Gold Economics Questionable; Facts Forecast Lower Prices

Includes: DGL, GLD, IAU
by: IntrinsicValue

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 (OTC:LEHMQ), 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.