A Few Supply and Demand Fundamentals of the Dollar and Gold

Silver Stock Report

by Jason Hommel, May 6, 2002

    Argentina’s peso crisis has highlighted a seldom discussed phenomenon in supply and demand analysis. One writer pointed this out, but I read from so many sources, I forgot to remember who said the following: The supply of the peso actually shrank, but demand collapsed faster, causing massive inflation, as the peso is now worth less than 1/4 of what it used to. That’s right, money supply shrank during inflation! The politicians tried to limit peso supply by limiting bank withdrawals, but it did not work. Demand fell much faster than supply.

    When analysts typically talk about the dollar, they usually focus only on the supply side, or how fast M3 is growing, or what the interest rates are. They forget that demand is the other part of the equation because they usually speak as if dollar investment demand is a constant. True, often in the circles of gold bugs, we will read about factors that may change the demand for dollars depending on what the world does. Foreigners have a strong investment demand for the dollar which they need for various reasons such as to buy oil, or make stock purchases, or repay IMF loans, or just to hold it as it remains stronger than their own fiat money. But this dollar demand could also wane.

    The point is that we too, like Argentina, could undergo a time when dollars are in much reduced supply, and nobody wants them!

    So, keep these facts about supply/demand analysis in mind while we consider recent big news in the gold market:

    1. Demand for gold is rapidly increasing in Japan, Germany, and now India is buying again at $310/oz., all at the same time. India buying at $310 is huge news because India usually buys on the dips, and stops buying when the price rises. India also buys about 1/3 to 1/4 of the gold mined each year, so the price at which they buy is extremely significant. The fact that India is now buying gold again at these high prices was brought to my attention in an article by David Walker on May 1, 2002, which you may have already read if you read enough commentary on the gold market. There is also a supply crunch in the gold market, as production by the mines is mostly down or flat overall, and supply is down as mining companies buy back gold to close out their hedge books. Those two factors, both reduced supply and increased demand for gold alone will work together to cause gold to increase in value.

    2. Regarding the dollar price of gold, the majority consensus of politicians, businessmen, and media reports now all seem to strongly indicate that we are quickly headed for a collapse of the dollar of about 25% of its purchasing power. There were also many media reports prior to Argentina’s collapse. If only the warnings were heeded! I feel that these reports are a reliable enough indicator that we can soon expect that every dollar will soon be worth only about 75 cents internationally. This alone could push up the price of gold very swiftly to $413/oz. from $310, and this does not take into account the supply/demand factors (mostly being driven by nations that do not use dollars) which will cause the price of gold to move up on its own.

    3. With the coming dollar collapse, we could also quickly see increased investment demand for Gold from the U.S. consumer/investor. This would actually manifest itself as a reduced demand for dollars. We could end up in a situation of massive deflation (dollar destruction) as major firms continue to destroy dollar capital through bankruptcies. Meanwhile we could watch Greenspan try to “put on the brakes” of inflation and reduce the supply of dollars through rising interest rates. But investors could easily jump ship out of U.S. equities and bonds and spend their dollars on gold much faster than Greenspan could destroy the dollars, similar to what happened in Argentina.

    We are already seeing the beginning of this cycle of dollar destruction beginning to take shape. Greenspan is creating money like crazy as M3 is skyrocketing at 15-20% annually. Soon, he will have to raise interest rates to put the brakes on this money creation type of inflation. Large firms have gone bankrupt. Large firms are having their credit ratings cut as they are heavy in debt and continue to lose money in operations with no earnings. Interest rate increases will squeeze debt-laden corporations to death. Investors are now increasingly looking at gold as it is the only market that is up. Yet, we are still in the very beginnings of a gold bull market as gold funds have still not yet reported significant inflows of new capital.

    The way I see it, the mighty dam holding back the waters of dollars and other currencies is leaking, and that the waters in a tiny puddle below the dam in the gold market is rising. I believe it is a terrible mistake to look at the rapidly rising puddle in the gold market and conclude that the gold market is overvalued at this time based solely on the recent run up. Get ready for a flood of fiat currencies into gold.

    May 6, 2002

    Disclaimer: I am not a licensed investment advisor. I am not a broker. I hold substantial positions in precious metals and stocks of companies that invest in precious metals. I stand to personally benefit from any rise in the price of precious metals. I am biased against what I consider to be the fraud of fiat money. I am biased against the fraudulent practice of creating money out of nothing. I am biased against debt, particularly when money is lent at any interest rate whatsoever, a practice called usury.