by: Joseph Brom
January 11, 2010
One explanation for the increase in today’s gold price is that it is adjusting for the past 26 years of monetary inflation. The consequences of the adjustment in the gold price will be a decrease in American’s net worth and an increase in their food and energy costs.Under a gold standard, or in a market, citizens can exchange their paper currency for gold. The gold standard gold price equals the supply of currency in circulation divided by the total supply of a country’s gold bullion. The graph below illustrates the relationship between the gold standard gold price (black line) and the actual gold price (red line) since 1950.
In 1950, the gold price was $34.72 and the gold standard gold price was $38.77. In 1971 gold price was allowed to float against the US dollar, it naturally increased. The reason for the increase was the gold price was adjusting for the 30 years of monetary inflation created by the Federal Reserve Bank. The graph below illustrates the gold standard gold price (black line), based on weekly currency data, and the daily gold price (red line) between 1979 and 1983.
From 1950 to October 1979 the gold price was adjusting for 30 years of monetary inflation. As the graph illustrates, the gold price equaled the gold standard gold price several times between 1979 and 1983. In 1979, the gold price stayed within 10% of the gold standard gold price for 12 weeks, 11 of which the gold price stayed within 5% of the gold standard gold price.
In 1981 the gold price again stayed within 10% of the gold standard gold price for 31 weeks, 7 of which were with 5%, despite a decrease of 482,261.25 ounces of US owned gold since 1979.
In 1982, the gold price again stayed within 10% of the gold standard gold price for 2 weeks, including 1 week within 5%, despite a decrease of 96,452.25 ounces of US owned gold since 1981.
Finally in 1983, the gold price again stayed within 10% of the gold standard gold price for 8 weeks, including 6 weeks within 5%, despite a decrease of 643,015 ounces of US owned gold since 1982.
Over the course of 3.5 years, the gold price tracked the gold standard gold price in spite of a 30% increase in the currency and a decrease of 1,221,728.5 ounces of US owned gold. The gold price followed the gold standard gold price within 10% for 30% of the time, and within 5% for 15% of the time. This suggests that the metric used to value gold during this period was the currency divided by the ounces of US owned gold. Thus the market backed the US dollar with gold even though the US wasn’t on an official gold standard.
For the gold price to adjust for the past 26 years of monetary inflation, the price will equal $3,286.06 (dividing the currency $859.1 billion by 261,498,900.32 ounces of gold held by the US). Since the Federal Reserve Bank’s average yearly increase in the currency since 1929 is 8% (11.5% since 1971), the $3286.06 gold price will continue to increase an average of between 8% and 11.5% annually. If similar price increases were to occur today as in the 1980s, the gold price could peak as high as $7000, and could easily reach $5500.
The consequences of an increase in the gold price are frightening. A store of value is one of the hallmarks of gold. An ounce of gold retains its purchasing power over time. Because of this, prices measured in ounces of gold remain constant in the long run. Three examples are the gold/oil ratio, the gold/CRB ratio and the Dow/gold ratio. To calculate the gold/oil ratio (currently 13.76), divide the gold price ($1138.90) by the oil price ($82.75). Other ways to say the same thing would be to say that 1 ounce of gold will buy 13.76 barrels of oil or a barrel of oil costs 1/13.76 of an ounce of gold. The graph below illustrates the gold/oil ratio since 1946.
As the graph illustrates, when gold prices were fixed, prior to 1971 the gold/oil ratio was fairly constant. However, beginning in 1971 the gold/oil ratio began fluctuating wildly. Since 1971 the gold/oil ratio fluctuates between 6 and 33 but revolves around the mean of 15. The graph below illustrates, in more detail, the US dollar price of oil compared to the gold/oil ratio from 2000 to the present.
For example in January 2002, the US dollar price of oil averaged $19.67 and gold was $282.30 or a gold/oil ratio of 14.3. In 2008 when oil was $145, gold was $920; the gold/oil ratio was 6, which means oil is overvalued compared to gold. When oil crashed to $32, gold was $845, a ratio of 26, which means that oil was undervalued compared to gold. Currently oil is $82.75, and gold is $1138.90, so the ratio is 13.76. From 2002, the US dollar price of oil rose 300%, but the price in ounces of gold remained nearly the same at 15. Thus gold is a proven store of value.
When the gold price adjusts for the past 26 years of monetary inflation and gold reaches $3,286.06, the US dollar price of oil will be $220 barrel. However, since the gold/oil ratio varies, the price of oil could range from $130 to $330 a barrel. At these oil prices, gas prices would vary from $3.59 to $8.99 a gallon. If the gold price reaches $5500, the oil price would range between $220 and $550 a barrel with gas prices between $5.99 and $14.99.
Another example of gold being a store of value is the gold/CRB ratio. The graph below illustrates the gold/CRB ratio.
The graph illustrates that over time gold has increased its purchasing power against commodities. However, as in the gold/oil ratio, an ounce of gold retains its purchasing power against a basket of commodities for long periods of time. The average gold/CRB ratio from 1956 to 1971 was .35. The ratio changed during the 1970s, and remained 1.6 for almost 30 years. Currently, it looks like the ratio may be changing yet again. If we average the gold/CRB ratio, the new speculative average would be roughly 3.75.
Therefore, when gold prices adjust for the past 26 years of monetary inflation, the CRB index will increase between 200% and 600% depending on which average is used; the 1979-2008 average or the new 2008 to the present speculative average. This will translate into between a 200% and 600% price increases in food and other commodity-based consumer goods.
The final example of gold being a store of value is the Dow/gold ratio. The graph below illustrates the Dow/gold ratio since 1928.
Over time, the Dow reaches parity, or close to it, with the gold price. This means that 1 or 2 ounces of gold bought 1 share of the Dow Jones Industrial Average at different periods in history regardless of the US dollar price of the Dow or gold. For example, on January 22, 1980, the gold price closed at $850 and the Dow closed at 866.22. Other examples of the Dow/gold ratio include 1 in 1896, 2 in 1932, and 3 in 1974. So the Dow/gold ratio will equal 1 or 2 at some point in the future.
When gold prices adjust for the past 26 years of monetary inflation and gold reaches $3,286.06, the Dow will decrease to between $3,286.06 and $6,572.12. However, if the gold price increases to $5500, then the Dow will be priced between $5500 and $11000. This translates into a 4% increase at best and a 48% decrease at worst.
Therefore, because gold is historically a store of value, the consequences of the gold price adjusting for the past 26 years of monetary inflation will be drastically higher food and energy costs and significant decrease in the Dow in real terms. In addition, these price increases don’t include the current and future increases in the money supply, which are exponentially larger than the past 26 years.
Disclosure: Long Commodities and Precious Metals. No Stock Positions.
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