Cartoon by Mark Hill for Merk Funds.

Readers of this site know that I am a proponent of owning physical gold and silver as a way to protect your savings in today’s bizarro world economy. If you’ve been considering diversifying into gold, I believe now is a great time to jump in.

The gold price has risen by double digit percentages for the past 11 years, but lately has been in a holding pattern.  Gold is exactly where it was one year ago today. (It’s had a very bumpy ride along the way.)  In that time, there have been major developments in the world economy that are all very bullish for gold. To name a few:

• U.S. Government debt has continued to soar with no end in sight.
• Central Banks around the world have been printing money like crazy.
• The crisis in Europe is boiling over.
• The Fed has expanded the duration of its balance sheet through “Operation Twist”.
• Various economic indicators are rolling over bringing the Fed closer to QE3.
• Nations such as China, Japan, Saudi Arabia, India, Russia, Brazil, Iran, Australia, etc. are establishing bi-lateral trade agreements to remove the U.S. dollar from their trade.
• Real interest rates continue to fall.
• And the list goes on…

But how do you put a value on gold? As many gold bears like to point out, it’s just a rock and is only worth what people are willing to pay for it. The price is all based on the whims of investor psychology. True. I would argue that’s true for any currency. The nice thing about gold is that they can’t print more of it and it has been accepted as money everywhere in the world for 3000 years.

So if the price of gold is determined by supply and demand, and the demand (and supply from existing stocks) is based on investor psychology, is there an objective way to value gold? In, fact there are several metrics one must look at, but the two most important metrics are exquisitely analyzed in the article by QBAMCO’s Paul Brodsky at the end of this post.

To put a value on gold, you must first ask, “in terms of what?” In this case, we mean priced in U.S. dollars. Therefore, when pricing gold, we must take into account the supply of dollars. Adding to the supply of dollars increases the demand (in dollars) for gold. In this article, Brodsky argues that base money- currency in circulation plus reserves held at the central bank- is the most appropriate gage for gold. Not only should we look at the amount of base money, but we should look at the future trend of base money creation to anticipate its affect on the gold price.

The second most important metric for valuing gold is real interest rates. That is, the interest rate for bonds, etc. minus the rate of inflation. When real interest rates are high, savers can buy bonds and expect to be able to purchase more goods at some point in the future. If real interest rates are negative, you would be better off buying the durable goods today that you will need in the future. Gold is one of those goods that is uniquely durable, portable, easy to store and liquid, so it is a good option for savers to buy in a negative interest rate environment. In addition to today’s real interest rates, one must anticipate the future of nominal interest rates and inflation rates to gage how real interest rates will affect the gold price in the future.

The article below is a must read for anyone who wants to understand the dynamics of gold in today’s economic environment.

[For those who are not used to looking at price charts over time, here’s a quick primer. These charts often have a few lines. One line charts the nominal price of the good- that is, the number of dollars it costs. But we all know that a dollar today doesn’t buy what it did ten years ago so we need to use a “deflator” usually the consumer price index, CPI, to account for inflation and get a better feel for how much purchasing power it takes to buy the good. Brodsky adds a third line that uses the Shadow Government Stats CPI as the deflator. The government changed the way the CPI is calculated in the ’80s and ’90s so the SGS CPI simply tracks the CPI inflation number using the methodology they used before 1980. For more on this check out my post Government Numbers.]