Gold may face two great enemies, but the underlying pressures for ever-higher Gold Prices are only set to grow worse...
ALL PAPER MONEY throughout history has proved defective when compared to Gold Bullion in terms of one of the classic functions of money.
Nineteenth century economists such as William Stanley Jerons (a great economist by any test) taught that money ought to act as a "store of value". But there is no fiduciary issue which has survived the period since the end of the Second World War in 1945 without very substantial depreciation.
Even comparatively respectable currencies, like the British Pound or the US Dollar, have lost a significant proportion of their purchasing power since peace broke out in Europe and Japan. They are expected to continue to lose purchasing power for the foreseeable future.
The classic statement of the problem comes in David Ricardo's book On the Principles of Political Economy and Taxation (1817). Ricardo, whom our Victorian ancestors regarded as the scientific authority on financial questions, stated:
"Experience shows that neither a State nor a Bank ever had the unrestricted power of issuing paper money, without abusing that power: in all States, therefore, the issue of paper money ought to be under some check and control [and] none seems so proper for that purpose, as that of subjecting the issues of paper money to the obligation of paying their notes, either in gold coin or bullion."
This established the rule, on which the historic gold standard was based, that convertibility is the test of value. Whereas a non-convertible paper money can be expected to depreciate over time, more or less rapidly.
In the twentieth century, for example, the great majority of non-convertible paper currencies depreciated by more than 90% in purchasing power, and money depreciated to zero.
Gold, on the other hand, has a high degree of stability in the purchasing price over very long periods, as demonstrated in statistical studies by Professor Roy Jastrom and others. English statistical series suggest that the purchasing power of gold in 1913, immediately before the First World War, was about 90% of the value of gold in 1700, when Isaac Newton was Master of the Mint.
One should not expect too much precision in these series of price indices, but the evidence is conclusive: gold tends to return to a constant purchasing power (hence Jastrom's phrase "the Golden Constant") while paper currencies tend to go to zero.
For that reason the Ricardian requirement of convertibility, which existed for the vast majority of the world between the Napoleonic Wars and the First World War, is a requirement that paper money should only be issued in quantities which maintain its level of scarcity, and therefore its purchasing power.
All of this, it must be noted, depends on accepting what's known as the "quantity theory of money". Since the 1960s there have undoubtedly been economists who held the quantity theory of money in a naïve and therefore misleading form. The quantity theory is probably best understood in terms of Irving Fisher's relatively simple equation...
mv = pt
...where m is the money supply, v is velocity of circulation, p is price and t is the number of transactions, or the level of activity. And one can see that these variables have to move together.
If the money supply doubles, prices will double, unless the velocity of circulation falls. If there are ten walnuts on the tree and ten pounds available to buy them, walnuts will cost a pound each. If there are twenty pounds available to buy walnuts, they will cost two pounds each.
No, this is not an econometric calculation, but it is a useful way of thinking about the relationship between money and prices.
The gold standard, however – and indeed the principle of stable money – had two great enemies. They were, and are, war and democracy.
The gold standard had to be suspended by the European powers in 1914, when the First World War broke out. It has never been fully restored. The Bretton Woods system, which was based on international convertibility into the US Dollar (and thus Dollar convertibility into gold), lasted for about twenty five years before President Nixon suspended gold convertibility in 1971.
After the Bretton Woods system collapsed, the final link of currencies to gold was broken. This led to a boom in the Gold Price which rose from the old fixed price of $35 an ounce to a high of $860 in 1980, before moving into a 20-year bear market which took the price down to about $260 in the late 1990s. It was at that point that Gordon Brown, then Chancellor of the Exchequer in the United Kingdom, sold a large part of the UK's gold reserve.
Politicians always get markets wrong, of course, and the Gold Price has now reached a new nominal peak of $914 an ounce – a price which is still only about half the 1980 level in real terms after accounting for inflation in the cost of living.
Gold still has a significant role in national reserves. In recent years, the reserves of the major Asian economies have been increasing much more rapidly than those of the West. The US Dollar has been falling, though the Euro has been firm. As a result, China has been increasing the holding of reserves in Euros, and has incurred significant losses in the Dollar content of China's holdings.
In the earlier stages of Chinese growth, this loss on US dollars was offset against the growth of Chinese exports to the Dollar zone. But there has been increasing reluctance to continue to add to dollar holdings, not only in China, but in the Asian countries generally.
Unfortunately, Asian countries have long-term reservations about the economy of the European Union. From the Asian point of view, the European economy, indeed Europe generally, seems to be in long-term decline. European costs are high. With the exception of German machinery, much of European manufacturing is seen as uncompetitive. Britain is respected as a financial centre, but that only supports the value of Sterling when financial activity is rising. At present Asia expects an American and European slow down, which will affect the earnings of London as banking centre.
The modern pattern of global trade is one of the transfer of wealth from North America and Europe to Asia, and particularly to the three largest Asian economies, China, India and Japan. That movement has created the surplus of reserves in the Asian countries, and a reduction of reserves in the West. The Euro may at present be preferred to the Dollar or Sterling, but Asia has little confidence in the underlying European economy and the high price of the Euro makes the European economy even less competitive.
One cannot expect gold to take the place of the Dollar in Asian reserves; there are too many dollars already in existence, and too little gold. Yet the surplus that exists of the Western currencies makes gold a very attractive alternative, particularly as Asia has always had a preference for the precious metals. Gold has its niche.
The supply position of gold is favorable to further rises in the Gold Price. Despite the rise in the price that has taken place already, there is no sign on the production side of the creation of excess supply, though of course, stocks are high relative to industrial and jewelry outtake. Because it acts as a reserve currency, gold stocks are always large.
There is also a link between the price of oil and the price of gold. In the 1970s, during which the OPEC oil cartel raised the price of its oil exports dramatically, gold rose with oil and also along with the general increase in world inflation. For some years I have been forecasting an oil price of $100 a barrel – which has now been reached, if ever so briefly – and a Gold Price of $1,000 an ounce. It would only take another 10% for the second target to be reached.
The oil price has traditionally been volatile. A short-term surplus could see a short-term fall in the oil price just as a war with Iran could force the price up to $150 or even $200 a barrel. However, the long term problem of oil supply, and the insatiable growth of Asian demand, suggests that the long term price of oil will continue to rise.
The same, in my view, is likely to be true of the price of gold. The great democracies of the West will find it difficult to make the sacrifices necessary to deal with the growing shortage of fundamental resources – most notably energy, including oil, gas and uranium. Our excessive levels of debt are likely at some point to lead to inflation in the cost of living, and that will wipe out the real value of debt.
In these conditions, the underlying economic pressures are for a still higher Gold Price. In the last decade, the price of gold has been doubling every five or six years. My own guess would be that gold will hit $2,000 an ounce in the early 2020s, but some analysts think that will happen much earlier.