Understanding Gold

Whenever I’m asked the question ‘how much of my wealth should I allocate to gold’, I usually advise that a person should only buy so much gold as their level of understanding allows. In other words the decision is a very personal one.

But a person should never buy a great deal of gold without really understanding its nature. It’s the lack of understanding which leads to emotionally driven and usually poor decisions.

Few who live in the Western (USA for example) world own any gold and even fewer understand gold. And I can tell because most of the questions that I receive and the commentary that I’ve heard is related to the topic of ‘where is the price of gold going to be next week, next month or next year’. Lately, questions and commentary has focused on why has the price of gold dropped.

I was listening this week to an excellent interview with Ian McAvity, who is a market veteran of 40 years and a true student of gold. He made a comment that I think strikes at the heart of the matter and that comment was, quote ‘those who fret the decline in the gold price don’t really understand gold’. I will repeat this comment again so that you can let it sink in:

‘Those who fret the decline in the gold price don’t really understand gold’.

I’d like to spend a video discussing this concept because it reveals a tremendous amount of wisdom about the nature of wealth. I won’t be putting up any graphs, statistics or equations. Just providing a discussion about the nature of gold. Please feel free to ask questions or start your own discussion in the comments section. After all we’re all here to learn from each other.

One of the reasons why we in the Western world no longer understand gold is that we’ve been trained to do all of our mental calculations in dollars. Stop to think about it for a moment. You probably know the approximate price in dollars of hundreds of items that you purchase on a regular basis. How much is a gallon of gas? Depending upon where you live, it will be in the neighborhood of about three dollars per gallon. How much is a gallon of milk? About the same maybe a little more. How about the new tablet that you’ve been thinking about buying, or the car. That price is probably burned into your memory more than the price of just about anything else. Dinner at your favorite restaurant? You know the price of that in dollars as well. How much is your labor worth per hour, per week or per month. You probably know that number very well, and the list goes on and on. The dollar is very effective at providing us with the means of comparing cost of hundreds of items and that is one of the reasons why it is such an effective device for facilitating trade. But such convenience comes with drawbacks.

The largest drawback is that in our minds at least in the Western world we have come to confuse the dollar itself with the tangible items that it can buy in the present. Because we know the price of things that we buy in the present in terms of dollars, we tend to measure our wealth in terms of dollars as well. As a result we think in terms of acquiring more and more dollars.

What is the Dollar that we seek to accumulate?

Is it wealth? At one time it was wealth.

coinage_act_of_1792_1st_page

The coinage act of 1792 defined the dollar as 416 grains of standard silver. Later, the coinage act of 1873 redefined the dollar as 25.8 grains of standard gold. From 1792 all the way through the signing of executive order 1602 in 1933, the dollar was defined as pieces of precious metal certified by the US mint for its weight and finest. Prior to 1933, the dollar was by definition, physical wealth. Those who held all of their wealth in dollars by definition had 100% of their wealth in precious metals gold and silver. Holding dollars was the safest way to accumulate wealth. After 1933 and up to 1979 the dollar was changed to be a claim on gold that could only be converted by foreign governments. It was credit not actual wealth. In 1971, Nixon eliminated the right of foreign governments to convert it.

So what is the dollar now? Is it wealth?

At this point in time, the vast majority of dollars aren’t even physical. They are just ledger entries. What do they represent? They represent an obligation of the people of the United States, present and future. In other words they are units of debt. Debt that can never be repaid. This debt which can never be repaid will inevitably be marked down in value. In fact, over time it has been gradually marked down in value. All one has to do to know that this is true is to compare prices of items from a decade ago against prices of items now. This debt will continue to be marked down in the future. Though the path that it takes on its way there cannot be known in advance. It may go down steadily and gradually, it may occasionally increase in value, as it has recently, and it may be written down suddenly as happened in Weimar Germany and many other nations.

It’s impossible to know what the value of this debt that we call the dollar will be a year from now, let alone 10-20 years from now. So why do we continue to measure our wealth in terms of dollars and judge our investments based upon their ability to provide us with more of them? The reason we do so is simply because our everyday experience is in dollars. We get paid in dollars. We buy our groceries in dollars. We pay our mortgage, if you have one, in dollars. We use dollars to buy movie tickets and dinner out. So we treat wealth accumulation and dollar accumulation as if they are the same thing. We’re even taught that as we approach retirement we should have most of our wealth in nice safe US treasury bonds. Which will pass us a reliable stream of dollars in the future. Pension funds are loaded with these treasury bonds. But a debt instrument that is guaranteed to pay a person in other debt instruments which can never be repaid, is certainly a strange notion of wealth, wouldn’t you agree? Yet our brains are wired to think in dollars and measure our wealth in dollars.

So when the dollar price of gold and silver that we hold goes down there’s a natural tendency to get upset. After all our wealth has declined, right? Here lies the crux of the issue. It is this false idea that prevents us from understanding gold and silver. This is the very false idea that Ian McAvity challenged when he said that ‘those who fret the decline in the gold price don’t really understand gold’. Let’s explore what Ian’s statement means and see if we can rid ourselves of a major misconception that most of us have about gold and silver.

I’d like to do a little thought experiment with you.

Please follow along with me. Let’s start by imagining that we can live under a different set of rules. Let’s imagine that everything that we buy can be easily stored and will last forever. It’s a strange thought to hold, I know. But, it will be important to allow ourselves to briefly entertain this thought in order to get to where I would like for us to go.

So with this thought in mind, we can imagine buying a lifetime supply of food and not having to worry about where to put it and not having to worry about it spoiling. We can buy all of our heating oil or natural gas that we need to heat our homes that will last for the rest of our lives, and it will just be there when we need it. We can buy a lifetime supply of clothing and it will just sit in storage and never go out of style. You can extrapolate this thought to any good or service that you think you might need, let your imagination run wild. What a great world this would be, wouldn’t it? It would completely change the way that we plan for retirement. All we would need to do to plan for a successful retirement, is to know ahead of time what it will be that we will need to buy, and just buy it now and store it. Once we have our stock of items we are guaranteed that they will be there for us in the future when we need them. Now imagine that you have bought all of these items that you will need for the rest of your life time. You’re pretty much set. You have no use for anything else and so you announced your retirement at work and you start your carefree retirement. Take just a moment and think about how wonderful this would be.

Now keep yourself in this frame of mind, and I will ask you a question that I’d like for you to think about. If you have a ready stock of all of the items that you will need to consume in retirement, do you care about the value that another person places on those items?

Suppose over the course of accumulating these items you paid millions of these unpayable debt units, called dollars, and then someone comes along after you’ve accumulated your stock and tells you that now it would cost you 1.5 million unpayable units of debt. You would probably breath a sigh of relief that you would accumulated the items when you did, but the change in how many dollars it would take to buy the whole lot again will not change your life in the least. What if instead, a person comes along and tells you that the whole stock of your accumulated wealth will now only costs 900,000 of these unpayable units of debt. You may consider with a little bit of frustration, that had you timed your purchases right it might have cost you less. But again, it will not change your life in the least. You still have a stash of everything that you will need to live in comfort for the rest of your life.

Ok, back to reality.

We do not live in a world where it’s possible to simply accumulate all of the items that you will need in the future and store them forever. The world simply doesn’t work that way. Food spoils, clothing goes out of style, cars wear out, houses need maintenance, fuel is impossible to store in large amounts. So we need another way to accomplish the task of providing for our future needs. Our current way of thinking in the West is that the best way to accomplish our goal providing for our futures is to accumulate the obligations of others. We have pensions, which are funded with these obligations. Social Security is one big pile of obligations. We are taught that as we near retirement age, our 401k should be heavily invested in these obligations. But as I’ve stated, and I hope you agree with me these obligations are unpayable in real terms and they will continue to be written down in value over time. They may at some point be written down value considerably and without warning. Obviously accumulating the unpayable obligations of others is a risky way of accumulating the wealth that you will need in the future. But is there an alternative? Yes there is. It’s time for another mental experiment.

This time let’s live in the real world where most of the items that we will need in the future are either perishable or too bulky to store. Imagine though that there was an item or two that everyone valued that did not suffer from the drawbacks of spoiling or taking up too much space. Let’s pretend that these items while always costing a different number of unpayable debt units, day-to-day, month to month can be traded for a relatively constant amount of food or gasoline or clothing or what have you. These couple of items are real game changers. Rather than attempting to hoard a lifetime supply of items for direct consumption, you can accumulate just those items that are easy to store and don’t spoil. With the full knowledge that when the time comes you’ll know how many of these items you will need to trade for the items that you will need at that time. You can calculate right now how many of these special items you will need to accumulate over the course of your life in order to provide for your future well-being in retirement.

Do such items exist in the real world? No, not really. Well we do have a few items that are very close to fitting the bill.

‘Gold and silver have maintained their price relative to other consumption-based items.’

I’ve shown you that over the past 150 years of available data, gold and silver have maintained their price relative to other consumption-based items. In fact, gold has actually appreciated by a couple of percent per year on average in terms of the quantity of perishable items it can be traded for. Is the relationship constant? No. But its close enough to make gold and silver ideal for wealth accumulation.

  • they’re easy to store
  • they don’t spoil

If purchased at times when they aren’t overvalued can be counted on to buy you the things that you will need in the future. And so let’s suppose that you choose to use gold, and or silver as your proxies for wealth. You sit down and calculate what you will need to buy in retirement and determine how much gold or silver that equates to in the present. Let’s suppose that you do the calculation and decide 300 ounces of gold is what you will need to accumulate. Depending upon your lifestyle and your assumptions, you may come up with a larger total or a smaller one. But let’s use 300 now to anchor our thoughts together. Month after month, you are paid a certain number of units of unpayable debt. Some of them you transfer to others to use to buy items that you need to consume right away. The rest of them you trade for gold. You do this each and every month without fail. After many years have passed you are about halfway through your career and have accumulated 150 ounces of gold. You’ve worked very hard to get to this point and you’re very pleased with your accomplishment. But at the same time you’re also very worried because you see, over the past few years the price of gold expressed in terms of the number of unpayable debt units needed to buy an ounce has dropped considerably. It now takes 30% fewer unpayable debt units to buy an ounce of gold than did three years ago.

Psychologically this is taking a toll on you and it’s taking an even bigger toll on your spouse. You feel much less wealthy. You decide to sit down with your spouse and see how many more years you’re likely to need to work as a result of losing so much of this wealth. The thought of what you might conclude fills you with dread. Maybe you’ll even have to work until you die. You tally up the cost of all of the things that you typically by in a year. Food, clothing, maintenance items, gasoline, healthcare and translate it into a price in terms of unpayable units of debt. Then you calculate how many unpayable units of debt your current horde of a 150 ounces of gold is worth. To your surprise you find that the 150 ounces of gold can still buy just about the same amount of goods that it could when you first calculated your retirement savings goal to be 300 ounces. So despite the 30% price drop, your 150 ounces of gold is sufficient to buy half of the perishable items that you will need in retirement. You’re still on track to meet your retirement goals and you assume that your retirement age is the same as it was when you first started planning.

But being the math nerd that you are, you do the calculations to project into your future anyway. You haven’t got much in terms of a pay raise over the past few years. But your salary has gone up slightly in terms of unpayable units of debt. But now you find that you have more surplus income left over at the end of each month because you’re paying less on gasoline and taking advantage of recent sale prices on clothing and other items. In addition, your surplus income can now buy gold at much cheaper prices. You discover that although each ounce of gold can still buy roughly the same amount of goods and services, you can by about 50% more gold at the end of each month than you have been before. If this condition persists you should be able to retire at age 60 instead of age 65 as you would thought. This was not at all what you are expecting to find when you sat down to do the math. Just for fun, you decide to go back three years and do the calculations based upon the price of gold and other items at that time. To your surprise even though you appeared to be much wealthier back then as measured by the quantity of unpayable debt you could obtain in return for your gold horde. If the price of gold and other items had persisted at that level for the rest of your working career you would have accumulated much less gold every month and would have had to delay your retirement to age 70. And this was completely counterintuitive to you. So you check your calculations again and assure yourself that you didn’t make a mistake. This brings us to the end of our thought experiment.

Let’s go back to Ian McAvity’s statement: ‘Those who fret the decline in gold price don’t really understand gold’.

If you followed along with my thought experiment you probably understand this statement by now. You see, gold is a compact and non-perishable form of wealth. Over long periods of time it tends to maintain its value relative to other goods and services. In fact, we have seen in my other videos that it even tends to appreciate a little bit on average each year. When the price of gold changes in terms of the number of unpayable debt units that can buy it is generally because the price of everything else is changing along with it. If the price drops, it’s an indication that real wealth of all forms is easier to obtain in return for your labor. If the price climbs, it’s an indication that real wealth is harder to obtain. The gold that you have already purchased, regardless of the quoted price can generally still buy what it could in the past. Assuming that you didn’t buy on price strength, which is generally a losing strategy.

So put yourself back in the position of the person who has all of the wealth needed for retirement in the form of gold which can be traded for consumption goods. Do you care what the quoted prices is in terms of unpayable units of debt, so long as you can still buy what you need when you need it? Maybe you do. But the change in price won’t hurt you. Now take a moment and put yourself in another position. Instead of accumulating gold, let’s say you decided to accumulate US Treasury bonds as you are instructed to do. Which are really just debt denominated instruments, that are denominated in more unpayable debt. How secure do you feel when you see the price of goods that you need to buy fluctuate by 20% to 30%, with a gradual and persistent general tendency to go up in price. How secure do you feel knowing that you are being paid a pittance for holding this debt denominated in just more unpayable debt? How secure do you feel knowing that at some point in the future, and likely so, the unpayable debt units will be written down suddenly?

Those who fret the decline in the gold price don’t really understand gold.

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