With the price of gold climbing, we are once again starting to hear the clarion cries warning us of a gold bubble. But how does one objectively evaluate that claim? The first step is to understand what a bubble means. A bubble occurs when there is a large disconnect between something’s price and its worth. Determining the price of gold is a straightforward proposition, but how do you calculate its worth?
Gold’s primary use is money. We can evaluate gold in the same manner we would an exchange rate between two currencies. Supply and demand are the usual starting points. Intuitively we understand why the demand for a currency can change. For example, when the viability of the European Union is called into question, demand for dollars increases as less people are comfortable storing their wealth in euros. Understanding demand is one thing, quantifying it is a bit more difficult.
Supply is easier to measure. Once you remove demand from the equation, an exchange rate simply becomes a ratio. If you compare the base money supply to the amount of gold held in the US reserves, you come out with a ratio of just over $10,000 for every ounce of gold.
Historically, if we take a look at the ratio of the value of the US gold reserves to the base money supply, we can start to quantify demand. In 1980, when the fear for the future of the dollar last peaked, the value of the US gold reserves went to over 130% of the base money supply. If you apply the same demand to the current supply you arrive at a price exceeding $13,000/oz.
But here’s the catch, as bad as the graph of the base money supply growth looks, it represents only what was necessary to keep the current status quo afloat for the time being. Nothing has been fixed. We still have a banking system that is largely insolvent, a federal debt that can never be paid in terms of today’s dollars, and a black box of OTC derivatives overhanging everything that is measured in the quadrillions of dollars. It certainly doesn’t appear that the experience of the ‘70s will be able to hold a candle to the coming global financial crisis.
A rational analysis of the situation would indicate that it is not gold that is a bubble, but rather the system of infinitely expanding paper and credit built on top of it.