Posts Tagged ‘bimetallism’

The behaviour of silver and gold prices

Sunday, March 2nd, 2008

When it comes to gold, our conviction is clear (this article assumes you have read Why should you invest in gold?). But when it comes silver, the answer is not that straightforward. As we explained before in A brief history of silver and bimetallism, silver used to function as money alongside gold, albeit as a junior version of gold. Assuming that one day, gold will once again play a very important monetary role in the global financial system, will silver be reinstated as secondary money along with gold?

In the past, when silver was money, there was hardly any industrial use for it. As we said before in Properties of good money, it is due to the lack of consumable industrial and practical use that makes a commodity suitable for functioning as money. Today, there is widespread industrial use for silver- see this Wikipedia article for more information on that. In 2006, industrial usage of silver accounts for 63% of silver supply. It is expected that the industrial usefulness of silver will increase, which will, on the other hand, be offset by secularly declining usage in photography (supplanted by digital photography).

This is in stark contrast to gold. As we explained before in Is gold an investment?,

Therefore, conventional supply and demand analysis cannot be applied for gold because it is not a commodity (see Is gold a commodity?). This is because with its extremely limited industrial use, gold will not be worth that much at all. It is worth so much because its value is largely derived from outside the realm of industrial and pragmatic usage (i.e. monetary value). Similarly, how much industrial and practical value is a piece of crisp US dollar? If there is no pragmatic use for a piece of paper called the US dollar, then why is it in so much demand (e.g. drug dealers use them for transactions)? Therefore, in conventional supply and demand analysis jargon, the monetary value of gold is consigned into a conveniently labelled group called ?investment demand.?

The same could not be said for silver because currently, it has both the properties of an industrial commodity (e.g. iron, zinc, copper) and money (e.g. gold).

Since 2001, silver and gold prices have been consistently moving together at a correlation of 0.98 (0.00 means completely no correlation and 1.00 means perfect correlation). Though they tend to track each other, the ratio between them tends to vary. During the days of bimetallism (A brief history of silver and bimetallism) in the 19th century, the prices were fixed by law at a ratio of 1:15.5. During the 20th century, the ratio was at an average of around 1:47, from a low point 1:38 in 1910 and 1:101 in 1990. Currently, it is at a ratio of 1:49. There are some who analyses the trend of this ratio as an indicator of what the price of silver will be. We have not comment on that yet.

However, relative to gold prices, silver prices tend to be more volatile because of its perceived dual nature (industrial and monetary). Assuming that (1) gold and silver prices will still maintain a tight correlation, (2) gold prices (measured in terms of fiat currencies) is on a long-term up-trend (perhaps even exponentially), silver can be interpreted as a ‘leveraged’ hedge against loss of confidence against fiat money (see What should be your fundamental reason for accumulating gold?).

Now, coming back to the original question: Will silver regain its free-market status as secondary money? We have our opinions on what the future of silver should be. But please note that since there is a difference between what we think should be and what the market thinks is the case, then there will be a difference between what we think ought to happen and what will happen. This means that in the short to medium term, our ‘predictions’ will not be ‘fulfilled.’ But if we are right, then it will be ‘fulfilled’ in the long run.

We will continue on what we think the future of silver should be in our next article.

A brief history of silver and bimetallism

Wednesday, February 27th, 2008

If you have been with us for a long time, you would know that we cover gold extensively. If you have not already, we suggest that you read our guide, Why should you invest in gold?, before reading the rest of this article. The material for today’s article comes from Professor Murray Rothbard’s book, What Has Government Done to Our Money?.

Today, we will talk about gold’s troublesome sister, silver. As we quoted the late Professor Murray Rothbard in our earlier article, What about silver?,

It is very possible that the market, given free rein, might eventually establish one single metal as money. But in recent centuries, silver stubbornly remained to challenge gold.

Why did silver stubbornly remain in circulation as money? As Professor Murray Rothbard continued,

Silver remained in circulation precisely because it was convenient (for small change, for example).

As we said before in Properties of good money, a commodity has to be sufficiently rare to qualify as money. But it cannot be too rare. Silver, the less rare sister of gold, was useful for smaller transactions because gold was too rare for further smaller sub-divisions.

Hence, in the free market of the past, both gold and silver circulated side-by-side,

The relative supplies of and demands for the two metals will determine the exchange rate between the two, and this rate, like any other price, will continually fluctuate in response to these changing forces. At one time, for example, silver and gold ounces might exchange at 16:1, another time at 15:1, etc.

In that sense, we can see gold and silver as two different ‘currencies’ whose values fluctuated freely against one another according to the free market. But then, the government came in to ‘help’ the market to ‘simplify’ matters by fixing the exchange rate between gold and silver. The fixed gold-silver ratio was known as bimetallism. The next step after bimetallism was to give specific weight of gold (and silver) a national name (e.g. dollar, pound, etc). Once these national names (instead of a specific weight of gold and silver) take root, it eventually became an abstract unit of value of its own, thereby losing its original meaning in terms of a specific weight of gold and silver. Eventually, these abstract units became the national currencies of today.

Bimetallism helped the government to manipulate money. But it introduced its own set of problems. The free market’s exchange rate between gold and silver would always be freely fluctuating, depending on the supply and demand relative to each other at each instance of time. But by fixing the exchange ratio between them, it introduced the situation whereby one will always be artificially undervalued or overvalued relative to each other. When that happens, Gresham’s law will kick in (see Artificially undervalued coins: government interference cripple the free market for an explanation of Gresham’s law), which resulted in the state of affairs that Rothbard described,

Gold then disappears into cash balance, black market, or exports, when silver flows in from abroad and comes out of cash balances to become the only circulating currency in Ruritania [hypothetical country used as an example]. For centuries, all countries struggled with calamitous effects of suddenly alternating metallic currencies. First silver would flow in and gold disappear; then, as the relative market ratios changed, gold would pour in and silver disappear.

Eventually, what happened? As Rothbard continued,

Finally, after weary centuries of bimetallic disruption, governments picked one metal as the standard, generally gold. Silver was relegated to “token coin” status, for small denominations, but not at full weight.

The next question for investors is this: assuming that one day the world will return to the gold standard, will silver regain its free-market status as secondary money? We will explore more on this idea next…