By Russell Shor

There's a shortage of rough diamonds, and it's growing ever more acute – so prices are rising.

Consumer demand from India and China will drive diamond prices through the roof.

The weak U.S. dollar will also drive diamond prices through the roof.

Russell Shor Photo by Melissa Jacobs/GIA

Ultimately, the truth of these mantras depends on one thing: how much consumers will pay for a diamond – not how many are mined. We've seen prices for truly rare and beautiful pink and blue diamonds soar to more than $1 million per carat. Large (5-plus carat) colorless diamonds have experienced double-digit price increases that have started to attract speculators. Prices for more "ordinary" goods, while not going wild, have held firm despite the softening of the U.S. economy. And many say we're just at the beginning.

Now let's go back to 1981, when we heard similar talk as Wall Street firms and hedge fund managers were socking away diamonds as investments. Many diamond people, and perhaps an even greater number of investors, believed the inherent rarity and value of diamonds would insulate them from inflation.

But they forgot to tell that to jewelry-buying consumers.

Prices for diamonds soared to the point that, adjusted for inflation, a 1-ct. G-VS stone would have cost, at wholesale, the equivalent of $25,000-$30,000. Even half-carat stones were "going bananas," according to the trade magazines. Sadly, the conventional wisdom that diamond prices could only go up was still being repeated as the trade publications started to report that sales were slowing, slowing and slowing even more.

The truth proved to be much simpler than the convoluted arguments that were offered to justify continued high prices. Consumers eyed the prices and decided against putting a large chunk of their money on a little diamond. If they did buy, many traded down to the lowest possible qualities.

By 1982, the diamond trade was in the midst of its hardest crash since the Great Depression, overstocked with overpriced goods. Some of the most venerable diamond houses fell into bankruptcy, prices headed south faster than a flock of birds fleeing winter, debts soared and "memo" replaced "30 days net" as the standard trading mechanism in the U.S.

Today, consumers are both more sophisticated and more affluent, so it's unlikely we will see serious downtrading in quality. But those dealers who believe that diamond prices have nowhere to go but up fail to understand that the day may yet come when consumers decide they aren't getting good value for their money and will stop buying, regardless of their affluence.

India and China are indeed booming. Diamond demand there is growing rapidly – 14-20 percent annually. But for all the talk about these two consumer markets and the Middle East, the U.S. still represents 46 percent of world diamond jewelry sales compared to less than 10 percent for those three markets combined. So their growth would only matter if supplies were already stretched very thin.

But supplies of most polished goods are not stretched.

Those who see a rough shortage – at least in the short term – may be on firmer ground. The shortage stems from manufacturers competing for supplies, however, not retailers or diamond dealers vying for polished goods to sell.

Competition for supplies among manufacturers is intense. During the 1990s, large operators in India and Israel built colossal factories equipped with high-tech systems that permitted them to cut thousands of stones per month and get them to market quickly. (One Surat manufacturer of small diamonds, for instance, produces 250,000 carats of polished per month.) Feeding these voracious operations requires a high volume of goods.

Running out of supplies means laying off skilled workers and allowing very expensive equipment to lie fallow.

While there probably is not enough rough mined each year to supply all of these operations to capacity, there is enough to meet public demand for polished diamonds. Indeed, industry bankers maintain that there's $1.5 billion or more in polished inventory languishing in safes and awaiting buyers, which is one reason why industry debt increased nearly 20 percent last year to $13 billion.

(Large diamonds – especially those over 10 carats – are difficult to find in the market, but it's hard to tell whether the scarcity of such goods is caused by actual demand or by a coterie of dealers and speculators sitting on them in hopes of further price increases.)

In short, even if the market fundamentals were favorable enough to support the kind of price increases some are predicting, there will be a day of reckoning when the public suddenly turns away. Ask any California real estate broker about that scenario.

These observations offer a cautionary note for those who hope to see skyrocketing diamond prices: Be careful what you wish for, you just might get it.