Gold Economics Questionable; Facts Forecast Lower Prices

The spike in last week’s gold price shows that there is a marked tendency to believe that the policies of the Federal Reserve will lead to an inflationary period. While I agree this is a logical outcome in a normal economic scenario, I do not view it as likely given our current deflationary outlook.

Many of the gold idolizers, who incidentally have loved gold since the 1970’s, are recently buoyed by the confidence of the recent rise in gold to near $1000 an ounce. The argument in favor of gold is simple and makes perfect sense – as the amount of paper currency in the system increases and the hard asset amount (gold in this case, but also applicable to other hard assets) stays relatively fixed, it will require more paper currency to obtain a the same amount of the asset. Very simple economic analysis – and these conditions will indeed lead to increased prices, provided the assumptions are correct.

The assumptions here are two-fold. First, the amount of currency in the system increases, and second, the amount of gold available stays relatively steady.

I remain skeptical that the amount of currency in the system is actually increasing, since the velocity of money has fallen so precipitously. Additionally, I find no other evidence of inflation anywhere in the system. Gold seemingly operates in some sort of vacuum; there are relatively fixed amounts of other things as well, but the prices of those are not increasing – there are not rising wages; other commodity prices, despite their recent strength, are still well off the highs of last year; and overall asset prices have continued to fall.

Most of the talk around gold is that you need to hold it as an inflation hedge for any future inflation that will occur – or to more precisely quote the talking heads, “coming soon.”

As a second point, the simple economic analysis offered as a catalyst to gold prices in the future negates a big factor – there is a massive incentive for gold producers to produce as much as possible at these higher prices. Rather than keep the amount of gold level, this actually increases the amount of gold.

So what is the likelihood for gold prices should we actually have a deflationary cycle and the amount of gold increases? I would think that these facts forecast much lower prices for gold. Another fact to remember: despite all the inflationary hand-wringing, and the absolute necessity to enter gold right now, gold has still not made a “higher-high” from the reaction to the Bear Stearns in March 2008. So despite the fall of Lehman Brothers (LEHMQ.PK), the collapse of AIG, the absorption of Merrill Lynch, the Fed decreasing the Federal Funds rate to 0.00-0.25%, and the initiation of a quantitative easing policy by the Federal Reserve – gold has still no surpassed the March 2008 peak. It is noteworthy that despite everything the gold bugs and inflation hawks have said would portend higher inflation and higher gold prices, they haven’t occurred.

While I can appreciate forward-looking investments, I find the economics behind the gold trade to be troublesome. While some of those who espouse the benefits of owning gold do so almost to the point of passion, I find the facts troublesome. When there is proof of the economics gold bugs find so persuasive, I will be more inclined to believe their eventual outcome, but as for right now, the economics behind gold tend to forecast lower prices.

Comments

[coastalpirate:]

I would like to hear more about central banks and their inventories, with the world's currencies being devalued at a high rate it would make sense for central banks to sell gold to raise lots of devalued cash. A few thousand tons here and there could burst the bubble.

Mar 24 05:46 AM

[Pat Shuff:]

Finally, regarding gold, the news is of weak rather than
strong production at least in once gold dominant S.
Africa. There, gold production has been waning rather
steadily with production last year falling to the lowest
level since the Boer War all the way back in 1901!
Last year, gold production in S. Africa fell 14%
compared to the year previous, falling to 232 tonnes,
down from 270 tonnes mined and produced in 2007.
Once the dominant gold miner by a huge margin, S.
Africa has now fallen to third behind China as #1 and
the US as #2. China in 2008 produced 288 tonnes of
gold; the US produced 234 tonnes.
S. Africans continued declining production has had a
material effect upon global production totals, as one
might reasonably expect. According to GFMS, gold
production globally fell 3.6% in 2008 compared to 2007,
falling to 2385 tonnes. This is the lowest sum of gold
mined since the mid-90s. Worse for the mining
companies, the cost of production an ounce of gold
has been rising almost relentlessly, and are now close
to $500/ounce, up 22% from that of 2007.
For those who care, last year only four nations had
more gold mining activity than they did in 2007: Russia;
China; Ghana and Mexico, with the Russians
increasing production by approximately 11 tonnes,
while the other three increased production by 8-9
tonnes each. Canada, Australia, S. Africa and
Indonesia saw their mining operations fall, with Canada
producing 8 tonnes less gold; Australia producing 33
fewer tonnes; S. Africa producing 38 tonnes and
Indonesian production falling 52 tonnes.

Mar 24 06:40 AM

[DONE_SONZ:]

Inflation is already ticking higher and currencies are basically worthless.The money printing presses keep on printing too.What world are you living in?

Mar 24 07:01 AM

[yellowhoard:]

It's this simple. If the government does not inflate our way out of this mess, deflation will cause such systemic crippling foreclosures that we will melt down into anarchy. Businesses will close on a wholesale level, unemployment will rise to unimaginable levels and people who put 20% down on their homes will be forced to walk away from them.

There is no happy middle where there is no hyperinflation or political instablity. Gold wins in either scenario.

Mar 24 08:55 AM

[paultheprofit:]

Talk about LIVING in FANTASY land...to the ORIGINAL Author of this...

""Additionally, I find no other evidence of inflation anywhere in the system.""

Who buys your bread, milk, paper towls...who pays your insurance, electric bills...ect

Certainly NOT YOU or you would've written something THIS absurd...must be the wife...

Mar 24 09:27 AM

[Vuke:]

Troublesome for you Mr. Bateman, but no problem for those who see inflation down the road. And, anybody who thinks we'll soon see floods of gold from mining does not know the industry. It's a very hard product to find, expensive to mine and unlikely to happen anywhere there's political or social upheaval.

There's nothing like a gold mine to attract the crazed, the greedy or the extortionist. They haven't yet got the message that it's a barbarous relic, of no value, likely to decline etc. Idiots they may be, but they know it's money.

Mar 24 09:46 AM

[pater_teneb...:]

'I remain skeptical that the amount of currency in the system is actually increasing, since the velocity of money has fallen so precipitously.'

this sentence makes no sense whatsoever. the velocity of money is not an independent causative variable at all for one thing (it is merely a lagging symptom of the thrust of monetary policy at an earlier time), and the supply of money is increasing by leaps and bounds currently - which has nothing to do with velocity. it may have escaped your notice, but the monetary base has increased by 100% over the past year, while broader monetary aggregates are currently all growing at double digit annualized rates.
we can rest reasonably assured that Mr. Bernanke will keep it that way.
as an additional point, the prospect of the current money supply inflation resulting in higher prices down the road is not the only thing motivating buyers of gold.
the possibility of a wholesale collapse of the monetary system must be considered as well.
just look what became of the 'well contained' little problem of subprime mortgages. recent actions by the authorities, including the Fed's announcement of accelerated monetization of debt, all reek of increasing desperation. there can be no assurance the current system will survive, hence people buy gold.

Mar 24 10:12 AM

[Jimmytom:]

I made the following observation in a prior post and it still seems approprite. My Health care costs are increasing; my food costs are increasing even though we are buying down and using more coupons; my utilities are up (especially water and sewerage); my local taxes are up; my mortgage ( I am refinancing, though) and car payments are the same; gasoline is down (for how long? If oil doesn't go up taxes in this area will make up for it.) The only reason my daily living expenses haven't increased is because we've substituted and cut back not because prices are lower. Prices seem only lower for housing and major purchases of durables. Is this really what deflation is?

Mar 24 10:12 AM

[carolinacoast:]

"I remain skeptical that the amount of currency in the system is actually increasing, since the velocity of money has fallen so precipitously"

"So what is the likelihood for gold prices should we actually have a deflationary cycle and the amount of gold increases?"

I'm not much more than a gold bug, but aren't we printing money? Isn't China showing concern toward that end? and isn't everything pointing to a weakening in the dollar? Why wouldn't gold go up?
A continued deflationary cycle I thought speeled doom for the economies of the world, surely everyone and everything is pointing toward recovery and inflation.

And what about demand? Won't future emerging nations increase demand? I don't buy anything in this article as useful. I've just read article after article in 2008 about the downward manipulation of gold prices. I think this article is based on a personal fantasy.

Mar 24 10:57 AM

[Carlos Lam:]

The author states that he "remain[s] skeptical that the amount of currency in the system is actually increasing, since the velocity of money has fallen so precipitously." Such a statement patently ignores the near 100% rise in the monetary base per the Federal Reserve's own data.

More importantly, though, is his seeming misunderstanding of the value of a currency. If we assume that the prices of things (including a nation's currency) are determined in part by their scarcity, the Fed's own actions are leading to a lower price for the dollar because the Fed is making the dollar less scarce. In essence, flooding the market with dollars makes the dollar worth less and, as a result, it will take more dollars to purchase a fixed amount of commodities and foreign products.

If the author believes that price increases will not be coming, then I challenge the author to short gold, oil, and coffee and publish the results of his investment in a year's time. If his observations are correct, then his investment should reap him rewards.

Mar 24 12:10 PM

[Alex Filonov:]

Demand for gold right now is investment only. There is no jewelry demand, scrap gold is equal or exceeds jewelry sold. India is not buying gold (30% of demand is out!). With outrageous amount of gold claimed to be in GLD safes, any sell-out of GLD can trigger strong sownward pressure on gold. Notice the crazy amount of gold ads on tv, internet and newspapers. Usually it's bearish (remember oil last year).

Mar 24 12:54 PM

[Gedankonomist:]

Grasshopper: Oh, why are you hoarding all that stupid yellow stuff?

Gold bugs: because we don't want to be left out in the cold when the Kondratieff winter comes.

Grasshopper: Kond...what? You guys are a bunch of conspiracy nuts! Nothing's gonna happen! Look, the sun's out and helicopter Ben's dropping money from the sky! I got my fiddle, c'mon lets celebrate together! There's nothing to worry about!

Mar 24 04:01 PM

[phdinsuntan...:]

alex, remember credit last year? is not there noq

Mar 24 06:46 PM

[Vox Rationalis:]

Here's my take, based on far less research and analysis than I would like.

Gold is overvalued relative to other commodities. Compare gold's historical valuations relative to silver. It appears that in August-September gold decoupled from silver, as fear of the financial crisis bolstered demand. Throughout the fall and early winter, as every other asset class except Treasurys and the dollar fell, gold stayed fairly level.

The Fed's announcement last week should tend to increase prices for many assets, including foreign currencies and commodities.

But the Fed's action should also have another impact - reducing fear. I think the Fed has effectively taken the specter of deflation clear off the table. With the chances of this most-feared scenario at or near zero, fear of the worst-possible outcome is reduced.

This should mean that people will leave gold as their risk tolerance increases, and gold will retrace some or all of its recent gains - not necessarily relative to the dollar, but relative to other commodities.

The correct metal-based inflation play is not long gold, but long silver or platinum. I am confident enough in this that I believe a long silver/platinum-short gold pair is a good trade.

Mar 25 02:01 AM

[yellowhoard:]

I agree Vox. My guess is we'll see consolidation in gold as the S&P 500 closes in on it's 200 day moving average. This will be a good period for anyone out of gold to accumulate. However, anyone currently long gold would be wise to build in silver and platinum.

Mar 25 09:17 AM

[Vox Rationalis:]

yellowhoard wrote:

> I agree Vox. My guess is we'll see consolidation in gold as the S&P
> 500 closes in on it's 200 day moving average. This will be a good
> period for anyone out of gold to accumulate. However, anyone currently
> long gold would be wise to build in silver and platinum.

No, you don't agree. You would advocate buying gold if gold "consolidates" - I wouldn't advocate buying gold at any price higher than 60 times silver, regardless of the dollar. You would advocate holding gold right now - I would advocate selling gold immediately and replacing it with silver and/or platinum - if a commodity-based inflation hedge is desired.

Mar 25 07:56 PM

[yellowhoard:]

Vox,

I've held gold for 15 years. It's the foundation of my insurance policy against stupid governance. I trade in and out short term as well. Right now I like silver, platinum and palladium better.

I'm just saying that if someone is starting to save for chaotic times, buy gold. Once you have a comfortable position, buy some silver, platinum and palladium. Steady accumulation is the key. Only buy when prices are down. If you can buy more in the $800 range, do it. I'm not buying gold here, but I am buying palladium and silver.

Mar 28 04:10 PM

[Freya:]

VOX: Silver rises to $15, Gold drops to $700.

Is Gold the better alternative?

YH: do you dump your Silver to switch into Gold?

Palladium should be held until parity with Platinum is reached.

Apr 15 04:10 PM