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Brett
Arends, writing in the Wall Street Journal Why I Don’t Trust Gold explains the
rise of gold in the following way:
If the
price rises you’d think there must be a shortage. But data provided by
the World Gold Council, an industry body, tell a remarkable story.
Over
that period the world has produced—or, more accurately, recovered—far
more gold than anyone actually wanted to use. Since 2002, for example, total
demand for gold from goldsmiths and jewelers, and dentists, and general
industry, has come to about 22,500 tonnes.
But
during the same period, more than 29,000 tonnes has come on to the market.
The
surplus alone is enough to produce about 220 million one-ounce gold American
Buffalo coins. That’s in eight years.
Most
of the new supply has come from mine production. Some, though a dwindling
amount, has come from central banks. And a growing amount has come from
recycling—old jewelry and the like being melted down for scrap. (This
is a perennial issue with gold. I never understand why the fans think
gold’s incredible durability—it doesn’t waste or corrode—is
bullish for the market. It’s bearish.) So if supply has consistently
exceeded user demand, how come the price of gold has still been rising?
In a
word, hoarding.
Gold
investors, or hoarders, have made up all the difference. They are the only
reason total “demand” has exceeded supply.
Arends’
explanation is based entirely on a series of misconceptions about how the
gold price is formed. He looks at it as if it were a commodity that is
produced and then used up. But this is not the case. Gold is produced
primarily to be held in the form of bars, coins, or jewelry.
We all
agree that prices are the mechanism by which supply and demand come into
balance. Arends is working from the assumption that the price of gold must
balance annual mine production against the annual use of gold for fabrication
and dentistry. That is not the case at all. This could only be true under the
following two (false) assumptions: if all of the gold that already exists
– about 100 times annual mine production — were destroyed or
otherwise permanently removed from the market, and if potential gold buyers
could only purchase gold that was mined in the last year.
The
market for gold does not consist only of gold that was mined in the past
year. In the gold market, newly mined gold and existing gold form a single
market. As I have written on this site, the supply of gold
that participates in the price mechanism is all of the gold that exists.. Gold
mining has very little impact on price. If mining were halted entirely that
would not affect the price by much.
The
demand for gold does include fabricators, gold smiths, jewelers and dentists,
but these sources of demand constitute a tiny fraction of the total demand.
The largest component of gold demand is reservation demand, or demand-to-hold
gold by people who own it – also known as hoarding. By not selling
their gold at or below the current price, gold hoarders ensure that the price
stays at or above that level. By not bidding at or above the current price,
dollar (and other money) hoarders ensure that the prices stays at or below
the current level.
Trying
to understand the gold price on an annual basis leads to the conclusion that
there is a phony surplus (or deficit according to others).
Arends
writes that more gold was mined than anyone wants to use, as if that has some
kind of bearish implications. The mined surplus, according to Arends, has not
yet depressing the gold price due to investors dramatically stepping up their
hoarding. He implies that this big bump in hoarding is sure to be temporary,
and then, gold will crash.
But
there is nothing new, or special as Arends seems to think, about hoarding.
Hoarding, or demand-to-hold, is the mechanism by which the price of any
stockpiled good is set. Arends makes the quantitative increase in hoarding
during the last few years seem about 100 times more important than it is by
looking only at annual supply. In fact, the demand-to-hoard only needs to
increase by about 1% per year in order to keep the market in balance because
that is the rate of growth of supply. As long as investors, collectively, are
willing to add to their hoards by 1% per year, the price of gold could stay
at the same level.
The
overwhelming majority of the world’s gold supply is hoarded by someone.
The annual demand for destructive uses of gold, e.g. dentistry or
irrecoverable industrial use is minuscule and can be met out of annual mine
production. The importance of hoarding applies as well to money or any other
financial asset as to gold. Take, for example shares of equity of a
corporation. Like gold, financial assets are not “used” as in
“used up”, they are hoarded. The price of any asset is set by the
competition between asset hoarders and dollar hoarders as they balance the
sizes of their hoards (otherwise known as accounts or portfolios). The
question is, what price will existing gold hoarders choose to increase their
stockpiles of money, and at what price will existing money hoarders choose to
increase their stockpiles of gold?
Suppose
that you read a research report from a brokerage like this:
Corporation
XYZ plans to issue 1 million shares in an upcoming equity offering. Last
year’s trading volume in this stock was 0.5 million shares. This new
share issuance represents two times annual consumption of XYZ shares. Unless
there is a 100% increase in the demand for XYZ shares this year as compared
to last year, then the stock price of XYZ will clearly fall. Last
year’s demand of 500,000 shares of XYZ was based on investor
“hoarding” of XYZ shares. This hoarding demand is clearly
temporary, speculative, and irrational; as such, it cannot be relied on to
carry into the current year. Therefore the price outlook for XYZ is bearish.
What
are the problems with this analysis? The analyst fails to look at how many
shares of XYZ are outstanding and then to compare the size of the new
offering to the total share count. Suppose that XYZ has already issued 100
million shares, then the new shares only dilute XYZ’s equity by 1%. If
the equity offering is priced at fair value, then an equal asset is added to
the firms’ balance sheet and existing equity holders are not diluted at
all.
The
analyst fails to understand that all shares of any equity are
“hoarded”, that is, held in a stockpile by an investor somewhere;
it is the nature of an asset to be “hoarded”. The analyst
confuses trading volume with demand: the 500,000 shares of XYZ that traded
last year is not a measure of the total demand for shares, only of the
turnover. The trading volume tells you nothing about the price – a
stock can trade either up or down on rising or falling volume. The analyst
fails to take into account that it is existing bids for the shares that are
responsible for maintaining the price where it is. All demand to hoard is
speculative in nature though not necessarily irrational. And so it goes with
gold.
Robert Blumen
Robert Blumen is
an independent software developer based in San Francisco, California
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