October 25, 2009 – Because people generally calculate the price of goods and services only in terms of the national currency of the country where they live, it is not easy for them to recognize what is happening to the value of the currency. To truly understand what is happening to the currency, they also need to calculate prices in terms of gold, which today is one of the world’s most misunderstood asset classes. For this reason, gold’s traditional and rightful role in finance and commerce is not fully appreciated, with the result that gold is undervalued.
This situation creates an opportunity for everyone who recognizes this undervaluation. Gold, just like any other asset, will be properly valued in time as its usefulness increasingly becomes better recognized because its attributes become better understood. Gold is money without counterparty risk and money that maintains its purchasing power over long periods of time. This last point is important.
A rising gold price means that the national currency in which gold’s price is being measured is being inflated, or more precisely, the currency is losing purchasing power. Consider what is happening to the US dollar.
For example, the price of crude oil has climbed from $25.76 on January 3, 2000 to $80.50 this past Friday, an obvious decline in the dollar’s purchasing power. During this same period gold has risen from $288.50 to $1055.60. In other words, an ounce of gold today buys approximately the same amount of crude oil it did at the beginning of this decade, while the dollar buys much less.
I have therefore prepared the following base-100 analysis chart to correctly present gold by illustrating how badly the dollar has been losing purchasing power.
1) The blue line shows how much less foreign currency the dollar can buy now. The currency basket is the US Dollar Index, and the dollar buys only 75 units compared to 100 at the start of the decade.
2) The red line is the key. The dollar could purchase 100 units of gold at the start of the decade, but today only purchases 27, a 73% decline in the dollar’s purchasing power.
3) The black line shows the dollar’s purchasing power in terms of crude oil, which trends pretty much in the same direction as gold, but obviously with considerable volatility. Compared to 100 units at the start of the decade, the dollar now purchases only 32, though this is an improvement from the only 18 units the dollar purchased during the spike in crude oil prices in mid-2008.
Thus, when we say the price of gold is rising, we are grabbing the wrong end of the stick, which contributes greatly to today’s misunderstanding of gold. To be correct, we should be saying that the purchasing power of the dollar is falling. And when it is compared to gold, it is clear that the purchasing power of the dollar is falling a lot.