Gold - Popular
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
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
The Popular Misconceptions
Misconception #1: A large deficit
between fabrication demand and new mine supply should result in a higher
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
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.
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.