first majestic silver

A Long Term View of Gold

April 24, 2003

Last week the discussion of the valuation of gold mines ended with the possibility that the prices of marginal, unhedged mines with extensive reserves that can at present not be mined profitably could increase 10-fold and more, should the gold price really get going. By ":really get going" the implication is a gold price of some thousands of dollars per ounce, as is being bandied around in certain circles – circles that are seen to consist of the more wayward of the gold bulls; those thought way out even by people who are believe a gold price of $600 or $800/oz is well within reason.

The question is how good is the probability that such a stratospheric gold price could materialise.

We know there is some risk of a major meteorite or comet striking the earth; astronomers might even be able to calculate the probability of it happening within the next 10 years, or geologists the probability of a really bad earthquake striking California before the end of next year, like the 1906 quake that left San Francisco in near ruins. But the odds of this happening are so low that nobody seriously considers building a deep survival shelter on the chances of a nearby meteorite strike; and millions of Californians are quite content to keep on living in the Sunshine State despite the risk of a major earthquake.

People very rarely take very important decisions based on low probabilities – at least not while current evidence points to the maintenance of the status quo. We tend to live one day much like the rest and hope for the best. Which is why so many investors keep hanging on to stocks that have and are still losing value; we have been conditioned by more than a decade of consistently rising equity prices to expect that is the ruling trend and that the bull market will return soon.

Something like a gold price of much more than $400 is not really ‘on the radar screen’, to use a phrase recently become popular, let alone a gold price approaching $600 or $800. A price of $2000, or more? Not on your life!

Yet, if one reads the opinions of a few important economists – people who are highly rated by their peers – on what could happen to the US economy over the next 2-3 years, then those views can easily translate into a gold price well in excess of four figures. And one gathers that they believe the odds of their expectations being realised better than 50-50, if not near inevitable.

So what is so dire about the prospects for the US economy? These economists believe the US has moved so far into a major Credit Bubble, feeding it with massive liquidity from an exploding money supply and other ‘money’ creating mechanisms, that there already is no turning back. That the only choice that lies ahead is between deflation or inflation.

Deflation is more than a climate of lower prices. Japan’s experience over the past decade, after their equity and mortgage bubbles were pricked, serves as an example of deflation – lower prices because of falling demand putting the squeeze on businesses, who then lay off people in order to survive financially, reducing consumer spending even more to add another cycle to the downward spiral. In the case of Japan, the economy could be kept on even keel, more or less, because of exports, predominantly to the US. If the US enters a deflationary spiral, there will be no importer of last resort to play the same role, so that the spiral will continue into depths not seen since the Depression of the 1930’s.

During that Depression demand for gold was so much that while the Dow Jones lost 95% of its value, the price of shares of Homestake gold mine increased seven-fold. Then, the price of gold was fixed; just think what would have happened to Homestake if the price was free to soar!

Inflation, strangely enough, is equally good for gold. If the US authorities should decide to address the risk of deflation through printing money at the rate promised by Federal Governor Bernanke, it is very likely that the stability of the forex market will be turned upside down to such a degree that many investors will try to escape into gold.

Good figures for the turnover in the bullion market – not paper instruments, real gold – are difficult to obtain. If annual mine production and scrap are used, there is a flow of 250 tons per month onto the market, which does not take into regard gold that have been sold forward by producers and that is delivered against these contracts and thus bypasses the market, nor any fresh gold from central bank vaults that gets leased by speculators and others and sold in the market.

250 tons are about 8 million ounces and is worth only about $2,5 billion at the ruling gold price. That is about 4% of the turnover on Wall Street in one day. So, just as an example, if US investors should decide to shift as little as one tenth of one percent of their turnover in equities – note, not what their portfolios are worth! – into physical gold, new demand for the metal will be half its monthly supply. That by itself will be more than sufficient for the price to go through the proverbial roof, and then one still has to consider demand from elsewhere in the world..

The point of this essay is that there is substantial risk ahead for the US economy and financial system. All it would take to trigger a crisis would be, say, for the bubble in the home property market to deflate, for which the probability is rather good. If, because of severe structural problems and probably a steeply declining dollar, investors attempt to flee from risk by buying gold, there is simply not enough of the metal to satisfy demand.

And the price will react accordingly.


In the Aztec language the name for gold is teocuitlatl which means "excrement of the gods."
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