Silver as a "giffen good": Setup could mean even more explosive upside

Is silver a Giffen good?

It appears to be behaving like one.

A Giffen good, named after Scottish statistician and economist Sir Robert Giffen who developed the theory, is an “inferior good” whose demand rises as its price increases (holding income and other prices stable), defying the typical laws of supply and demand.

If silver behaves as a Giffen good... it means its upmove could be even more explosive.

Let me explain...

First, you might balk at the notion that silver is inferior to gold, but I am using an economic definition, not a subjective description.

A good is considered economically “inferior” when demand for it generally falls as incomes rise. Think of meat and potatoes. Potatoes are “inferior” because, as income rises, a household will typically consume more meat and fewer potatoes.

Conversely, when a household faces economic stress, it will typically try to substitute cheaper goods for more expensive ones. Potato consumption increases, and the amount of meat consumed falls (the substitution effect).

In a Giffen setup, the income effect (the way changes in purchasing power alter demand) is stronger than the substitution effect (as the product gets relatively expensive, people buy less of that product).

The potato behaved as a Giffen good during the Irish famine. As prices rose, the Irish people effectively became poorer. This made it impossible for them to purchase more expensive meat. To cope, they had to buy even more potatoes, even as the price was rising, because it was still the least expensive way to get calories. Therefore, demand for potatoes skyrocketed even as the price climbed.

Silver as a giffen good

As the price of silver has gone up, investment demand has increased sharply.

Is there a Giffen mechanism at play?

I can make the case.

While they might prefer to buy gold, silver is the go-to precious metal for many poor and middle-income investors because it is much less expensive than gold.

You can think of gold as the "meat" precious metal and silver as the "potato."

If an investor has a fixed monthly amount available to invest. He would prefer gold as the “superior” investment. However, silver is less expensive and more “practical.” As a result, the bulk of his investment is in silver even though he’d prefer gold.

That’s not to say he spurns gold altogether. He may occasionally buy a small gold coin when the price dips, much like a poor Irish family occasionally eats meat even though potatoes dominate the diet. He might also trade silver for gold when he’s stacked enough silver to make the transaction viable. In other words, gold is the “upgrade.”

When silver becomes more expensive compared to gold, the dynamics change.

As the prices of both metals rise, our investors' overall purchasing power falls. His fixed investment budget buys fewer total ounces. In response, the investor will cut back first on the “luxury” item, buying even less gold. However, to get enough metal exposure, our investor will have to shift even more of his investment budget to silver despite the rising prices.

If the income effect is strong enough, the result will be growing silver demand in ounces even though the relative price keeps increasing compared to gold.

A real-world example

This dynamic already seems to be playing out in India at this very moment.

Typically, Indian investors prefer gold. But as the price of gold scaled record highs in October, many poor Indians found themselves priced out of the market. To continue to protect their wealth, they turned to silver.

This sharp increase in silver demand was one of the dynamics that drove the recent silver squeeze in London and pushed the silver price over $50 an ounce for the first time ever.

The higher silver prices have been going, the more they seem to chase it.

When you combine the Giffen effect with the silver supply and demand dynamics, you have truly explosive upside price potential.

As we've reported, silver supply is already strained.

According to Metals Focus, silver is on track for its fifth straight structural market deficit. 

Metals Focus projects demand will outstrip supply by 95 million ounces this year. That would bring the cumulative 5-year market deficit to 820 million ounces, an entire year of average mine output.

Since 2010, the silver market has accumulated a supply deficit of over 580 million ounces. 

Even with higher prices, it is unlikely that mine supply will quickly grow to erase the supply shortfall.

Silver mine output peaked in 2016 at 900 million ounces. Up until last year, silver production had dropped by an average of 1.4 percent each year. In 2023, mines produced 814 million ounces of silver.

It appears that for the next few years at least, we will have to depend on drawdowns of above-ground stocks to meet the silver supply deficit.

Rising prices will likely create headwinds for industrial demand; however, substituting silver in electronics applications isn’t easy given the metal’s superior characteristics. Metals Focus projects just a modest 2 percent drop in industrial offtake this year. This will be offset by skyrocketing investment demand.

When you combine inelastic supply and inelastic demand with surges in both industrial and investment interest, PLUS the Giffen effect, you end up with an extremely bullish setup.