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What Is Wrong With Gold?

2012-11-23 14:20:28

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?