-- Posted 8 October, 2011 | | Discuss This Article - Comments:

Having just read another article by an able job-smithing hack in The National newspaper purporting to explain the gold and silver market to readers my toes curled up at the lack of understanding about the most crucial factor that investors in these precious metals need to grasp.

It’s the money supply stupid! The focus is always on demand for gold jewelry or the industrial uses of silver. But really the rising price of gold and silvet is all about money and the devaluation of paper money against the one money that nobody has ever succeeded in manufacturing.

Rare metals

The alchemists of old tried very hard but they never succeeded. All the gold we have has been dug out of the ground by man over the past several thousand years, and we do still have most of it but not very much. All the gold in the world would fit into a cube less than the size of a tennis court.

Silver is actually more rare because it does get used up in many industrial processes, particularly these days in electronics and medicine. The estimate is that all the silver in the world is roughly one hundredth of the value of gold or in volume terms roughly half.

Scarcity does not of itself confirm value but it does when you are dealing with the only two monetary metals. Silver and gold have been used as money at least since the pharoahs built the pyramids. The US has its gold and silver reserves stashed in Fort Knox. Indian ladies are reckoned to have a similar amount in their personal possession as jewelery.

Central banks of the world include gold and silver in their reserves and have recently been net buyers of gold. It is the ultimate money with no third party risk.

Now let us consider what global central banks have been doing to the money supply, especially in the past decade. There has been an orgy of money creation.

Last week the Bank of England did it again with $110 billion more in quantitative easing. The upcoming eurozone bailout may well involve a fund that can create $2.7 trillion. And to bail the world out after the 2008 crisis the Federal Reserve created $16 trillion and that is an audited fact.

Increase the money supply and you automatically reduce the value of money. Does that make sense? Basically you have more paper and the same number of goods so they cost more in paper. That is textbook inflation, too much money pursuing too few goods.

Gold supply static

What happens to the supply of gold and silver at the same time? Well, apart from a bit of mining activity the supply is pretty static and nobody can change that. So you have more money pursuing the same amount of gold and silver and the price goes up.

Ah, but let us not forget that as money is created more and more investors seek protection against this devaluation of their savings. So actually you have more and more buyers for gold and silver, and that will push the price up way beyond the actual rate of inflation.

It is true this upward movement in price for precious metals is seldom a straight line. Sometimes the market enthusiasm overreaches itself and prices dip back, like silver in April or gold last month. Would a global asset sell-off like the one in late 2008 pull gold and silver prices down for a while? Yes but not for long as central banks will fear deflation and print even more money.

ArabianMoney has been saying this for over three years and has been right (click here). We also commented when silver fell below $10 in late 2008 and said it was a great buy when everybody else ran scared.

Unless there is a signal that central banks are moving to seriously reduce the money supply then there is only one way for precious metal prices to move over the medium term and that is up and up. It’s the money supply stupid!