More on the ‘Sound Money Indicator’

April 13, 2009 – There is no doubt that I have some amazing subscribers. I received a bunch of emails regarding the new Sound Money Indicator (SMI) that I presented in the last letter, and all of them, quite frankly, are loaded with good ideas and suggestions. They are obviously the product of some very serious and brilliant thinking. Many thanks to everyone who wrote.

I will over time in future letters share many of these ideas with you. I would like to do some more work and thinking about the SMI in the meantime, but there are some points from one email that I would like to share with you now.

They are particularly relevant and timely in view of the recently concluded G-20 meeting in London. The reason of course is the discussion leading up to the meeting about replacing the dollar as the world’s reserve currency.

Everyone knows that the dollar is not worthy of that central role in global commerce. It has become too debased. What’s more, the dollar has become a tool of politicians, rather than what it is supposed to be – a neutral tool to be used by one and all for completing cross-border transactions. In short, the dollar is not sound money.

Interestingly, in the lead up to the G20, the benefits of the gold standard were considered, particularly that it imposed discipline on the money creation process. This jab was no doubt pointed at the United States, but the other G20 countries shouldn’t be throwing stones. All the fiat currencies of the world are being debased because of the absence of any external discipline on the money creation process as there was under the classical gold standard.

In any case, after the G-20 concluded, an interesting article by Gillian Tett mentioning gold appeared in London’s Financial Times. Here’s what she said: “For the moment all this muttering about gold is simply wild speculation. Even if Western leaders suddenly were to decide they wished to turn back the clock, the logistics of embracing a new gold standard would be mind-boggling. UBS, for example, calculates that the US reserves of gold are so small, relative to its monetary base, that a price above $6,000 an ounce would be needed to reintroduce a gold standard. To implement that standard in Japan, China and the US, the price would be more than $9,000.”

Here’s where the SMI comes in. It basically confirms that indeed, these price levels would be needed to return to gold. I’ll paraphrase what my subscriber wrote, and will also withhold his name since I didn’t ask his permission to use it.

The analysis of the SMI in the last letter (with gold then at $952) concluded that the quality of the dollar is only 11.5% of the dollar in January 1934. It was also 11.5% of the dollar in January 1945. So we can calculate gold’s price today to determine the same parity at these previous times. The calculation is:

This price indicates that the conclusions mentioned in the FT were not unreasonable.

There is one other insight from this subscriber, who happens to live in Mexico. If the dollar were devalued today from $952/oz to $8,278/oz he suggests that knocking-off a couple of zeros to the dollar – just as Mexico knocked off three zeros in 1993 – would make for a more easily handled gold price of $82.78/oz in so-called ‘new dollars’. Thereafter, all prices would be expressed in ‘new dollars, and what previously cost $100 dollars, would now cost $1 ‘new dollar’.

Again following the Mexican precedent, by devaluation and knocking off two digits, US politicians could proclaim a great success: the price of gold is down and the ‘new dollar’ could be sold to the public about being the answer to the day’s monetary problems. As my subscriber notes: “About 1 in 100,000 people would figure out what really happened!”

Of course, the above is speculation. But who would have thought as recently as a year ago that the FT would be writing anything even half-way positive about gold?