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July 26 2010| Filed Under Auto Insurance, Economics, Gold
In one scene in the James Bond film "Goldfinger", the gold-intoxicated villain
- the film's namesake - watches delightedly as a laser inches closer to a
gold-topped table to which Bond is tied at the ankles and wrists. Before
bidding farewell, Goldfinger leaves Bond with this thought: "This is gold Mr.
Bond. All my life I have been in love with its color, its brilliance, its
divine eminence." Movies like this epitomize the human fascination with this
precious metal and the greed that it sometimes inspires. Contrary to what
Goldfinger thought, gold may not be the most valuable investment in the world -
it may be nothing more than a form of insurance.
Here we look at the major issues facing gold, such as its demand/supply
imbalance and its potential to share the same fate as silver, and we examine
what gold really means as an investment.
Gold's Unique Demand/Supply Imbalance
The biggest factor influencing gold's price is the staggering amount of it held
by central banks around the world. This is a legacy from the days of the gold
standard, which existed in one form or another between 1821 and 1971. (For more
on this history, see The Gold Standard Revisited.) During this period, U.S. and
European central banks hoarded massive amounts of gold (see graph below).
According to the World Gold Council, in 2003 this stockpile consisting of
33,000 metric tons accounted for nearly 25% of all the gold ever mined. In that
same year, a total of only 3,200 metric tons of gold was supplied to the
marketplace through mining and scrap - this means the central banks' stockpile
of 33,000 tons could overwhelm the market if it were sold. In other words,
there is enough gold in the vaults of central banks to satisfy world demand for
10 years without another ounce being mined! What other commodity has this kind
of demand/supply imbalance?
Furthermore, without a gold standard, this precious metal has limited strategic
use for these central banks. Because gold does not earn any investment
interest, some central banks - like that of Canada during 1980-2003 - have
already eliminated their gold stock. The potential for gold supply to dwarf its
demand poses a hindrance to the metal's potential return well into the future.
Figure 1: Note the gradual decline of the central banks' reserves since the
fall of the gold standard. As this decline continues, the price of gold also
faces a continual downward stress. Sixty percent of the current gold reserves
are held by U.S., Germany, France, Switzerland and Italy. Data provided by the
World Gold Council.
Does Silver Foreshadow Gold's Future?
Silver and gold have shared a common history over the past five millennia.
Prior to the 20th century, silver was also a monetary standard, but it has long
since faded from this monetary scene and from the vaults of central banks
around the world. According to the Economist article "Goldbears" (May 30,
2002), silver's elimination from the central banks' reserves may help explain
why its return has not exceeded inflation rates over the past 200 years. If the
current stockpile of gold were to be sold off, the downward pressure on its
price could result in it having the same fate as silver.
Perhaps history demonstrates that it is just too difficult for the world to
work under a monetary standard based on a commodity because the demand for
these metals depends on more than monetary needs. When these metals were used
as monetary standards, the divergence of the market price and mint price for
these metals seemed to be in continual flux. (The mint price refers to the
price a mint would pay someone to bring gold or silver in to be melted down
into coinage.) And continual arbitrage opportunities between market and mint
prices created havoc on economies. The rise and fall of the silver standard -
which just happened to be the first victim - perhaps demonstrates how gold's
price as a commodity cannot absorb the demand/supply distortions created by its
past position as a monetary standard.
The Real Meaning of Gold
So how should an investor really view gold? For the most part, it is a
commodity, just like soybeans or oil. So, when making any buy or sell decision,
an investor should put future supply and demand issues at the forefront.
At the same time, gold can be seen as a form of insurance against a
catastrophic event hitting the global financial markets. However, if that were
ever to happen, it's possible that gold would be of use only to those investors
who held it physically. The attacks on the World Trade Center in 2001
demonstrated this point all too well. Hundreds of millions of dollars worth of
gold may have been stored in vaults underneath these towers, but these vaults
became inaccessible after the towers collapsed.
Gold also may be helpful during periods of hyperinflation as it can hold its
purchasing power much better than paper money during these periods. However,
this is true for most commodities. Hyperinflation has never occurred in the
U.S., but some countries are all too familiar with it. Argentina, for example,
saw one of its worst periods of hyperinflation from 1989-90, when inflation
reached a staggering 186% in one month alone. In such situations, gold has the
capacity to protect the investor from the ill effects of hyperinflation.
Conclusion
Gold means many things to many people. Its history alone has lured some
investors. One of gold's most important historical roles has been as a monetary
standard, functioning much like today's U.S. dollar. However, with the gold
standard no longer in place and industrial demand representing only 10% of its
overall demand, gold's luster - as an investment - is not quite as bright.
Until the fate of the gold stockpile accumulated by governments is determined,
the price of it will have difficulty surpassing the US$850 per ounce reached in
1980. According to the "Goldbears" article, if gold undergoes the same monetary
fate as silver, gold will trade around $68 per ounce.
Therefore, holding gold as an investment is really a form of insurance against
a period of hyperinflation or a catastrophic event hitting our global financial
system. Insurance comes at a price, though. Is that price worth it?