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A FIRST Lesson in Why Gold Can Hit $4,000

By Barry Elias   |   Friday, 07 Jan 2011 07:42 AM

This week, I added a significant position in gold and gold mining to my portfolio.

By 2020, a justifiable price for gold is roughly $4,000 per ounce.

I will present my rationale in a moment, but first things first.

FIRST (For Inspiration and Recognition of Science and Technology) was founded nearly 20 years ago by renowned inventor, Dean Kamen. This incredible organization promotes innovation, creativity, and critical thinking, key ingredients in effective problem solving.

Tomorrow, the FIRST season gets under way with the official presentation of the game objectives. This is done via satellite to more than 200,000 elementary and secondary students throughout the world. They have six weeks to construct a robot that will address the issues, so they can compete against their fellow robots. President Barack Obama showcased this competition during a White House ceremony in each of the past two years.

Why do I mention FIRST?

During a recent interview with Anderson Cooper of CNN, Kamen stated that we don’t need a stimulus program, we need to stimulate our kids.

Prescient advice, indeed. This organization promotes real solutions for real people.

Now, how does this relate $4,000 gold by the end of this decade?

Focus on one word: real. In this case, real assets.

Financial (not real) 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 click of a mouse can now add $2 trillion to the balance sheet assets of the Federal Reserve Bank. No need to cut down trees, produce pulp, manufacture paper, and print currency. (I suppose one might argue this is a cost-saving operation for the taxpayers: no thank you.)

The creation of money needs to create value for society. This is where gold comes in.

Gold is rare, not easily mined (produced), and historically functions as a proxy for currency exchange. 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 $1,400 per ounce, this translates to a market value for all gold reserves of $1.37 trillion.

If the price of gold tripled, the value of these reserves would approximate the money stock of $4 trillion, and 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 $2.5 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 $2.45 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 financial system was decimated over several decades. A new equilibrium can take a decade or more to mature. It’s possible for gold to 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 can not be readily reproduced.

A current, practical model for this behavior is FIRST: real engineering that produces real results for real people.

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

Remember: FIRST things FIRST.

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This week, I added a significant position in gold and gold mining to my portfolio. By 2020, a justifiable price for gold is roughly $4,000 per ounce. I will present my rationale in a moment, but first things first. FIRST (For Inspiration and Recognition of Science and...
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