Mostly: Classical

[amarksp]

Any comments on this article by Paul van Eeden...?

When you are in a place such as Dubai, where so much trade in physical gold takes place, it is easy to understand why people think jewelry production is important to the gold price. However, the price of gold is almost completely insensitive to jewelry demand, scrap sales, mine production, producer hedging or central bank sales.

Total jewelry consumption during 2005 was 2,736 tonnes of gold. Industrial and dental demand added another 419 tonnes for a total of 3,155 tonnes of primary gold demand. Mine production during 2005 was about 2,515 tonnes. Some people believe that this 640 tonne primary shortfall of gold mine production relative to fabrication demand is relevant to the gold price. They also seem to think that net investment demand, official sector sales and purchases, etc. are important. Jewelry demand is important to jewelers but it makes no difference to the gold price.

The bulk of international gold trading occurs through the facilities of the London Bullion Market Association (LBMA) and from their website we learn that the average DAILY volume of gold trading was 513 tonnes during 2005. Now let me explain what that number means. The LBMA only reports the net amount of gold transferred between its clearing members at the end of the day. So if two members trade 100 tonnes five times during the day (total trading volume is therefore 500 tonnes), and at the end of the day one member owes the other member 200 tonnes of gold (i.e. net position at the end of the day) then only 200 tonnes is reported by the LBMA. The LBMA trading volume reflects the net amount of gold transferred between clearing member accounts at the end of the trading day. It is estimated that the actual volume of gold trading is possibly as much as 4 to 6 times larger than the net positions reported by the LBMA. Remember, these are not derivative trades; these are the settlement numbers for actual gold trades.

Now, if the volume of gold trading through the facilities of the LBMA is in the order of 500 tonnes per day, then I am afraid that a 640 tonne annual shortfall between mine production and fabrication demand is totally irrelevant. In fact, the entire 2,736 tonnes of annual jewelry demand are irrelevant: they represent less than 6 days of trading through the LBMA. It makes no difference to the gold price whether India had a good harvest or a poor harvest, even though, again, it is probably important to the jewelers.

Gold is money; it is not a commodity. Its value relative to fiat currencies is purely a function of the relative inflation rates of gold and other currencies. The gold price may fluctuate based on investor psychology, just like the price of any financial asset, but it will always revert back to its fundamental value, which is determined by relative inflation rates.

Just like the inflation rate of money is the increase in money supply, the inflation rate of gold is the increase in the above-ground stock of gold, i.e. mine production as a percentage of all the gold that has ever been mined. If we know what the inflation rate of a particular currency is we can calculate its relative value to gold, assuming we have a starting point at which we knew what the fair value of the currency was. This can be done for the US dollar. In 1933 the gold price was defined by the fact that a $20 gold coin contained 0.9675 ounces of gold. From this we know that the gold price in US dollars during 1933 was $20.67. If we now take in consideration the inflation rate of the US dollar (as defined by M3 and the Consumer Price Index for those years that M3 did not exist), and the inflation rate of gold (annual mine production) we can calculate that the gold price in US dollars should be around $850 an ounce.

However, gold is not unique to the United States; it is an international form of money and so we also have to take into consideration the US dollar exchange rate, since anything we price on international markets in US dollars will fluctuate along with changes in the US dollar exchange rate. We know from the US trade deficit that the US dollar is over-priced on foreign exchange markets and the US is putting considerable pressure on China to help devalue the dollar. The only reason gold is not $850 an ounce (or thereabout) today is that the US dollar is over-priced. As the US dollar exchange rate falls the gold price in US dollars will rise.