In the final pages of his 1994 book, The Case Against the Fed, Murray N. Rothbard presents an interesting example about what might happen to the price of gold should the United States revert back to a 100% gold-backed currency. Rothbard states that at the time of writing the book the market price of gold was varying between $350 and $380 per ounce while the Federal Reserve valued their gold stock (260 million ounces) at only $42.22/oz. As at April 6th, 1994, the Federal Reserve had approximately $404 billion in liabilities (mainly in the form of U.S. Government securities).
Rothbard then argues that the process of reverting back to a hard currency (100% backed by gold reserves) is as simple as paying down the Federal Reserve's liabilities with the gold that they currently have in stock. As an example, back in 1994 this would have involved fixing a new price of gold at $1,555/oz in order for the 260 million ounces to be able to pay down the $404 billion in liabilities. This would then remove the "need" for having the Federal Reserve in the economy and also solve the problem of fractional reserve banking that has caused all the inflation, fluctuation and crony capitalism present in our markets today.
Let's take a look at the Federal Reserve's most recent balance sheet and try to determine a price of gold based upon Rothbard's scenario.
As at 31st December 2011 | ($ millions) | |
Assets | Gold Certificates | 11,037 |
Liabilities | System Open Market Account | 2,867,829 |
While for accounting purposes the Fed's annual report values the "System Open Market Account" as an Asset, Rothbard places it as a liability in The Case Against the Fed. If this seems strange to you, you can read all about it in his book. Stranger yet is the following excerpt from the Fed's 2011 annual report:
"The value of gold for purposes of backing the gold certificates is set by law at $42 2/9 per fine troy ounce."
So even though the value of gold in the market is presently at $1,600/oz, the Federal Reserve still values gold at $42.22/oz in 2012. I don't understand how their annual report could have been audited properly with this obvious fallacy. In any case, returning to our analysis we can see that the Fed still posses approximately 260 million ounces of gold (most of which is in US Treasury coffers). If we divide the liabilities of $2.87 trillion by the 260 million ounces we obtain a new price of gold of $11,030/oz. Back in 1994 the "Rothbard price" of $1,555/oz was a factor of 4.3 times higher than the market price of $365/oz. Today's Rothbard price of $11,030/oz is a factor of 6.9 times higher than the market price of $1,600/oz. For the factor to fall to 4.3 again gold's price would have to rise to $2,600/oz.
A gold price over the next couple of years in the vicinity of $2,600 and higher is certainly possible, especially when you keep the macroeconomic fundamentals in mind. Eric Sprott of Sprott Asset Management mentioned in a recent blog video that he sees only 2 likely scenarios on why you should sell gold:
1. If you believe there is a mania driving up the price higher and not fundamentals;
2. If you believe the government will begin enacting fiscal and monetary responsibility;
While the first scenario has received all the financial media's attention of late, one only has to look at the second scenario to realize in what direction the economic policies of Europe, China and the US will inevitably push the price of gold. Their inflationary policies pushed gold to a high of $1,884/oz in September 2011 and because nothing has changed since then it's now simply a matter of time before gold is driven to new heights. While the occurrence of Rothbard's scenario of a return to the gold standard is extremely unlikely (unless there is a severe depression followed by a revolution), I believe that investing in physical bullion is the best way to get exposed to gold long-term.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
