I want to start a series on Gold and its long run properties because I see that gold has a unique place in the a lot of folks economic thinking. For example, Bob Murphy says

I submit that Krugman, DeLong, et al., will have a hard time really understanding the market’s embrace of gold (and silver), if they try to explain its price with a model that ignores gold’s historical role as a medium of exchange. (To his credit, the deflationist Mish has always emphasized gold’s special place as the market’s money.)

When bad news from Greece causes Treasury prices to rise, everybody accepts the commonsense explanation that, "Investors are fleeing the euro into the dollar." So why should it be such a mystery that Bernanke’s incredible dollar pumping would send worried investors into safe-haven currencies (gold and silver) that cannot be debased?

I’d like to start by suggesting that gold can be effectively debased. I don’t want to get into definitional issues and I am aware that technically debasement of gold would mean swapping out some of the gold for a less precious metal.

However, what I think people have in mind is that the world could not be suddenly flooded with gold. Yet, it could.

So we have one obvious historical example and this was the discovery of the New World. Looking at the effects of gold and silver rushing into Europe is some of the earliest evidence that “money matters” and that markets cannot be understood without appealing to money itself.

This was no debasement by an Empire in decline or other policy or technological advance that could effect real variables. It was simply the discovery of what was at the time more money.

The result was a boom and a subsequent period of rapid inflation.  In addition, bankers and others with large holdings of gold saw big losses after the New World discoveries.

Could something like this happen again? I submit to you that it could. For example roughly 5 billion ounces of gold have be mined in human history. Yet, conservative estimates suggest that at least 25 billion ounces of gold are dissolved in the world’s oceans.

At present it is highly uneconomical to attempt to extract gold from sea water. However, this may not always be the case. There are bacteria which seem to be able to collect gold from the water and form flutes. If these bacteria could be mass engineered in the lab and then seeded into the water they might form an economical way to extract gold.

I am not suggesting that this is likely anytime soon or that you should run out and invest in gold bacteria! It is simply to point out that there is no reason to think the supply of gold is roughly constant or will necessarily grow at the rate of the overall world economy.

The supply of gold could grow much slower than the world economy in which case we would expect the real price of gold to rise quickly. The supply of gold could also grow much faster than the world economy in which case we would expect the real price of gold to decline.

There are other issues which I think dominate the price of gold in the short run, but I want to first make the point that a practical debasement of gold is completely possible.

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