Gold: Commodity or money?

How should you view gold – as a commodity or a form of money...?

"SO YOU'RE a good old-fashioned gold bug then?" asked my companion at lunch today.

"You're sold on the money argument for gold, and you won't consider it as part of the commodity market?"

"I don't know about gold bug. But gold's only real use is as a high-value asset, so why not? Okay, so gold's no longer used as a means of payment, not unless you count the huge transfers of wealth that would be needed between governments during war-time. But for private individuals, it's still a fantastic way of locking up wealth for the future.

"That's why people keep digging it out of the ground after 3,000 years. That's why Indian farmers swap the Rupees they earn for metal each week. It's not just a social convention or ancient tradition. Gold makes a great store of value."

"It hasn't stored much value over the last couple of months though. Look at the gold price! It dropped $10 an ounce on Tuesday!"

"Absolutely! Leveraged gold buyers using the futures market might wonder if gold's got any value at all! But longer-term it's still twice the price against Dollars and Sterling that it was six years ago. It's never been higher against the South African Rand or Indian Rupee. Turn that on its head, and the Rand has never been lower against gold, in fact. Pretty much all official world currency has sunk in value against gold so far this decade."

"But why choose gold as a store of value? What's so magical about it?"

"There's actually nothing magical or mystical about it. Gold is just fantastically valuable in the most basic, the most simple, economic terms. It doesn't rust or corrode or decay. Buy physical gold bullion and lock it away safely today, and it will still be there – unchanged – in ten, twenty, a hundred years time. It's also incredibly heavy, so it doesn't take up much space. And it's rare, six times rarer than platinum.

"You've been practicing this blurb, right?"

"Only once or twice. You probably shouldn't dismiss the commodity argument, though. That's all the analyst notes you have to read each day will be focused on. The difference, in their terms, comes down to how you view supply and demand in the gold market."

"You mean the physical gold market vs. futures and options?"

"Not quite, no. The futures market really IS the physical market in terms of pricing. A spike in one carries straight through to the other, because there are too many traders waiting to arbitrage one or the other for a gap to open up. The futures market trades a little higher than the spot market, because it has to account for storage and insurance costs between now and delivery. But beyond that, gold tomorrow is simply gold today, only with the risk of a promise thrown in for fun."

"Okay, so what is the difference between the commodity and money arguments, then?"

"Well the first school, the commodity school, simply looks at mining output, scrap gold from old jewelry, and central bank sales – and it measures this supply over a period of time, let's say over a year, for instance. Then it pitches that annual supply against physical demand – new demand from the jewelry business, gold leaf for micro-chips, a couple of tonnes for dentistry..."

"Plus investment demand, of course."

"Yes, but a big chunk of that is only ever 'implied' investment. Now, this is a statistical fiddle for the gold-market analysts. It lets the number-crunchers plug any gap between their data for annual supply and annual demand. Because if the physical gold supply outweighs physical demand, then the accountants say the difference must be going to investors. It's certainly not going to DisneyLand on holiday, right? And if demand outweighs supply, then there must have been DIS-investment..."

"And the story here? That physical gold supply is fixed, but Asian consumers are getting rich and buying more gold?"

"Well, one analyst says gold prices can't rise on the back of rising demand for jewelry alone, because that kind of bull market would soon eat itself. Consumers would stop buying gold as it became more expensive. Virtual Metals in London just published a report too, saying that gold jewelry might lose out to iPods and four-wheel-drive jeeps as Chinese consumers grow rich. But they can't say when this kind of substitution might kick in, and they're certainly not convinced that Asian demand will collapse anyway. On the other side of the equation, meantime, mining supply has yet to pick up despite huge growth in exploration spending."

"So fixed supply meets rising demand from where – Western investors?"

"That's what kept the gold price rising in 2005 and '06 according to the commodity argument. Investment demand soaked up the supply that jewelry consumers couldn't afford any more – or so goes the theory. But the commodity school of thought doesn't explain WHY people buy gold, either as rough jewelry in rural India or stored as investment-grade bullion in Swiss vaults.

"That's why it's missing the point to look at annual gold supply versus annual demand. True supply on that logic would be all the gold that's ever been mined, because it's still around in one form or another. Remember, gold is incredibly hard-wearing. You need cyanide to dissolve it! And most crucially, people have never let gold just vanish – it's too valuable. They might bury it in the ground, but you can guess they meant to come back and collect it."

"There's still a certain quantity of demand each year though. If it drops year-on-year, and supply is static, the price is going to fall."

"But will it? Gold isn't like crude oil or copper. It doesn't get burnt up or lost forever in electrical cabling. It doesn't really have any uses besides storing value. Its prime utility is its rarity. I mean, it's six times rarer than platinum. Silver used to be used as money, too. But it's primarily an industrial commodity today, rather than a store of wealth. Gold, on the other hand...there's 150,000 tonnes of the stuff above ground. At the right price, that supply would flood back into the spot market, just like it did when people queued up outside jewelry shops and gold dealerships to sell their gold in 1980.

"So gold doesn't get used up and that means it's not a straightforward commodity. So what?"

"This is where the money school of thought comes in. Because instead of viewing the demand for gold against annual supply, it rates the demand for gold against the demand for paper money – Dollars, Pounds, Yen, Euros..."

"The competition..."

"Yes, the competition as money. Now, what is money? Mervyn King, head of the Bank of England, put it pretty well in a speech last week in the City..."

"You were there?"

"No, I just like to keep track of his speeches. Actually, I'm waiting for him to get pelted with bread rolls...but never mind that. The value of paper money depends on trust, said King – and this guy is the UK's chief central banker, remember. People need to trust that it will hold its value. They also need trust that other people will accept it as a means of payment..."

"You accept Pounds today, though. I don't see anybody here paying the waiter in gold."

"Right again, but that only proves – like we agreed a minute ago – that gold doesn't act as a means of exchange any more. Given its price as a store of value, how could it? Whip out a gold coin to pay for lunch today – and it's really very nice of you to both pay AND listen to me go on – and we'll be washing the dishes before they let us go home. We might just get mugged once we're outside the door though..."

"I'd need, what, a quarter-ounce to settle up?"

"You order that second bottle of wine and it'll be nearer half-an-ounce I reckon. But that's inflation for you. Even against gold..."

------------------------------------------------------------------------------------------------
Thanks to Adrian Ash for the info.

Adrian Ash is head of research at BullionVault.com, the fastest growing gold bullion service online. Formerly head of editorial at Fleet Street Publications Ltd – the UK's leading publishers of investment advice for private investors – he is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.