FOOL's GOLD

WHY GOLD IS OVERRATED

Much like the merciless hangover that haunts a drunkard after a night of excessive alcohol binging, the world seems to be hung-over from the Gold rush of the 1840s. The major difference being that the latter was actually novice gold mining during an era in which gold-digging had nothing to do with beautiful women clawing into wealthy men to siphon their heavy pockets. The absurd price-tag of Gold today is more a reflection of foolhardy ‘financial markets’ lusting over a hollow yellow metal with a questionable economic and future relevance, at best.

At US$1140/oz (and increasing) I am beginning to think that the Greenhouse Gases causing Global Warming must be having an adverse effect on our rational behaviour. Either that or I am eligible for a tuition refund from years of studying economics and financial markets.

Pardon me if I’ve lost you but, try to make sense of this; Gold is said to be a store of value and thus a hedge for inflation. Pundits say the price of Gold, when adjusted for inflation, has actually been stable over the past gazillion years. So what? There are two major assumptions here; both fundamentally incorrect and based on flawed thinking. The first is that the past equals the future. Whereas I am a great enthusiast and an avid reader of the world’s financial history, I constantly find myself at odds with the idea that history always repeats and that what worked well historically will reign true in the future.

Gold has historically been a reliable asset class during times of economic instability, much like now, that many people automatically assume that Gold is a safe haven for their money. Hasn’t the new world intellectual moved on? During the Great depression of the early 1930s when the world was still on the Gold Standard, the global trade a quarter of what it is today, global debt negligible and where you could literally go to the market and buy bread using Gold, there was good economic sense in keeping Gold as an asset. In today’s context however, where total Gold reserves can only settle 8% of total sovereign debt, how could the value of Gold be different to that of an antique chandelier, a rare bottle of vintage champagne or a set of limited edition Golf clubs?

The second problem I have is that the foundation of the store of value notion is premised on painfully bizarre thinking. An Economist I greatly respect put it to me that, if the world lost trust on fiat money (money with no intrinsic value) somehow the world would be forced back into the Gold standard, where people use Gold as a unit of measure i.e. a loaf of bread equals a half ounce of Gold. Based on this ideology, Gold would once again become a scarce resource and its price would appreciate many times over and a handful of holders would be set for life. Please!

Let me provide you with a little historical and economics context. Real prices work on the basis of demand-supply economics, that’s just how the world is engineered to work. In other words, if there’s demand for something its price will continue to rise until demands recedes, unless the supply of that product increases sufficiently to meet the demand. A simple example is crude oil; there’s a finite amount of oil that can be mined economically and therefore if the demand for oil continues to rise and supply remains suppressed by cartel prescriptions, volatility in oil producing countries or other economic forces, the price of oil will rise, the converse is also true.

So why then does the Gold price continue to rise inexhaustibly? Simple, ever since about 1641 BC, when Spain was the economic powerhouse of the world, the world has engaged in wild orgies of precious metal crusades. Most trade was done using Gold and Silver as units of measure. Why? because Gold and silver were scarce enough to be accepted by large societies as mediums of exchange. In other words peter was willing to take 5 ounces of Gold from Paul in exchange for a Ton of Wool only because he knew that John would accept an ounce of Gold in exchange for a live turkey. This helped them navigate the barter problems! Make sense?

Gold as a medium of exchange was a mere innovation to the barter system that aimed to eliminate the problem of doubled coincidence of wants. Greek! The inherent flaws in the barter system revolved around two key problems; a) if Peter needs wool and is willing to give a basket of apples in exchange, but John who has the wool wants chicken not fruit in exchange for his wool. This presents them with a problem, which prevents them from transacting with each other. This is a double coincidence of wants problem. (b) Barter systems lacked standards of measurement, i.e. how much fruit is fair trade for 3 metres of wool? And how much wool should you give for a turkey? So the valuation system becomes highly subjective if you don’t have a standardised unit of measure.

Enter Gold and Silver. Precious metals have always been in short supply and highly valued for their decorative and cutlery usefulness. The scarcity in the metals creates a limited amount of supply, which in turn ensures that the value of that precious metal becomes stable and fosters effective, predictable and consistent trade. If only an X amount of Gold coins are available in circulation for trade and the supply doesn’t increase, you are not likely to have inflation in that society because the currency (Gold and silver) is in limited supply but circulates freely and consistently within that economy.

Then more globalisation occurred and faster, Gold and Silver with their limited supply were more a hindrance than a catalyst to global trade. So a new innovation was sort and manifested itself in the form of paper money but backed by Gold. So a Government could issue promissory notes (a piece of paper) promising to pay a specified person and/or a successor in title and/or bearer a specific amount on money (in Gold) on a specified date or upon presentation. This worked well until bank-runs happened. Rumours would typically start that a bank has issued more bank notes that it had Gold to honour those notes; so much like in the Saambou, Lehman Brothers, Northern Rock, and many other cases in history, depositors would run to the Bank and demand their money, only in those days, in Gold. Needless to say many banks collapsed.

Enter fiat money, another innovation! Unlike Fiat the car maker, fiat money is anything that the Government calls money, signs into law and circulates as legal tender so that everyone accepts it. Trust me, the R100-00 you have in your pocket is not worth the paper it’s written on. This new money would be backed in part by the faith (fiat) you have in your Government and in part by (Gold). After much protestation and uproar, everyone behaved like a schoolboy and accepted that this would be the new order of the world. At that stage most Gold was deposited in the Bank’s and there was limited Gold in circulation so everyone was forced to use clay coins and paper money, imposing a difficult divorce to a society so in love with what they had known and believed to be real money, Gold.

Fast forward a few decades and Europe is in World War II, infrastructure is dilapidated, currencies plummeting, resources scarce and trade virtually extinct. The Europeans didn’t trust each other’s fiat money anymore, because they weren’t sure how much Gold reserves each country had to back up their fiat money. So they came up with yet another invention third party currency trade, they agreed to trade using the American Dollar. Only one catch, Americans wanted Gold so that they could issue more currency in line with their reserve requirements. So the world’s wealth moved further west, much more quickly and then America became the powerhouse of the world with the most Gold reserves of any country in the world.

Problem? American accelerated from emerging economy to superpower too quickly, in the process creating enemies all over the world. Fatally so in the Cold Wars’ with Russia and Cuba and more so the Vietnamese War and the Genocide they committed in Hiroshima. So with American printing more and more money to fund their Wars’, the world (Europe) grew increasingly sceptical of the American Dollar and its Gold backing and so they began reclaiming their Gold back and giving America what was becoming worthless Dollars. Solution? ‘We regret to tell you that the United States of America will not be accepting any more Dollars in exchange for Gold’! Why? ‘Sorry, we just don’t have enough Gold to pay everyone back’. If America were a bank, this is when it would have collapsed (before the bailout days) on a classic case of a Bank run.

Today, we use virtual money, money has become so abstract that it is now a mere number on a screen and if Government wishes to increase the amounts they have, they just press another zero and boom it’s ten times more. The only thing that stops them is the threat of hyper inflation and currency devaluation in a high money supply economy with little or no GDP growth. That’s the short history of money. If you think about it Gold was just an innovation it had no industrial value whatsoever, just lauded for its decorative use!

That brings us back to the subject at hand, why does Gold continue to rise like a phoenix in a storm? Based on pure economics, there’s absolutely no reason as to why Gold is still relevant as an asset class or investment. The only justification my mind can conjure up is limited to the above history. From a pure economics point of view we know that about 160 000 tonnes of Gold has already been mined and only 50 000 tonnes (disputed estimate) remains underground as reserves. Gold is currently being mined at 2 600 tonnes per annum with 130 000 tonnes having been mined in since the California Gold rush in 1848. So only about 25% of all known Gold remains to be mined and at 2 000 tonnes per year, we are talking about another 25 years of Gold mining. So yes, Gold is a finite and limited resource.

The problem is this; 100 000 tonnes and more of all Gold ever mined is held in the form of Jewellery, collector coins and privately held bullion. Do you see the picture? This means at-least 75% of the price of Gold (Demand-Supply) has been driven by consumerism, luxury goods markets and non-investor related forces. So the actual price of Gold should be around US$50/oz and not the US$1140 at which it currently trades. This might explain why the IMF (international Monetary Fund) is currently offloading its Gold reserves to member countries at US$42/oz, a price fixed in 1971 when President Nixon’s administration permanently severed ties between the value of the US Dollar and Gold Reserves.

Only about 30 000 tonnes are held by Central Banks around the world as a reserve asset. Today that would be worth around US$1 trillion, which pales against the estimated US$26 trillion that western Governments owe in paper debt. Somehow, I doubt that US$1 trillion would suffice for the demands of Global trade. So in a sense all this Gold is absolutely worthless if the Western Currencies collapse. Makes me wonder why China has been on a Gold binge over the last decade. India is the largest importer of Gold in the world, the Indians love their Jewellery and it has nothing to do with investment strategy.

South Africa, which has mined about half the Gold in the world, only has around 125 tonnes of Gold in reserves, which covers about 10% of all reserve assets. It is now reported that South Africa might only have around 3 000 tonnes of Gold reserves underground and not the previous figure of 36 000 tonnes bandied about for many years. If this is true, then world un-mined Gold reserves should be around 14 000 tonnes (7 years worth of mining at current levels).

Gold has got virtually no industrial use and as a result the world can do without gold. In-fact because Gold is such a soft metal it is usually alloyed with other metals, such as copper and ferrochrome, for Gold coin production and Jewellery making. I don’t believe that the new generation of wealth has any allegiance with the past and instead new money is continuingly evolving into a abstract phenomena. In good time I will either be vilified for my dismal view on Gold or I will be vindicated and lauded for my foresight. For now if you are bullish on Gold, you are bullish on Fool’s Gold.