In the next installment in our weekly column from What’s Next? author Lyric Hale, the top economic commentator discusses the rising price of gold, brought on by the debt crisis and recent febrile stock market activity. Hale explains the concept of ‘Peak Gold’, challenging conventional wisdom on the subject and providing a thorough analysis from fellow editor and contributor David Hale.
Article by Lyric Hughes Hale
If you own stocks, you have probably lost some money over the past two weeks. But if you own gold, you have made more than a 10% return in a matter of days, not years. In a gloomy time it is heady stuff, and many analysts think gold’s bull market has longer to run. An array of economic and market commentators, including David Hale, co-editor of What’s Next? think that gold will go even higher than its recent $1800 record peak. They cite the gold price back in 1980, when it was about $2400 per ounce in inflation-adjusted dollars, as gold’s new target price.
Gold bugs are even more excited, and forecast that the “parabolic” price will rise to $5000 or even $10,000. Why am I skeptical that this kind of price rise is inevitable? It is possible that we have now reached peak gold, but only in terms of price. There is certainly a bit of irrational exuberance in the air.
Peak gold and peak oil are not necessarily symmetrical concepts. Both reference the Hubbert curve. The midpoint of this curve occurs at the maximum rate of extraction of a resource, based upon known reserves. After reaching this peak, supplies diminish, and prices rise. Does this trajectory apply to gold? Most probably, no, because both gold and silver are not just resources, they are units of exchange. These metals have value as commodities, subject to production and demand factors, but they also serve as alternatives to paper money. Another key difference is that oil is consumed, which is of course generally not true for gold. The buyer keeps gold until it is sold to another buyer.
Albert Bressand, in his provocative chapter in our book, calls peak oil itself a “mirage”. He writes that oil is abundant in our world, that better technologies and new sources of supply will make hydrocarbons affordable for the foreseeable future. Might not the same be true for gold? Innovative exploration and mining technologies, coupled with improved infrastructure in gold-producing countries, could mean that more rather than less gold will be coming to market.
For example, South Africa’s production has been declining, but that is primarily because the energy grid is inadequate to the task. Now that the gold price is higher, incentives to cure this problem should lead to increased production. Africa’s rapid development in fact might lead to long-term stabilization of gold prices. In a sluggish world economy, it is the fastest growing continent. Gold is being mined in Ghana, Tanzania, Zimbabwe and the Cote d’Ivoire, and if political stability is achieved as well, even more production can be expected.
In his chapter “Will the Gold Rally Continue?” David Hale gives three reasons for his affirmative conclusion that the gold price will continue to rise. The first is the medium term outlook for low global interest rates, which is positive for gold as an asset class. (The Federal Reserve has now said that it doesn’t plan to raise interest rates before 2013!) However, historically gold was seen as a way to store value in times of inflation, and indeed the price was highest back in January of 1980 when interest rates were 13.9% in the US.
His second argument in favor of a continued gold rally is tied to his forecast for a weak dollar. Since gold is priced in dollars, these two numbers should move inversely, and the case for a high gold price is really a case for a low dollar. However, John Greenwood, in his chapter on the future of the dollar as a reserve currency, thinks that demand for the dollar will be unabated, simply because there are not really any good alternatives. The Chinese yuan is not yet a convertible currency. There are only so many Swiss francs. It is widely expected that the Bank of Japan will continue to aggressively intervene to weaken the yen to help its exporters. In terms of the obvious competitors, the euro and the yen, in light of both current problems and long-term negative demographics, the US might be better positioned than its rivals. You don’t need to run faster than the tiger, just faster than the other guy the tiger is chasing.
China is the third factor David feels will push gold higher. The theory is that China’s central bank wants to diversify its portfolio, and in so doing will persistently push up the price of gold. My thought, in the nothing is forever category, is that China’s foreign exchange reserves could fall if exports lag due to lower worldwide demand. If China is able to transition from an export-led economy to one based upon domestic consumption, then foreign exchange holdings will be smaller and less critical and the People’s Bank will have less need to diversify into an alternative such as gold.
Certainly there is retail demand in China, but on the other hand, China today is itself the world’s largest producer of gold. So the Chinese could satisfy their need for gold internally, rather than on international markets. We have no idea how much they have in their vaults, how much there is in the ground, and what their true appetite is for more. I wouldn’t bet on China alone. Other central banks might play a role.
South Korea recently announced that its central bank had purchased 25 tonnes of gold. Ten years ago, South Korea did not have enough foreign exchange reserves to worry about diversification. They suffered humiliation under the IMF during the Asian Financial Crisis, when individual citizens contributed their gold wedding bands in order to help their country avoid default. Reserves have now topped 300 billion dollars. The Bank of Korea has its annual parliamentary grilling in September, where they will face politicians who have called for the creation of a gold reserve. So perhaps there is a whiff of politics, rather than pure economics, which has motivated Korea’s gold purchases, and this is a one-off event.
For these and other reasons I can see a scenario for falling gold prices. An investment that has gained 50% in one year, especially when everything else has gone southward, will cause any serious money manager to think about selling off at least some of his position. According to the World Gold Council, most of the 100-tonne increase in demand for gold in the first quarter of 2011 came from investors. So profit-taking is likely to be the leading cause of any price decrease, or a sideways movement. Stocks are looking cheap so there is an alternative.
Buyers will start to realize that new sources of supply are coming on stream, and falling production costs due to innovation and other improvements could depress prices. The music might stop when investors tire of paying three times production costs for gold. The dollar could strengthen, and China and other central banks could become less interested in holding gold in their portfolios. Rather than buying gold, it is possible that some cash-strapped countries (the US?) might actually begin to sell gold at these prices.
Central banks and production are long-tailed factors. Analysis of overall global demand for gold is probably the most helpful to the investor trying to decide whether to buy gold. If the global economy stagnates or weakens, retail demand might be weaker than expected. This is important, because half of the world’s gold exists in the form of jewelry. According to Symmetric Information, in 2010 53% of the net demand for gold came from jewelry production. Buying gold is a bet that China, India, Brazil will increase retail consumption. In all three cases, these formerly superheated economies are cooling.
35% of the demand for gold is from private investors, and as I mentioned at least some of them will be selling. 11% is for industrial use, (silver is 49%). Again, a slowing global economy means that it is unlikely that demand will come from this sector. Coming in dead last: central banks at 2%.
On Friday, although it had risen as much as 13% over the past two weeks, gold prices fell 1.5%, driven in part by actions here in Chicago by the CME Group, increasing margin requirements by 22%. Other measures could be taken to contain speculation.
A final thought—it is possible that there is more gold in the world than is currently estimated. Symmetric and others point out that the London Bullion Market Association trades more than the entire annual production of gold every 3½ days. So the supply might be more than officially stated. The problem with peak gold and peak oil is that no one really knows what the world’s reserves are, so it is rather hard to figure out the halfway point.
Whenever people begin to think that prices can only go up, I worry. It could be that the world is so politically and economically unstable that they are right. I just think it is always good to wonder, what if they aren’t? There are no safe havens. That is the entire idea behind What’s Next? Not a forecast, but a call to question each other, and the conventional wisdom.
What’s Next? Unconventional Wisdom on the Future of the World Economy by David Hale and Lyric Hale is available now from Yale University Press.