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Gold in a Deflationary Global Economy - Part- III

Analyzing History Using the Jastram Study

December 3, 1998

Although our own database goes back 200 years, the Jastram study is the best to use not only because it contains data back to the year 1560, but because Jastram was able to keep the basket of commodities he used consistent from 1560-1976, and because I am able to keep them constant through the present day. This is true of his study of both the English experience and the American experience beginning in the year 1800. Additionally, Jastram was able to find a constant value for gold's purchasing power to which gold returned repeatedly throughout time, both in England and in America and both on and off the gold standard. This value is called parity and was assigned a value of 100 in Jastram's Gold Price Index (to which we'll refer as GPI).

To answer a few questions regarding the study-such as, why 1560? Why gold? And, why England?- I note that Jastram set up his statistical study to construct a unified series of gold prices throughout the entire study, to construct a unified series representing the level of wholesale commodity prices throughout the study, to determine the statistical relationship between these two series in such a way as to measure the purchasing power of gold throughout the period, to discover the behavior of the purchasing power of gold in periods of inflation and deflation, and to judge the extent to which gold has served as an inflation hedge in history and as a conservator of operational wealth in periods of price recession.

By operational wealth I mean the real measure of wealth-after inflation or deflation is factored in-as it relates to one's actual purchasing power. The term is used by Jastram, and it describes the ability of a person to operate with his or her dollars or local currency. This ability depends on the amount of currency a person has and the prices of the items he or she wishes to command with them. For example, a person's monetary wealth might be $100,000 but his operational wealth will be cut in half if prices double or will double if prices are halved.

This is a very important concept because most consumers consider only the nominal price of a particular commodity or stock and not the real price. Milton Friedman refers to this phenomenon in Money Mischief as "Money Illusion," which he defines as "the tendency of individuals to pay primary attention to nominal prices rather than real prices or to the ratio of their incomes.....hence, there is a widespread tendency for inflation, provided it is fairly mild, to give rise to a general feeling of good times, and deflation, even if it is mild, to give rise to a general feeling of bad times." Another reason for dissatisfaction during deflation is that it affects debtors and creditors in very different ways. Falling prices make the same number of dollars correspond to a larger volume of goods, but also make loans more expensive to pay because the consumer makes installment payments with stronger dollars each month. As a result, debtors lose from deflation and creditors gain, but debtors gain from inflation by their ability to pay off loans more easily since they have more dollars in their hands to pay each fixed payment, and creditors for the same reason lose.

Thus, it is the purchasing power of gold that is important since it determines a person's operational wealth, and that is what we seek to measure by studying past history via the Jastram study and projecting out in the future-or at least from the end of the Jastram study in 1976 out into the 21st century, which presently would be of concern to investors seeking to maximize returns and protect wealth in the coming years. Thus, this concept of converting nominal monetary wealth into operational wealth to reflect actual purchasing power and, hence, actual wealth, leads to the second index in the study: Purchasing Power of Gold Index (PPG). The purchasing power of gold, simply stated, is how much gold can be sold for. Put differently, it is how much can be bought with the proceeds of its sale. This is comparable to stating how many goods one can buy with one man-hour of work. For gold, we mean how much can be purchased with one ounce of gold.

As for why 1560 and why gold, I note only that Jastram began the study in 1560 since that was the year of the Great Recoinage in England. Debasement and defacement of the coins existed prior to that, becoming particularly severe in 1540. The Great Recoinage solved these problems rather permanently6. Why England? England is not the only country for which one could examine the gold constant, but it is a country for which data are available over unusually long spans of time, and it is an economy with constant political boundaries for many centuries. It has not been occupied by a foreign power since 1066, and as such has not had its monetary table disrupted. Even more important is that England's economy has been at the heart of economic development and global transactions for many centuries. The economy of all the western world was derived for the most part from England.

Gold has been used most consistently as a medium of exchange, has been well defined for a very long time, and is a consistent way to represent value. Traditionally in economics the standard of value for comparative purposes in different times, places, and context is human effort. Economics refers frequently to the number of man-hours it takes to build an office building or the amount of work required to feed one's family for a day. But many kinds of wealth or earnings cannot be represented by man-hours. One cannot reflect the earnings of Bank of America, for example, in man-hours, nor the price of IBM. The most common way to value assets-fixed, liquid, earned or otherwise, and with all kinds of income and all currencies, is with gold. Gold is permanent, too. One does not bury 400 pounds of wheat in his backyard to preserve wealth during times of war, but one might consider burying gold. Hence, PPG is calculated by dividing the GPI by Commodity Prices (CP), and according to Jastram deserves a close look since, as we see, every sharp gyration of the purchasing power of gold coincides with sweeping institutional changes in monetary systems.7" This is consistent with The Global Market Strategist's forecast that, for the late 1990s/early 21st century, sweeping structural changes in monetary systems and a complete reevaluation of the entire global foreign exchange mechanism likely resulting in a change in the function of gold to that of a monetary commodity.

Wholesale prices are used to measure CP since there are consistently well-recognized wholesale price indices available since 1790, and since before that wholesale prices extend homogeneously from 1560 through 1850 with data from meticulous records from England, chiefly from statistician Lord Beveridge and his associates published in their Prices and Wages in England from the Twelfth to the Nineteenth Century. As you can see, then, the Jastram study plays right into our hands as investors of today.

To best illustrate gold's tendencies over the past 438 years, I focus on what Jastram calls The American Experience-the statistical analysis of gold prices in America-for two key reasons. First, American colonies were, as Jastram notes, essentially English, and their settlers felt themselves to be Englishmen. Anglo-Saxon law prevailed, and cultural attitudes were similar. Secondly, and most importantly, I use the American Experience since I seek to continue the Jastram study, which ended when gold was at only $100 in 1976. Gold has since made a virtual round trip to $900 and nearly back again, but more importantly America is the economic superpower of today. I say this not as a statement of American vanity but as one of true economic power and the power of seignorage-the ability to profit from the mintage of money. The U.S. dollar is the international reserve currency and as such it gives the U.S. power (unfair power, one might add) and income that other countries do not have. Other countries, for example, must settle their deficits with owned reserves but the U.S. has been able to settle its deficits by writing out its own IOU's, which, instead of being returned for payment, are added to reserves. Other countries, therefore, have a drain on reserves whereas the U.S. pulls in reserves8. This makes extrapolation of the Jastram study to support forecasts made over the years by The Global Market Strategist best suited in U.S. dollars.

Another reason to present the American experience here is that 1999 will bring the inception of a new and powerful currency in Europe, the euro. This is the most significant monetary and political development in decades, and The Global Market Strategists forecasts that the euro will rival the U.S. dollar in such a way as to begin to remove that unilateral power from the U.S. In fact, it ultimately may be the powers that be at the new European Central Bank, vis a vis the euro, that force the globe back on the gold standard. Obviously, though, the euro is too new-a fetus in a millennia-long world of English and American experience-to use as a study of the golden constant.

Well-recognized and consistent data in America begin in 1800, and one will find that conclusions to be drawn from both the American Experience and the English Experience are exactly the same. Additionally, Jastram observes that many economists have agreed that "no business cycle of a modern type can be found before the close of the eighteenth century," again making the American experience relevant to the purpose of this report: to isolate investment opportunity in 1998 and beyond, and as such we are more concerned about the future than the past. (With regard to the business cycle, though, it must be noted that one should not infer from the episodes of monetary inflation and deflation presented here movements in trade approximating what we now refer to as business cycles). In any case, for all these reasons (but not to discredit pound sterling or England) I stick to the American experience in this particular presentation. Even before 1971, purchasing power was lagging. During the period between 1933 and 1997, the same wholesale price index used by Jastram to analyze prices in the 16th century soared a whopping 1013% but gold's purchasing power increased only 51% (although there were periods of better performance, such as the late 1970s). If it were not for the fact that during the same period real wages (adjusted for inflation) have risen sevenfold since 1700, the deterioration in purchasing power of the 20th century fiat currency system would have sent humankind back to the Stone Age in terms of poverty and strife.

In fact, Jastram indicates that rough calculations made from the Abstract of British Historical Statistics and the Annual Abstract of Statistics of the Central Statistical office in London show that money wage rates of manual workers increased by 4600 percent between 1700 to 1972. This is how he was led to derive the statistic given above that indicates that the value of a hour's labor increased sevenfold during the nearly three centuries being considered.

However, The Global Market Strategist has discussed many times the increasing likelihood of currency crisis and economic strife as we progress through the 1990s, the Decade Of Currency. From the collapse of the British pound and Italian lira in 1992, to the Mexican currency crisis leading to the collapse of the peso in 1995, to the collapse of the Asian currencies of 1997, the 1990s time and again have proven that a fiat currency system is not only difficult to manage, but is not working. This is because, in part, emerging countries into the unifying global economy do not have the experience of an Alan Greenspan Federal Reserve, for example, in managing their currency and making the necessary economic structural changes to maintain a stable economy. It is this global currency instability, along with the advent of the new European single currency, the euro, in January 1999 that will very likely provide the political force and incentive to move off the fiat currency system and back onto a form of the gold or bimetallic system. It will also likely help increase sentiment against the U.S. dollar's status as the "official" world reserve currency and lead to a change in the system. The euro will very likely be a key catalyst since, already, talk is that countries such as Russia will convert reserves over to the euro as soon as is feasible. This will begin a period of time in which power is drained from the U.S. dollar and the advantages of seigniorage to the United States diminish.

Getting back to Period 5 (1933-1997), the latter 21 years of which I continue the Jastram study and bring gold's characteristics into the present, note on the charts on pages 12 and 13 the period after 1971 when the U.S. abandoned the gold exchange standard and moved to a pure fiat currency system. This move allowing gold to fluctuate freely in the world marketplace and allowing citizens to again own gold resulted in a skyrocketing gold price to well above the Index of Commodity Prices where it presently remains. Jastram's Retrieval Phenomenon, then, has been at play yet again as the Commodity Price Index subsequently soared, chasing gold higher after it's post-1971 explosive advance. Throughout the 18-year bear market in gold since its 1980 peak, commodity prices have continued to play catch-up to the price of gold, as the Retrieval Phenomenon maintains would occur.

Yet the most significant development of the post-1971 period that makes it much different from other periods of inflation in the last four centuries is that, with the gold standard removed and a pure fiat currency system in play for the first extended period of time in history, investors can for the first time in history during an inflationary period retain operational wealth even though the purchasing power of gold has not kept up with commodity prices. This is an extremely rare historic opportunity since it marks the first time investors have been able to invest in gold in a freely fluctuating market during inflation, enabling them to gain operational wealth from an advance in gold's nominal price, not just in its increasing purchasing power. This important factor leads us to the final sections of this report-to its conclusions and recommendations.

The naturally occurring gold-silver alloy is called electrum.
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