In Gold: An Intro. to Supply & Demand Analysis, Part 1, I argued that holders of non-monetary gold (jewelry, technology, dentistry) could be seen as “warehousers” of gold…and that viewing gold in this way can explain what determines its price.
However, I also argued that the forces determining the price are not quite as simple as this model would have us believe.
Today, I want to elaborate on that point.
In order to refresh your memory, take a look at the chart of what I call “the gold monetary demand deficit”. This is the gap between the amount of gold that savers (“investors” in mainstream terminology) want to keep vs. the amount produced by gold miners each year.
At first glance, it appears that the price is going up as the gap is going down. This is what I argued is happening.
However, look at the amount of gold available for non-monetary uses in 2013-2015 compared to the amount available in 2006-2008.
To make this more clear, here is the raw data I used to make the chart:
Q1 2016: 201.9
Q2 2016: 197.3
Q3 2016: 234.6
Estimated full 2016: 845.1
In 2006 to 2008, the amount of gold available for non-monetary purposes fluctuated between 1420-1950 tonnes per year. It then fell below 1,000 tonnes from 2009-2012 before returning to this range in 2013-2015. This means that if we could explain the entire price of gold based on the monetary demand deficit, we would expect 2013-2015 to have produced prices similar to those of 2006-2008.
However, that is not at all what happened. In 2006-2008, the price was in the $450-$740 range. Whereas in 2013-2015, it was in the $1000-$1600 range. Of course, inflation also occurred during this time period, but not enough to explain that large of a price increase.
So what in the world is going on here?
In order to understand what’s happening, let’s consider what a supply and demand curve might look like for non-monetary gold (gold “jewelry and technology”).
To begin with, we know that gold jewelry demand is elastic over the short-run. When the price goes up, demand for gold jewelry falls. So we can imagine that a supply and demand chart looks something like this (please excuse my poor artistic abilities):
Notice I put “investment supply” at the top of the supply curve. It is not miners that supply gold for jewelry and technology. It is monetary gold savers that do so. The higher the price, the more savers are willing to dis-hoard monetary gold. The lower the price, the less they are willing to do so.
From the demand side, jewelry and technology buyers will buy less gold if the price is higher and more if the price is lower. So the actual price will end up being the point where monetary gold supply is equal to non-monetary gold demand.
So what happens if the stock market has a negative real yield and interest rates on long-term bonds are near or at zero, as they were in the early 2000’s?
We can imagine this would cause savers to hoard more monetary gold. This would result in less supply available for jewelry and technology at every price point:
The new price would be higher and the new quantity of non-monetary gold demanded would be lower. This is exactly what we saw throughout the 2000’s. As the price of gold got higher, jewelry and technology demand continuously fell.
This was not a shift in the demand curve for gold jewelry. It was simply a movement along the curve caused by the price increase.
But then investment demand fell in 2013-2015, increasing the supply of gold for non-monetary uses. We should have expected then that the price would go back to its previous levels after adjusting for inflation.
But instead, this happened:
This chart doesn’t express exactly what happened, because the quantity demanded didn’t increase – it simply went back to what it was before…even though the price did not fall back to its previous levels. But it should be close enough to illustrate the point that I am making.
What this proves is that non-monetary gold demand is elastic over the short-run, but inelastic over the long-run. When prices go up, jewelry buyers reduce their purchases. But only for a period of time. After a while, they get psychologically used to the idea of higher prices. In some sense they may even like higher prices because it makes them feel they are buying something valuable.
This explains why gold never falls below it’s previous value at the bottom of every cycle. In other words, it explains why gold always retains its value over the long-run.
The real question that remains is as to why jewelry demand is inelastic over the long-run. And, I can only guess that it is because gold is a finite resource that becomes depleted over the long-run.
As gold is dug up year after year, it becomes harder and harder to get it out of the ground. As a result, the price of gold must always rise…if not in terms of inflation adjusted prices, then at least in terms of the quality of goods and services that can be bought with it. And this means that its inflation adjusted price must at least stay the same over time. It can never go down over the long-run.
Otherwise, if gold was to actually fall in terms of the things that could be bought with it, or at least to trade sideways in terms of the quality of consumer goods that could be bought with it, then gold miners would be put out of business if for no other reason than that they would have to dig deeper and deeper in the ground at greater cost as the gold on the surface of the Earth got depleted…and therefore it would have become unprofitable to mine for gold long ago.
I am not suggesting that jewelry buyers today consciously think this way. I am not suggesting that they eventually cave in and buy jewelry at higher prices because they realize they have been unreasonable in expecting a finite resource to never increase in price. But there seems to be a lingering recognition in human culture of the value of gold as a scarce resource that will one day “run out”. Even modern jewelry buyers who use debit cards denominated in digital fiat currency backed by nothing seem to intuitively recognize this fact.
So, to summarize this point: in the long-run, non-monetary holders of gold are not the “warehousers” sought after in the previous article. But over the short-run, they act like they are. And if we want to predict the price of gold, we need to pay attention to what they are doing.
If gold flows into the hands of jewelry buyers, the price is going to fall. But in the long-run, it’s going to go back up anyway.
In the meantime, just enjoy the low prices while they last.
I use GoldMoney to buy my gold at half a percent over spot.