Built on Facts

This is a little off the beaten path, but it’s a silly little diversion with some classic “the press lacks numeracy skills” complaints as a bonus. Thomas Frank writing in the Wall Street Journal has written a rather wild piece – One Cross of Gold, Coming Up: How the government could get even with right-wing cranks.

It’s mainly in a Modest Proposal sort of vein; I don’t expect he’s even a little serious. Still, fun to take a look at. His proposal runs more or less as follows:

1. All those right wing cranks are hoarding stashes of gold.
2. The federal government has lots of gold in Fort Knox.
3. Sell it all on the open market, reducing the deficit, cratering the price of gold, and wiping out the finances of the right.
4. Cackle maniacally in the manner of Sesame Street’s Count von Count!

As it is satirical in nature, I’m not giving the Journal a hard time for publishing something so reminiscent of Dr. Evil. I am going to give them a hard time for not thinking about the math of the situation. If they had, they’d see two gaping holes in the plan, either one of which alone would in reality end the plan with an empty Fort Knox and an entirely undamaged group of right wing gold bugs.

1. The Theoretical Problem: To flood a commodities market, you need a flood of that commodity. According to Mr. Frank, Fort Knox contains 261 million troy ounces of Gold. According to The Economist, world production of gold is around 2.4 billion troy ounces per year. In short, the liquidation of the entirety of Fort Knox would be the equivalent to adding a little over a month’s worth of natural mine production. Since essentially all the gold that has ever been mined is still in circulation, such an action simply wouldn’t necessarily dent the price very much. It would be analogous to the occasional pre-election releases of oil from the Strategic Petroleum Reserves. It produces a limited and temporary price drop, but the extra supply is so small as to not make much difference. On the other hand investors could take it as a sign of governmental instability and drive up the price of gold.

[UPDATE: Hubris, meet Nemesis. I have myself made a serious mistake! World gold production is actually only 75 million troy ounces a year. On the other hand, Fort Knox only holds about 147 million troy ounces, as not all the US gold is stored there. As such it represents a little under two years worth of world production. A sudden release probably would dent prices significantly, though only on a temporary basis since central banks would immediately seize on the opportunity to buy a valuable commodity at a discount during a period of otherwise uncertain economic times. Ditto other large exchange-traded funds and industrial users. Thus Point 1 is likely still valid over the mid to long term, but over the short term the government could flood the market if it wanted. Point 2 still stands unaffected.

UPDATED UPDATE: There's some discussion in the comments indicating that in fact my original point is still likely to be correct even with the updated information on the yearly mine rate. Either way, the overall point about the overall lack of effect stands, but it may in fact still stand even in the short term, which my update cast doubt on.]

2. The Observational Problem: Individual investors in the US – right wing or otherwise – don’t actually buy much gold. Frank seems to believe right-wing paranoia has driven up the price, but that’s just bananas. The entire US only consumes a fraction of the world gold supply. Much the gold that is sold in the US goes straight to jewelery manufacturers and industrial users. The fraction that is purchased as an investment generally circulates among central banks, exchange-traded funds, and other large interests – not your average investor with a gold eagle coin or two. Their impact is certainly much smaller than the massive purchases of the central banks of China and India. Conversely, there’s very little evidence that anyone, right or left, is actually investing any meaningful percentage of their assets in precious metals. No massive 401(k) exchanges for pretty metal, no sudden demand for safes, no sudden surge of reporting in the somewhat arcane IRS tax disclosures that commodities sellers must follow. Further, the dinky gold-selling outfits that advertise on Glenn Beck and the like are explicitly geared toward small transactions. If it were anything other than a niche within a niche within a niche, large-scale exchange-traded gold funds would be looking for customers in those markets as well. They ain’t.

Either one of those two problems renders Frank’s plan unworkable. Still, it’s a cute little thought exercise. I do, on the other hand, wish an explicitly Wall Street publication had put a little more number crunching into it.

Comments

#1 Russell
January 21, 2010

It’s hard to take the WSJ seriously any more.
#2 MattXIV
January 21, 2010

You have to realize that the most likely reason the WSJ hired Frank to write for their editoral page is they wanted someone to make liberals look stupid. The project appears to have been a success.

Bonus innumeracy: Use of the nominal dollar value of gold for historical comparisons of it’s worth.
#3 Eric Lund
January 21, 2010

Frank seems to believe right-wing paranoia has driven up the price, but that’s just bananas.

I agree here: Frank is conflating correlation with causation. I’ve been lurking lately on a site which has a few right-wing paranoid gold bugs among the commentariat, and I’m sure they would agree too. ISTM that the factors driving their paranoia overlap significantly with the factors driving up the price of gold, such as a fear of hyperinflation to get out from under our national debt (this one has some rational basis to it) or that the government will break down and people will need something tradable (we’re wandering into tinfoil hat territory here).

Back here in the real world, mere retail investors like us have somewhere between negligible and zero influence on the value of anything traded on Wall Street. It’s mostly a guessing game based on recent past experience (at best), played by a few dozen big financial firms, and the rest of us who invest are along for the ride. The list of private individuals (excluding C-suite executives–that rules out Warren Buffet, who is head of Berkshire Hathaway) I can think of who could cause even detectable perturbations consists of (1) Bill Gates, (2) um….
#4 Matt Springer
January 21, 2010

In a true tinfoil hat Mad Max scenario I’m not sure gold would be such a useful thing anyway. It’s hard to assay its purity or weight accurately, and even with all the current conveniences of modern civilization there’s associated large transaction costs for small trades. It’s just unmanageable – imagine how difficult it would be to do everyday purchases in gold right now; a Big Mac would cost about 80 milligrams. Transactions that small just can’t happen without HUGE transaction costs, so you’ll lose your shirt. The gold might be good for retaining value after the crisis, but not so much during.

Those who’re really worried about collapse ought to invest in a huge pile of canned goods. But I guess that doesn’t have the same je ne sais quoi.
#5 Art
January 21, 2010

“I’m not a member of any organized political party, I’m a Democrat.” – Will Rogers.

It explains a lot.
#6 Moopheus
January 21, 2010

“imagine how difficult it would be to do everyday purchases in gold right now; a Big Mac would cost about 80 milligrams.”

Well, sure, but that’s always been true. That’s why, in Ye Olde metal money days, most ordinary daily transactions were carried out with copper or silver. If you really want some post-collapse spending money, you should be stocking up on vintage copper and silver coins. I mean, if the financial system as we know it collapses, and we are reduced to using metal money again, there aren’t going to be any Big Macs to buy, anyway.

Sure, the effect of central bank dumping would be temporary, but it’s happened in the past–England in the 80s and Russia in the 90s. Helped depress the price of gold for years.
#7 Carl Brannen
January 21, 2010

Gold is actually quite rare.

The total amount of gold mined per year recently is under 80 million troy ounces, according to the graphs at the bottom of the link you gave. I don’t know where the larger figure comes from because I don’t know what the unit “mt” means. Maybe it means “metric tons”. Certainly it doesn’t mean “millions of troy ounces”.

In fact, the total amount of gold that has ever been mined comes to around 1/4 ounce per person alive today. It would be a cube about 50 or 60 feet on a side, if I recall correctly.
#8 Carl Brannen
January 21, 2010

I should add that nevertheless, it is my guess that dumping 240 million troy ounces (3 years world production) on the market would not substantially modify the price of gold (i.e. get it much below $1000 per troy ounce). The reason is that most of the gold ever produced is still held as bullion. The amount in storage is quite vast. If it dropped significantly with a one-time sale, everyone would snap it up. I would expect the Chinese and others to leap at the opportunity to trade dollars for gold.

For example, see “Total inflows into gold ETFs rose by 46 tonnes and 459 tonnes in the second and first quarters respectively, taking the total gold held in funds to 1,694 tonnes worth US$50.8 billion.”
http://uaeinteract.com/docs/Four-fold_Increase_in_Dubai_Gold_Securities_6-month_volume/37758.htm
#9 Paul Murray
January 21, 2010

They orta mint coins out of (say) plexiglass that have a miligram of gold in em that’s spread into a thin layer on which a hologram is printed. Oh – and there should be a serial number “this coin, serial # whatever, is one miligram of gold, in God we trust, 128 random bits” signed with a cryptographic certificate.
#10 Moopheus
January 21, 2010

But commodity markets don’t care that much about how much of a thing exists, they only care about how much is available for sale, and how many people want to buy. Now, if the price goes high enough, some of the stuff in storage might get dropped on the market. Enough to disrupt the market? Hard to say–though of course, that’s what happened to the Hunt brothers.
#11 Matt Springer
January 22, 2010

Err, I think I have egg on my face per Carl Brannen. “mt” probably is metric tons. In this case Fort Knox (which actually holds only part of the US gold reserve, about 147 million troy ounces) represents a little under two years worth of mine production. Immediate liquidation probably would dent prices pretty solidly in that case, at least temporarily. It almost certainly wouldn’t last long – the various central banks of the world would buy it up so fast it would make your head spin.

Thus my point 1 is somewhat damaged but probably still mostly valid, and point 2 is unchanged.
#12 Rogue Medic
January 22, 2010

One thing that might lead to an accelerating drop in gold prices is the amount held in ETFs. They are required to buy and sell to meet demand. If the price of gold drops and holders of these ETFs start to sell, that would force the ETFs to sell gold to cover redemptions.

Of course, if the ETF market is made up of people able to recognize a bargain, that might temper the drop in prices, but I would not anticipate such restraint in the face of falling prices.
#13 Eric Lund
January 22, 2010

If the price of gold drops and holders of these ETFs start to sell, that would force the ETFs to sell gold to cover redemptions.

The paranoid gold bugs I referred to upthread disdain precious metal ETFs for exactly this reason. They fear that the ETFs don’t actually have the physical gold to sell. I’ve never read the prospectuses myself (I neither own nor am interested in acquiring any of these investment products), so I don’t know how well-founded this fear is. But anybody who buys gold on margin (a foolish thing to do unless you think the price is going to spike) would be wiped out in this scenario.
#14 cb
January 22, 2010

The post author may know a lot about physics, but his knowledge of economics is lacking.

Prices are set at the margins, not in the whole. The price of gold is a function of the balance of supply and demand, and dumping 261 million troy ounces of gold onto the market at once, regardless of how much annual production that amount represents, has the potential to dramatically change the supply & demand balance and thus the price.

The appropriate comparison is the Fort Knox inventory to the quantity of gold bought/sold in the spot/cash market at a given time, not to the annual production or cumulative historical production.
#15 Matt Springer
January 22, 2010

I think you’re overlooking a few things, CB. The prices are set at the margins, but the math that sets them is the math of supply and demand. Supply is strongly a function of the rate at which mines introduce gold to the market, so the relative magnitude of any dumping to that rate is a key factor. The cumulative supply of gold already mined is as you say not automatically part of that supply, but by the same supply/demand logic it will have a moderating effect on prices that (say) oil doesn’t have because it’s destroyed by use at essentially the same rate it’s pumped.

But as per my correction you are right that the effect would be substantial at least over the roughly 1-2 year range.
#16 Carl Brannen
January 22, 2010

No, in the case of gold, supply is not at all dependent on the rate at which mines make the stuff. Instead, each year mines increase the supply by something around 1 to 3%, if I recall correctly.

And so the US suddenly dumping 3 years’ mine production would only increase the supply of gold by 3 to 9% which is not enough to change the price significantly.

Gold is very different from other commodities, for example oil. If you suddenly dump an extra 9% oil into the market the price will crash for a bunch of reasons that do not apply to gold. (1) Oil is very expensive to store but you can bury gold in your backyard. (2) Oil takes up a lot of space, but all the gold mankind has ever minted would fit into two Olympic size swimming pools. (3) Oil has limited demand, but the demand for gold is limited only by its price.

As a “commodity” gold is used as a “store of value”. As such, increases or decreases in the supply of gold can be replaced by increases or decreases in other stores of value. The primary alternative store of value worldwide right now is the US dollar. The total amount of US dollars (M2) in existence is about $8500 billion as of the end of last year (according to the Federal Reserve).

The total amount of gold that has ever been mined is about 5 billion ounces which is worth around $5000 billion dollars. Most of that gold is still in the supply. For example, if the price of gold went high enough, everyone would melt down their gold jewelry, or alternatively, such jewelry would acquire a melt value and be owned as a store of value rather than artistry.

Selling $300 million worth of gold into a supply that is currently worth around $5000 billion is not going to significantly change the price.

A similar situation would be if the Federal Reserve suddenly put $500 million worth of US dollars into the market. Since the market is around $8000 billion, it would absorb it without huge changes to the value of the US dollar.
#17 Moopheus
January 22, 2010

According to the World Gold Council, total global demand is around 3500 tons a year. The US is holding around 8000 tons. If that got dumped onto the market all at once, it would definitely have an effect on the price. And that’s in addition to the normal supply from mining and scrap. I’m surprised none of you wizzes saw the real flaw in the plan–if you succeed in suppressing the price of gold, then you don’t get a very good price for the gold you sell, so it’s not going to make a big contribution to the bottom line. So the payoff for the guv is not that great. You can’t both disrupt the market and make a big profit.

According to the WGC numbers “bars and coins for retail investment” is actually a bigger component of consumption than ETFs, except for about a year ago, when ETFs were buying like mad in the panic. Would ETFs and other investors sell off if the price dropped substantially? I don’t know. Personally, I don’t really care. You certainly can’t expect goldbugs to be rational when it comes to their preciousss. Might be a break for jewelry, though–lower retail prices would help sales.

A better comparison than oil would be houses, which are durable, and exist in large quantity relative to the number sold, and yet if the number of houses for sale doubles, the market goes into a tailspin.
#18 TheDude
January 23, 2010

In 2009 the IMF put 400 metric tons of gold up for sale. http://www.imf.org/External/NP/EXR/faq/goldfaqs.htm . India purchased half of it Nov 2009. It didn’t seem to put much of a dent in the price.
#19 TheDude
January 23, 2010

The other thing to consider is that right wing gold buggery might be a distinctly American phenomenon. Gold is a global market and I’m not sure that, for example, the asians buying gold are wingnuts fashioned in the likes of Alex Jones. What seems more likely to me is that financial uncertainty and low central bank interest rates are driving the price rather than simply ideology. In which case the wingnuts Thomas Frank wishes to target may not make up a very sizable proportion of those who hold gold internationally. (Although admittedly the wingnuts may be more likely to allocate foolishly large percentages of their wealth in this one asset.)
#20 Matt Springer
January 23, 2010

Just for clarity the cb to whom I was referring above is not (I think!) Carl Brannen. In fact if Carl’s right (and he usually is), my original point 1 was actually more correct than my updated one. Which I’m fine with!
#21 Carl Brannen
January 24, 2010

The difference between gold and a house are: (a) You have to pay taxes to own a house. (b) Vacant houses get vandalized. (c) Houses are not fungible, that is, every house is different, gold is all the same. (d) You can’t carry a house around, much less carry it out of the country in your bags. (e) Houses burn down, gold is forever.

So no, houses, like oil, are not a commodity useful as a store of value.
#22 CCPhysicist
January 24, 2010

Sorry, but I actually knew personally a right wing gold hoarder, and he didn’t own just a few coins. However, he was also unconcerned with the current market, so the investment point is totally moot. Why he believed that someone would trade food for a piece of metal is another question entirely.
#23 Lyle
January 24, 2010

To answer #22 this was true for over 3000 years so unless you have strong evidence to suggest a change that applies to all circumstances it make sense to assume a continuation of the trend.

As noted gold is to valuable to use for day to day purchase, which is why up to the middle of the 19th century silver was the money base (pound sterling was at one time a pound of sterling silver). In the early 19th century silver was 1/15 of the price of gold, then the western us found the Comstock lode, the price went to 16 and the US moved from silver to gold. Then add Silverton, Co, and the Kellog area in ID and silver is now at 1/64 the price of gold. As noted old silver dollars and the like are a good emergency hedge, as well as old quarters. So I think its clear that silver is a better hedge than gold.