Is gold in a bubble?

To answer this question is not straightforward. As the gold-sceptics keep reminding us, gold pays no coupon and no dividend, it does not offer a running yield, so traditional measures of ‘fair value’ do not apply. But gold is money, and just as the paper ticket in your wallet does not pay interest, neither does gold. Gold is a monetary asset that has functioned as a medium of exchange and a store of value for thousands of years, around the world and in almost all societies and cultures. Many modern economists believe that gold has now been successfully replaced with state paper money, such as paper dollars, paper euros, paper yen, and so forth. Holding gold is therefore redundant. The present crisis is a stark reminder that this faith in fiat money is misplaced.

Gold is still a superior monetary asset. It is not under the control of any political institution. It cannot be printed to artificially lower interest rates and to ‘stimulate’ the economy, to create fake booms in financial assets and in real estate, to fund credit growth with printed money rather than true savings, to subsidize the banking sector and then bail it out when the banks overreached, to allow the government to run never-ending budget deficits, to make unfunded promises to voters and fund wars. Gold is hard, inelastic, apolitical and truly international money. It does not bow to anybody. Paper money is a political tool.

Now that humankind’s latest and most ambitious experiment with fiat money, launched in 1971, has once again created massive imbalances and led the world into financial crisis, gold is experiencing a renaissance. But after the spectacular rally in the gold price over recent years many observers ask if the precious metal has not moved ahead of its fundamentals – even though it is not that easy to assess these fundamentals. They ask if gold has not entered speculative bubble territory. Even fiat money sceptics such as Bill Bonner and Marc Faber, who have long been fans of the precious metal, warn that this is not a one-way street. From its all-time high of $1,900 in September of last year, gold has already corrected by about 20 percent. The current price action in gold is certainly disappointing given the ongoing and even intensifying Euro Zone debt crisis, which should encourage additional shifts out of fiat money and into gold. This week The Wall Street Journal concluded that “Gold’s status as a safe haven is looking shaky.”

The question is therefore, if and how we can assess gold’s fundamental value, and by fundamental value I mean its role as money and a store of value, not its role as an industrial commodity. Are there any quantitative tools to determine if gold is in a bubble?

In this essay I will try and provide some back-of-the-envelope calculations that can give us some guidance as to the fundamental drivers of the gold price and the relative weight of these drivers through time. This is not meant to be a definitive analysis of the gold price and I certainly do not intend to give investment advice (my usual disclaimer!) or make any predictions as to where the gold price is heading. What I am doing here is a simple mental exercise that may be useful as a framework for how to think about the dollar-price of gold.

Gold’s PPP-price

Over long periods of time gold has done an extraordinary job at preserving purchasing power. Not surprisingly, it has beaten all fiat monies as a store of value.

Since the dollar came off the gold standard domestically in 1933, and in particular since it came off the international gold-standard-light (Bretton Woods) in 1971, massive quantities of new dollar currency units have been created, thus substantially reducing the dollar’s purchasing power. The question I asked myself was this: at what price would an ounce of gold have had to trade in any given year to exactly compensate its owner for the loss in the dollar’s purchasing power since 1933, the year the dollar became an irredeemable piece of paper?

In 1933, one ounce of gold was fixed at $35. By using the US Inflation Calculator we can determine, based on official US inflation statistics, how many dollars it would have taken in any subsequent year to buy the same quantity of goods and services that $35 dollars bought in 1933. For example, in 1970 it would have taken $104 to buy the same goods that $35 bought in 1933. In 1996, it would have taken $422. Therefore, if the ounce price for gold had been $104 in 1970 and $466 in 1996, gold would have exactly compensated its owner for the loss of purchasing power that the inflating paper dollar experienced.

Given gold’s historic role as money and its superiority as a store of value over longer periods of time, it is not unreasonable for the owner of gold to expect that – on trend and in the long run – he should be compensated for inflation. I call this synthetic price the purchasing-power-protection price of gold, or the PPP-price of gold, which can be thought of as some long-run lower limit of the actual gold-price.

Of course, it is unlikely that gold would trade precisely at that price. At any moment in time, the price of gold will reflect many other factors, too. There are, first and foremost, expectations as to future inflation. Then there are potential concerns about the stability of the banking system, or geopolitical considerations. Additionally, a lot of gold has been mined since 1933, and in particular since 1950. Furthermore, we can debate whether official CPI statistics are really a good measure of the dollar’s declining purchasing power. As Mises has explained, there is no such thing as a clearly identifiable and measurable purchasing power of money. Every index that is being used is a compromise, and we know that the US government has repeatedly changed its methodology of how to calculate the debasement of its own fiat money. It would be reasonable to assume that the market has a superior way of assessing the dollar’s loss in purchasing power and that this would then be the true driver of the gold price, rather than the government’s official measure. Then there is the question if $35 is the right staring point. Before all privately held gold was confiscated by Roosevelt’s executive order in April 1933, the dollar was fixed at $20 dollars an ounce. $35 dollars was simply a new, administratively set price.

I decided to take the $35 dollar price simply because at that stage (1933) so many paper dollars had already been printed – by the banks and with the encouragement, since 1913, from the Federal Reserve as the government’s backstop for Wall Street – that the $20 dollar price was no longer reflecting the true price of gold: Americans were ditching bank deposits and paper dollars and accumulating gold thus pulling the rug from under the banking system. This was the reason for Roosevelt’s intervention.

In any case, there are many reasons why we should take this analysis with a pinch of salt. But nevertheless, I do not think that this approach is entirely without merit as long as we understand that it is simply a rough framework and do not read too much into it.

I calculated the PPP-price of gold for the 43 years from 1970 to 2012 and compared it to the average market price for gold in every year. The time series for the average gold price was provided by my friend David Goldstone, who obtained it from http://www.measuringworth.com/datasets/gold/result.php.

It was a discussion about the gold price with David that gave me the idea for this analysis.

I also calculated a simple ratio between the two prices, the market price and the PPP price. When this ratio is below one, the gold price is below the PPP-price and gold at this level would not even compensate for the massive dollar debasement since 1933. If the ratio is above one, the gold price compensates fully for the dollar’s loss in purchasing power and also provides an additional margin on top.

As one would expect, both PPP-price and gold market price increased substantially over those forty-three years. The average ratio was 1.16, which means that gold traded on average at a 16 percent premium to its PPP price. This makes sense. We would expect gold to compensate – most of the time – not just for present inflation but also for the extra risk of accelerating inflation in the future, or to also compensate for other risks. It should neither be surprising that the volatility of the market price around PPP was substantial. Only in about half the years in our study was gold trading even within 25 percent on either side of its PPP price.

Using the PPP-measure, gold was most undervalued in the early 70s when it traded at a more than 60 percent discount to PPP, and between 1999 and 2001, when it traded at a 40 percent discount. I will discuss the reasons for this shortly. Gold seemed most overvalued in 1980, when it traded at more than twice its PPP price, and from 2010 until today, when its price is again more than twice the level that would be justified on up-to-date paper dollar inflation alone. It seems obvious that in both these instances the gold price reflected concerns about an imminent further acceleration in inflation or even, I would argue, imminent monetary regime change. Before we look at these instances a bit closer let’s try and develop a narrative for our time series.

Gold in the 1970s

We start in 1970 when the gold price was massively undervalued. The golden shackles had come off in the US domestically 37 years earlier when relentless paper money printing had commenced, albeit at first at a somewhat moderate pace. However, in blatant disregard for economic reality, the official gold price was kept at $35 an ounce, which by 1970 had become a joke. Remember that the US state banned its own citizens from investing in physical gold (the currency that the country’s own constitution had decreed!), and that restrictions on private ownership of gold or on exporting and importing gold remained in place in many countries. Still, many foreigners could exchange dollars for gold, not least the central banks, and they did, which began to put further upward pressure on the gold price. In the 1960s, Western governments formed the gold pool – first secretly, then openly – to manipulate the gold market and to keep a lid on gold. (Yes, dear reader, the governments of the ‘free’ and ‘capitalist’ West banned their citizens from holding the world’s oldest monetary asset and were for years engaged in outright large-scale market manipulation to make their fiat monies look good. Be under no illusions what these ‘democratic’ governments will be prepared to do when the present system is on its last leg!)

By 1970 the US was hemorrhaging gold and by 1971 Nixon had to close the gold window (well, he could have stopped printing paper dollars but that no longer seemed an option).

Between 1974 and 1978, gold traded consistently within a 20 percent band on either side of PPP. In 1974 and 1975, gold traded for the first time above its PPP price and probably for the following reasons: From January 1975 onwards, US citizens were again allowed to hold gold privately. 1974 was also the first year since the late 1940s that the US registered official annual inflation rates of double-digit figures. Gold was in demand because ever-higher inflation seemed inevitable. Gold began to trade at a premium.

This was the time of the ‘oil shock’, which is often described as the nasty colluding of oil-producing countries to artificially boost the price of their produce but which can also be described as a pooling of interests of the oil exporters to make sure they were not selling their precious oil for constantly depreciating paper dollars. James Turk of the Gold Money Foundation has an interesting chart that shows that when measured in gold the oil price has hardly moved since the 1950s.

1980: First paper dollar crisis

Be that as it may, gold moved up relentlessly and in the late 70s did so at an even faster pace than the dollar’s purchasing power was plummeting, which was already pretty fast to begin with. In 1980, US inflation reached a peak of 13% p.a.; the gold price reached a then all-time high of over $800 and an average price for the year of $613, which was 2.7 times its PPP-price ($222). Gold was trading at a substantial spread over its inflation-protection price because the public feared that inflation could spin out of control any minute. Having a pure paper dollar with no anchor in any commodity suddenly appeared to be a bad idea. The fiat money concept seemed to be failing. The market began to contemplate imminent paper money meltdown and monetary regime change.

As John Butler has pointed out, at 1980 gold prices the 260-million-ounce gold hoard of the US government (at least that is the number that I have in my head) would have covered the entire US monetary base (between $133 and $144 billion in 1980 – those were the days!) The gold price thus reflected the prospect of an imminent return to a gold standard.

Indeed, Ronald Reagan campaigned on a promise to investigate a return to gold and upon being elected president he set up a gold commission to do so. The 17-member commission decided almost unanimously against a return to hard money and voted to keep the paper dollar. I say ‘almost unanimously’ as two members objected to this verdict. They were Lewis E. Lehrman and ….Rep. Ron Paul from Texas!

But it was Jimmy-Carter-nominated Fed Chairman Paul Volcker who gave the paper dollar another lease on life. He stopped the printing press, allowed short rates to shoot up and liquidate the misallocations of capital from the inflationary boom. The US went through a biting recession – then the worst since the 1930s – but inflation was crushed, so were inflation expectations and the gold price. Paper money collapse had for once been averted.

The premium over PPP declined from 2.7 times PPP to around 1.5 times PPP by 1983. Throughout the 1980s, gold continued to trade substantially above its inflation-protection price although by 1990 the premium had disappeared completely.  From 1990 to 1996 gold still traded exceptionally close to PPP but then the gold price went down in the late 1990s and for the first time since the early 1970s gold traded at a considerable discount to its PPP. How can we explain this?

The gold underperformance from 1996 to 2000

Gold market analysts such as Ferdinand Lips point toward various technical factors, such as massive gold sales by certain central banks, in particular the Swiss National Bank and the Bank of England in the late 1990s, and the growth of the gold-lease market, which gave mining companies cheap tools to sell gold production forward using again the substantial gold hoards of the central banks. I find it difficult to independently evaluate the impact of these factors but am willing to believe they played a role. I also believe that the overall macro-environment between 1996 and 2000 was very unusual. With hindsight we may say that, structurally, politically and cyclically, not everything was as squeaky-clean as it may have appeared at the time. But still, if there was ever a period over the past 43 years during which all major problems of the paper money economy seemed to be under control or even solved for good, this was it.

These were the ‘good Greenspan years’. Real short-term interest rates were positive, bank reserves grew slowly, the yield curve was flat and the dollar fairly strong. There was a new belief in entrepreneurship and innovation, particularly in information technology. NASDAQ boomed. Productivity gains seemed high and there seemed to be no limit to growth. The business cycle was declared dead; the New Economy had arrived. In any case, growth was not manufactured by the government through deficit spending and money printing. The US was top dog, politically, economically and ideologically.

President Clinton had been elected on the promise to introduce state health care but once in office had to bow to the zeitgeist and advocate free trade instead (NAFTA), and even cut taxes. In 1994, the Gingrich Republicans shut down the government for some time, loudly contemplated closing various government departments for good, and started blocking much of Clinton’s spending proposals.

In 2000, the US had a budget surplus for the first time since it had severed its last link to gold in 1971.  In 2001, the gold price reached a low of $272 an once and thus traded 43% below its PPP price, its largest ‘undervaluation’ since 1972. Then the wheels came off the US economy and economic policy-making became outright bizarre.

2001 to today: crisis, deficits and cheap money

The NASDAQ boom turned out to be a bubble and it ended like all bubbles eventually do. The record bankruptcies of Enron and WorldCom in 2002 exposed recklessness and even fraud at the top of America’s New Economy. The 9/11 attacks in 2001 put America on a war footing. The Gingrich-Republicans were replaced with the neoconservatives, and instead of closing government departments many new departments and agencies were created, most infamously the Department for Homeland Security. As the ‘War on Terror’ had from the start no clearly defined enemy and no clearly defined objective it promised to be an instance of ‘never-ending peace through never-ending war’.  The budget deficit exploded.

Short-term economic growth was now engineered through easy monetary policy. Greenspan kept rates at 1 percent for 3 years and blew a massive housing bubble, and when that popped in 2007, a much worse financial correction than in 2001/2002 commenced. Lehman and AIG collapsed and a run on the entire system seemed imminent. The new policy tools included TARP, nationalization, massive stimulus packages, zero interest rates and repeated rounds of debt monetization (“quantitative easing”).

Through Greenspan’s 1-percent policy phase the gold price had already begun to recover and by 2006 gold was again trading at a premium to its inflation-protection price, for the first time since 1990. Since the financial crisis commenced in 2007, gold moved up relentlessly, the market-price-to-PPP ratio moving from 1.25 to 2.64 last year. At its present price of $1,600 per ounce gold is trading at 2.6 times its PPP price, a ratio that is close to where it was in 1980.

So is gold in a bubble?

I do not think so.

That it is trading at an inflation premium similar to 1980 should not surprise us. Just as in 1980 there is again a clear and present danger that the authorities are losing control over their fiat money. There is a risk of monetary regime change, just as there was in 1980. That the authorities managed to pull this thing back from the brink thirty years ago does not mean they will succeed this time.

In 1980, the key point of concern was high headline inflation. This is not the reason for concern at present. Back then the official inflation rate was almost 14 percent. By contrast, last year’s CPI-inflation in the US was slightly more than 3 percent. The concern stems from two other areas in my view: the massively inflated monetary base and the out-of-control budget deficit. The former is a clear indication of how sick the financial system is. Since 2007 the Fed injected $1,800 billion in new reserve money into the financial system, or more than twice the amount of reserves that existed in 2007 when subprime fell out of bed, and more then ten times the amount of reserves that existed in 1980. This money is not circulating through the economy, hence inflation is still fairly low. But this money is needed by somebody. It is evidently required to keep the banks in business or at least to prevent them from shrinking and from selling assets that nobody wants to buy at present prices. In short, all this money is needed to sustain a mirage of solvency of the financial system and an illusion of ‘recovery’.

At the same time, there is no self-sustaining recovery that would allow the Fed to reduce its balance sheet. Quite to the contrary, the weak employment report today will ignite new calls for another round of debt monetization (‘quantitative easing’). The Fed is boxed in. Without their massive support the chimera of recovery and of solvency would quickly disappear.

At the same time, the hyperinflated monetary base is a gigantic powder keg. When this money starts dripping into economy, inflation will go up and then what? Will the Fed be able to hike rates and stop the printing press to restore faith in paper money, just as they managed to do in 1980?

The key difference between 1980 and 2012 is this: in 1980 inflation was high but the Fed had room to manoeuvre. All that was needed was the political will to stop the printing press, to allow rates to go up and to allow a painful but cleansing recession. I am not saying that it was easy but it only took will. Paul Volcker had that will and resolve, and Reagan managed to sell it to the public.

Today, inflation is still fairly contained and without the Fed’s ultra-generous reserve policy there would even be deflation. But the Fed has no room to manoeuvre. The Fed has to stay super-easy to support an incredibly overstretched and bloated financial system, a system that is addicted to cheap credit much more than anything in 1980. If this easy policy leads to rising inflation or even rising inflation expectations, the Fed will be in a heap of trouble. If they hike rates they pull the rug from under a system that is on constant life support.

Also, the disappointing ‘recovery’ is bound to increase the pressure on the Fed to become even more accommodative and that increases the risk that things will ultimately slip out of their hands.

Then there is the gigantic budget deficit. In 1980 the US budget deficit was $73.8 billion in 1980 dollars, or $206 billion in 2012 dollars. In 2012 the deficit is likely to be $1,330 billion. In 1980 public debt was 33% of GDP, in 2012 it is 100% of GDP. Already the Fed is the largest buyer and the single largest owner of the government’s debt. Last year, 61% of new Treasurys were placed with the central bank.

Strangely, US Treasurys still seem to enjoy safe haven status in the private capital markets. Should this change and should investors begin to demand a higher running yield on these bonds, then the Fed would have to step in and buy even more in order to avoid a rise in the state’s funding cost and to mitigate the hugely deflationary impact on the inflated financial infrastructure that higher yields would have.

Everywhere we look things seem unsustainable and fragile, and everything seems to point in the direction of more accommodation rather than ‘exit strategy’. The printing press has become the last line of defence for a hopelessly over-leveraged financial system and an out-of-control government. And the gold market knows it.

But our analysis can also explain why gold has traded sideways for the past 12 months. The monetary base is roughly unchanged from where it was last spring as the Fed has refrained from additional net asset purchases and has ‘only’ manipulated the yield curve via ‘Operation Twist’. The unchanged base seems to have caused the gold market to pause. The fiscal situation is still very bad but nobody expects any change here until after the election anyway.

In summary, gold is not cheap but its high price does not seem unreasonable either given the current policy predicament. If the Fed refrains from further easing measures and if there are no shocks to the system, the gold price could drift lower as the market decreases the premium over the PPP price. However, I would be very surprised if the ratio would fall below 1.5. That would mean a gold price of about $950. This would also constitute a retracement of 50% from last-year’s all-time high, a fairly brutal correction but one that also occurred in previous bull markets.

On the other hand, any additional measures from the Fed to ‘stimulate’ the economy, or any ‘accidents’ in the financial system, and the premium could even expand further. Additionally, any rise in inflation from still fairly low levels should also feed through into a higher gold price, even if the premium over PPP was unchanged.

Personally, I can still not envision an endgame here that does not involve either high inflation or a substantial correction (meaning collapse) of large parts of the financial infrastructure. In either case I want to hold gold, the superior monetary asset that is no-one’s liability, that is outside the banking system and outside of political control. Gold remains my favourite asset because it is a self-defence asset rather than a quick way to make a (paper money) buck. And don’t forget:

In the meantime, the debasement of paper money continues.

This article was previously published at Paper Money Collapse.