Monday, March 2, 2009

Something's Funny With Gold And Money

Something that gold investors often fail to realize is that the aboveground supply of gold can increase just as fast as – or much faster than – the supply of money. This is an important part of why the view of gold as a “solid currency” is a fallacy.

Gold inventories are currently the highest they've been in the history of the world. And throughout the twenty-year bear market in base metals, gold exploration skyrocketed. Even in 2003, 75% of mining exploration was allocated to gold, up from 50% only three years earlier.

I do not have the current CRB Commodity Yearbook figures, but it is without a doubt that gold exploration has dramatically increased since then, with new mines coming on stream, in response to high market prices.

In other words, the supply of gold is huge and expanding, especially relative to that of every other commodity. And since gold is an element, it cannot be destroyed. Compare this with a commodity such as crude oil, which gets used up and can't be renewed.

Here is a graph of gold production:

As you can see, production skyrocketed after 1980, even when prices went into a multi-decade bear market. The current numbers are probably substantially higher than what is reported there, possibly going right through the top of the chart, in response to such high market prices.

As for the demand side, the demand for gold used in jewelry – the commodity's staple use – is so small that the CRB Commodity Yearbook doesn't even bother to report the figures anymore. All demand for gold has been falling – except for use by financial speculators.

I have no idea where the gold price will go, but with the market at a thirty-year high, today's buyers have no margin of safety. And in terms of supply and demand, I can hardly see why gold investors would be concerned about the money supply: unlike the supply of gold, the money supply has not increased by several hundred percent.

If we look at M2, the monetary aggregate used to forecast inflation, it has only expanded by about 10% from where it was a year ago:

Individual money market accounts are included in M2, but wider measures of the money market – like commercial paper and repurchase agreements – are included in M3.

The Fed discontinued its reporting for most of the components of this latter aggregate, but my guess is that the extreme stress in the credit markets probably would have shown M3 sharply contracting, hence the need for a massive liquidity injection.

While the Federal Reserve can print money, so can the giant mining companies ramp up gold exploration and production. And the facts show that the latter have been much more successful in supplying the market.

While this may be a vote of confidence for the free enterprise system, it presents an ugly picture for today's buyers of gold.

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This work by Nicholas E. Radice is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.