Why gold is going to USD 500 an ounce.

There’s been a lot of talk recently about gold, with some gold-bugs suggesting it will reach USD 2000 a troy ounce and others predicting a return to some variation of the gold standard.  I think neither of these scenarios is likely, instead, I expect gold to be USD 500 an ounce within a couple of years.

The price of gold has been rising since the low of 250 reached between 1999 and 2001.  The rise accelerated dramatically between August 2007 and March 2008, when gold jumped from 600 to 1000.  The rise in price from 2001 to 2007 can be explained by rising standards of living and wealth in Asia, particularly India, which is the largest market for gold in the world (approximately 30% of total consumption).  The rise since August 2007 has been due to demand from financial markets, driven entirely by fear.

Demand from end-consumers for jewelry has evaporated, and may even be net negative as people mail in their gold jewelry and receive cash from the producers of late night infomercials.  The price of gold is supported entirely by financial participants who, in the grip of fear, have latched onto it as the last “safe haven”.

At some point the fear will dissipate in one of two ways.  People will become accustomed to a lower standard of living, or we’ll see some economic growth and optimism will return.  In either case, the fear driven demand for gold will evaporate, and just like oil, I expect to see a sharp, spectacular drop in price.  It may be even more vicious, since we can warm our homes and drive ours cars without gold.

There is a sub-species of gold-bug who thinks we will return to the gold standard as governments realize the error of their post-Bretton woods ways and repent.  Another group feels the masses themselves will realize they have been taken for a ride by monetarists and spontaneously switch to using gold for their money (these folks seem to have financed Ron Paul’s campaign).  

The fact is that we have had two generations come of age since the last time gold played any meaningful role as a currency.  Nobody under the age of 50 can remember the mythical perfect time when gold provided the basis for a stable currency and all was right in the world (not that such a time ever existed, during the depression plenty of people believed they’d been “crucified on a cross of gold”).  Fear makes people fall back on the familiar, and  the vast majority of the world’s population thinks of gold-bugs as Davos’s equivalent of the crazy uncle at Thanksgiving. You want to be polite, but you don’t really believe anything he’s saying, when you can understand him at all.

So, where does that leave us.  

As the global economy begins to function again, we’ll see buyers for gold ETFs, customers storing gold bullion in Swiss bank safety deposit boxes and speculators buying up gold futures slowly lose interest and the price begin to fade.  Eventually, at around 350-400 we should see buyers of gold jewelry re-enter the market.  I expect the price will eventually stabilize around 500.  The most dedicated buyer of gold jewelry, the Indian matron, is currently priced out of the market, and her savings are being deposited into banks and used to buy washing machines.