The Purchasing Power of Gold
Synopsis: In this essay, I will briefly outline the use of gold in India, the world’s largest gold consumer market, and then use various methods to compute the value (purchasing power) of an ounce of gold and silver as of September, 2009.
Gold and Silver Usage in India.
In my nine years outside India, I’d almost forgotten my countrymen and women’s obsession with gold—ALMOST. On my return back here, this obsession hit me again, square in the face. I came back during festival time (August through November) when people mark every festive occasion with purchase of jewelry. During earlier, more politically incorrect times, people would openly ask how much gold (in jewelry form) the bride’s father would be giving the young married couple (read: the groom).
When I was young, I’d asked my dad why we Indians were obsessed with gold. He told me that gold was a fallback during tough times. I’d later realized that Indians always had a healthy mistrust for their government. Back in the 70’s, when marginal tax rates in India were above 90%, Gold was used to hide wealth from the government and the practice of gold as a store of wealth continues till today. While they may not have exactly understood why gold held its value better than rupees, they knew they needed to put away some gold for safekeeping. India had restrictions on gold bullion for a long time but none on gold jewelry, so that became the preferred method of accumulating gold.
Silver, while nowhere near in vogue as gold, is still widely used in India for jewelry and ornamental purposes. Silver is the metal of choice to make statuettes of Hindu gods and goddesses and other religious paraphernalia such as oil lamps, incense holders, etc. Many households in India maintain full sets of silver utensils to commemorate special occasions such as festivals and anniversaries.
Gold and Silver as Monetary Instruments
Since ancient times, throughout the world, gold and silver coins were used as money and a store of wealth. Gold and silver were used as money in parts of the world which had no contact with each other earlier. For example, gold and silver coins were used in Spain. When the Spaniards conquered the new world, they discovered that the Maya, Inca and Aztec royalty had massive stashes of gold and silver as well. Obviously, these two groups of people had never before been in contact with each other. One may then surmise that gold and silver have special properties that render them the most suitable for use as money.
Professor Hans Sennholz describes eloquently in this essay why gold was used extensively as money throughout the history of man. Ludwig von Mises summed up gold’s appeal for monetary purposes in the following way:
a) it is homogeneous and divisible.
b) it has a high value per unit weight and therefore portable.
c) it is the best store of value as its quantity cannot be increased at will – gold’s occurrence is rare and has a high cost of extraction.
The Purchasing Power of Gold
Since the advent of a completely fiat currency system worldwide since the Bretton Woods system disintegrated in 1971, the nominal value of gold in US Dollars has not kept pace with the growth of fiat currency money supply. This is because the use of paper money has reduced the demand for gold as money.
However, I believe the world has reached a stage where the paper-currency system is on the verge of failing. I will explain in detail why I believe this to be the case in a future article. For now, let us assume there will be a major currency crisis in the US Dollar and maybe several other major world currencies. My best estimate is that this event will happen within the next 5 to 10 years as the U.S. saturates the world with its debt and more freshly created dollars but it wouldn’t surprise me an iota if it occurred sooner. At that point, gold and silver will reassert their superiority over paper currency as money. The question to ask then is what will be the purchasing power of gold and silver when this event occurs?
(Please visit this wikipedia page to learn more about the different monetary aggregates if you aren’t already familiar with them.)
Method I – Using M1 and U.S. Gold Reserves
In this method, we look at the Federal Reserve’s balance sheet and equate the amount of gold in its balance sheet to the M1 money supply. M1 is what we use as money is our everyday lives. It compromises the total of currency notes and coins as well as money in checking/demand accounts. We can do this because essentially currency note in circulation are a liability of central banks, representing a claim on the bank’s specie (gold) assets. (Hint: If you examine any currency note, you’ll find the words “I promise to pay the bearer a sum of ten dollars” or whatever the face value is. What is this if not a liability of the issuer, in this case, the Federal Reserve?)
From this Wikipedia page, the total gold reserves owned by the United States (let’s be conservative and assume gold owned by the U.S. Treasury also backs the currency) has gold reserves of about 8,133.5 metric tons or 261.5 million troy ounces. The latest Federal Reserve’s H.6 release states that the non-seasonally adjusted M1 money supply as of September 7th, 2009 was $1,617.4 billion.
Therefore, using M1 we obtain a gold value of $6,200 per ounce.
Method II – Using M2 and U.S. Gold Reserves
Because of “innovations” in the US financial market place, the M1 figure can be heavily distorted and dare I say, manipulated. For e.g. bank and brokerage accounts that allow checking balances to be swept into money market funds–so called sweep accounts–do not have those balances reflected in M1. That is because money market accounts are part of the M2 money aggregate. However, for all intents and purposes, this is money that must be paid to an individual on demand.
In addition, most banks allow customers to withdraw money or write checks on savings accounts. For e.g. when I banked with TCF Bank, they allowed me three free, no limit withdrawals (by cash or check) per month from my savings account. This too was then as good as a checking account.
Also, one must consider the FDIC insurance. The FDIC insures all savings deposits as well as certificates of deposits up to $250,000. In the event of a bank failure, FDIC reimbursement essentially will convert money currently designated as M2 to M1 money. In practice, there is very little difference in M1 and most forms of M2 when it comes to paying for transactions.
Therefore, I believe that M2 is the more relevant metric to be used to compute the price of gold. The same Federal Reserve release gives the non-seasonally adjusted M2 figure as $8,321.4 billion.
Therefore, using M2 we obtain a gold value of $31,800 per ounce.
Method III – Using Nominal World GDP (PPP basis) and Total Gold Stock
Despite Method II being technically the right method to compute the purchasing power of gold if it were to be used as money, we must remember not all the gold in the world is owned by central banks. In fact, a majority of gold is in the possession of private citizens. Therefore, the above M2-derived figure overstates the purchasing power of gold. I’ll cite two examples to prove this point.
1. Suppose, hypothetically, the Federal Reserve had lent ALL its gold to bullion banks to be sold into the open market and those banks then went broke, then technically there would be NO gold backing for the M2 money supply. In that event, the value of gold per ounce would be infinite, which is absurd.
2. Suppose, again hypothetically, an individual has already converted ALL his US Dollars into gold and hold them as savings. Clearly then, this gold has purchasing power that will subtract from the $31,800 per ounce figure.
Therefore, I suggest a third method to determine the purchasing power of gold. Let’s assume ALL the gold in the world is used to purchase the world’s entire output of goods and services i.e. Nominal World GDP in a given year. Wikipedia estimates the world GDP on a Purchasing Power Parity (PPP) basis was about $69.5 trillion in 2008. The world gold council estimates the above ground stock of gold to be about 165,000 metric tons or 5.3 billion ounces.
Using this method, we obtain the purchasing power of gold to be $13,100 per ounce.
However, let’s not forget silver’s monetary claims as well. In a world that used both gold and silver coins to purchase goods and services, gold’s purchasing power would be reduced to the extent silver is used.
Total silver amount mined in history is estimated to be about 45-50 billion ounces. Let’s use the 50 billion ounces for our purpose. The above ground stock of silver though is severely depleted due to silver’s multiple industrial uses. I wasn’t really able to get a reliable estimate to silver’s present above ground stock. It’s safe to say the amount of recoverable silver is way less than the 50 billion ounces because silver is used in minute quantities for many industrial purposes and it is cost ineffective to trace all this silver back. Even so, let’s be conservative and assume that all 50 billion ounces can be recovered and used for monetary purposes. In this event, gold would roughly purchase half the world’s output and silver would purchase the other half.
These calculations then result in the following values:
1. Gold has a purchasing power of $6,500 per ounce.
2. Silver has a purchasing power of $695 per ounce.
Given that today, the price of gold is about $1,000 per ounce and silver is about $17 per ounce, we can conclude that both metals are trading at huge discounts to their intrinsic value and silver appears to be the better deal than gold. We can also surmise that, given the huge discounts, gold and silver look more attractive as investments than any other asset class such as stocks, bonds and real estate.
Caveats:
1. Please note that these above values are moving targets as the quantity of money keeps increasing year after year due to Federal Reserve inflation.
2. Therefore, it helps to use this article as a guideline and compute the value at a later date using the latest figures for nominal world GDP and the above ground stock of gold and silver.
3. The price of gold and silver will not reach the above values unless a majority of the world renounces paper currency and begins to use gold and silver for all transactions. However, the discount is so great that it is possible to earn fabulous increases in purchasing power even if both metals do not reach their full value.
4. If the total recoverable silver turns out to be much less than the 50 billion ounce figure I used in my computation, then the upside for silver is even higher than we computed.
5. Keep in mind, the value of gold/silver vis-s-vis other goods will fluctuate between regions. For instance, in an area where food, say bread, is scarce, an ounce of gold will purchase less quantity of bread than in an area where bread is abundant. My point is, however, that the average worldwide purchasing power of gold and silver will be close to the figures computed using Method III and the variations would be in small amounts around those figures.
