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The Problem with Gold October 12, 2010

Posted by federalist in Finance.
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I’ve been a longtime critic of the fringe theory that gold is the best hedge against inflation and fiat currency risks.  Gold bugs revel in the relatively stable historical value of gold, and seek refuge in the fact that it has been a traditional store of value.  One problem I have pointed out is that its intrinsic value for industrial/practical purposes is not much higher than that of lead or copper.  Its stratospheric market value is entirely a function of (1) scarcity and (2) a speculative bubble.  I.e., it trades where it does because buyers believe that there will continue to be other buyers ready to pay these elevated prices.  If everybody decided one day that they would rather own platinum jewelry and hoard casks of single-malt whiskey as a hedge against inflation then the price and value of gold could collapse.

The other problem is that the supply of gold is not fixed.  True, the cost of mining and refining has historically been proportional to industrial capacity.  The last technological breakthrough in production came in the 19th century with the MacArthur-Forrest Process for extracting gold from low-grade ore.  But even barring another breakthrough in production the gold supply does increase with demand: The WSJ reports that the present surge in demand is leading to accelerating investment in mining.

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