Gold: Commodity or Money?
By Adrian Ash
June 28, 2007
How should you view gold –
as a commodity or a form of money...?
"SO YOU'RE a good old-fashioned gold
bug then?" asked my companion at lunch today.
"You're sold on the money argument for gold, and you
won't consider it as part of the commodity market?"
"I don't know about gold bug. But gold's only real use is
as a high-value asset, so why not? Okay, so gold's no longer
used as a means of payment, not unless you count the huge
transfers of wealth that would be needed between governments
during war-time. But for private individuals, it's still a
fantastic way of locking up wealth for the future.
"That's why people keep digging it out of the ground after
3,000 years. That's why Indian farmers swap the Rupees they earn
for metal each week. It's not just a social convention or
ancient tradition. Gold makes a great store of value."
"It hasn't stored much value over the last couple of
months though. Look at the gold
price! It dropped $10 an ounce on Tuesday!"
"Absolutely! Leveraged gold buyers using the futures market
might wonder if gold's got any value at all! But longer-term
it's still twice the price against Dollars and Sterling that it
was six years ago. It's never been higher against the South
African Rand or Indian Rupee. Turn that on its head, and the
Rand has never been lower against gold, in fact. Pretty much all
official world currency has sunk in value against gold so far
this decade."
"But why choose gold as a store of value? What's so
magical about it?"
"There's actually nothing magical or mystical about it.
Gold is just fantastically valuable in the most basic, the most
simple, economic terms. It doesn't rust or corrode or decay. Buy
physical gold bullion and lock it away safely today, and it
will still be there – unchanged – in ten, twenty, a hundred
years time. It's also incredibly heavy, so it doesn't take up
much space. And it's rare, six times rarer than platinum.
"You've been practicing this blurb, right?"
"Only once or twice. You probably shouldn't dismiss the
commodity argument, though. That's all the analyst notes you
have to read each day will be focused on. The difference, in
their terms, comes down to how you view supply and demand in the
gold market."
"You mean the physical gold market vs. futures and
options?"
"Not quite, no. The futures market really IS the physical
market in terms of pricing. A spike in one carries straight
through to the other, because there are too many traders waiting
to arbitrage one or the other for a gap to open up. The futures
market trades a little higher than the spot market, because it
has to account for storage and insurance costs between now and
delivery. But beyond that, gold tomorrow is simply gold today,
only with the risk of a promise thrown in for fun."
"Okay, so what is the difference between the commodity
and money arguments, then?"
"Well the first school, the commodity school, simply looks
at mining output, scrap gold from old jewelry, and central bank
sales – and it measures this supply over a period of time,
let's say over a year, for instance. Then it pitches that annual
supply against physical demand – new demand from the jewelry
business, gold leaf for micro-chips, a couple of tonnes for
dentistry..."
"Plus investment demand, of course."
"Yes, but a big chunk of that is only ever 'implied'
investment. Now, this is a statistical fiddle for the
gold-market analysts. It lets the number-crunchers plug any gap
between their data for annual supply and annual demand. Because
if the physical gold supply outweighs physical demand, then the
accountants say the difference must be going to investors. It's
certainly not going to DisneyLand on holiday, right? And if
demand outweighs supply, then there must have been DIS-investment..."
"And the story here? That physical gold supply is
fixed, but Asian consumers are getting rich and buying more
gold?"
"Well, one analyst says gold
prices can't rise on the back of rising demand for jewelry
alone, because that kind of bull market would soon eat itself.
Consumers would stop buying gold as it became more expensive.
Virtual Metals in London just published a report too, saying
that gold jewelry might lose out to iPods and four-wheel-drive
jeeps as Chinese consumers grow rich. But they can't say when
this kind of substitution might kick in, and they're certainly
not convinced that Asian demand will collapse anyway. On the
other side of the equation, meantime, mining supply has yet to
pick up despite huge growth in exploration spending."
"So fixed supply meets rising demand from where –
Western investors?"
"That's what kept the gold price rising in 2005 and '06
according to the commodity argument. Investment demand soaked up
the supply that jewelry consumers couldn't afford any more –
or so goes the theory. But the commodity school of thought
doesn't explain WHY people buy gold, either as rough jewelry in
rural India or stored as investment-grade bullion in Swiss
vaults.
"That's why it's missing the point to look at annual gold
supply versus annual demand. True supply on that logic would be
all the gold that's ever been mined, because it's still around
in one form or another. Remember, gold is incredibly
hard-wearing. You need cyanide to dissolve it! And most
crucially, people have never let gold just vanish – it's too
valuable. They might bury it in the ground, but you can guess
they meant to come back and collect it."
"There's still a certain quantity of demand each year
though. If it drops year-on-year, and supply is static, the
price is going to fall."
"But will it? Gold isn't like crude oil or copper. It
doesn't get burnt up or lost forever in electrical cabling. It
doesn't really have any uses besides storing value. Its prime
utility is its rarity. I mean, it's six times rarer than
platinum. Silver used to be used as money, too. But it's
primarily an industrial commodity today, rather than a store of
wealth. Gold, on the other hand...there's 150,000 tonnes of the
stuff above ground. At the right price, that supply would flood
back into the spot market, just like it did when people queued
up outside jewelry shops and gold dealerships to sell their gold
in 1980.
"So gold doesn't get used up and that means it's not a
straightforward commodity. So what?"
"This is where the money school of thought comes in.
Because instead of viewing the demand for gold against annual
supply, it rates the demand for gold against the demand for
paper money – Dollars, Pounds, Yen, Euros..."
"The competition..."
"Yes, the competition as money. Now, what is money? Mervyn
King, head of the Bank of England, put it pretty well in a
speech last week in the City..."
"You were there?"
"No, I just like to keep track of his speeches. Actually,
I'm waiting for him to get pelted with bread rolls...but never
mind that. The value of paper money depends on trust, said King
– and this guy is the UK's chief central banker, remember.
People need to trust that it will hold its value. They also need
trust that other people will accept it as a means of
payment..."
"You accept Pounds today, though. I don't see anybody
here paying the waiter in gold."
"Right again, but that only proves – like we agreed a
minute ago – that gold doesn't act as a means of exchange any
more. Given its price as a store of value, how could it? Whip
out a gold coin to pay for lunch today – and it's really very
nice of you to both pay AND listen to me go on – and we'll be
washing the dishes before they let us go home. We might just get
mugged once we're outside the door though..."
"I'd need, what, a quarter-ounce to settle up?"
"You order that second bottle of wine and it'll be nearer
half-an-ounce I reckon. But that's inflation for you. Even
against gold..."