Is Gold Cheap and Therefore, Good Value?

June 28, 1999 – The price of Gold ended Friday at $260.40. One year ago the price was $293.80, so over the past twelve months Gold has lost $33.40, or 11.4% of its purchasing power. However, this simple calculation tells only part of the story about the change in Gold’s purchasing power.

During the past year the US Dollar also lost purchasing power. As measured by the Consumer Price Index (CPI), it today takes $102.03 to purchase what $100 purchased one year ago. Therefore, the decline in Gold’s true purchasing power, when measured in terms of Dollars, is even greater than the loss indicated by its $33.40 price decline. In other words, because the Dollar also lost purchasing power during this period, an imprecise picture emerges when using Dollars to try measuring the purchasing power of Gold. But still more of this story needs to be told in order to present the entire picture about purchasing power.

One year ago a barrel of crude oil cost $14.03. Today it costs $18.39, so by this measure the Dollar lost 23.7% of its purchasing power, a much greater decline than the CPI indicates. But also consider the next example, which furthers highlights the difficulty of trying to accurately measure the purchasing power of the Dollar.

One year ago a top-of-the-line Dell computer cost $2799, while today it costs $1999, so by this measure the purchasing power of the Dollar has gained 28.6%. And this gain does not even reflect the fact that this year’s computer is faster, more powerful, and comes with better graphics and greater storage capacity.

Thus, it is becoming clear that we have a problem. How can purchasing power be measured? If purchasing power cannot be accurately measured, then how can we value Gold? And more importantly to the matter at hand, how can we determine whether or not Gold at $260.40 is cheap and represents good value?

Value arises from the usefulness of some good or service. In other words, if a good or service is useful, it has value. Further, if it has value, it has a price at which it can be bought or sold. Does Gold have value? Of course it does, so Gold also has a price. But as I have just demonstrated above, Gold’s price in US Dollars cannot be used to accurately determine whether or not Gold represents good value, which I define to mean that it is cheap by historical standards.

To examine this point more closely, Gold today at $260.40 looks expensive when compared to the just $35 needed to purchase one ounce of Gold in the 1960’s. But again, simple comparisons can be deceiving. Because of inflation, a Dollar today has far less purchasing power than a Dollar had in the 1960’s. Therefore, is Gold today in reality expensive after taking into consideration all of the purchasing power the Dollar has lost since then? In fact, is the 1960’s even a good measuring point?

The $35 exchange rate was first established in January 1934, and the Dollar has lost purchasing power generally every year since that $35 exchange rate was established. So should we begin our measurement at this earlier date? All of these are good questions, so let’s see if I have some good answers.

In January 1934 the Dollar was devalued against Gold, from $20.67 per ounce to $35 per ounce. It is incorrect to say that the price of Gold was fixed at $35. This statement puts the cart before the horse. Rather, the Dollar was defined as 13.714 grains of Gold (i.e., 1/35th of an ounce).

As measured by the CPI, it now takes 416.56 1999-Dollars to equal the purchasing power of those 35 1934-Dollars. Clearly, the Dollar has changed. Because of inflation, the Dollar has lost 92% of its CPI-calculated purchasing power since 1934. But again, this loss is only part of the story of measuring value. The Dollar has also been debased in terms of Gold.

An ounce of Gold today is no different from an ounce of Gold in the 1960’s, 1930’s or any other point in time, which cannot be said for the Dollar, and I am not referring to the Dollar’s considerable loss of purchasing power due to inflation. The Dollar has been debased. This debasement is a matter altogether different from the Dollar’s loss of purchasing power, but as I will show, debasement also has to be factored into this equation to determine value. I use my Fear Index to measure this debasement.

The Fear Index is measured as follows, and the numbers below are for the end of May:

As of May 31st, the Fear Index was 1.16%, which is a record low. Never before has confidence in the Dollar and the US banking system been this high. Never before has the value of the Dollar been so reliant upon the promises of others. For every $100 in circulation, only $1.16 is derived from the value of Gold.

The balance, or $98.84 of every $100, is based on IOU’s that have been turned into Dollar currency by the Federal Reserve and the banking system.

Compare today’s 1.16% Fear Index with the 14.66% that prevailed in January 1934. It is a big difference, and it shows how much the Dollar has been debased in terms of Gold.

Debasement is a difficult concept to get one’s hands around, so let me explain this point further. I’ll use the example of how currency used to be debased when Gold coins still circulated. Debasement measures the difference between Gold content and face value.

Prior to the 1930’s, some dishonest people clipped Gold coins. For example, a Double Eagle had a face value of $20. It contained 516 grains of Gold 90% fine, which equaled 464.4 grains of pure Gold. Because $20.67 equaled one ounce (i.e., 480 grains) by statute, a Double Eagle therefore contained Gold valued at $20. If a Double Eagle was ‘clipped’, robbing it of some Gold content, the coin would still have $20 of face value, but something less than 464.4 grains of pure Gold.

Generally, clipped coins did not cause a problem. However, periodically the value of the currency became so debased (the weight of coins was far less than the coin’s nominal face value), a currency crisis would arise. Coins with less than the required weight of Gold would create havoc in commerce.

Paper substitutes for Gold (i.e., paper currency redeemable into Gold) emerged in part because the paper ostensibly could not be debased by clipping. But other problems arose such as counterfeiting and fraud. In the case of fraud, the paper was bogus because no Gold was in fact being stored, so the ‘promise’ to redeem the paper for Gold meant nothing, and consequently, the paper currency was worth nothing when the fraud was inevitably discovered. And this realization explains why the Fear Index is so useful.

Today the ‘Gold content’ of the dollar is only 1.16%. In January 1934 the Gold content was 14.66%, some 12.6 times greater than it is today, which has to be taken into consideration when determining the Dollar’s value. The Dollar has been debased in terms of Gold because there is less Gold today imparting value to the Dollar. In other words, the weight of Gold on the asset side of the Federal Reserve balance sheet at current Gold/Dollar exchange rates is far less than it was in January 1934, or for that matter, at ANY time in the past because the Fear Index is at a record low. In short, the Dollar has essentially been horrifically ‘clipped’.

So let’s bring all of the above together in order to make some conclusions about whether on not Gold today is cheap and therefore, good value. First, adjustments have to be made to the Dollar price of Gold to measure the relative and comparative value of these different moneys over time. Second, the $35 Dollar/Gold exchange rate established in January 1934 can be used as a reference point to complete this analysis only if the Dollar is adjusted for both inflation and its debasement in terms of Gold. Third, it takes 416.56 1999-Dollars today to purchase what $35 purchased in 1934, adjusted for CPI measured inflation. And finally, the Gold content of the Dollar has been debased, as 14.66% of its value was derived from Gold in 1934 compared to only 1.16% today. So is Gold cheap today, and therefore good value?

Well, we know it is indeed cheap. Gold at $260 today equals only 21.85 in 1934-Dollars. But this answer is only an attempt to measure purchasing power, which admittedly is a nearly impossible task because of technology and other immeasurable factors. But it is one measure of Gold’s relative value, the loss of purchasing power because of inflation, and it is a useful indication of relative value even if, as I have shown, that measure is imprecise.

Also to be considered is another equally important impact on the value of the Dollar – its debasement in terms of Gold. This other measure of relative value can be attained by comparing Gold and the Dollar directly, thereby achieving an objective measure of the relative value of two different moneys. I say different because Gold and the Dollar really are very different. Gold is commodity money that is no one’s liability, but the Dollar is bookkeeping money, which means that it is always dependent upon someone’s promise. And right now, it is more dependent upon those promises than ever before.