Central banks don't need to dig to get their hands on more gold
It's no secret that I am a big believer in gold.But today I want to take a look at the case againstgold.Starting from a low of about $250 per ounce in mid-1999, gold staged a spectacular rally of over 600%, to about $1,900 per ounce, by August 2011. Unfortunately, that rally looked increasingly unstable towards the end.
Gold was about $1,400 per ounce as late as January 2011. Almost $500 per ounce of the overall rally occurred in just the last seven months before the peak. That kind of hyperbolic growth is almost always unsustainable.
Sure enough, gold fell sharply from that peak to below $1,100 per ounce by July 2015. It still shows a gain of about 350% over 15 years. But gold's lost nearly 40% over the past four years. Those who invested during the 2011 rally are underwater, and many have given up on gold in disgust. For long-time observers of gold markets, sentiment has been the worst they've ever seen.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Yet it's in times of extreme bearish sentiment that outstanding investments can be found if you know how and where to look.
There's already been a change in the winds for gold so far this year.
A change that, in many ways, I predicted in my most recent book: The New Case for Gold.
But today I want to show you three main arguments mainstream economists make against gold.And why they're dead wrong.
The questionable case against gold
They say there's not enough gold to support that money supply; that the money supplies are too large. That argument is complete nonsense. It's true that there's a limited quantity of gold. But more importantly, there's always enough gold to support the financial system. But it's also important to set its price correctly.
It is true that at today's price of about $1,300 an ounce, if you had to scale down the money supply to equal the physical gold times 1,300 that would be a great reduction of the money supply.
That would indeed lead to deflation. But to avoid that, all we have to do is increase the gold price. In other words, take the amount of existing gold, place it at, say, $10,000 dollars an ounce, and there's plenty of gold to support the money supply.
In other words, a certain amount of gold can always support any amount of money supply if its price is set properly. There can be a debate about the proper gold price, but there's no real debate that we have enough gold to support the monetary system.
I've done that calculation, and it's fairly simple. It's not complicated mathematics.
Just take the amount of money supply in the world, then take the amount of physical gold in the world, divide one by the other, and there's the gold price.
You do have to make some assumptions, however. For example, do you want the money supply backed 100% by gold, or is 40% sufficient? Or maybe 20%? Those are legitimate policy issues that can be debated. I've done the calculations for all of them. I assumed 40% gold backing. Some economists say it should be higher, but I think 40% is reasonable.
That number is $10,000 an ounce. In other words, the amount of money supplied, given the amount of gold if you value the gold at 10,000 dollars an ounce, is enough to back up 40% of the money supply. That is a substantial gold backing.
But if you want to back up 100% of the money supply, that number is $50,000 an ounce. I'm not predicting $50,000 gold. But I am forecasting $10,000 gold, a significant increase from where we are today. But again, it's important to realise that there's always enough gold to meet the needs of the financial system. You just need to get the price right.
Regardless, my research has led me to one conclusion the coming financial crisis will lead to the collapse of the international monetary system. When I say that, I specifically mean a collapse in confidence in paper currencies around the world. It's not just the death of the US dollar, or the demise of the euro, it's a collapse in confidence of all paper currencies.
In that case, central banks around the world could turn to gold to restore confidence in the international monetary system. No central banker would ever willingly choose to go back to a gold standard.
But in a scenario where there's a total loss in confidence, they'll likely have to go back to a gold standard.
The second argument raised against gold is that it cannot support the growth of world trade and commerce because it doesn't grow fast enough. The world's mining output is about 1.6% of total gold stocks. World growth is roughly 3-4% a year. It varies, but let's assume 3-4%.
Critics say that if world growth is about 34% a year and gold is only growing at 1.6%, then gold is not growing fast enough to support world trade. A gold standard therefore gives the system a deflationary bias. But that's nonsense, because mining output has nothing to do with the ability of central banks to expand the gold supply.
The reason is that official gold the gold owned by central banks and finance ministries is about 35,000 tons. Total gold, including privately held gold, is about 180,000 tons. That's 145,000 tons of private gold outside the official gold supply.
If any central bank wants to expand the money supply, all it has to do is print money and buy some of the private gold. Central banks are not constrained by mining output. They don't have to wait for the miners to dig up gold if they want to expand the money supply. They simply have to buy some private gold through dealers in the marketplace.
To argue that gold supplies don't grow enough to support trade is an argument that sounds true on a superficial level. But when you analyse it further, you realise that's nonsense. That's because the gold supply added by mining is irrelevant, since central banks can just buy private gold.
The third argument you hear is that gold has no yield. It's true, but gold isn't supposed to have a yield. Gold is money. I was on Fox Business with Maria Bartiromo recently. We had a discussion in the live interview when the issue came up. I said, "Maria, pull out a dollar bill, hold it up in front of you and look at it. Does it have a yield? No, of course it has no yield, money has no yield".
If you want yield, you have to take risk. You can put your money in the bank and get a little bit of yield maybe half a percent.
Probably not even that. But it's not money anymore. When you put it in the bank, it's not money. It's a bank deposit. That's an unsecured liability in an occasionally insolvent commercial bank.
You can also buy stocks, bonds, real estate, and many other things with your money. But when you do, it's not money anymore. It's some other asset, and they involve varying degrees of risk. The point is this: if you want yield, you have to take risk. Physical gold doesn't offer an official yield, but it doesn't carry risk. It's simply a way of preserving wealth.
I believe the primary way every investor should play the rise in gold is to own the physical metal directly. At least 10% of your investment portfolio should be devoted to physical gold bars, coins and the like.
Get the latest financial news, insights and expert analysis from our award-winning MoneyWeek team, to help you understand what really matters when it comes to your finances.
How to use SAYE and SIP schemes to multiply your money
Sizzling sales at Sysco – should you invest?
