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Gold is Golden

Commodities / Gold and Silver 2011 Jun 20, 2011 - 02:18 AM GMT

By: Barry_Elias

Commodities

Best Financial Markets Analysis ArticleGlobal uncertainties abound: geopolitical, financial, and economic.

The aforementioned is a strong underlying driver for a more stable medium of exchange. The confluence of these events suggests $4,000 gold (per ounce) by 2020 seems more probable.


I recently added a significant position in gold and gold mining assets to my portfolio.

Financial engineering wreaked havoc with our financial system during the past three decades. Rather than acting as a catalyst to enable productive endeavors, finance metastasized into a machine that simply transferred enormous wealth while adding little value to society.

It was enabled by a fiat currency that could be produced at virtually no cost. The Federal Reserve Bank can expand its balance sheet assets by $2 trillion digitally, by pressing a button: no need to deforest,
produce pulp, manufacture paper, and print currency.

Money creation is justified when it creates significant value for society. Gold can effectively serve as the fulcrum for this process. Gold is rare, not easily mined (produced), and it has functioned as a proxy for currency exchange historically. Some say we don’t have enough gold to back all the money in society.

This may not be the case.

The global money stock (M0, in economic jargon) represents the physical currency in circulation and the excess physical reserves held at banks. This amount totals roughly $4 trillion. The total money supply (M3), which includes credit issued by financial institutions, is nearly $60 trillion. Hence, the money stock is 1/15 of the total money supply. This amount of money supports a global GDP (income) of approximately
$60 trillion.

Imagine that we merely focus on backing the actual money stock (base) with gold.

The World Gold Council estimates 30,500 tonnes are held in reserve by world governments (of the nearly 160,000 total tonnes mined in history — the balance of 130,000 tonnes is primarily held in the form of jewelry and industrial products). At the current price of roughly $1,400 per ounce, the total market value for all gold reserves is $1.37 trillion.

If the price of gold tripled, the value of these reserves would approximate the money stock of $4 trillion, and the price per ounce would be more than $4,000.

Is it reasonable to expect the price of gold to triple?

Currently, the United States holds 73.9 percent of its foreign currency reserves in gold, while China holds only 1.7 percent. China has nearly $2.85 trillion in reserves, with only $50 billion in gold. Recently, they purchased a significant quantity of gold, apparently to begin diversify their portfolio: smart move. They have an additional $2.80 trillion to spend (some on gold, perhaps).

Credit Suisse estimates global private net worth to be $194.5 trillion, yet only 0.2 percent (that is, 1/5 of 1 percent) is invested in gold (less than $500 billion total). There is a significant amount of net financial assets available ($194 trillion) to rebalance global portfolios toward gold.

As time passes, it is becoming very clear that global government debt (federal, state, and local) is risky business, which is easily manipulated.

The world central banks have engaged in a series of financial gymnastics to promote liquidity, avert defaults and prevent economic implosion. Unfortunately, these remedies treat the financial symptoms, not the root cause. The problems will come back, except more severe.

Similar to the infection not completely killed by the antibiotic, the strongest strain survives, multiplies, and further debilitates the patient.

All of this spells a large increase in future demand for gold.

The cause of our ills: easy money. Too easy to create, camouflage, and manipulate.

Some may argue, what about growth? To grow, we will need more money, and therefore, more gold to back it. Very true.

A healthy nominal growth rate is typically 5 percent to 6 percent per year. This includes growth in population (1 percent), productivity (1.5 percent), and inflation (3.5 percent). For growth to increase 6 percent, the total money supply would need to grow as much (actually or less in a more healthy economy).

Today, global income and money supply are both $60 trillion.

Therefore, each dollar changes hands once per year (velocity of money equal 1). A healthy economy has a velocity of more than 1.5. In this case, only $40 trillion would be needed to generate $60 trillion of income.

In a worst-case scenario, for the total money supply to increase 6 percent, the money stock needs to increase 1/15 of 6 percent (earlier, I indicated the money stock = 1/15 of the total money supply). This would equal 0.4 percent of $4 trillion, or $16 billion. At today’s price of $1,400 per ounce, 360 tonnes would be required to back the additional money stock.

The World Gold Council projects annual gold production of 2,000 to 3,000 tonnes. This quantity can adequately support the growth of money stock and satisfy consumption and investment demand.

Moreover, the U.S. Geological Survey anticipates a 25 to 50 year supply of known gold reserves, given the current rate of production.

Enhanced exploration techniques may identify additional deposits in the future. Once supply is limited, the price of gold will appreciate to back the additional currency required to generate more income.

The underlying demand for gold seems to be appreciating, especially given the volatile events occurring in the Middle East and North Africa (e.g., Tunisia, Egypt, Libya, Iran, Iraq, and Afghanistan). “Geopolitical tensions in the Middle East and North Africa region continue to fester, keeping risk aversion elevated and enhancing the appeal of safe-haven assets,” reports Marc Ground, an analyst at Standard Bank Plc in
Johannesburg.

Moreover, gold is now functioning as collateral to compensate for potential losses in the portfolios of financial institutions.

Natalie Dempster, director of government affairs at the World Gold Council (WGC), recently told The Wall Street Journal, "Gold is increasingly being used as collateral around the world. All these moves reflect a growing recognition of gold's role as a high-quality, liquid asset."

According to the World Gold Council (WGC), daily trading volume for gold is $100 billion. It is more liquid than most European government bond markets. This increased liquidity for gold has increased its demand as a form of collateral.

Additionally, the WGC has been in talks with the Basel Committee on Bank Supervision to include gold as tier-1 capital, along with government bonds and international currencies. These assets represent the safest capital reserves to function as collateral for more risky investments. The Basel Committee is charged with creating international regulations to ensure a more stable financial system around the world.

Exchanges around the globe, including New York, Chicago (Chicago Mercantile Exchange), and Europe have accepted gold as a form of collateral. Recently, JPMorgan was added to this list, and considering the possibility is LCH Clearnet, a consortium of the London Clearing House and the Paris-based Clearnet.

In 2010, LCH Clearnet cleared roughly $180 trillion of fixed-income securities. They also clear transactions involving equities and derivatives on international and Over-The-Counter (OTC) exchanges.

John Burke, the director of fixed income at LCH Clearnet, said “at times of market stress, clearing becomes increasingly important" and that “maintaining liquidity and managing collateral are top of the list of priorities for banks”

“With counterparty and sovereign risk remaining elevated, gold is no longer being seen simply as a commodity. Rather, it is increasingly viewed by market participants as an important asset and a currency with no counterparty risk. We are gradually seeing the monetization and indeed the 'financialization’ of gold, as gold is gradually being reincorporated into the modern financial and monetary system,” according
to GoldSeek.

Xia Bin, a Chinese Central Bank adviser, said China must increase its gold and silver reserves. In fact last year, Chinese officials announced they plan to increase gold reserves to 10,000 tons from 1,200 tons during the next decade. They believe accumulation of these reserves, when prices decline, will enhance their strategy to internationalize the Yuan (Chinese currency).

According to the Chinese Gold & Silver Exchange Society, Hong Kong will soon be offering Yuan-based gold futures possibly by April 2011. This further strengthens gold as an asset and a stable medium of exchange while increasing the international credibility of the Yuan.

Italy also seems to recognize the inherent value of gold reserves currently in the system.

Mario Draghi, Italian Central Bank Governor, has requested that Italian banks increase their core capital ratios (readily available liquidity to absorb potential portfolio shortfalls), says The Financial Times. To meet this objective, Italian banks, which own shares in the Italian Central Bank, suggest gold deposits be marked-to-market (priced at the current market value). This would increase the value of gold assets held by banks from 156,000 euros to 30 billion Euros (180,000-fold rise).

The global financial system was decimated over several decades. It may take a decade or more to stabilize the monetary exchange mechanisms and reach a mature, adaptable equilibrium. During this time frame, the underlying economic dynamics suggest the price of gold may approach $4,000 per ounce by 2020.

Finance should function as a catalyst for economic growth and development. This requires discipline and responsibility, where money is a reflection of real assets, which cannot be readily reproduced.

When we focus on learning and wisdom, a purpose develops. From this purpose sprouts a career, and the money we need follows suit.

By Barry Elias

eliasbarry@aol.com, beb1b2b3@gmail.com

Barry Elias provides economic analysis to Dick Morris, a former political adviser to President Clinton.

He was cited and acknowledged in two recent best-sellers co-authored by Mr. Morris: “Catastrophe” and “2010: Take Back America - a Battle Plan.” Mr. Elias graduated Phi Beta Kappa from Binghamton University with a degree in economics.

He has consulted with various high-profile financial institutions in New York City.

© 2011 Copyright Barry Elias - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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