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A Perspective on Gold Valuation
by James Turk

Over the years I have presented in these letters several different, but meaningful, ways to measure Gold's relative value. Long time readers are aware that my favorite measure is my Fear Index, which by the way has at the end of January reached an all-time low of 0.97%.

The average Fear Index since the Federal Reserve's creation in 1913 is 7.9%. If the Fear Index today was equal to this historical average, the Gold price would be $2,164. Even if we just used the 3.0% level the Fear Index has averaged since the Dollar's formal link to Gold was abandoned in August 1971, the Gold price today would still be $831.

Another measure I have presented in past letters is the inflation adjusted Gold price. Although this measure seriously understates the rate at which the Dollar's purchasing power is being eroded, it nevertheless still shows how undervalued Gold has become. Using the Consumer Price Index to adjust for the Dollar's diminishing purchasing power, the $35 per ounce Gold price in January 1934 today equates with $463 per ounce.

I've also shown how Gold is cheap compared to the $20.67 price in December 1933, which we know from the horrific banking crisis underway at the time was a price which significantly undervalued Gold. Incidentally, this $20.67 price up until recent years had been the record undervaluation of Gold, or I should say to put it correctly, the greatest overvaluation of the Dollar. But no more.

At $259.90, Gold today is valued less than the extreme low valuation from 1933, although again, the correct way to state this relationship is that the Dollar has never been more overvalued. Using the CPI to adjust from December 1933 to the present, the Gold price today would be $274 per ounce.

I have also used crude oil to show how Gold is undervalued, by measuring the price of crude oil in terms of GoldGrams. In November it took a record 3.989gg to purchase one barrel of crude oil. Even though this relationship has fallen somewhat to 3.469gg, it is still well above the historical average of 2.239gg. At a current crude oil price of $31.03 per barrel, Gold today needs to be $431 per ounce to give GoldGrams their average purchasing power of 2.239gg/barrel.

I guess you get the message. By any of these measures Gold is cheap and undervalued. But to reinforce this message by giving it yet a different perspective, I've come across another interesting method of valuation.

A friend had asked me to provide him with some international financial statistics. This data is compiled by the International Monetary Fund and is available in their annual International Financial Statistics Yearbook. The usefulness of this new method of valuation struck me while I was putting together this data. But before I explain this new valuation method, some background information about 'fractional reserve banking' and a little bit of banking history is necessary to appreciate this methodology's importance.

Fractional reserve banking is the practice of keeping only partial reserves against banking deposits. For example, if one ounce of Gold (valued at $35 per ounce) was deposited in a bank, the bank would typically issue $87.50 of currency. All banks employ this practice, which many people including me believe to be deceptive, and some argue is fraudulent. Be that as it may, the relationship between the quantity of reserves and the Gold price is important.

The 'money' (i.e., reserve of Gold) in the bank was always the indisputable and final measure of the value of the currency (i.e., the 'money substitute' circulating in commerce). In other words, when a banking crisis occurred, the Gold established the value of the money substitute.

In the worst case scenario, if a bank was imprudent and did not maintain sufficient reserves and/or had a portfolio of bad loans, it failed, and the money substitutes it had created became worthless. In the best case scenario, if the bank had sufficient liquidity and reserves, the money substitutes were redeemed for Gold at the rate fixed by law (i.e., one ounce for every thirty-five Dollars), with the result that the bank survived the crisis.

Generally speaking if the banks had never engaged in fractional reserve banking in the first place, the value of the money/Gold in reserve would be identical to the money substitute. But with fractional reserve banking, the money substitute was always worth less than the Gold in reserve, even though they exchanged at equivalent value. In other words, one ounce of Gold bought the same quantity of goods or services as $35 of paper (the money substitute), but with fractional reserve banking, Gold was undervalued and paper overvalued.

These different valuations weren't a concern until there was a banking crisis. In a crisis, the reserves determined how overvalued the money substitute had become.

Reserve Value graph

Therefore, it is useful to look at this relationship between Gold and reserves, which is what I've done for the world economy. The result is presented in the chart above.

There are two prices for Gold in the chart, the actual price and its reserve value (labeled the 'target price'), which is calculated by dividing total reserves in the world's central banks by the weight of Gold they report that they own. The right hand scale shows in percentage terms whether the actual price was more or less than this calculated target price.

You can see from the chart that back in the early 1960's when the Dollar was still considered to be 'as good as Gold', the actual price was less than the target price. In other words, central banks had adequate reserves on hand to maintain the value of the national currency circulating as money substitutes. But that relationship began to change by the mid-1960's. The target price rose above the actual price. In other words, Gold was worth more than $35 per ounce.

This $35 valuation could no longer be maintained because the Dollar had become so debased. So eventually the Dollar was devalued from this $35 level, and subsequently, the formal, fixed link to Gold was broken. Nevertheless, the actual price and the target price stay more or less in synch with each other, until the late 1980's. While the target price has continued to rise, the actual price has moved sideways, creating an unprecedented gap between them.

Today Gold is trading around $260, but the target price is $1,812. The important question is why?

There are only two alternative answers, and I've mentioned them before in other discussions, so long time readers should know what they are. Either Gold no longer is money, or Gold is extremely undervalued. There are no other explanations to this 'gap' in prices on this chart. In my view the latter alternative is the correct answer.

We today look back at Mississippi Bubble and the South Sea Bubble with smug amusement and ask ourselves laughingly how could the people back then have been so foolish. No doubt people generations from now will look back at circa 1970 to 2000 and ask themselves the same question.


In the preceding text I state that the target price is calculated "by dividing total reserves in the world's central banks by the weight of Gold they report that they own". The reality is that the central banks have on hand less Gold than they report, because they defy both logic and generally accepted accounting principles by reporting "Gold in the Vault" and "Gold Receivable" as the same item.

I used their reported number because unfortunately, we don't know exactly how much Gold they have loaned out. But it means that the target Gold price is even higher than the amount that I calculated because the denominator of the equation is smaller than the number I used in my calculations.

One other point is worth mentioning. The data is only complete through 1998, but it is timely enough so as not to diminish the importance of this data. And since 1998 central bank reserves (the numerator of the formula) have continued to grow. For this reason and because the weight of Gold in central bank reserves (the denominator of the formula) has declined, Gold's international reserve value today is even higher than $1,812, and my estimate is considerably higher, probably in the $2,500 range.


One of the most striking things to me about the chart above is the moment in time at which a relationship that lasted for decades began to deteriorate.

The actual price of Gold moved more or less in tandem with the target price from 1960 until the late 1980's, but by 1990 it had become quite clear that this relationship had changed. That change becomes even more obvious as the 1990's proceeded.

What could have caused this change? What was different in the late 1980's, and then continued through the 1990's, that could have impacted this relationship between the actual price of Gold and its target price?

To me the answer is obvious - hedging. Though the first hedges were established in 1985, the practice didn't really begin catching on until the late 1980's, and as we know, the volumes hedged really soared in the 1990's.

While the practice of hedging coincides neatly with the divergence between the actual price of Gold and the target price, this relationship is not just coincidental. Logic also explains why hedging is the culprit that has caused this divergence. It can be explained by one basic monetary principle -- extending credit cheapens a currency.

This principle has been obvious to observers of money for hundreds of years. I have books written in the 19th century that explain this basic concept, but this monetary principle did not become widely accepted until Milton Friedman began writing about it in the late 1950's. He used a very simple example to explain an important component of what has come to be called the 'Quantity Theory of Money'.

Assume that while a community slept at night a helicopter showered it with newly created currency, doubling the quantity of money overnight. The next day as the community awoke and began spending this money, they would soon realize what had happened. The result is that manufacturers and shopkeepers would begin raising prices of their goods, and prices would keep rising until the price level doubled from what had prevailed before the community was visited by the helicopter.

The point is that doubling the quantity of money does not make the community richer. Only newly created goods and services can do that, and this new abundance of money does nothing to increase the quantity of the physical goods and services by which the community can become wealthier. All the money does is cause prices to double over time.

The obvious way to double the money supply is to print twice the amount of banknotes circulating in commerce. Thus, assume in the above example you went to sleep with $100 in your pocket but you woke up the next morning with $200, courtesy of the mysterious helicopter. Another obvious way is for the helicopter to double the amount of money in your checking account. But whichever way the money supply is doubled, there is always a corresponding transaction. The reason is that the increase in the quantity of money is only one-half of the double-entry accounting required to complete the transaction.

The currency in use today is a liability of some bank. Namely, cash currency is a liability of a central bank, and the money in your checking account is a liability of a commercial bank. If you double the quantity of money on the right side of the banks' balance sheet, double-entry accounting also requires the left side (i.e., the asset side) to be increased by the same amount. How does this happen? By the extension of credit.

If that helicopter was spreading cash currency, the central bank was making a loan to someone who was willing to finance this doubling of the money supply. Or if the helicopter was doubling everyone's money in their checking account, the commercial banks were making the loans. But the point is that regardless how the quantity of money is expanded, it is expanded by the extension of credit. And importantly, we see from the example that the extension of credit cheapens the currency. Doubling the quantity of money meant in the end that it purchased only one-half as much as it did before the helicopter distributed the newly created currency.

Do you see how this principle relates back to hedging? Do you see why hedging cheapens the currency (i.e., diminishes Gold's purchasing power by lowering the Gold price)?

Hedging in effect increases the quantity of Gold. The central banks even take steps to perpetuate this illusion by not properly accounting for the Gold they have loaned, so everyone regularly states that central banks have 30,000 tonnes when in fact they probably have less than 20,000 tonnes, the difference having been loaned out.

These Gold loans are what has cheapened Gold. The central banks lend Gold to the mining companies (via the middleman bullion banks), so the mining companies have cheapened their own product. By hedging they have in effect increased the quantity of metal through the extension of credit. What? They've created Gold 'out of thin air'?

Well, yes, sort of. They really haven't created Gold; all they have done is created 'Gold substitutes'. These substitutes are extensions of credit in effect masquerading as Gold. And the central banks have pulled off this masquerade much longer than I thought them capable of doing, but for how much longer?

I don't have the answer to that question; no one does. But we all know the answer to how it will end? Badly. Just as all extensions of credit inevitably end. There will be widespread defaults. As a consequence, many people who think they own Gold will find out that they in fact only owned a Gold substitute, and they will end up owning nothing if the Gold substitute they owned was defaulted upon.

As a practical matter, the big losers are going to be the central banks who have loaned out their metal. They are the biggest providers of Gold credit, so they will suffer the most defaults. But the ripple effect of defaults I expect will have a knock-on effect throughout the Gold community. Any and all Gold substitutes will be doubted, and many will be defaulted upon. It will be a typical credit contraction, which is always the inevitable result of the credit expansion.

by James Turk
February 12, 2001

First published on February 12, 2001 in Letter No. 279

Freemarket Gold & Money Report--A Commentary on Precious Metals and Monetary Matters

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Please e-mail any questions or comments to: jamesturk@fgmr.com

Copyright © 2001 by Freemarket Gold & Money Report. All Rights Reserved.


Reprinted by USAGOLD with permission of James Turk / FGMR. No further reproduction without permission.

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