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Friday, August 24, 2012

Gold Prices

The question

Economystified reader Tim C. sent this along to me via Facebook:

“If this doesn't look like a bubble about to burst, I don't know what does.

What say you?”

Well Tim, here’s what I say…

Mankind’s inexplicable love-affair with gold

Gold is one of the great mysteries of economics.  It’s well sought after, its revered - and its expensive. 

All this, despite the fact that it has absolutely no economic value at all.  In economic terms, gold is worthless. 

You can’t eat gold, or live under it.  Wearing it doesn’t keep you warm in cold weather. Swallowing it won’t ward off disease.  It doesn’t make you smarter or safer.  It doesn’t pay a dividend, and holding a brick of it doesn’t entitle you to payments of interest.  Gold is just a weird rock.

I’ll say that again, gold is worthless - in economic terms.

So if gold has no economic value, why is it so expensive?  The frank answer is that the price is pumped up by what I'll “human brain spriziness.” Basically, 5000 years of mass hysteria.  Its worth money because everyone thinks and acts as if it is.

Despite this, we can buy it, store it, hoard it, and sell it off for a profit.  Indeed, many people do. 

The only reason this works, is because we know people will buy our gold when we want to sell it down the road.  And those future buyers will buy it because they know that even later down the line other people will be willing to buy gold.  Those future souls will buy it because they expect future future folks will buy it.  And the circle of crazy perpetuates itself. 

The standard counter arguments, and the standard rebuttals

I can hear cries of protest now:

“But doesn’t gold have value because it is rare?”

Scarcity alone doesn’t make something valuable.  Locks of my hair are rare.  Record breakingly large balls of twine are rare.  So are guys named “Jesse,” and mint-in-box “Biker Mice from Mars” toys.  That doesn’t mean they automatically have major economic worth.  Just because there isn’t a lot of gold in the world doesn’t mean it should have any real, intrinsic value. 

Heck, there’s rarer metals on Earth.  But in the absence of our fascination with them, they just don’t have the allure of gold.  No one ever totes their products as being the “Platinum Standard” in the industry; no one ever celebrates when their single goes “Uranium” - even though this would imply a greater level of exclusivity.

“But doesn’t gold have some practical usages?”

Ok, honestly, you got me there.

There are some real needs for gold.  It has high electro-conductivity – so it’s a must for USB cables.  It’s still used to fill teeth in some parts of the world.  That sort of thing. 

But this makes up a relatively small portions of the market – around 12% or so. 

And more over, unless you are working in these industries, what value is the gold to you?  Beryllium has plenty of industrial usages too, and is probably more rare.  And do you hear anyone clamoring for you to sink you money in that?  Anyone ever show off their beryllium engagement ring around the office?

“If it’s so worthless, why did so many of our ancestors fight and die for gold?”

When the human obsession with gold started, there actually was a really good reason for it.  It can’t be counterfeitedTherefore, it’s easy to regulate the quantity in circulation, making it a great material for currency (when societies go around to inventing currency, that is). 

Imagine an economy using dead leaves or plain rocks for money.  Everyone gets to be a counterfeiter.  No one would know how much currency was in circulation at any given time. Chaos.

The volatility of gold prices

The fact of the matter is nothing in this world has intrinsic, inalienable economic value.  Otherwise, the price of whale oil would still be high (despite the spread of electric lighting).  We’d still be shelling out top dollar for typewriters (despite the creation of word processing software).  Things are only worth what we are willing to pay for them.

Since the price of gold is largely just a function of human emotion, its swings around a good bit.  The chart Tim provided starts at a low point for gold prices.  When we look at how its price has varied over a longer time scale, we see dramatic ups and downs in the gold market are not atypical.

(NOTE – the US government arbitrarily set the price for gold up until 1971.  This is what we used to call the “Gold Standard.”  The price line is flat at the start because gold wasn’t a market good, its price was determined by the Federal Government.)

Getting back to Tim’s question – why the recent spike in gold prices

When the bubble burst in the derivatives market, and big, bad “The Financial Crisis” got rolling, investors pulled their money out of CDOs, MBSs, and CDSs as fast as they could.

Then they went looking for “the next best thing.”  Everyone went searching for alternatives to the instruments that previously were viewed as such sure things.

Some people put their money in oil.  Some went for government or corporate bonds.  And some of the herd ended up dropping their money into gold.

The huge and rapid growth in demand for these “alternative assets” ballooned so fast that supply hasn’t caught up, thus driving up the price.  (Supply may never catch up to demand in the gold and oil cases – there’s only so much of those commodities in existence.  Governments and companies can issue as many bonds as they please.)

That’s the main driver of the recent price spike, the one in Tim's chart.  In the past, it has fluctuated for other reasons: energy crises, financial crises, technological changes, the discovery of new supply, and just plain old everyday changes in fashion.

So is this a bubble?  

Most likely.  But there really isn't that much of the world's wealth tied up in gold today.  So if this bubble pops, its unlikely it would be a huge disaster.  

Honestly though, in my mind, I’d say gold is always in a bubble, almost by definition.  Here’s why:

First off, there’s not many rote factors that influence its market price.  Remember, gold has no practical value (outside some industry, and I guess you could argue jewelry), so much of its market price is the result of our subjective whims.

Second -  and more importantly – gold provides no predetermined income stream, so its impossible to calculate its value as an investment except in hindsight, I suppose. 

What do I mean by that?

A loan pays interest.  Stocks pay dividends.  If I buy a company, I get some of its profits.  Most investments have a fixed or predetermined income stream associated with their ownership.

Gold only earns you money when you sell it, and you have no idea what you’ll be able to sell it for when the time comes.

Say I’m a bank, and Tim takes out a mortgage with me.  I give Tim $30,000, and he promises to pay me $3,100 a year for 10 years. 

This arrangement gives me the right to $100 a year for 10 years that wouldn’t be available to me otherwise.  I can therefore calculate the “value” of the loan beforehand.  $100 a year for 10 years…this mortgage is worth $1,000 to the Bank of Me.

If that bank were instead to have bought $30,000 of gold, with the intent of selling it off again in 10 years, how much is that arrangement worth?

It’s a question that can’t be answered without guesstimations and assumptions about the future.   So ANY price you put on the deal is a "bubble" price.

What the professional say

I always get a kick out of articles written by economists, bankers or financiers about gold investing, because they’re always kinda angry sounding.  I can just see the authors quietly fuming at their desks, trying to reign in their language as they type away.

Here’s some examples.  As with most topics, you can check out:

The Wall Street Journal for an overstatement,
The Economist for an understatement,
Forbes for a tantrum.

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