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July 10, 2005

Two Tales of Inflation
by Roland Watson

A rare and desirable coin was sold on eBay recently. It was an English Edward VI gold pound coin minted in 1550. When it sold for £1,379 ($2,500), the spot price of gold was about £237 per ounce. Weighing 11.31 grammes and being 22 carat gold would give this coin a gold content of about 0.3334oz or a current metal value of £79.

Now think about this. For the next 400 years the value of that gold pound (or sovereign) would fluctuate according to the various wars that Britain got involved in until 1931. In that year, Britain went off the gold standard and the last monetized sovereign weighed 0.2354oz. This is only a devaluation in gold terms of 30% but what happened next as a fiat money regime was introduced for the next 70 years?

A British pound is now valued at 0.0042oz, in other words, a 2005 British pound has 1.26% the purchasing power of the 1550 pound in terms of gold. More worrying is the fact that it only has 1.78% the purchasing power of the sovereign we mentioned from 1931. This was calculated by dividing the 0.0042oz into 0.2354oz. As a confirmation of this, the British Office For National Statistics was consulted to determine the official purchasing power of the British pound. They published a document in 2004 detailing pound inflation since 1750, which can be found here. The numbers for 1931 and 2004 given in table 3 are 602.8 for 1931 and 14.0 for 2003. We can estimate that 2005 is probably 13.5 based on continuing deterioration of the pound. This makes the 2005 British pound worth 2.24% of a 1931 pound. This contrasts with the 1.78% for gold value. As you can see, gold has reflected the depreciation of the British pound very well despite being decoupled from the monetary system.

But what about between 1550 and 1931 when gold reigned supreme as money? Using the inflation calculator linked here, the result is that a 1550 pound had the purchasing power of nearly five 1931 pounds. Yet the gold content of a 1550 pound is only 30% greater than that of a 1931 gold sovereign, how do we account for this discrepancy?

The answer lies in the increase of the gold money supply. Even though gold cannot be created by fiat like modern money, it was nevertheless mined out of the ground at ever increasing rates over this 400-year period. A look at the graph below shows the cumulative gold production since 1835.

Graph courtesy of Goldsheet Mining Directory at http://www.goldsheetlinks.com/production2.htm

As you can see the rise has been near exponential as the industrial revolution took place and mining operations became more and more effective in extracting gold from the ground. The amount of gold extracted as of 1931 was about 46,000 tonnes. But how much gold was in existence in 1550? Thanks to an article by Ted Butler in 2000 (see here), this can be estimated at 9,400 tonnes. Dividing 46,000 by 9,400 gives us 4.9, which is very close to the drop by a factor of five between the purchasing power of a 1550 and a 1931 sovereign. Once again, gold confirms its sensitivity to inflationary forces.

However, one must compare this 80% drop in the value of English money over 400 years with the breakneck acceleration in the decay of money since the abandonment of the various gold standards in the 1930s. In fact, when Britain went off gold in 1931 it took only 40 years for the British pound to lose another 80% of its purchasing power! If history is anything to go by, we deduce that fiat money decays at rate 10 times greater than gold-backed money.

Moving onto our next example of inflation, I noticed this article on the coming revaluation of the Romanian unit of currency, the Leu.

The Leu has had a hard time of it since the dictator Ceausescu was ousted and shot in 1989. Things came to a head as the government began to print their banknotes like confetti and the inflation rate nearly hit 320% in 1993. I don't know if that qualifies as galloping inflation or hyperinflation. Today, one US dollar will get you almost 30,000 Leu, but help is at hand.

With a stroke of their pen, the government will lop off four zeros and declare a new Leu which will presumably trade three to the dollar. Wonderful stuff this fiat money! Is your money running out of control due to incompetent government? Easy, just remove a few zeroes and start again!

Of course, there are conditions attached. You don't prune your currency while it is still hyperinflating. You would be back next week repeating the exercise all over again. As it happens, Romanian inflation is down to a mere 10%, so the government feels confident that some kind of stability has been reached. Their claim of 3% inflation by 2008 should be taken with a large pinch of salt.

So I say good luck to them. But it all came home to me when I remembered the old Romanian coin in my coin collection. It was a 5 Lei silver coin from 1880 ("lei" is the plural of "leu"). The 5 Lei was the Romanian equivalent of its contemporary, the Morgan Dollar. It was 90% silver and weighed 25g and measured 37mm across. You can see one here.

Now, the silver value of the coin is currently $5.10. So, dividing by five, one old Leu gets you one dollar today. One modern dehyperinflated Leu gets you 33 cents. Nice to see it is still holding its value against its fiat descendant. But it has to be said that like the old Morgan dollar, the 5 Lei would have purchased you more in 1880 than what you would have got for $5.10 in scrap silver today. Indeed, one quote I found says this:

"An 1899 Morgan Silver Dollar struck at the Mother Mint in Philadelphia had punch when it came to purchasing power at the turn of the century. Just one Morgan could buy a wood parlour table from the Sears catalogue during a time when many Americans earned a silver dollar for a hard day's work."

I suggest we are talking the equivalent of nearly $100 in today's money. You can be sure an 1880 silver dollar-sized coin from Romania was not far off in similar buying power.

In fact, going back to our British coinage, the equivalent of a dollar in 1880 was the 5-shilling crown. Since a British pound was then defined as 3.5 pounds of sterling silver, an ounce of silver was fixed at 74 old pennies. Since the pound was decimalised in 1970, this equates to 31 new pennies. Going back to our pound purchasing index table, 1880 comes in at 1067 and we have already given 2005 a value of 13.5. Dividing these two numbers gives a depreciation factor of 79. If silver were to reflect this loss of purchasing power then it should be priced at 79 * 31p which is £24.50 or $42.70 at current exchange rates.

It seems that silver has some revaluation ahead if it is ever remonetized.

In conclusion, our two stories confirm what has been known for some time about gold and silver. They are historically a great store of value, they are both currently greatly undervalued in relation to the explosion in fiat money supply and when the next and final fiat money crisis hits, we can expect a major revaluation to occur in these two sister metals.

Roland Watson writes the investment newsletter The New Era Investor that can be purchased for an annual subscription of $99. To view a sample copy of the newsletter, please go to www.newerainvestor.com and click on the "View Sample Issue Here" link to the right.

Comments are invited by emailing the author at newerainvestor@yahoo.co.uk.

Roland Watson
http://silveranalyst.blogspot.com

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