accurately measure relative purchasing power, can be made with the Fear Index.
Therefore, to correctly relate and measure in terms of Dollar prices the value of one ounce of Gold today with an ounce of Gold at its February 1985 low, two steps need to be completed. First, the CPI measures the debasement in Dollar purchasing power, which indicates that $429 are needed today to purchase what $282 bought in February 1985.
Second, because Gold is being less highly valued today than it was in February 1985, the Fear Index must be used to further adjust the Dollar price of Gold in order to capture this debasement in the quality of Dollar assets on the monetary balance sheet. Because a tangible asset is inherently more valuable than an intangible asset, it is clear that an ounce of Gold is worth more than the promise to repay Dollar loans, which is the monetary equivalent of the old saw – a bird in the hand is worth more than two in the bush.
Therefore, taking both of these steps to make an exact comparison of Gold to its February 1985 low, Gold today would be $654 per ounce (2.50/1.64 times $429 per ounce). In other words, if the Fear Index today were 2.50% and the Dollar was further adjusted so that 1997-Dollars were made the equivalent of 1985-Dollars, the purchasing power of Gold would be $654 per ounce.
I know this number seems unbelievable. I keep questioning it myself. But $654 per ounce is an accurate measure of Gold’s relative purchasing power in terms of a constantly changing (i.e., eroding) Dollar. It is also a measure of the confidence being placed today in the Dollar currency system, and it is this confidence that we should be questioning, not the $654 per ounce result.
Is this confidence well founded? Are all Dollar monetary problems a curse of the past never to be seen again? Is the decision today to disparage and avoid Gold in preference to the Dollar being made on the basis of excessive, groundless blind faith or prudent judgement?
I don’t have the answer to these questions; today nobody does. But we will find out the answers as the days, weeks and months go by, and as Gold responds and reacts from here. But even though I don’t know with certainty the answer to these questions or the outcome for Gold’s diminished monetary role, because the Gold price today is not even one-half of its adjusted $654 price level, we know that Gold represents truly exceptional value. These are values not seen since Gold was $35 per ounce in 1971. These are values seen only once a generation.
But to take the other side of the argument for the moment, maybe Keynes was right, that Gold is a “relic of the past” and that it has no role to play in a modern currency system. Maybe we humans for the first time in recorded history after all can live without using Gold as a monetary metal. Maybe the price of Gold will fall lower still as Gold’s usefulness as money is further scorned.
Of course the intervening fifty years that has passed since the world renowned economist made his infamous statement proves either of two alternatives. Namely, either Keynes was wrong, or just half a century too early. Which of these two alternatives do you think is correct?
If Keynes was right but early, avoid Gold. Don’t buy it, and don’t bother to accumulate it. However, if you think Keynes was neither right nor just too early, then accumulating Gold makes sense in the recognition that it represents exceptionally good value.
As for me, I will rely on Gold’s track record. Hundreds of years of history as a proven monetary metal carry a lot of weight in my view. So despite all of the conventional wisdom to the contrary, I don’t for a minute believe that we are in a new era and that Gold has no role to play as money. We are only in a bubble economy, the apt term invented by the Japanese at the beginning of this decade as their stock market collapsed.
In a bubble economy, reason, prudence and good judgement are lost. Expediency, greed and shallow thinking come to the fore. These two statements I think accurately describe the totally unloved state of Gold today, as well as the unbounded confidence being placed on the general economy and the Dollar currency system as a whole.