Is Gold Overvalued?

Gold may seem overvalued because of the recent record highs in its 6-decade ascent from $35 to $2500, but prices – like appearances – can be deceiving. What’s more, the value of any asset is more important than its price.

Price and value are too often conflated, which is a mistake. An asset’s price and the usefulness that determines its value are different sets of information that need to be viewed separately, but interrelatedly because price communicates an asset’s value. The undervaluation or overvaluation of anything are seminal circumstances that enable the informed observer to gain wealth because assets inevitably return to fair value.

The Difference Between Price and Value

Home prices provide a good example of the difference between price and value. Using the popular Case-Shiller Home Price Index, a home priced at $165k ten years ago is now being priced at $323k. Nevertheless, the home did not increase in value. It is the same house providing the same usefulness (shelter) it did a decade ago. Only its price has changed.

Gold – measured by the US dollar and the world’s other major currencies – closed at a new record high. Nevertheless, based on my objective calculation gold is undervalued. We can expect new records will be achieved as gold’s usefulness and undervaluation is recognised by ever more people, repeating what happened to it in the 1970s and many other occasions throughout monetary history.

Value is subjective. An uneducated journalist who did not understand gold’s usefulness got a cheap laugh years ago by calling gold a pet rock. This derisive term is still used from time to time to disparage gold, even though some people may own gold for contentment or peace of mind instead of a family pet. Regardless of why someone owns gold or how it is used by them, usefulness gives gold its value, which for 5,000 years has been and primarily remains its usefulness as money.[i]

The Monetary Balance Sheet

Few people today know that gold’s value can be measured objectively, which is necessary to overcome the limitations of fiat currency, as shown in the house price example above. To value gold, we need to think in terms of purchasing power[ii] and balance sheets, what I call the Monetary Balance Sheet (MBS).

The MBS is self-explanatory and can be prepared for any fiat currency. Dollars are liabilities of banks, and specific bank assets give value to the dollars in circulation. It is assumed that bank equity and non-deposit liabilities offset the intangibles and other assets owned by banks, including illiquid assets like buildings.

A dollar conveys an amount of purchasing power one can spend, save, or invest. M2[iii] is the total quantity of existent dollars and the numerical expression of the aggregate amount of purchasing power they convey. These dollars are liabilities of the banks where they are deposited. Paper dollar bills are a liability of the Federal Reserve. These bank liabilities have purchasing power because the assets on the balance sheets of these dollar issuers have value, which are the US Gold Reserve and debts (credit extensions to the bank customers manifest as bonds and loans).

The value of debt rises and falls for many reasons, some unique to individual banks (e.g., bad loans, bad management, etc) and some that impact all banks (rising or falling interest rates, monetary policy, etc).[iv] As the debt falls in value, gold rises in value and vice versa. It is this concurrent duality of these two categories of bank assets that is essential to keep the MBS in balance, a foundational requirement of accounting.[v]

National currencies are a derivative of the gold and debts that a nation’s banks record as their assets. If those assets are of questionable value, the currency will be doubted too, causing people to be fearful about their purchasing power placed in the doubtful currency. When those circumstances occur, the Fear Index rises.

Measuring the Value of Gold with My Fear Index

The market never ignores an imbalance in the MBS and responds by selling the overvalued asset and buying the undervalued one. Increasing worries about the monetary system cause an exit from currency and its reliance on bank debts. Conversely, when confidence in the monetary system grows, the MBS rebalances as purchasing power moves from gold to fiat currency.

Over time trends develop to reflect this market activity. These trends in the relative value of the two categories of bank assets in the MBS are captured by my Fear Index, a useful measuring stick I developed forty years ago to objectively assess gold’s value in a world of fiat currencies.[vi]

The underlying principle upon which the Fear Index rests is that bank liabilities will only have value and circulate as currency if the assets backing them have value. The formula to compute the Fear Index is:

Using the market price of gold and the MBS as of July 31, 2024, the Fear Index on that day was 3.01%, calculated as follows:

The Fear Index measures the percent of the dollar’s purchasing power derived from the weight of gold backing the dollar. As of July 31st, there is $3.01 of purchasing power derived from gold for every $100 of M2. The other $96.99 of purchasing power conveyed by each dollar is backed by and derived from the aggregate credit extension of banks (bonds they own, and their loans made to customers). If these bank debts decline in value, become doubted, and questioned as to whether they will be repaid in full, the price of gold will rise to offset the decline in the perceived value of these doubtful bank assets so that the MBS remains in balance.[vii]

The Fear Index captures these changes in the relative value of the two categories of bank assets and rises (or falls) along with gold. The Fear Index is most effective when its trends are viewed from a long-term perspective, as illustrated in the following chart:

Since the establishment of the Federal Reserve in 1913, three periods of monetary disruption stand out: the deflation[viii] of the 1930s, the inflation[ix] of the 1970s, and the 2008 financial crisis. Though these are very different types of monetary disruption, they had the same result – people feared for the safety of their purchasing power held in dollars. Consequently, they moved their purchasing power away from the promises of fiat currency – minimising their exposure to the debts on bank balance sheets.

Deflation is the opposite of inflation, but both are monetary phenomena. Inflation is an increase in the quantity of money, with the consequence that each unit of money purchases less and less over time as the inflation proceeds. Deflation is a contraction in the quantity of money, with the result that each unit of money purchases more over time as the deflation proceeds.[x]

The financial crisis and near failure of several large banks in 2008 are another type of monetary disruption. Because of government policy, balance in the MBS is no longer restored by a reduction in bank liabilities, as happened in the 1930’s. Governments instead act so depositors will not lose the dollars they have on deposit in their bank, even if it requires nearly unlimited amounts of government debt to offset the decline in the value of debts owed to the banks. The ultimate outcome of this policy is dollar debasement as purchasing power moves into gold because government creditworthiness diminishes as its debt obligations mount.[xi]

Rely on Purchasing Power, Not Prices

In each of the three historic Fear Index rising trends, gold rose too, but its rise can be masked when measured in dollars. For example, gold rose from $20.67 to $35 in the massive deflation of the 1930s caused by the 28% decline in M2. However, this 69% increase in the gold price masks the actual 344% increase in gold and dollar purchasing power (assuming of course your dollars were not deposited in a bank that failed) as the Fear Index soared to 30% during the height of the Great Depression.

When the gold price rises, no new wealth is being created. All that happens is that purchasing power already existing simply moves from holders of dollars to holders of gold.[xii] The rise or fall in gold simply keeps the Monetary Balance Sheet in balance by offsetting decreases or increases in the perceived value of the banking system’s credit extensions.

As the fear for the safety of one’s purchasing power grows during a bank or currency crisis, the purchasing power conveyed by gold will rise regardless of whether the dollar inflates like the 1970s or deflates, repeating what it did in the 1930s when M2 declined because of bank failures. Or will gold’s purchasing power rise during the wealth destruction that accompanies a financial collapse like it did in the 2008 crisis? Finally, how high will the Fear Index climb in either of these events?

What Does the Future Hold?

The future of course cannot be predicted, but we can nevertheless make the following observations:

• Because only 3.01% of the dollar’s purchasing power is derived from gold as of July 31st, the Fear Index is near historic lows (and that assumes all the US Gold Reserve still exists in Ft Knox). Gold is undervalued and can be expected to return to fair value. Though that level is subjective, the Fear Index since 1913 has averaged 7%.
• Monetary disruption is a recurring event when purchasing power is conveyed by a currency whose value to an extent is derived from debts on bank balance sheets. Consequently, during banking or currency crises, purchasing power moves from the holders of dollars to the holders of gold.
• Because they are recurring events, another banking and currency crisis can be expected. Although the timing is problematic, the Fear Index has been in a rising trend since October 2022, suggesting that momentum is building for another period of monetary disruption. Given reckless federal government spending, a rising tide of red ink, and the growing federal debt burden, the next crisis I expect will result in dollar inflation, which is also my expected outcome for all fiat currencies. All the countries that issue fiat currency are in a similar situation to the US.
• It is clear from the 111-year track record of the Fear Index in the above chart that it is now well below the peaks reached during each of the three previous periods of monetary disruption. If the Fear Index were to rise to, say 12% like it did in January 1980 to match the peak of that crisis, the purchasing power of gold will rise fourfold (12% divided by 3%) if the dollar inflates (the likely outcome) or more than fourfold if the dollar deflates, as it did in the Great Depression. The market determines the outcome for gold, but central banks and the policy makers and politicians who control the quantity of currency cause inflation or deflation.

The Fear Index is signaling that gold is undervalued. Gold’s purchasing power will rise during the next financial crisis, the timing of which is problematic but is an inevitable event for recurring crises in today’s broken monetary system that has distanced itself from gold. Existent purchasing power will move from holders of dollars to holders of gold. Fear for the safety of one’s purchasing power always sends gold higher, and if it becomes a widely shared view can send gold soaring.

Another bank crisis, a rising Fear Index, and greater purchasing power for gold will happen sooner or later. The unanswerable question is whether the next crisis will be a minor one that is papered over (like Silicon Valley Bank) or the fourth major crisis since 1913? And if the fourth, does the world in the aftermath return to gold?

Gold is the essential pillar needed in every monetary system to exert discipline. What’s more, we need to rediscover gold’s inextricable link to liberty, which has been ignored for most of the 20th century. Otherwise, we will continue down the road of fascism.

[i] The words ‘money’ and ‘currency’ today are used interchangeably, which obfuscates their differences. A country’s circulating currency can include money (e.g., South African Krugerrands) and money-substitutes (rand banknotes and deposits). Money is any tangible asset voluntarily chosen by the seller and buyer as tender in payment to complete their exchange of marketable goods or services. Only a tangible asset meets all four functions of money, and gold has become accepted throughout the world as the preferred tangible asset.

https://www.fgmr.com/the-forgotten-fourth-function-of-money-g-sibs/

[ii] Purchasing power is the reason money exists. Money emerged in pre-history as individuals began to interact for their mutual benefit. Money developed as a tool for economic calculation, a means of communication to convey through purchasing power one’s expression of value, and a means of payment. All three processes are essential for human interaction. The fourth function – a store of purchasing power – is a requisite of all good money. https://www.fgmr.com/natural-money/

[iii] M2 for July 2024 is an estimate. The actual amount will not be released by the Federal Reserve until after this article is published.

[iv] Bank assets can decline because of loan defaults by its customers, causing these bad loans to be written off in whole or in part and removed from the bank’s financial accounts. The market value of bank assets can decline if interest rates rise, as happened with the failure of Silicon Valley Bank. Contrary to conventional wisdom, rising interest rates are bullish for gold as clearly evidenced by what happened in the 1970s. Rising interest rates cause the value of debts owned by banks to decline, and gold to rise to rebalance the MBS.

[v] This simultaneous unity and duality of the two categories of bank assets is most relevant in fiat currency regimes. If it did not exist, bank liabilities would need to decline, causing deflation. Under the Gold Standard, a decline in the value of bank assets perforce led to a decline in bank liabilities. An example is the collapse in bank deposits during the Great Depression. Under today’s fiat currency regime and central bank policy that prevents deflation and widespread bank failures to protect the deposits of bank customers, gold rises or falls to keep the MBS in balance.

[vi] As debasement of the dollar began to accelerate in 1960, the Federal Reserve and other leading central banks formed a cartel called the London Gold Pool to manipulate gold’s rate of exchange to the dollar to maintain the $35 per ounce rate. Because an ounce throughout that decade became increasingly worth more than $35, the pool was unsuccessful and eventually collapsed. The dollar’s formal link to gold was broken in August 1971 by President Nixon, and other countries followed his lead, creating a world of fiat currencies with no formal link to gold. Nevertheless, gold remained then and now an asset owned central banks and government treasuries. While the formal link between gold and national currency was broken, an informal link remained, with gold’s rate of exchange to national currencies driven by market forces, instead of being fixed at an unchanging rate by government. In this new model and as occurs in all markets, gold and fiat currencies now compete for holders. Governments have responded with propaganda and interventions antagonistic to gold in their attempts to make their fiat currency appear attractive so demand for it continues.

[vii] Knowledge within markets varies among its participants, and asset prices do not necessarily respond immediately to changes in asset values. If a lag occurs, the MBS may temporarily be out of balance, with one category of bank assets undervalued to the other category’s overvaluation until the market eventually catches up and the gold price accurately reflects the fair value of each category.

[viii] Deflation is not wealth destruction, a point which is often confused. For example, the 2008 financial crisis was caused by the collapse of the housing bubble. Over six years home prices dropped from $185,000 to $134,000 using the Case-Shiller Home Price Index while the Consumer Price Index each year reported a higher cost of living than the year before. This decline in the price of homes was wealth destruction, not deflation.

[ix] Inflation has come to mean a rise in prices, a distraction from its real definition which is an increase in the quantity of currency. Deflation, which is a decrease in the quantity of currency, now means falling prices. There is another dimension to fully explain these terms. In a deflation, purchasing power of the money increases, and decreases during inflation.

[x] The accumulated aboveground gold stock increases each year from new mine production, so gold cannot deflate. Further, it cannot inflate (lose purchasing power from the increases in its annual supply) if the stock of dollar currency (M2) grows faster than the gold stock and/or demand for gold grows faster than the demand for dollars.

[xi] Note how S&P in the aftermath of the 2008 financial crisis lowered its credit rating on US government debt to ‘AA+’ from ‘AAA’ stating its action “was prompted by our view on the rising public debt burden and our perception of greater policymaking uncertainty.”

[xii] Note that no new purchasing power is being created when gold rises. An individual owning gold becomes wealthier, but not from new wealth creation. It therefore follows that gold is not an investment, nor a wealth producing asset. Rather, gold is money that can be spent, saved, or invested in an enterprise that hopefully is successful and generates new purchasing power to the benefit of its investors.