Engineering the Price of Gold
Science, and in the real world mathematics is used by mankind to strictly describe nature as objectively as possible. Certain laws must be obeyed and these laws allow the mathematician to model; that is to write an equation that is as close as humanly possible to describe a function of nature.
In order to see where one is going it is often good to take a look at where one has been. One of the most simplistic methods used to determine the price of gold is to divide the outstanding currency by the amount of gold and determine the price of gold in paper dollars. Simple yet elegant!
If we look at the reported M1 figures http://www.stls.frb.org/fred/data/monetary/currns we can determine the theoretical price of gold for any period. For example most often quoted is the fact that gold soared to $800 per ounce in early 1980. If we take the currency component in 1980 of 105.144 Billion dollars and divide it by 262 Million ounces ( reported US gold holdings) see Status of Treasury Owned Gold http://126.96.36.199/gold/99-12.html We find the dollar price of gold to be $400.00. That is $105MM/262M = $400. We know for a fact that gold sold briefly for over double that amount, over $800 per once in January 1980.
Now if we fast forward to our present condition we find that the M1 supply in early 2000 was reported to be 523.078 Billion. Doing the math again yields a quotient of over $2000 per ounce. Does this mean the price of gold is going to reach $2000 per ounce? Possibly, but if we stick with known facts, we find something very interesting. First, as any gold bug will tell you, regardless of the government's spin, the money supply has increased dramatically in the past 20 years. Secondly, the Treasury held gold has remained constant. Lastly, gold has the potential to overshoot the currency price. I wish I could stop here, but I must not, because to fully understand and appreciate this economics lesson we must "kick it up a notch." I am going to attempt to develop my model further, so please bear with me.
In the beginning a student of advanced math is taught to look at the upper and lower boundaries in the physical universe. That is a quantity that does not exist; that is zero , to a quantity that encompasses everything that is; infinity. This would logically include all possibilities and therefore provide the widest possibilities for any observed system to exhibit it's characteristics or behavior. To try and remain less theoretical, let's look at water( H2O) over a temperature of absolute zero to a temperature of the Sun ( approximately infinity). We would observe ice below 32 degrees F and water above 32 degrees F. Above 212 degrees we would observe steam. So the limits set are available to show all possibilities but do not necessarily have to reach the limit in order to reach a conclusion. What in the heck has this got to do with the price of Gold you ask? Please bear with me, like a good lawyer I am trying to lay a foundation in order to make a point. Perhaps better stated, the equation ( system we are studying: price of gold) is integrated (looked at) between these two extremes to determine what the system response will be under all circumstances.
A troy ounce of gold has the same mass anywhere in the entire universe. That is an unchanging objective truth that no one, not gold bears, bullion bankers, stock brokers, the CFTC or the World Gold Council, can change. However, a "dollar" (read Federal reserve note) has an upper limit that is not a strictly held value. The money supply or amount of dollars has no upper limit. Perhaps if all "dollars" were actual currency it might be restricted by the number of trees on earth but since the currency supply is a mere 5% of the total money supply , the vast majority being held in computer memory the point is mute. The salient point is that the number on a piece of paper ( or amount of zero's added to computer memory) can literally be moved so close to infinity that for all practical purposes it is infinite. Before you argue that this is a rather subjective argument I would ask the reader to verify with the Federal Reserve itself just exactly what percentage of a 1913 dollar the current "dollar" is worth. You would verify that 93% of the value is gone and a current "note" is worth about 7 cents of what a 1913 dollar was. Although this allows the fact that a FRN ("dollar") is worth something most of it's value has slipped away in 88 years. Contrast that with the original fact that an ounce of gold will not change anywhere in the universe forever!
So if we go back to our basic function , the price of gold. We must look at paper money over time, and we have determined that unbacked paper money over time always loses value. In fact the value of paper money approaches zero over time. We already know that the "dollar" has lost 93% of it's value as stated by the Federal Reserve Board, the very body whose stated purpose is to keep the value of the money stable. ( Fine job gentlemen!) So the basic function or equation we are working with is simple, to determine the paper price of gold or perhaps better stated the dollar price of gold, we need to take something that is so plentiful that it's value approaches zero (paper money supply ), divided by something of real value, (gold). This might be expressed as $/oz. or "dollars" per ounce. This of course is exactly what we did earlier in this article. However, we are now advanced math students and we will also use our thinking to put into the equation what happens to the numerator over time. We know for an absolute fact that the numerator ( money supply) grows ever larger, in fact in time it approaches infinity. So now the equation can be expressed as infinity divided by a real number. For those not familiar with the rules of advanced math do not take my word for it but the idea is the $/oz or infinite ability to expand the money supply divided by a finite amount of gold equals infinity!! Yes, that is correct the paper price of gold over time approaches infinity. How readers can we use this to help us? First I would ask that you truly ponder this. Does it make sense? Is the money supply created out of thin air? Who determines how many dollars are in existence at any given period of time? Next, I would ask the reader to again take a look back to see if we can find any facts that support this hypothesis. I will provide one, your job is to prove to yourself that it won't happen again, and WHY?
The rentenmark is an example of the limit of paper money. The world witnessed this event in Germany following W.W.I. Just prior to the currency crisis, politicians and government economists made loud claims the economy was prospering.
The combined money supply rose from 12 billion marks to 63 billion marks during the war. Prior to the hyperinflation of Weimar Germany a bellhop was given a gold coin as a tip. He saved this coin (Gersham's law) and continued about his business. During the worst of the hyperinflation this same bellhop bought the entire hotel at which he was once employed, for that same gold coin he had saved earlier.
Our greatest concern is not the facts stated above but, the theory that the next precious metals run will be one generated by FEAR of a currency collapse. Yes, friends there was fear in the late 1970's but most people were buying gold based on the increase in money supply and inflation figures, CPI. Today, the Money supply is scarcely mentioned in the press and the reported inflation numbers leave out such non-essentials as food and oil. What would cause the kind of FEAR that we see? A major run to gold by any of the United States trading partners. When was the international gold window closed by Nixon? When France sent enough American paper in exchange for that barbarous relic GOLD. Once a country or even a major bank decides to save it's own currency and starts to exchange bonds for gold the game will be over. Will this happen? It already is happening, the only valid question about the current gold situation to be asked is one that gets little mention. With all the gold selling in the Press and Wire services--Who's BUYING?
8 December 2000
David Morgan (Silver-Investor.com) is a widely recognized analyst in the precious metals industry; he consults for hedge funds, high net-worth investors, mining companies, depositories and bullion dealers. He is the publisher of The Morgan Report on precious metals, the author of Get the Skinny on Silver Investing, and a featured speaker at investment conferences in North America, Europe and Asia. You can receive a free 30 day trial subscription here http://www.silver-investor.com/joinfreelist.html