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Gold in a Deflationary Economy - Part- XII

April 15, 1999

Earlier in this report, I discussed common misperceptions on how gold behaves during cycles of inflation and deflation. Another common public misperception is that gold mining companies are not profitable during deflation, and that if gold falls below the cost of production mining stocks are not good investments. This could not be farther from the truth.

The reasons? First, during deflation, prices are falling-including costs associated with mining gold. Second, gold typically bottoms during deflation and begins to rally. Third, mining shares tend to be sold off to levels of severe undervaluation early in the deflationary cycle, which typically emerges after years of bear market in gold and gold shares. And there are other reasons.

Milton Friedman, for example, says "the prices that were declining [during deflation] included those entering into the cost of producing gold, so that gold mining became more profitable....Such a reduction in cost must have multiplied the profit margin at prior levels of production several fold. In other words, it justified the spending of up to 20% more to extract additional gold."

Gold shares soared from 1930 until 1935, bucking the
80% collapse in the general stock market at that time.

Still other factors go into the psychology of mining gold during deflation. As Jastram put it, South African policy is to mine ore of the lowest grade profitable at the prevailing gold price. With ore mining capacity subject to severe physical limitations, the quantity of gold produced therefore falls as the gold price rises. Over the same period the net effect was a 25% decrease in the mined supply of gold in the free world during the 5 years when gold prices rose by an amount unprecedented in history [1970-1975]. This production policy and the phenomenon of the "backward-rising" supply curve is not confined to South Africa. The president of Homestake Mining Company, operator of the largest gold mine in the Western Hemisphere, said in an interview published by the Pacific Coast Coin Exchange in 1974:

"With higher gold prices, it's become profitable for us to mine lower grade ore. So while the amount of ore we process remains about the same, actual gold output is lower. For instance, during 1972 our gold output declined 20% from 1971, yet our income and profits are considerably greater than a few years ago. The situation is similar for gold mines in South Africa. Over the years, I expect gold production will continue to drop-the faster the price of gold rises, the faster the drop. If gold were at $300 per ounce [at the time of this quote it was closer to $100 per ounce], I think gold production would be something like a half or third what it is now." Further affecting the price-quantity relation is the 10% of free-world gold production that comes as a by-product of base metal mining...."

Thus, as Jastram indicates, factors leading to fluctuations in gold production are also dependent on the factors affecting the markets for the base metals, that is, lead, copper, and so on, than the price of gold taken by itself.20" And, in turn, this is yet another reason why one cannot simply consider the supply/demand situation when attempting to forecast gold prices.

The Incas thought gold represented the glory of their sun god and referred to the precious metal as “Tears of the Sun.”
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