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-- Posted Wednesday, 31 May 2006 | Digg This Article
What would the gold price be if we could replace all the existing notes and coins in the world with gold? Not such a long time ago paper receipts for gold in storage were used as currency, and people would trade these receipts because it was more convenient than carrying around a lot of gold. Over time, those who held the gold and issued the receipts noticed that physical gold was seldom claimed even thought the receipts changed hands several times. The temptation to issue more receipts than the gold in storage became too large to resist, and fractional banking was invented. This allowed the issuers to charge interest and increase the amount of currency in circulation. The scheme would work as long as everyone did not claim his or her gold at the same time. Those issuers (or later, banks) who egregiously abused the system suffered from bank-runs, in which receipt holders claimed their gold. Since there was not enough gold to cover all the outstanding receipts, only the first folks through the door would get any gold. The system was based on the faith the public had in the gold receipts, with all issuers not being equal. The Federal Reserve Bank was therefore created to regulate the system and stand ready to bail out any bank that could not meet its obligations. Fractional banking was allowed to continue subject to additional regulation and scrutiny, but the system is still based purely on the faith and confidence that people have in pieces of paper. Many hardcore believers in the gold standard feel that fractional banking has to be demolished. I personally never liked the idea of fractional banking, but I also don’t think the population at large is ready to do without it. And, even if fractional banking were eliminated and a pure gold standard recreated, the temptation to issue receipts in excess of gold on deposit would just exert itself again. So instead of the most conservative extreme of a gold standard without the ability of debt creation, let’s consider what would happen if we accepted fractional banking, but just took away governments’ right to seigniorage. If we add together all the currency in circulation (notes and coins) in the US, Japan, China, Britain, Canada, Russia, Australia and the European Union, converted to US dollars for simplicity, we arrive at $2.6 trillion. These countries represent roughly 80% of the world’s GDP so by extrapolation we can estimate that all the currency in circulation in the world today is approximately $3.25 trillion. Total historical gold production is about 5 billion ounces and most of it is still around. If all the gold in the world were converted to money to replace existing notes and coins, it would imply a gold price of $650 an ounce. Back in the 1940s the United States alone held about one third of all the gold in the world and two thirds of the official reserves (gold held by governments). At the time, governments held approximately 50% of all the gold. If we assume that only half the gold in the world could be converted into money then it would imply a gold price of $1,300 an ounce. Another model I have used to estimate the fair value of gold is based on relative inflation rates. According to that model (see http://www.paulvaneeden.com/Library/200304%20Gold.php), the gold price should be around $900 an ounce. I found it interesting that both these calculations came up with gold price values in the range of $1,000 an ounce, which is intuitively more acceptable than some of the deflationist models that predict gold at $300 an ounce or alarmist predictions of $8,000 to $10,000 an ounce. While either extreme is a possibility, I do not consider either one to have a very high probability. On the other hand, I believe there is a high probability of seeing gold at around $1,000 an ounce in the not-too-distant future. Gold is currently less than that because the US dollar is over-valued on foreign exchange markets. A rise in the gold price from $600 to $900 an ounce purely due to weakness in the dollar would imply that the dollar lost 30% to 35%. Such a decline in the US dollar does not have to be uniform against all currencies, and I doubt that it would be; the dollar will probably fall most against the Chinese Renminbi, the Japanese Yen and other Southeast Asian currencies. A newcomer to the ranks of The Dollar Bears is the Organization for Economic Co-operation and Development (OECD). The OECD was quoted in Forbes last week as saying the dollar had to fall by 35% to 50% in order to balance the US current account gap. I don’t know how they came up with those figures, but they correspond incredibly well to my own expectation of how much the dollar should decline. I still maintain that we are not currently in a gold bull market but that the gold price is merely adjusting to monetary inflation and foreign exchange rates. We might well enter into a gold bull market if the decline in the US dollar precipitates a crisis, but we are not there yet. Paul van Eeden P.S. If you enjoy reading these commentaries I suggest you go to my website at http://www.paulvaneeden.com/commentary.php and register to get them by email. Rest assured that I do not sell or rent any of my subscribers’ email addresses. Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477. Disclaimer This letter/article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be -- either implied or otherwise -- investment advice. This letter/article reflects the personal views and opinions of Paul van Eeden and that is all it purports to be. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in this letter/article. The information contained herein is subject to change without notice, may become outdated and will not be updated. Paul van Eeden, entities that he controls, family, friends, employees, associates, and others may have positions in securities mentioned, or discussed, in this letter/article. While every attempt is made to avoid conflicts of interest, such conflicts do arise from time to time. Whenever a conflict of interest arises, every attempt is made to resolve such conflict in the best possible interest of all parties, but you should not assume that your interest would be placed ahead of anyone else’s interest in the event of a conflict of interest. No part of this letter/article may be reproduced, copied, emailed, faxed, or distributed (in any form) without the express written permission of Paul van Eeden. Everything contained herein is subject to international copyright protection.
-- Posted Wednesday, 31 May 2006 | Digg This Article
Previous Articles by Paul van Eeden
Paul van Eeden is an independent investor, analyst and newsletter editor.
Born in South Africa, Paul graduated from university with a degree in chemistry and applied chemistry with additional credits in accounting, economics, business economics, philosophy, statistics, mathematics, biochemistry and physics.
Paul's first business was an African art distributorship, of which he acquired a 50% interest during his first year at university in 1985. He has experience, either as an owner, manager or director, in plastics manufacturing, food supplements and cosmetics distribution, advertising & marketing as well as the manufacturing and distribution of gas detection equipment.
Paul van Eeden left South Africa in 1994. He joined Yorkton Securities in Toronto as a stock broker in 1995 and moved to Global Resource Investments in Carlsbad, California in 1996. In November 2002, Paul decided to leave the brokerage industry and joined Doug Casey as co-editor of the International Speculator (www.internationalspeculator.com) newsletter.
His investment approach was shaped by the ideas of Benjamin Graham and David Dodd so Paul is always on the search for tangible value that can be bought at a reasonable price. That can usually be accomplished only during the trough of a market, which is currently not the case for general US equities.
Therefore Paul decided to focus on the natural resources sector, specifically gold. The period from 1996 to 2001 was a trying time - the bottom of the worst bear market in gold in twenty years - but, of course, it was also a time of opportunity.
At the San Francisco Gold Show in November 1998, Paul van Eeden introduced his original thesis that the gold price in US dollars is driven by the US dollar exchange rate, and that traditional commodity style analyses would not yield predictive results when applied to gold. He showed that a dollar-only view of the gold market is inadequate: understanding the gold price requires a global view, incorporating exchange rates across many currencies. This novel line of thinking is now ubiquitously accepted.
In 2003 Paul went further, showing that the price of gold in US dollars is tightly correlated to the expansion of US monetary aggregates (M3) and that an analysis of gold as money not only clarifies the gold price from 1971 to the present, it has other implications that are still unforeseen by most financial and commodity analysts today. One of these is that the gold price will soon exceed $1,000 an ounce. Another is that, aside from operational differences, not all gold mining companies will benefit equally from this increase in the gold price.
Paul van Eeden not only does his own research on the fundamental drivers behind the gold market, he also takes a hands-on approach to investment analysis: interviewing management, studying exploration projects and visiting mining operations. Whilst investing in mining and exploration companies is inherently risky, value is never far from his mind and features forcefully in his selection criteria.
Most of Paul's time, now, is devoted to finding investments for his own portfolio.
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Musing on a Gold Standard
