A baseline overview and a psychological, political, and historical approach regarding the emerging gold bull market
Part I of XI
SERIES OVERVIEW, THE DUAL NATURE OF GOLD, and A MYSTERY
In the long run, gold has been very effective for preserving purchasing power, and has won out over all efforts by governments to manipulate and suppress it. It is one of the oldest, most tried and proven forms of money,. It often serves as a long-term inflation barometer. However, in the short run, in addition to suffering as a victim of anti-gold campaigns sponsored by governments and central banks, gold may also be a laggard in keeping up with inflation and commodities. It may even do better in certain deflationary environments.
There are obviously some paradoxes involved here, since gold at some point has to play "catch up ball" with commodities and inflation if it is to preserve its purchasing power over the long run. It must also somehow outperform periods of inflation while also outperforming deflation. On top of all of this, gold must somehow remain an eternal form of money.
This series will try to explain these paradoxes and why gold may still be significantly undervalued despite its 68% run from its July 20, 1999 London PM fix low of $252.80 to its most recent high on Jan 13, 2004 at $425.50. I discuss why we may now be in the sweet spot of a continuing gold price appreciation cycle that could possibly last longer than five years and may carry gold well over $1,000 an ounce. This could be augmented by macroeconomic and political fault shifts that may become timely. I also explain political and philosophical reasons for why gold may be significantly undervalued today, and address the risk that the US Government's confiscation of gold in 1933 may be repeated.
Gold prices are more ideologically and politically driven than virtually all other commodities, if not investment vehicles in general. Gold can serve as a social litmus test regarding respect for property rights and for governmental self-restraint and transparency. Particularly fascinating to me is strong historical evidence that when societies cut their "golden anchor" (go off a gold standard), this frequently coincides with cutting other important social, political, and ethical anchors as well. These societies tend to become more socially "leveraged" as well as more financially leveraged. The abandonment of gold correlates with increasing fraud, centrism, and intrigue, which in the initial phases tends to coincide with increasing marginalization and demonetization of the precious metals. At some point economic imbalances and various forms of social and political fraud reach a crisis tipping point, and then gold and silver tend to make huge moves as they play "catch up."
I use the term "fraud" in this series in a very loose sense. "Fraud" suggests forms of continuous institutionalized or individualized deception resulting from active measures, sins of omission, or willful blindness in regard to determining and disclosing truth. Often deception and denial are performed on a subconscious level, hence my use of the psychoanalytic "Id" concept. It is not just "neurotic New Yorkers" who are involved here. We are all victims of self-deception to some degree or another.
Although I use the term "fraud" loosely, the reader still needs to be mindful of how even white lies can become destructive. The hard dark side of fraud can be criminal or war-like. The ancient Chinese martial philosopher Sun Tzu once noted that, "All war is based on deception." A society that experiences growing internal fraud is likely a society that is increasingly at war with itself. It is increasingly filling itself up with all the toxins of rising "hate by other means." Intuitively we can already begin to grasp how such a society is likely to become increasingly distorted economically and turn its attention away from things of real value. The poisoned tree starts producing stunted limbs and withered fruit.
Intuitively, the reader may also begin to grasp how in an ironic way, societies often get treated in the very long run the way they treat gold.
THE DUAL NATURE OF GOLD
Gold has a dual nature, both as a commodity and as one of the oldest forms of money.
Gold is the most nonreactive, ductile, and malleable of all metals. It is one of the most reliable electrical conductors for extreme conditions and is also an excellent conductor of thermal energy. A single ounce can be drawn into a wire five miles long, and it can be hammered into a sheet so thin that light can pass through. In addition to jewelry, gold has industrial uses that include dental fillings, "fail safe" auto airbag electrical contacts, and components for cell phones and DVD's. Gold is used in the manufacture of over 50 million personal computers a year.
An estimated 90% of all gold ever mined still exists in some above ground form. According to Gold Fields Mineral Services, at the end of 2002 this came to 147,800 tonnes (or about 4.75 billion ounces). Perhaps 23% is held by central banks, although the amount of gold they have loaned out since the early 1990's and can feasibly retrieve is subject to debate. The remaining approximate 77% is privately held for jewelry, bullion, and coin. Average annual demand from 1997 to 2002 was 3,823 tonnes, of which 81% was for jewelry, 9% for retail investors, and 10% for industrial use. Since around 1987, demand has exceeded mine and scrap supply. In 2002 mining supply totaled 2,600 tonnes. The amount of scrap on top of this is difficult to determine but is probably not significant. This suggests a supply deficit of roughly one thousand tonnes. (Note regarding measures: 1 tonne = 1 metric ton = 1,000 kg or 32,151 troy oz of gold, 12 troy oz = 1 troy pound, not 16)
SUPPLY AND DEMAND IMBALANCES AND A PRICE MYSTERY
One might expect that if demand has exceeded supply since 1987, that the price of gold would steadily increase. Up until early 2001, this has not been the case. In fact, adding to the mystery, gold began a decline from $414 in Feb 1996 down to the mid $250-$260 area in mid 1999 and early 2001, threatening to put half the world's gold mines out of business. As noted by Sprott Asset Management, while officials have acknowledged cumulative gold short position at over 5,000 tonnes, realistically they may exceed 15,000 tonnes, which is roughly five times annual mine supply. A day of reckoning could eventually result in an explosive upside. In Part II of this series I discuss how an artificially strong dollar in the late 1990's correlated with declining gold prices, and in Part X, I discuss the ongoing law suit by bullion dealer Blanchard & Co. charging conspiracy to artificially lower gold prices against Barrick, a major gold producer, and JP Morgan Chase, a major US bank.
Gold remains one of the most difficult and costly metals to find and extract. Compared to iron, which must be concentrated in geological anomalies five times more than it is randomly found in the earth's crust to be economically mined, gold must be at least 1,000 times more concentrated than its random natural occurrence. Only about one in five thousand gold mining claims results in a profitable mine. Most rich surface anomalies quickly fade out rather than form economic trends. It takes typically five to seven years from the discovery of an economic anomaly to complete the permitting and feasibility study stages and get a mine into production. Gold costs an average of between $238 an ounce to $300 an ounce (1997 Fed Reserve Board estimate) to extract. The average wedding ring requires extraction and processing of ore in a volume amounting to about six feet by six feet by ten feet.
Despite its rarity, like other commodities, the price of gold responds to supply and demand changes. As an example, over a period of two centuries (16th and 17th), the steady accumulation of gold and silver brought to Europe from the New World by Spain doubled the supply of these precious metals, and dramatically reduced the price of gold and silver in many countries. Supply additions from the California gold rush of the 1840's and also from South African finds and Klondike in late 1800's also had an impact. However, since 1492 the annual global gold supply increase has never exceeded 5%, and in the last century it has never exceeded 2% a year.
The demand for gold within a country varies directly with both its degree of industrialization and its per capita wealth. Jewelry demand corresponds not only to wealth but also to cultural and other "mind share" factors. Asians have historically demanded more gold per unit of wealth per person than their Western counterparts. Despite America's relatively lower "mind share," the Mineral Information Institute and the Geological Society of America supply information suggesting that the average American consumes in his lifetime more than twice the .75 oz of gold that exists per each of the 6.3 billion inhabitants of earth.
GOLD AS MONEY
Gold increases dramatically in price as it becomes "monetized," that is, the more people use it in the place of fiat currencies. Fiat money consists of paper currencies backed only by the taxing power of government. Based upon thousands of years of trial and error, civilizations have found gold to be the most highly desirable form of "commodity money." Gold is highly portable, divisible, fungible, durable, and has a high ratio of value per unit of weight. These characteristics make gold highly suited to fulfill the three basic functions of money, namely as a medium of exchange, store of value, and unit of account.
Gold can significantly lose value when it is "demonetized" and shoved aside by fiat currencies, but still it tends to retain a certain minimal "mind share" relative to national wealth based on both its jewelry value and fear that some day the fiat currency will become totally debauched.
Significantly, no major countries today are on the gold standard. For the first time in history, they all float on oceans of fiat currencies backed only by confidence in their respective governments that they will not completely debauch their currencies. It is very hard to think of any fiat currency in history that has survived for many generations without becoming totally debauched.
Under a gold standard, owning gold can act almost like owning a share in a country mutual fund that benefits from steady GDP growth. As an example, a person in Britain could buy nearly twice as much with an ounce of gold at the end of the gold standard period in 1914 as in 1821. During this entire period one ounce of gold remained fixed at 4.25 British pounds. Average consumer prices during this period declined by roughly one half as a result of the Industrial Revolution, prosperous overseas trade, access to raw materials, the absence of catastrophic wars, and other factors. Trains reduced the cost of overland transportation by over 90%, and steam and electrical engines dropped the cost of manufactured goods over 50%. During this period, additions to Britain's gold-based money stock from mining supply grew at a much slower rate than the rate of productivity increases. As explained in Part VI of this series, a number of sources such as the Mises Institute video on Money, Banking, and the Federal Reserve claim that business cycles were less severe and economic growth was more consistently strong for both Britain and America while both were on the gold standard than after they abandoned it.
Obviously there are a lot of relativistic variables that continuously impact on the value of gold as both a commodity and as a form of money. The platitude that gold will always be "the eternal constant," or that in the long run "gold only stores but never gains value" are both too simplistic. Gold is very likely, but not guaranteed, to remain relatively more constant and limited in supply than most other commodities. Under certain conditions, it can steadily gain in value as well as preserve wealth. The value of gold can also decline dramatically due to such factors as demonetization, supply increases, or catastrophic reductions in per capita wealth. It remains highly unlikely in the foreseeable future that nuclear physicists will figure out how to economically move elements on the Periodic Chart into the "AU" square.
When the pros and cons of a gold standard are weighed against those of alternative monetary systems, I believe that gold remains the least bad long-term approach to money, particularly when managed by a least bad form of government.