Monday, February 23, 2009

Is There a Speculative Bubble in Gold?

The price of gold topped $1,000 per ounce this past Friday, only the second time it has done that, the last being last March for a few days. Yes, I think there is a bubble, but some other observers disagree (Patrick Heller: "Gold Reaches $1,000 Again: This Time It's Different"). Heller claims that "this is different" (from last March), with "prudent buyers" still buying, and various "mainstream pension funds" getting into the act, with him forecasting a major "shortage" of gold coins and loose jewelry later this spring. He suggests we will not see a price below $1,000 again any time soon.


Quite aside from my vague sense from people coming up to me randomly with this sort of frenzied tone when asking me about gold (always a bad sign), there are some aspects of this that do not smell right. Sure, I would not be surprised if the price rises some more. This bubble could bubble away for some time more, even some months. But usually the drive to gold is a flight from currency based on fears of inflation. Now, maybe there are people fearing hyperinflation from the fiscal stimulus, but a lot of forward swap markets still show expectations of deflation. Jim Hamilton at econbrowser is all pleased that there was a slightly positive increase in the US CPI in January, but is still hoping for much more inflation (his favored target is a 3% rate), and the price of oil has only gone down since then.

Of course, a deeper possibility here is probably a fear of just total collapse of everything, call it fleeing from nameless black swans that may be flying towards us. The same sort of thing probably explains the newly recent highs we are seeing on the US dollar, this absurd "flight to quality" to the dollar, when it is facing massive foreign imbalances and indebtedness, rather like what happened in mid-September when we briefly saw negative nominal interest rates. However, the most likely Awful Event still does not look like the sort of hyperinflation that feeds the gold bugs's mania, but a deep decline into deep depression, which would mean deflation. This would mean a collapse of the price of gold. Sure looks like a speculative bubble to me.

12 comments:

TheTrucker said...

The bet on gold is that more stimulus will be needed and inflation is the only cure for what ails the housing market and all the rest.

Essentially, all paper money must lose value vis a vis land (real estate). The retreat to gold makes sense in that light. The holders of long term bonds will take a major hit as will the holders of paper money in general. The owners of land and other "means of production" demand to be made whole. Unfortunately for all of us the holders of money and land are the same people. Bailing out the banks just makes the rich people richer without causing any inflation.

The bet on gold is that people are beginning to understand that inflation is the only way out of the trap for the producing sector of the society.

cian said...

The problem I've always had with gold is that most of its value is based upon a sentiment. Its not a terribly useful metal, and there's more than enough to meet demand for electronics/jewelry, etc. Its valuable because people think its valuable, which seems like the ideal bubble commodity.

The other problem I've had with gold is that it really does attract the cranks...

wellbasically said...

Speaking of....

Hello again!!! Been looking for a chance to jump in.

The history of gold in politics is an interesting one and shows us how monetary manipulation is attempted to get around thorny political problems. During Bretton Woods, with Keynesian theory in full flower, gold was the bad guy. Keynesian planners would attempt to inflate the currency to achieve growth that they couldn't get fiscally through political votes. But every time they did it, and plowed money out into the economy, banks and foreign central banks would show up and use the extra money to buy US gold reserves. This caused an outcry.

So gold provided an automatic measure of when the Treasury was trying to inflate. To get around this pressure mounted to get the US dollar delinked from gold which happened in 1973.

To a strict gold-watcher however, the gold standard still operates, and is still the best measure of inflation and deflation. Monetary policy continued to be the method for planners to attempt schemes outside of raising or lowering taxes, or improving the efficient use of capital to bring about higher wages.

What gold was pre-Bretton Woods the derivative became in 1973 -- a method for the lender or borrower to hedge on the actions of the government (now the Federal Reserve Board) which would alter the currency for the sake of political goals.

With the floating dollar, the old Keynesian ideas of inflation from growth, and deflation from ungrowth are turned on their heads. During a period of growth, the central bank will always have to print money for an expanding money supply. Without gold this happens according to the judgement of the Federal Reserve Board. If there is a contraction, the Fed may not observe it, or may not want to see it, and so continues "printing" money. That is when your gold price will rise even during a contraction, so that's what you're seeing now. This is the simplest explanation for "slugflation" and "stagflation".

rosserjb@jmu.edu said...

Trucker,

Well, last year when gold hit a thousand (and Heller says it was all these naive new buyers doing it, signaling a later decline, unlike now supposedly) commodities in general were going up, led by poster boy oil, but foodgrains and all kinds of other metals, and so on. They are all down now, and as for land, well, it is down at least partly due to the crash of real estate. In the long run, nature and oil and all the rest should go up, but what Keynes said about the long run I think dominates any claim that what is happening to gold now reflects a rational assessment of all that.

cian,

Actually, we have a lot more serious uses for gold than we used to, given its seriously high quality usefulness in electronics. To heck with the jewelry. Of course these kinds of bubbles because of the recrudescence of this old hanger on of fascination of gold as some sorty of mystical store of value just messes all that up (and, yes, the fascination with the mystique goes back to the Egyptian pharoahs at least who saw its inertness and sun-like yellow color as reflecting the divine status of the pharoah as Ra, the sun-god).

wellbasically,

Certainly traditionally the "barbrous relic" has been the great inflation hedge, and if one is deep-died monetarist, the Fed and most of the other central banks have been running expansionary monetary policies out the wazoo. However, with all these banks and funds failing, or trying to, endogenous money has been going down, and as I noted in the post, while there are a few hints that we might actually have mild (insufficiently high) inflation rather than the outright deflation forecast by other parts of the financial markets besides that for gold, the evidence of some incipiently widespread hyperinflation remains mighty thin, with the strongest argument the rise in the price of gold itself, unless of course it is sending a wrong signal because it is in the midst of a feverish speculative bubble.

Actually, the biggest sign that it is comes to me from recently hearing people, intelligent people even, including some professional economists, that the price of gold "can only go up." That is what a lot of "experts" were saying about the price of housing back in 2005, not to mention stock commentators about high tech stocks back in 1999.

wellbasically said...

Well what are your terms... if we have bankruptcies left and right, and companies are selling off their inventory in fire sales, prices will go down, but is that deflation?

rosserjb@jmu.edu said...

Yes. The unhooking from gold in the Great Depression was due to its becoming overvalued (relative to its official pegs (which it already was before the GD hit hard anyway), not the other way around as you and others suggest.

Down, baby, down!

cian said...

RosserJ: Actually, we have a lot more serious uses for gold than we used to, given its seriously high quality usefulness in electronics

Yeah, but not enough to justify its price/value. The only reason that Gold is a useful hedge against inflation, is because "serious" people know that its a useful hedge. Its completely circular.

Or to put it another way. We're in recession. Demand for electronics has collapsed. Demand for jewelry has presumably slumped. Yet the value of gold (for which there is spare production capacity) is soaring. The only demand for gold is from people fearing inflation - pure sentiment.

wellbasically said...

On deflation: so the solution is for the government to spend more, to keep prices up and so avoid deflation?

As for the value of gold, even the conservative goldies are divided into two camps: the Paul-ite goldbug investors, who believe that the government is holding DOWN the price of gold, and want us to get rid of paper currency and only use gold coinage, and the supply-side or Wannisk-ite goldies who believe that gold is still functioning as a monetary unit of account, and the dollar and other currencies fluctuate around gold.

I know a little more about the second group... they would generally argue that the supply of gold is so huge compared to the yearly demand, and the methods of extraction hardly change the amount available, so changes in demand don't affect the price.

Nobody really knows however why it works. I would only suggest this with regard to our current situation. When gold made a major runup in 2004-2005, the Fed could have understood that as a result of its own mismanagement. Instead, when prices of all other commodities followed, the Fed decided that the economy was too hot (total Keynesianism) and so raised interest rates 8 times over 2005-2006. We all know the story from there, the ARM holders were destroyed, but more importantly, the borrowers on subprime mortgages, who were the most tenuously employed, lost their jobs. 70% of subprime foreclosures were due to lost jobs. Of course the Fed with its Keynesian theory fully intended this to happen, their fingerprints are all over the situation.

As for your bubble market in gold: the gold price generally will work in the opposite direction as the economy, because a growing economy will draw in more dollars, and if the Fed remains tight, the dollar with strengthen against gold. It's hard to know what will happen with Obama, his tax increases are being priced in as contractions. Will he actually pass them? I think gold expects that he already has. If there is some surprise and he doesn't get the tax increases through, you will see gold go down.

rosserjb@jmu.edu said...

cian,

Oh yes, I agree it is purely sentiment. But one has to realize that the most serious gold buyers are in places like India. It is their sentiment that counts most.

wellbasically,

The Fed follows "Keynesian theory"? Well, maybe some version of it. But one should realize that the Fed is a hellhole of macro theories. The Minneapolis Fed is full of rational expectations-real business cycle hotheads, no Keynesians there. The Richmond and Cleveland, and Dallas, and St. Louis Feds have to varying degrees been old timey classical monetarists, although that has been sort of on the fade more recently. The modeling gang in the basement at the Board of Governors tends to be "New Keynesian" DSGE modelers, who also imbibe of ratex stuff, so not really Keynesians at all in the eyes of Post Keynesians or other harder core Keynesians.

Regarding your two camps, the first one is simply in lala land. The issue is that there has never been a society anywhere in the history of the world where the most used medium of exchange was gold coins. You might say, "well what about the US in the late 1800s in the good old days of the gold standard with all those good old $20 gold pieces?" Yeah, sure. Do you know how much a $20 gold piece bought back then? How frequently do you think those things were actually used in transactions? Oh, maybe for buying a horse or a house, but not groceries or paying rent. Way too high a denomination. Gold has simply always been too scarce for that. When it has been used, it has been as a store of value/unit of account, not as a general medium of exchange. Copper, silver, paper, or other things have served that function.

The latter group is off too. Have you checked how much the price of gold in the currencies has flucuated over the years? It was nearly as high as it is now back in 1980, but then was down to a quarter of that in-between. "Fluctuating around the world currencies"? Baloney.

Now, one thing that has gone on is that the four central banks that actually hold large gold stocks, left over from the bad/good old days of the gold standard (US, UK, France, Russia), have sold some of their stocks off gradually in recent years when the price has been high. If you want, that has fed the fantasies of the first group. But it has been more that the banks would just as soon unload the stuff. After all, it earns no income.

BTW, price is back down below $1,000 again, at 969 or around there this morning. Bubble may already be over, hah!

wellbasically said...

Ah you're right about my Keynesian comment. But notice how it is a monetary solution to a Keynesian problem. The Keynesians would have said raise taxes or cut spending, but since they could never get it through Congress, the solution became for mean Mr. Fed (insulated from the political process) to raise rates.

Dan said...

Lets be careful here... I happen to buy many of the arguments for gold, and think that this is more than just a speculative bubble. Speculative bubbles are, as we know, fueled by cheap money and always -- always -- end with a mania and blow-off top before the crash.

We're not seeing this hear. We have something of a fear-induced mania that is, in my view, a very real consequence of the wild gyrations of the world monetary and financial systems. Gold is sensing that a major currency or credit event may be brewing.

But while gold gets a lot of press, relatively few people hold it as part of a portfolio. Compare with oil, which is a much bigger market.

The big move in gold will come when interest rates start to rise, IMO. The bond market is enormous, and if even a fraction of that money goes into gold looking for a safehaven we will see big moves. This has happened before.

rosserjb@jmu.edu said...

Dan,

More people hold oil in their portfolios than hold gold? Not many that I know, although I know a few, all of whom have lost money doing so.

I do not see why a mania driven by fear is all that fundamentally different from a mania driven by happy times, making money. There have been people making money recently on the runup in gold, which continues to appear to be over for now. It is the same pleasure centers of the brain that light up when those short term returns roll in either case. And the number of "regular people" coming up to me and telling me that "gold is the answer" and "gold cannot go down" ring the same bell in me that rang in Bernard Baruch (or was it Joseph P. Kennedy?) who sold his stocks in late 1929 (before the crash) when the shoeshine boy started giving him stock tips.

As for the scenario wherein gold is supposed to really soar when interest rates do so, how does that jibe with the argument that it is "easy money" that triggers bubbles? Oh, I know, this is (was) not a bubble, right?