Something strange is going on in the gold and silver markets. The higher the price goes, the more demand has increased. I've asked my colleague Tom Cullis to weigh in on this phenomenon. His response below is somewhat long, but it's a great read for people who are interested in what's driving gold and silver prices right now. In any event, it will give you yet another unique perspective into the precious metals markets.

Tom writes:

Imagine a poor family that gets half of its calories from bread and half of its calories from meat. This family would spend several times more money on meat than on bread simply because calories from bread are much cheaper than calories from meat, let's just say that this ratio is 3:1. On a $100 budget this family will spend $75 on meat and $25 on bread. If the price of bread doubles the family will have to spend $50 on bread to get the same number of calories which means they will have only $50 to spend on meat. If they attempt to do this the family will only get 5/6ths the amount of calories that they used to from $100 budget and there is only one way to combat this price rise. The family now has to spend all $100 on bread to get the same number of calories, and as such they are now buying twice as much bread due to the price increase.

The above is the classic example of a Giffen good. Under normal economic circumstances when the price of a good rises then less of that good is consumed, but under our very specific example the price increase of bread leads to more bread being eaten. Wikipedia kindly lays out the conditions that must be met for a good to be considered a Giffen good.

1.the good in question must be an inferior good

2.there must be a lack of close substitute goods, and

3.the good must constitute a substantial percentage of the buyer's income, but not such a substantial percentage of the buyer's income that none of the associated normal goods are consumed.

Examples of Giffen goods are rare for a variety of reasons but the primary reason is that the price increase cannot stem from a supply decrease. Gerald Dwyer and Cotton Lindsay pointed out in 1984 that though the potato rose in price and forced many families to eat more potatoes in place of more expensive foods it is ridiculous to assert that more potatoes could possibly have been eaten when it is well established that the blight caused many fewer potatoes to be produced. The reality of the situation was that the famine caused a great reduction in the number of people eating potatoes due to death and emigration and that the total tonnage of potatoes dropped precipitously.

Gold and Silver might be entering the realm of Giffen goods in their relation to money as I type this. Let us examine the definition and then some evidence.

1. The good in question must be an inferior good

You won't here many who believe in investing in gold and silver calling it inferior to US dollars, but the definition of an inferior good in this context is one where demand of a good decreases when income rises. In our example above bread would be an inferior good as it can be assumed that a family with such a budget would buy less bread and more other foods if their food budget were to double to $200.

A strong case can be made for gold acting as an inferior good in the US, and in fact the world, over the past 80 years. In the decades since the Great Depression the amount of individual wealth that has been held in the form of gold has not kept pace with the amount of wealth in general. Until the financial crisis household wealth in the form of stocks, bonds and home equity were at all time highs not just in nominal value, but in percentage of a person's total wealth. It's true that the illegalization of gold ownership, the rise and fall of the Bretton Woods agreement and tax policy have all contributed to keeping both gold holdings and prices down. But all that matters for this portion of the analysis is that gold has acted as an inferior good over a substantial portion of this time period.

2. There must be a lack of close substitute goods

Gold clearly fits this mold. The uniqueness of gold and its role as a monetary metal and a backing for government bills is so well documented that it is unnecessary to rehash them here. Suffice to say no other metal in history has acted the way that gold has. The case for silver is less strong, but not so much that it is disqualified from the discussion.

3. The good must constitute a substantial percentage of the buyer's income, but not such a substantial percentage of the buyer's income that none of the associated normal goods are consumed.

There are certainly large numbers of people who acquire no gold, but for those that do, and especially for those that did prior to the '08 crisis, this portion of the definition is satisfied.

Simply satisfying the prerequisites for becoming a Giffen good hardly qualifies for membership in this club. We need evidence of demand increasing in tandem with price increases. Adrian Douglas provides some evidence for this in a recent article entitled "Strong Indications of Gold & Silver Shortages" in which he analyzes the open interest against silver and gold prices (ie short positions) against the price of gold and silver. His conclusion for silver:

"The exciting revelation comes from ellipse #5 which is shown in red. This encompasses the open interest versus price data since silver went above $22/oz. The long axis of this ellipse is downward dipping. This means that as the price increases the open interest contracts! This means that in general existing shorts are covering their positions as the price rises. This is indicative of a looming chronic shortage."

And for gold

"The clear trend in the data clusters that has developed over the last ten years indicates that the gold open interest will soon be declining with a rising price as is the case for silver. Taken together the data shows that in both gold and silver there is a growing reluctance of the traditional short sellers to meet rising demand even at elevated prices."

If he is correct then gold is on the verge of acting as a Giffen good if it isn't already. The case for silver is stronger in the price action but does not automatically fulfill the earlier supposition- that the price increase cannot be the result of a shortage. Gold has no chance of this as virtually all the gold ever mined is still available for use as it has only a few industrial uses, and the volumes used are quite small. Should it be demonstrated that silver's apparent supply shortage is not due to an actual shortage but to an increase in demand that would be extremely bullish for silver as well.

So far we have looked only at whether or not gold and silver could be Giffen goods and we have not explored the implications if they do become so. The largest implication of a Giffen good is that their prices have a tendency to spiral upwards. Under normal conditions an increase in price leads to lower demand which acts as a dampener on the original cause of price increases. When oil shot to $150 a barrel many people cut the amount that they drove and new vehicles were produced with more efficient engines. Among other things these developments helped to bring oil's price down, but imagine what would have happened if $150 oil had caused everyone to buy a Hummer and drive across the country? Oil's price wouldn't have dampened- it would have exploded.

Kevin here.

So we have the Giffen good ingredients. But what's the real motivating force behind this trend? People are beginning to recognize that gold and silver are, indeed, money. That explains the move out of dollars (a poor money with lots of good substitutes) and into precious metals. We can see how this cycle can be self-perpetuating. The more people who begin to realize that the dollar is a poor substitute for gold, the more people who will be piling more of their capital into precious metals.

In Tom's original example, he talks about the family that spends more and more money on bread, and as a result, they eat more and more bread. Right now, the dollar is the meat and precious metals are the bread. Dollars are more expensive, because they're constantly being devalued. Dollars don't do a good a job as a money as gold in satisfying our family's money needs. So the more expensive gold and silver get, the more likely we are to eschew the dollar, and pile into gold and silver.

Good investing,

Kevin McElroy
Editor
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