Who doesn’t find gold intriguing?
I’m not a huge fan of gold as an investment. I can’t relate to what I consider an obsession about the yellow metal by gold bugs. But I do think it’s a fascinating topic.
When an American thinks about gold, he has images of mystery and intrigue–of pirate treasure, or James Bond, or hard-bitten solitary miners making a strike in the hills of the Dakotas or northern California. In an earlier age, the picture would have been of a guy in a funny hat, wearing an elaborately-decorated bathrobe, trying to “transmute” base metals into gold.
A better image for today might be the situation of a citizen in China or India, Vietnam or Turkey–which are four of the largest consumers of gold (the US and Italy are, too, but the uses are somewhat different). Someone in one of these countries may not be wealthy enough to have a bank account, or may not want an official record of his transactions. He may also worry that to be seen as wealthy will attract unwelcome government attention, or that a bank account is subject to nationalization in a way that a gold bar buried in the back yard is not. He may have experienced, or worry about, hyperinflation. His holding may well technically be jewelry, but more than likely it will be 22 karat or 24 karat (chuk kam), and bought and sold by weight.
Gold in three posts
I’m finding this topic surprisingly hard to write about. It’s not so much that I don’t have an opinion–fat chance. It’s that I think the situation with gold is very complex.
1. For most of the world it’s an artifact of a past way of life–like spittoons or ashtrays, or writing letters instead of email or chat. It used to be money but isn’t any more. It’s a consumer jewelry commodity, like diamonds or colored stones. Like any capital intensive business, gold mining is potentially subject to periods of boom or bust, depending on productive capacity entering or leaving the market. But price swings can be dampened by movements of supply in and out of jewelry inventory. Inventories, by the way, are immense relative to mine production.
2. For some parts of the world, it still acts as money, because it’s the best alternative available.
3. There’s also a question of old dogs and new tricks. As the world changes, not everyone adjusts at the same rate. When ATMs first became available, for example, banks found it almost impossible to convince customers over the age of fifty to use them. In the case of gold, I personally don’t believe it’s very effective as an inflation hedge. And there are also much easier instruments available today, like foreign currency futures or even asset-based stocks, to use to guard against home currency depreciation. But some people will rely on the tried and true, no matter what the advantages of a new development may be. If so, gold will act to some degree as an inflation hedge because some people act that way. This is not a great rational for an investment, though.
I’m going to break the topic down into three parts.
The first, which follows below, gives some basic information about gold.
The second will deal with whether gold is an inflation hedge in today’s world. I’ll argue that it isn’t so great as one, and has some risk if holders become more aware of its true character.
The third will outline what I think are the investment attributes of gold and the various ways to participate in the gold market, from physical gold to gold mining stocks.
The Gold Standard adds to the mystique of gold
From antiquity, gold has been recognized as a store of value and gold coins have been recognized as money. The gold standard, however, is a relatively modern phenomenon. In its simplest form it consists in the definition of a country’s currency in terms of gold (for example, $35 = 1 troy oz. of gold), along with a pledge to redeem bills or coins for gold if asked. The circulating currency, typically made of paper or base metals, derives its value, not from any intrinsic characteristics, but from the conversion pledge.
The most recent instance of the gold standard was initiated in the Bretton Woods agreements at the end of World War II. The value of world currencies, except for the US dollar, was defined by a fixed conversion rate into dollars. The dollar was pegged to gold, at the ratio of $35 = 1 troy ounce. The US promised, for everyone other than US entities, to exchange their dollars for gold at that rate. The arrangement fell apart in early 1971, as persistent selling of the dollar (notably by France) began to deplete US physical gold reserves. Put another way, the US printed a lot more dollars than it had physical gold to back.
(An aside: The pledge to exchange paper money for gold is what made Goldfinger’s plot to rob Fort Knox so fiendish. If successful, foreigners would have lost faith in US money. That would have stopped US trade, hence the US economy, in its tracks. Who knew?)
Gold used to be super-money…
Until less than forty years ago, then, gold was regarded as a special kind of super-money. Adding to its mystique is the fact that from 1933-1974, it was illegal for Americans to hold more than small amounts of gold bullion or gold coins. Part of an earlier attempt at instituting a gold standard, the government required citizens to turn over their gold to the government in return for $20.67 an oz.. The fact that the gold price shot up by over 4x from 1971 before Americans were allowed to own gold again in 1974 did little to undermine the idea of its special status.
Gold Statistics–gold inventories are huge! (all figures, at December 2007, come from The Gold Council),
One of the most striking facts about gold is how small supply and demand are in relation to inventories.
mine production 2,200 tons
recycled metal 950 tons = a reduction in inventories
central bank sales 500 tons = a reduction in inventories
jewelry 2500 tons = an addition to inventories
investment 700 tons = an addition to inventories
industry 900 tons
In simple terms, then, 2,200 tons of new gold came out of the ground, of which 900 tons was used for computers, other electronic equipment, and medical and dental devices. The other 1,100 tons went into jewelry, the principal source of demand for gold.
What about inventories? They are (again from The Gold Council):
jewelry 82, 700 tons
investment 26,500 tons
central banks 29,000 tons
industry 19,000 tons
Total 157,200 tons
Let’s subtract all the jewelry from the total (this is clearly not right to do, since 22 karat and 24 karat jewelry have a strong investment motive). We’re still left with about 75,000 tons of gold sloshing around in the world, or about 34 years of mine production.
More in my next post.