How much is gold worth? Under normal circumstances most of us don’t dwell on how a product we pick up on a store shelf came to get its price. If we take a few moments to contemplate the raw materials, labor and transportation costs needed for that product to reach us, not to mention the retailer’s markup, it is clear that the price assigned to a given product is the result of a series of complex yet logical forces involving various actors and transactions throughout the supply chain. Is the price of gold any different?
For most, including many bullion investors, the gold price is simply the amount of dollars, pounds or other currency unit offered for an ounce of gold on the trading floor of any major stock exchange. The truth is that the forces at play that determine the price of gold are much more powerful than this simplistic formula. In order to gain a genuine understanding of what is behind the spot price we must first delve into the history of the yellow metal.
GOLD AS A MEDIUM OF EXCHANGE
The great Austrian economist Ludwig von Mises defined money as “the most marketable good.” This means that people will choose for money that which is most widely accepted by their peers. Consider a farmer with 100 bushels of corn to sell. He hauls his corn into town in order to acquire what he needs: a new pair of jeans, a full tank of gas and an HDTV. We all know that neither Levi’s, Shell nor Best Buy accepts bushels of corn for payment. Corn is not the most marketable good. Imagine the owner of the Shell station trying to pay rent, bills and employees with bushels of corn. Would all of his suppliers agree to accept corn as a payment for their services? Of course not! They might prefer apples to corn. If the farmer doesn’t have apples on his farm, how could he possibly pay the gas station attendant?
The inefficiency of the system of exchange described above, known as the barter system, gave rise to the concept of money. Gold has filled this role optimally for thousand of years. It is easy to understand why: gold is rare enough to be considered scarce, yet sufficiently abundant, divisible and easily transported so that it has been utilized as money since the dawn of civilization.
THE DAWN OF PRICE FIXING AND THE MODERN ERA
Throughout human history gold’s worth has been determined by both market and State forces. Ancient civilizations such as Greece, Rome and the Byzantine empire used gold as a currency. At any time in history, the value of the goods a determined amount of gold could acquire was determined either through voluntary exchange or State decree. It was not until the late 18th century that gold’s value became manipulated on a global scale due to the birth of the modern banking system at the hands of the Rothschild family. The industrial revolution along with increased efficiency in worldwide transportation had unified global economies like never before.
It was in 1919 that the London Bullion Market Association (LBMA) held its first official meeting with the goal of establishing a fixed gold price for traders around the world, providing a reference that would prevent volatility and facilitate world commerce. The LBMA met with its five members and declared a fixed gold price twice a day.
Today’s Spot Price
To this day, the LBMA gold price continues to be fixed twice daily, albeit with much less influence than before. Many more factors determine the gold spot price in the modern globalized economy. The role of the LBMA has been mostly usurped by the futures and commodities trading floors of the modern world, such as COMEX and the Australian, Hong Kong, Swiss and London futures exchanges. These markets trade future gold contracts, typically requiring physical delivery two to six months from the purchase date. However, it is unusual for investors to accept delivery on these contracts. They are usually sold before the end of the contract and the money netted is used for further speculation.
Supply and demand along with futures (both short and long) define the spot price of gold. Aside from the futures trading in the commodity markets, physical demand can also exert an influence on the price of gold. Most demand for physical bullion consists of the desire of private individuals, industry or organizations to acquire gold.
Jewelry plays an important role in the spot price of gold. Although not investors, the demand from jewelers can have a significant influence on the price of gold. The Indian subcontinent is a culture that historically has held gold jewelry in high regard (a tend that continues today) and is a large consumer of gold for that purpose. It is estimated that consumption of gold for jewelry is as high as 50% of the gold produced in the world, the rest being accounted for by investments (%40) and industry (10%).
For decades central banks have been net sellers of gold. The price per ounce dropped to as low as $250 at the turn of the century. However, since the crisis sparked by subprime mortgages in the United States in 2008, the monetary authorities of all governments worldwide have begun to purchase gold bullion. This has an important effect on the gold price due to simple supply and demand. It is believed that most of the gold ever mined in history is still present as supply. More than anything, it is demand that is pushing gold prices up, as central banks, hedge funds, private investors and jewelers continue demanding the precious metal. More and more private individuals are choosing gold bullion for wealth protection as the value of their 401Ks and retirements continue to decline.
The Chinese historically have never been a culture that placed much importance on the use of gold, especially after the Han dynasty, which was the last issuer of gold currency in China, almost 2000 years ago. Traditionally a country devoid of gold and silver, China relied heavily on copper and even silk for use as a currency. The small amount of gold held in China as reserves was evacuated to Taiwan during the Maoist revolution. Recently, China has been an important player in the gold market, and its central bank has been increasing its gold reserves by acquiring physical bullion on the open market. Other countries increasing their gold holdings include India, Mexico, Thailand, Korea and Russia. Most Western countries already have a substantial amount of gold in their vaults.
So, How Much is Gold Really Worth?
As described above, there are two principal forces that determine the gold spot price: physical supply and demand, and speculation through the futures markets. The spot price changes according to how many people are buying and selling bullion in the physical market, and how many people are buying and selling futures contracts at the COMEX and other futures exchanges. These two forces are constantly causing upward or downward pressure on the spot price. If everyone is selling bullion and gold contracts, the price will go down. If most are buying bullion and gold contracts, the price will go up. These are logical market forces at work.
Gold has been rising steadily since 2001, taking the spot price to $1900 per ounce. However, there are two forces a bit harder to detect working behind the scenes that could have an explosive impact on the price of gold. It is important to mention what is happening behind the scenes to understand what gold is truly worth.
Many gold contracts do not have physical bullion backing them up. The larger investment (and State) banks of the world (we will not name names here) typically sell to investors more gold contracts than what they physically have on hand, speculating that they would never be forced to honor all of their contracts at the same time (what could be described as a vault run instead of a bank run). As long as there are always buyers and sellers interested in exchanging these contracts, the banks are safe. However, with demand for gold bullion rising every day as a safe haven, the time will come when some investors will prefer that the bank deliver them physical bullion at the end of the contract. If the banks do not have enough gold on hand to pay out all the contracts, there would be an exponential explosion in the gold price. This would be akin to an overnight plunge in the gold supply, as investors worldwide realize that the banks are playing with gigantic sums of money based on small amounts of bullion. The gold contracts, in this sense, are a form of “supply” of gold.
The other force at work behind the scenes is monetary inflation. Central banks around the world continue to debase their paper currencies in order to keep their debt-laden economies on life support. One important consequence of Mises’ theory of money being the most marketable good is that whatever good is used for currency, counterfeiting that good will reduce its value due to increase in supply until people finally abandon that good when it becomes worthless (or not marketable). This is what is happening with the fiat currencies of the world. “Printing” money with a stroke of the Enter key at a central bank keyboard can only lower the value of the currency. The dollar has lost 90% of its value since 1913, and the Federal Reserve continues to pump money into the banks in a futile attempt to reactivate the economy. This is inflationary. The dollar is being counterfeited. Gold cannot be counterfeit. It is costly and time consuming to extract it from the gold mines. Its supply is relatively steady.
It is not hard to see that gold, in real terms, is worth much more than what the spot price shows today. How high gold will go is anyone’s guess. One fact that will always be valid is that gold is worth its weight in gold, whereas paper currencies are not worth even the paper they’re printed on.