Price and value and these two very different things. Regarding gold, the price that we are all used to hearing about is the spot price of gold. The spot price is used to create the price chart that we use for market analysis.

Spot price vs physical price of gold

The theoretical definition of the spot price is the price of gold for immediate delivery. However in reality, the spot price does not reflect the supply and demand of the physical metal, instead it is derived from the paper markets where only a fraction of contracts stand for delivery. This has led some commentators to criticize the use of spot price. Preferably, the physical gold price should be used to reflect the true price of the metal. In practice it is not so simple. There is demand for the physical metal from both retail and commercial entities and these entities legitimately manage their risk by hedging using futures contracts. The problem is that speculation and arbitrage are also trading activities that occur within the paper markets and it is very difficult to disentangle these.

Factors affecting the price of physical gold

  • Dealer
  • Country
  • Form of gold bullion
  • Supply and demand
  • Purchase volume
  • Level of taxation

If we were to just consider the retail physical prices, the issue is that the premiums over spot vary according to a variety of factors. For example, different dealers charge different premiums over spot. Gold premiums also vary by country and level of demand. Six months ago the US Mint reported record low gold bullion sales whereas at the same time the Perth Mint experienced very high demand for their gold bullion. As a result, the premium would have varied between those two countries. Premiums also vary depending on the form of gold bullion. For example, cast bars tend to have a lower premium compared to minted coins. Additionally, discounts to the premium are applicable to high volume purchases. Taxation may also affect the purchase price of physical gold. UK applies a 20% value-added tax (a form of goods and service tax) when purchasing silver bullion.

As a result of all these factors , it is not possible to produce a reliable, globally applicable chart of the physical price of gold bullion.

Gold priced by currency

The price of gold also varies according to the currency you are pricing it in. The standard is to price gold in US dollars, however when gold is priced in other currencies the charts look quite different. Currently gold is trading at all-time highs in most currencies around the world. In contrast gold priced in US dollars remains below its all-time high. This is simply a reflection of the relative strength of US dollars compared to other fiat currencies.

Gold priced in US dollars (bars) Turkish Lira (orange) and Bitcoin (yellow)

The chart above shows gold priced in three different currencies scaled by percentage change. Gold priced in Turkish Lira has risen significantly. This is purely a reflection of weakness of the Turkish Lira relative to US dollars. In contrast Gold priced in Bitcoin is actually dropping, suggesting strength of Bitcoin relative to fiat currencies. All of this is still based on the spot price of gold and therefore values gold in terms of fiat currencies. Is this the correct way of valuing gold?

Purchasing power of gold and silver

Purchasing power of the US dollar (Source: FRED)

An alternative way of valuing gold and silver is to consider purchasing power. The chart above shows the purchasing power of the US dollar has dropped over 90% since the early 1900’s. Looking at these charts may seem rather abstract so let’s look at some practical examples to illustrate the loss of purchasing power of US dollars over time.

In 1918 the price of a gallon of petrol (gasoline) cost 25 cents. In 2019 the average price of petrol in USA was around $2.50. The 25 cents from 1918 would only buy you 1/10 of a gallon of petrol in 2019, so saving that quarter over a long period of time resulted in a significant loss of purchasing power. However, in 1918 a quarter weighed 6.25 grams and consisted of ninety percent silver. If you sold the quarter based on its silver value, not its face value in fiat currency, then the quarter would be worth $2.62 in 2019. That would be enough to buy you a gallon of petrol. Therefore, the silver retained its purchasing power over a period of 100 years, the fiat currency did not. But it is not quite as simple as that. What if that 25 cents had been invested in stocks. The Dow Jones had an average 6% annualized rate of return, so that twenty five cents would now be worth eighty seven dollars! Although this would have been subject to taxation, it is still worth much more than the silver price. On the face of it, it appears that investing in the stock market more than made up for any loss in the purchasing power of the US dollar. Well will address this point further but before doing so, let’s have another look at that silver quarter from 1918. Have we actually valued it correctly? On eBay, the Buy Now prices ranged anywhere from $30 to $8,000 due to the numismatic value. This illustrates how silver can be valued in multiple ways.

Wholesale price index vs gold

History of the purchasing power of gold (Source: goldchartsrus)

The wholesale price index may be used to determine purchasing power. The chart above uses British data from the 1500s to 2015 indexed to 100 at the 1930. The difference between the wholesale price index (green line) and the gold price (blue line) indicates the purchasing power of gold (red line). there was little fluctuation in the purchasing power of gold. Note that because the British Pound was tied to gold for centuries, there was little fluctuation in the purchasing power of gold. Interestingly, the last 100 years has seen a step by step decoupling of the British Pound from gold. Two things happened as a result. Firstly, the wholesale price index has risen constantly and significantly over that time. Secondly, the purchasing power of gold has become a lot more volatile with much larger swings in purchasing power. Since we are seeing higher highs and higher lows, this is an uptrend.

Why have these fluctuations in the purchasing power of gold occurred? Perhaps they relate to the inflation deflation cycles that occur in the early to middle part of fiat monetary systems. The chart illustrates how gold behaves quite differently depending on the type of monetary system. What would the chart looked like in the case of the hyperinflating currency?

Wholesale price index, stock index and gold price in Venezuela

A modern day example of a hyperinflating currency is the Venezuelan bolivar. The chart above shows the wholesale price index (top), stock index (lower left) and gold price (lower right) for Venezuela, with all values indexed to 100 in 2007. In January 2019 the wholesale price index was 3.8 million. The Venezuelan stock market chart looks pretty impressive, however the index number is 1 million. Although it may seem as if investors made money, the currency inflation meant that the stock returns did not keep up with the wholesale price index (i.e. stock investors lost purchasing power). The observed rise in stock market was just an illusion.

In contrast, the indexed price of gold priced in bolivars was 16.1 million. Not only did gold preserve wealth, golds purchasing power increased.

The down side of high gold prices

High gold prices may sound exciting for investors. There is hype about $10,000 gold coming in the future, but that would be a worrying sign. Such high gold prices comes at a cost. Those costs will be in the form of poverty and social unrest, so don’t look forward to it too much.

Conclusiom

Gold behaves differently depending on set up of the monetary system. Under a gold standard, the purchasing power of gold remains relatively stable. In a Fiat system, particularly in the early to middle stages where have inflation deflation cycles occur, the purchasing power of gold fluctuates up and down. This means that there are certain times that are better than others for purchasing gold. In general, gold does continue to preserve purchasing power due to the uptrend. It is in the final stages of the fiat monetary system that gold really comes into its own. Not only does gold preserve wealth, but it also increases purchasing power substantially.

It is the inflation deflation cycles that has led many to misunderstand gold. Even now, many people try to directly compare gold to other assets such as stocks but gold’s function is not to allow you to make a quick buck as it is not meant to be used as a speculative tool. Gold has survived for thousands of years as a store of wealth and has been successful at that function for that duration of time. Golds primary function is insurance against inflation and hyperinflation as well as wealth preservation.

There are some that might say “the US dollar is not going to hyperinflate in my lifetime so I don’t need to own gold” yet it is those same people who are willingly pay insurance premiums for their whole life for events that may never occur. The reason that they do so is that if such an event does occur, resulting in disastrous losses, the insurance can come through and save the day. The value of gold lies in its properties that allow you to preserve wealth and provides an insurance against fiat currency inflation and hyperinflation.