Gold’s Fundamental Value

by Michael Rozeff

The estimate of gold’s fundamental value reported in this article won’t be much different from
earlier estimates of mine or others. What’s new here is a tad more insight into the assumptions
that go into this estimate. Knowing this might alter one’s confidence in the estimates, up or
down. The perspective herein is definitely fundamental.

The United States has a gold stock of 261.5 million ounces. The first assumption is that the gold
stock of the United States is what it says it is. One can adjust the estimates if one makes different
assumptions about how much gold the United States has. I think the Treasury does in fact have in
its possession the gold it claims to have.

The second assumption is that gold is Money. This means that gold retains its historical character
as a highly marketable and liquid asset. It’s globally acceptable.

The third assumption is that the gold stock is a monetary or money reserve. This means that the
United States is not holding it for a strategic or industrial purpose. The Treasury of the United
States holds it because it is Money. If it did not serve that purpose, that is, if the United States
disposed of its gold stock, the State would lose a degree of control over its economy. That is why
it keeps the gold.

The United States suspended redemption of Federal Reserve Notes (FRNs) for gold domestically
in 1933 and internationally in 1971. Yet gold remains a reserve currency, not only in the United
States but abroad. Suspension doesn’t immediately destroy a paper currency. It removes one of
its desirable features, which is convertibility into gold, but it doesn’t destroy the value of that
paper totally.

If gold is a reserve, against what is it a reserve? Against those persons who might hypothetically
demand gold from the United States in exchange for Federal Reserve Notes (FRNs) or dollar-
denominated United States Notes that they now hold – if they were given the chance. It’s a
hypothetical demand because the United States hasn’t redeemed gold against its obligations since
1971.

Since there is an open market in gold, everyone now has the ability to redeem. The central banks
that hold FRNs and dollars debts of the United States and other paper currencies as reserves had
and have their reasons for doing so. Whatever these reasons, there are strong reasons for selling
their dollar-denominated obligations for gold. For one thing, each one dollar’s worth is backed by
a few cents worth of gold. They can get more gold for their dollars by exchanging a dollar for a
dollar’s worth of gold. The average person in the United States isn’t redeeming FRNs for gold in
the open market. As long as they can buy bread and pay their bills in paper, FRNs and food
stamps serve their purposes. Americans with wealth are different. They are increasingly more
likely to redeem dollars for gold.

If gold is a reserve against hypothetical redemption, who might want to redeem? How far might
such redemption carry? Let’s think about specific sets of persons who hold dollar obligations
who we think have reasons to convert the dollar-denominated obligations they hold into a
different form of money, namely gold Money.

In two previous articles, I chose two sets of person and made two estimates of gold’s
fundamental value. Each set of persons holds an inventory of dollar-denominated paper or the
equivalent obligations of the United States and Federal Reserve. Those persons were either (1)
holders of the monetary base (FRNs + bank reserves), or (2) holders of bank deposits in the
United States. I made two “Zero Discount Value” (ZDV) calculations for these two groups.

The ZDV is the implied market price of gold (in FRNs) such that each FRN is worth its weight in
gold at that price when redeemed in gold from its issuer. At the ZDV, a person is indifferent
between redeeming by sale in the open market and redeeming from the issuer (the United States
and Federal Reserve.)

To understand this, take some easy numbers. Suppose those who hold the monetary base hold
20,000 FRNs. Suppose the issuers of the FRNs hold two ounces of gold to back the FRNs.
Suppose the market price of gold in FRNs is 1,000 per ounce. Then 20,000 FRNs can buy 20
ounces of gold in the market. A hypothetical redemption from the issuers would fetch two
ounces. A person has an incentive to redeem by sale in the open market, because he gets 20
ounces, not two. Only when the market price equals 10,000 FRNs per ounce does this incentive
disappear. That price is the ZDV. The ZDV is the maximum market price at which gold should
rationally sell if the issuers keep the supply at 20,000 FRNs.

The first article explained the meaning of the ZDV. The second article estimated a ZDV in the
neighborhood of $7,500 an ounce, using the monetary base, and $11,090 and higher, using the
whole banking system. The latter method is my preferred method. My guess is that bank assets
are overstated by 30 percent. That implies a ZDV of $17,973.

In an article he wrote in late 2008, Brian Bloom used a different estimation method which I’ll
update now.

The implicit set of persons in his article is foreign central banks that hold dollar-denominated
reserves. This makes sense as an alternative because in the good old days they could demand
gold for these obligations.

The latest IMF data show that “allocated” U.S. dollar reserves are $2,828 billions. This is 62.1
percent of total reserves. Then there are “unallocated” reserves that total 3,520 measured in
billions of dollars. I assume, as he did, that 62.1 percent of this is also held in dollars, which
gives another $2,186 billions.

The sum total of U.S. dollar obligations (Treasury securities) held in central bank reserves is
$2,828 + $2,186 billion = $5,014 billion.

The U.S. gold stock of 261.5 million ounces is worth about $314 billion at a price of $1,200 an
ounce. The ZDV is $5,014,000/261.5 = $19,174 an ounce. This is not far from my banking
system estimate of $17,973. Both of these should be rounded off because they are such iffy
estimates. A ZDV of the mean of these or $18,600 is my estimate.

Another way of looking at is that the ratio of gold value held by the United States to potential
claims on gold (if there were redeemability) is 314/5,014 = 6.3 percent. This is how much
backing there is in gold Money against these obligations in paper money.

It’s a fascinating fact that in August of 1931, just one month prior to Great Britain going off the
gold standard, the Bank of England’s gold reserve was 6.3 percent of the total demand deposit
and note liabilities of the banking system. (See p. 10 of Elgin Groseclose’s The Decay of Money
(1962).)

In the olden days of the Federal Reserve, gold reserves of a minimum of 40 percent were
legislated in the United States. The Bank of England had a ratio of 40 percent in July of 1914,
before the inflation began. I take a 40 percent ratio as something reasonably realistic, meaning a
price at which the desire to redeem paper for gold falls off substantially. In that case, we get 0.4 x
$18,600 = $7,440.

If the market brings about a 40 percent implicit backing of the dollar by gold, by bidding up the
price of gold, even without it being redeemable by the United States, but instead being
redeemable in the market at that ratio, then we can expect a price of about $7,440. That’s my
bottom-line estimate of fundamental value of gold based on each method separately.

Actually, unless there is double-counting, it seems that the obligations against gold include both
domestic banking and foreign central banking obligations. If that’s correct, then we need to add
the two estimates together, in which case, even at a 40 percent coverage, we get about $15,000.

Distrusted paper currencies do not usually go to zero right away. Sometimes they do, but usually
the government has to print vast quantities of assignats, continentals, or whatever, before this
happens. The British pound didn’t go to zero after August 1931. It did get devalued several
times, including in September 1931, but its trip downwards has taken decades. Governments
sometimes fight the declines using exchange stabilization funds.

If these kinds of estimates are meaningful, we have a pretty good idea of gold’s fundamental
value. Backing of 6.3 percent is low. Backing of 40 percent is more normal. If mean reversion is
the name of the game, then we have some idea where the gold price in dollars is likely to head,
which is half the battle, but we don’t know when. We also know that such trips are not one-way
streets. Markets can do anything. The authorities can fight the rise in various ways. If the backing
to gold goes up to 40 percent of ZDV of just one of these pools of funds, not both, that’s a 6-fold
rise. Over the following horizons, here are the continuously compounded annual rates of return
(rounded off):

50 years 3.6 percent per year

40 years 4.5
30 years 6.0
20 years 9.0
10 years 18.0
5 years 36.0

Why is gold so far below its fundamental value? Why is gold so cheap, even at $1,200 an ounce?
The estimate depends on gold as Money as it was 75 years ago and more. The reason gold is so
cheap is that governments disestablished it. Governments of the world stopped using gold as
Money in order to be able to run monetary policies of their own choosing. Yet the major
governments were unable to divorce their currencies entirely from gold. They still hold gold
reserves. Markets take time because they depend on people acting, and people are now used to
paper money, not gold. There is no routine payments and credit system in gold. Even when there
was, silver was commonly used. Gold was for larger behind-the-scenes transactions.

Mean reversion isn’t automatic. There have to be forces that impel governments into restoring
gold for mean reversion to occur. Those forces are political-economic in nature. It may be the
case that no nation becomes and remains an important commercial, mercantile, and industrial
power unless it has a solid, honest. and stable money system. Gold affords such a system.
Without gold or without a viable substitute for it – and what substitute is there – a nation’s
progress is thwarted.