Gold's Price Is Not A Bubble Price

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Gold remains undervalued, even at its current price of $1,150 an ounce. One signal of this is that at current market prices of gold, the notes of the FED — its dollar bills — are not fully-backed by gold. That is to say, gold’s price is lower than the Zero Discount Value (ZDV) of gold by a wide margin.

Medley Global Advisors does not accept this idea or does not understand it. They may be operating on a different theory of money than mine, which is that gold never stopped being the medium of account for prices, even though the FED has suspended convertibility of its notes into gold since 1971.

Since people can exchange the dollar for gold in the open market, they can bypass the lack of FED redemption. The market can substantially remove the undervaluation of gold and the overvaluation of the dollar. It has done this before and it can do it again. The reasons why the market drives gold’s price further away from its ZDV, as in the 1990s, or closer to its ZDV, as in the 1980s, may be cloudy; but the fact of undervaluation is clear from the following. Dollars can be converted into gold at a rate of $1,150 an ounce in the open market, but the implicit rate of conversion derived from the FED’s gold holdings compared with the dollars it has issued is at least $7,725 an ounce in order to equate its asset and liability values.

Medley Global Advisors sells advice to the financial elite:

"Medley Global Advisors LLC (MGA) is the leading macro policy intelligence service for the world’s top hedge funds, investment banks, and asset managers."

"We combine intensive dialogue with senior policymakers, years of experience with the most sophisticated investors, and in-depth knowledge of global markets to provide concise, timely, and accurate analysis that helps clients understand and anticipate the major policy events driving interest rate, currency, equity and energy markets."

But Medley doesn’t understand why gold is rising in price, or pretends not to. In a recent note that was published by the New York Stock Exchange called "The Vogue of Gold," it jocularly pooh-poohs

"…the usual lectures on Austrian Economics, u2018fiat money’ and fractional reserve banking conspiracies that make most gold bugs such incredibly boring dinner partners."

Instead the reason for gold’s rising price, it says, is that people in China are saving more than they spend, and saving in the form of gold. If so, why is this so? Because "they don’t trust local banks, and they don’t trust green paper money." So Medley is right back to Austrian Economics, fiat money and fractional reserve banking.

The Medley note ends with something that puzzles them:

"Still, the most thought provoking statistic of the week had to be from a Societe Generale report. Their analyst calculated that with the U.S. monetary base of $1.7 trillion, and 263 million troy ounces of gold in the U.S. government’s vaults, that the dollar could be fully u2018gold-backed’ if the price per ounce rose to $6,300. We’re not sure what that really means in practical terms. Maybe Ron Paul can tell us."

Let’s bring the numbers up to date. The monetary base is now 2.02 trillion dollars. I use 261.5 million ounces in calculating the Zero Discount Value (ZDV) of gold, which is the same concept as the fully gold-backed price of Société Générale, and that price is now $7,725 per ounce. This doesn’t take into account the bad loans in the banking system. In the next two years, many more bad mortgage loans are going to surface in areas other than subprime. In addition, a large volume of commercial real estate loans is going to default. The system-wide ZDV of gold as a result of these bad loans can easily become $10,000 per ounce or more.

There is no need to split hairs, worry about trivial differences in calculations, or forecast the future, for the ZDV at present is already far above gold’s market price of $1,150 an ounce.

What does this mean in practical terms? It means that gold’s price is not a bubble price. It means that gold is undervalued. It means that the downside risk of gold is less than that of the dollar and that the upside potential is large. It means that one might be better off holding assets in gold than in dollars, unless one’s dollar investments provide enough return to compensate for various dollar risks that are mentioned below. It does not mean that buying gold is a sure-fire winner or that gold is going to jump to $10,000 an ounce. Markets do not usually work that way; crashes and parabolic rises are not as common as prolonged price movements that form into major trends with many intermediate ups and downs.

The FED is like an open-end mutual fund whose shares have a fixed nominal price of $1 a share. The shares it issues are the notes (dollar bills) in the monetary base. It has issued 2.02 trillion shares (dollar bills.) The asset it holds is gold certificates. The physical gold, which is held by the Treasury, is supposed to be 261.5 million ounces. If the FED were an open-end mutual fund, we’d calculate its net asset value by dividing the worth (in dollars) of its assets by the number of shares. Instead let us calculate a real net asset ratio by dividing the FED’s gold holdings in ounces by the number of notes outstanding. We get 0.000129455 ounce of gold per Federal Reserve note (dollar). This measures the amount of real assets per share of the FED, viewed as a fund.

As the FED issues more and more shares (notes) without changing the ounces of gold it holds, the real assets per share decline. It’s convenient to calculate the inverse of real net assets per note. This is 1 divided by 0.000129455. It comes out to $7,725 notes per ounce of gold. This is the ZDV. The more notes that the FED issues, the lower the ounces of gold per FED note, and the higher the ZDV. The ZDV measures the FED’s note inflation directly. If the FED reduces the monetary base, the ZDV will decline.

If we view the FED as a mutual fund that issues notes, then the ZDV tells us how many notes it takes to get an ounce of gold through participating in the fund by buying or holding the fund shares. At present, it takes $7,725 FED notes to have an interest in one ounce of gold via the FED mutual fund.

There is a cheaper way to gain an interest in gold, and that is in the open market. Gold’s market value of $1,150 an ounce is just under 15 percent of $7,725. For $7,725 we can buy 6.72 oz of gold in the open market.

We can also think of the FED’s open-end fund in terms of market net asset value. The market value of the 0.000129455 ounces of gold (per FED note), at the current gold market value of $1,150 an ounce, is $0.14887, which is just under 15 cents. Thus, the market net asset value of the fund is $0.15 per note (or share). But the fund shares are selling at $1 a note. This suggests that the fund’s shares (FED dollar bills) are overvalued.

Gold selling at $1,150 an ounce in the market is selling at an 85 percent discount to what it sells at if we hold on to the dollars and get a gold participation indirectly in that manner. In other words, by holding dollars, we are always acting as if we are buying gold at the ZDV of the FED’s mutual fund. At present, it is as if we are paying $7,725 an ounce when gold is actually available for 85 percent less in the market. This is a remarkable discrepancy.

One practical meaning of this is that the FED’s notes have an insecure foundation. The notes have a valuation risk that has several sources. For one thing, they are trading at a price ($1 per note) that is far above the current market worth of the gold that the FED holds ($0.15 per note.) There is therefore at all times a strong incentive to dispose of these notes in exchange for gold at its current market price.

Another source of valuation risk arises from dilution. The FED has a long history of adding to the number of these notes, which dilutes the equity. This drives the ZDV higher, which strengthens the incentive to exchange the notes for gold. Since the notes have a constant nominal value of $1, the movement out of notes and into gold shows up as a rise in the price of gold. This is not to say that gold must rise in price or rise when we may think it should. The vagaries of the market do not make life that simple.

The dilution is variable in extent over time. All of a sudden, the FED can increase its note issue because of fiscal pressures and because it costs the FED virtually nothing to produce more notes. These two factors add further to the valuation risk of holding dollars over long periods.

Due to the dilution brought about by the FED’s note issues without adding to its gold holdings, the dollar has not maintained its purchasing power. Hence, there is a risk of capital loss to anyone who uses dollars as a store of value.

The discrepancy between gold’s market value and its ZDV is an indicator of all these risks. If every dollar were fully-backed by gold and the market value equaled the ZDV, these risks would be negligible for as long as that full backing lasted or until people began to expect legal or other changes to decrease the backing. The risks of holding a fully-backed dollar become the risks of holding gold itself and the risks of holding it in the form of a claim to physical gold issued by whoever issues the dollars. There are no riskless assets in this world.

Another risk to holding the FED’s notes over time is a "peso" risk. This is that they may suddenly lose widespread acceptance, or that people en masse turn to using alternative currencies and stores of wealth. If that happens, the price of gold rises quite sharply. The FED’s notes carry this risk because the gold backing is low and because people understand that fiscal and political pressures on the FED can induce it to print more notes. If gold fully-backed the dollar by law, this risk would be diminished. The main risk would be of future changes in law to debase the dollar.

The risk of non-acceptance is not well-understood. It is a judgment or decision to move one’s business out of one currency and into another (gold included). It is a decision that involves a major change in habit and customary way of engaging in transactions. It is a decision that may be influenced by others who may also be revising their judgments or seriously reconsidering what currencies they use. What all this means is that once this decision is made, it is unlikely to be reversed. When people make up their minds, there is something of a point of no return about it. Once confidence is lost in a currency, rebuilding it is no longer a routine matter. There have to be basic changes made for a depreciating currency or a new currency to regain acceptance.

In the present situation, a tipping point seems to have been reached in which major players like India and China are moving away from dollars. Japan has not done this. Japan is still buying dollars. The momentum is shifting away from the dollar. Central banks have started to buy gold. There has been a turn in the tide. There is no tidal wave, although one could develop. Reversing the tide seems increasingly unlikely.

The practical meaning of a ZDV of $7,725 (or higher due to bad loans in the banking system) is that gold can rise in price substantially without ever being overvalued. The high ZDV is an indicator of the dollar’s substantial overvaluation. It is an indicator that dollars are a poor way to store value over the long run. It is an indicator of substantial valuation risks and risks of capital loss in holding dollars. The ZDV by itself does not tell us in which direction the tide is running, but it suggests the probable direction.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire.

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