GOLD IS NOT A COMMODITY

GOLD IS NOT A COMMODITY

GOLD RING

Many gold analysts fall into the trap of treating gold like a commodity. So they analyze demand and supply to try to determine what the price should be, the same way they would look at copper or lumber.

Here’s the problem with that view. There are approximately 5.5 billion ounces of gold above ground and available to buy today. Nearly all the gold ever mined has been saved somewhere by someone. Gold is not consumed. The same ounce of gold may take different forms…a coin, a ring, a gold bar…but it remains in someone’s hands because it has value.

The amount of gold produced every year is only about 1.5% of the gold already available above ground. The level of production is therefore virtually irrelevant to the price. That’s not like a commodity.

How do you do a supply-demand analysis for something that is not consumed and has a huge permanent supply that dwarfs current production? You don’t.

Every day, there is a demand for 5.5 billion ounces of gold because that is the amount that is being held. Most of it is what is called ‘reservation demand’, which means people who are happy to hold gold at the current price and do not want to sell it for dollars, or any other currency.

Ah, you say. What happens when the price goes up? Then there might be more sellers and the gold market could start to look more like a commodity market. Not so. And we can prove it with a simple thought experiment. Let’s consider ice cream cones. The first one on a hot summer’s day is pretty good. It’s worth $5 to me. The second one is a little less desirable but maybe I can be induced to buy it for $3. The third one…forget about it. Maybe tomorrow, but not today. Right now, it has no value to me. So, economists say that ice cream cones have a marginal utility of less than one. Each additional cone, at the margin as economists say, has less value.

Now consider gold coins. The second one has just as much perceived value as the first. The third one is no less desirable than the one before.

For a commodity, if the price goes up you probably want less of it. You only need so much today. Food and drink might be an exception if you are worried about running out. But for other commodities, a rising price will have you wanting less and looking for substitutes.

That’s not how it works for gold. If you have watched the gold market long enough, you have probably noticed that demand tends to rise with the price. Economists call that a giffen good, named after the economist Robert Giffen. Its marginal utility is one. That’s because the satisfaction derived from owning gold does not come from consuming it, but rather saving it.

So, gold is not a commodity. We think it’s real money. But that’s a subject for another day.

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