Do we see a gold bubble?
In times where within less than a generation humankind has seen several asset bubbles come and go (Japan’s real estate and stock market bubbles, the tiger states, the Dotcom bubble and now housing in the US, but equally e.g. in Spain and elsewhere plus one brewing in China and maybe one again in the US) and still left standing albeit on feet of clay, the recent rallies in gold obviously beg the question if we not only see another bubble, this time in gold. The argument seems to rest on the assumption that any price change with a certain gradient above “what feels right” must be unjustified.
(See more statistical material in our References section!)
To cut a long story short, CrisisMaven believes: no, there’s no gold bubble, he believes the gold “price” has natural causes that can be explained on other merits than just more irrational exuberance. For that I have already tried to lay the theoretical groundwork, albeit still in its nascent state and still to be expanded further:
As I have argued in “What’s wrong with Economics?” real bubbles (as against any kind of price hikes in general) tend to be in assets, not in commodities:
“Sometimes it’s commodities as well, however, speculation in these is different – you need to eventually sell or use them up or you lose out in the long run. So there’s maybe speculation in commodities, but real bubbles will be in assets, …
Now, paintings aside, most assets are bought for the “services” they render, e.g. as a return on investment: bonds and shares pay dividends, real estate pays rent or its equivalent in “rent saved” when owner-occupied. That is the reason they exist, to be of use as an investment with a purpose.”
Even the “tulipmania” in the Netherlands was an asset bubble – like factories or other investment goods, tulips were meant to be planted and later produce tulip plants to be harvested or gloated over, like paintings bought with bonuses. Its origin was a widening demand for tulip flowers that turned into madness and only in its later stages it developed the typical traits of any speculative asset bubble: bulbs were bought to be “flipped” like houses or the dotcom stocks. And it even came with the same pattern of moral hazard of an unwarranted bailout mechanism: “The high prices may also have been driven by expectations of a parliamentary decree that contracts could be voided for a small cost—thus lowering the risk to buyers.”
Undeniably there is such a thing as gold speculation, as much as there is always e.g. wheat, oil, copper or pork belly speculation. I’ve also already argued the obvious, man’s life is nothing but a chain of speculations, from the trivial (“if I buy her that valentine, will she kiss me?”) to the most complicated mark-to-myth models which are nothing but a means to get a testosterone-laden yuppie enough of a bonus to blow it on an even bigger valentine …
You see: you can have a glut in houses that have been built due to every beggar getting a loan with no down payment. You can have overshooting stock prices if people not only shift money from their savings accounts into stocks but then begin to borrow against them and set off a vicious cycle. Then, when a real estate bubble bursts, the houses are seen in a more sober light, everyone notices that they pay less rent than would be required to square with interest rates for equally “secure” investments which then brings their prices back in line with generally accepted and expected profitability levels in a society. And that is happening now, albeit distorted by further subsidies that push off the final day of reckoning. In stocks, everyone eventually comes to their senses and sees that price/earnings ratios are way beyond what compares with e.g. interest levels on well rated mortgages and back down those prices come. But with gold (there is an ongoing controversy where George Soros has weighed in amongst others)? No one bought it for its propensity to yield interest in the first place so it can’t be affected by any change in returns on other assets. And no one in his or her right mind should have bought money against credit so any credit squeeze or margin call would not disturb their sleep at night.
What clouds the issue here is, is that gold has two uses (apart from some direct use in dentistry and electronics that don’t count for much):
- as (a) money (substitute) and
- as raw material for jewellery.
The latter is a collector’s item, much as paintings are with which I dealt briefly in “What’s wrong with Economics?” also. Ancient gold coins are also collectors items, not assets, while modern coins such as the Krueger Rand, the silver dollar, the Canada Maple Leaf are money and usually trade for a certain but modest mark-up a large part of it is due the extra cost of minting, quality assurance, handling etc.
When you look at jewellery, that could be classed as an asset along with paintings or antique furniture but its external value (e.g. price per ounce) at the time is always much, much higher than its gold contents would warrant. In fact, as all of you might have learned to their grief when trading in their wedding ring after a successful divorce, gold in the form of jewellery is like a house that needs to make room for another: the proceeds from the sale of undeveloped land would be higher by the amount required for the obsolete building’s demolition. When bringing jewellery to the smelter you also have to deduct the overhead required for parting work plus the time elapsed (= interest foregone) between bringing the object there and receiving sterling gold back.
To carry the analogies even further: in time of need people will sometimes bring their jewellery to the smelter before they go hungry although they realise the enormous loss that entails. Equally so people have been known to use their furniture as firewood, yet in both cases, or even if they did that with their cherished paintings, it would be because they had no better options.
Here’s a litmus test or rule of thumb to decide if an item is rather (a) money (substitute) or an asset: would you rather spend (exchange) it directly for another object you desire, as you are accustomed to with money, and with money only, or would you, given the choice, rather pawn it only to be redeemed later?
Only people who do not yet know the character of money as solely a means of exchange would do otherwise: during the Great Irish Famine some counties laid on public works projects for the starving farmers through which some of them for the first time in their lives earned real banknotes they had never seen nor used before. All they knew was that these pieces of paper had tremendous value but they didn’t, strange as it may sound today where school kids have credit cards (and, may I add, again don’t seem to understand money …) know how to buy with them or how to save them by opening a bank account. So they brought them to the pawn shop! Historians have unearthed several pawn slips from the archives where these illiterate peasants had been given a fraction for their pawned twenty-pound notes only to sometimes not be able … can you believe that … pay ‘em back and have their pawn forfeited.
Oh, how much cleverer are we all today in light of a “General Theory”! And still gold puzzles us, when it’s price falls everyone proclaims the end of gold, when it rises considerably it’s a comeback to some (as if it had been in an infirmary in between booms) and to others a bubble.
Now, let’s for a moment assume , since gold can act as money, we give it a currency name, say, the “bollar” or the “mollar”. How convincing would we find talk about a “bollar bubble”, in fact, to generalise, we would coin the phrase “foreign exchange bubble”, a rather unheard of thing. Up to a minute ago I could have sworn that Google would return a complete blank for that expression, but not quite: there are 22 (twenty-two) hits for “foreign exchange bubble” (with the “exact phrase” option of course). But still, look up “housing bubble” (equally in quotes) and you get about 1,310,000 results (and counting no doubt), so that’s a ratio of 0,00169231% or almost sixty thousand as many hits for the latter, so still that’s quite some evidence one doesn’t easily dub rising exchange rates a “currency boom” even outside the realm of academe.
[For epistemological reasons let me stress right here that I tend to see economics as a logical science which, to be practical, should make predictions that are useful and can guide one's decisions, but which need to be derived through deduction rather than tests through physical proof and from mathematical "models". Therefore, strictly speaking, comparing the frequency of a term in a search engine is of course no "proof" of the real existence (or absence) of the underlying real-world phenomenon, why, some company or rock band might even call itself the "foreign exchange bubble" an I'd get a billion hits ...]
The whole argument hinges on the question if gold is a kind of money and chases goods or if goods chase money. While one can engage in foreign exchange arbitrage and call that (as any other entrepreneurial activity) speculation, but like anticipating or hedging against commodity price swings their nature is entirely different from asset bubbles.
But then why would gold rise (or other currencies relatively fall against it) but not prices in general? Don’t in these hyperinflationary times the “contrarians” always argue just that and try to make us believe those effects are “just around the corner” or are “already here”?
For that, as in prudent economics, there is also a simple explanation: people do not, I repeat myself, speculate in commodities in the same way as they speculate in assets such as shares or houses where one bids up the other and so forth.
When people are desperate to get rid of their money in inflationary times and buy tangibles “no matter what” like they recently did in Venezuela, they do not speculate in, for example, electric heaters or radios or TV sets all of a sudden. Had they planned to become radio wholesalers all of a sudden they could surely have picked a better moment. No, when inflation strikes and people go on such buying binges, they do not expect the value, the real price of their radios to go up tomorrow, all they hope (and even that is in vain!) to hold in their hand a store of value by which tomorrow they hope to still get no more than the fair value of a radio, only that the nominal value has risen due to price inflation and thus the tangible radio is the hedge against the debased paper currency. In fact, they get even less than the normal real price, because all of a sudden everyone has a spare radio he/she wants to trade which drives down the real price (as against the still increasing nominal price) of any radio for hundreds of miles around.
But if radios are, as we’ve discussed, already a bad store of value, they’re an even worse means of exchange. So when people begin to hoard appliances it is out of sheer desperation. And as with most such items they are subject to fashion trends. Yesterday’s Blackberry is tomorrow’s iPhone, so to speak.
So, when people have time and the resources and some spare (paper) money they look for a general means of exchange which will still keep its value also in times of (anticipated) price inflation (there’s no denying we already have money inflation unless we talk to people who didn’t learn their tables or, as mathematical economists, may have forgotten them) and down the ages they’ve always settled for gold.
So is gold “overpriced”, bubble theory pricked or not?
Certainly not, and that’s equally an easy rule of three: There have so far been about 161,000 tons of gold mined in the entire human history. With 6 to 8 milliards (Br.) resp. billion (Am.) people living on the earth that would mean about 20 to 25 grams or roughly one troy ounce of gold per capita. The US Fed has recently one way or another created a few trillion (Am., billion in original British English) fresh US Dollars. Let’s say, the whole world wanted to go back to a gold standard. Let’s assume, of the 161,000 tons ever mined there were about 60,000 tons available either already in central bank’s vaults or for sale on the market for that purpose. Let’s say the per capita amount of gold would be equal across all countries then with six billion people and sixty billion grams of “free” gold for money purposes and with about 300 million dollar “inhabitants”, i.e. counting not only the US population but also the people in dollarised nations such as Ecuador, Zimbabwe (back to the roots, I say) etc., then that would mean a share of 3,000,000,000 or three billion grams of gold (or 107,142,857 = 107 million ounces) for the US Fed to hold against its circulating US Dollars.
Currently the Fed has issued over two trillion US Dollars:
So to get back onto a meaningful gold standard divide 2 trillion US Dollars by 107 million troy ounces and you get (sit down) to get 18,691.5 (almost eighteenthousandandsevenhundred US Dollars per ounce). With a gold price currently (2010-01-22) currently at around 1,100 US Dollars
P.S.: CrisisMaven is no gold bug. In fact, he owns not a shred of gold with the exception of his inlays; rather he invests everything into that mass between his ears which, after all, is the only thing he sees a chance of taking across borders with him should the need arise and the exudations of which he hopes to exchange for his daily bread should some Roosevellian double-speak spin doctor once again get the idea that gold is bad for you.