Gold - Popular Misconceptions

Overview

A lotof misinformation is deliberately disseminated by those who are anti-gold and a lot of misinformation is unknowingly distributed by the pro-gold camp. Below we describe several of the popular misconceptions about gold, most of which come about because gold should not be analysed as though it is just like any other commodity. 

The vast majority of the world's gold has been accumulated for monetary, or investment, purposes. The way in which gold is analysed should therefore be similar to the way in which the US Dollar (or any other currency) is analysed. For example, the demand for the US Dollar is always massively in excess of the new supply of Dollars, but that does not mean that the relative value of the Dollar is bound to always increase. History shows, as a matter of fact, that the opposite is generally the case - the value of the Dollar tends to decrease over a long period of time. The salient point is that the quantity of new Dollars that comes into existence during any given week or month is largely irrelevant compared to the total quantity of Dollars (currently approaching 7 trillion) that already exists. It is the relationship between this total supply of Dollars and the investment demand for Dollars that determines the Dollar's relative value. It is a similar story for gold.

There are, however, four important differences between the Dollar and gold. Firstly, Dollars can be created by banks out of thin air, whereas significant expenditure must be incurred to increase the total supply of gold. Secondly, the total supply of gold is physically limited (there is a finite amount of gold above and below ground), whereas there are no physical limitations on the quantity of Dollars that can be created. Thirdly, Dollars can disappear just as easily as they were created (the total supply of Dollars is reduced whenever bank loans are repaid or defaulted-on), whereas gold is almost indestructible. Fourthly, the US Dollar is money only because the US Government says it is money - those who carry out economic transactions within the US are legally bound to accept Dollars in payment for goods and services (the Dollar is money by government fiat). Gold, on the other hand, evolved as a form of money through individual choice. 

The fourth difference between gold and the Dollar cited above is not always significant. For example, at the present time the vast majority of people throughout the world are happy to accept Dollars in exchange for their goods and services. However, if history is any guide this will not remain the case indefinitely. To paraphrase Alan Greenspan, fiat currency is seldom accepted in extreme situations.

We thought about adding a fifth difference - Dollars are liabilities of the banks that issue them whereas gold is no-one's liability - but this difference no longer applies to a significant portion of the world's gold. Around 10,000 tonnes of gold have been lent by central banks to mining companies, speculators and jewelry manufacturers via intermediaries (bullion banks). This gold is certainly someone's liability.

The Popular Misconceptions

Misconception #1: A large deficit between fabrication demand and new mine supply should result in a higher gold price.

The logic in the above statement is backwards. It can be shown that fabrication demand increases as the price of gold falls, and vice versa, and that fabrication demand is therefore at its highest when the gold price is at its lowest. The cause here is the gold price, the effect is fabrication demand. The high fabrication demand for gold in the current environment is a direct result of the low gold price. As the gold price moves higher due to an increase in the monetary demand for gold, the fabrication demand for gold will decline. In other words, the fabrication demand for gold will tend to reach its peak near the bottom of a gold bear market and will steadily decline during the ensuing bull market.

Misconception #2: The gold price will rise in response to higher inflation.

It is true that the gold price usually rises during periods of high inflation, but the cause of the gold price rise is not inflation it is the loss of confidence in the government-sponsored money that occurs as a result of inflation. In a situation where the inflation rate is high but there is no resultant loss of confidence in the official currency, the gold price is unlikely to move-up in response to the inflation. This is, of course, a situation that cannot prevail for a long period of time. Eventually, excessive increases in the supply of a currency lead to a loss of confidence in that currency and an upward adjustment of the gold price in terms of that currency.

Misconception #3: The oil price and the gold price tend to move in the same direction.

This is a very common misconception, but anyone who took the time to compare charts of the oil price and the gold price over the past 20 years would see that oil and gold prices often move in opposite directions. For example, the best gold rally of the past decade (1993) occurred in parallel with a decline in the oil price. Furthermore, the gold price broke upwards out of a multi-year down-trend in early 1986 at the same time as the oil price was collapsing from $32 to $10. It is not difficult to understand why there would be little positive correlation between gold and oil prices since they are generally driven by different economic forces. The oil price tends to move up in response to increasing global economic growth whereas gold performs best during periods when the US Dollar's exchange value is falling. Sometimes the forces coexist, resulting in the gold and oil prices rising together. At other times they do not.

Misconception #4: Gold will perform well during a period of deflation.

The perception, amongst some analysts, that the price of gold will appreciate during a period of deflation appears to be based on one or both of the following:
a) The fact that gold performed extremely well during the deflation of the 1930s
b) A belief that declining asset prices constitute deflation

Gold certainly proved to be an excellent store of wealth during the 1930s, but that was because gold and the Dollar were officially exchangeable at a fixed rate. As the purchasing power of the Dollar increased due to a sharp contraction in the total supply of Dollars, the purchasing power of gold increased by the same amount. In an attempt to increase the quantity of Dollars and hence curtail the deflationary trend in existence at the time, the US Government then reset the Dollar-gold conversion rate so that one ounce of gold became convertible into a much larger number of Dollars. However, the prices of the commodities that were not officially linked to the Dollar, including silver, collapsed during the deflation of the early 1930s. Due to gold's monetary quality we are quite sure that it would out-perform all other commodities during a period of deflation, but the fact that there is no longer an official link to the Dollar means that it would under-perform cash US Dollars.

Gold can be expected to perform very well in a non-deflationary, or inflationary, period during which asset prices are either declining or, at best, rising at a rate that is less than the rate of inflation. SE Asia during the 1997-1998 period provides an extreme, but pertinent, example. Asset prices in the countries previously known as the 'Asian Tigers' collapsed, but the money-printing presses were turned to top speed and the supply of money ballooned. In local currency terms the prices of gold, any imported goods and the basic necessities of life skyrocketed.

Conclusion 

There are other misconceptions, but they are mostly corollaries of the above. The key point is that gold is primarily accumulated as money and it must therefore be analysed as such. As money it competes with the US Dollar and is, in fact, the Dollar's only serious competitor. The major determinant of the gold-USD exchange rate is the level of confidence in the Dollar.