"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Thursday, September 23, 2010

Gold Will Be A Bubble Until It Isn't

Many people, including George Soros, have recently described gold as being in a bubble.  But economically speaking, what is a bubble?  From Wikipedia:
An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is “trade in high volumes at prices that are considerably at variance with intrinsic values”.[1][2] (Another way to describe it is: trade in products or assets with inflated values.)
Gold is definitely trading at high volumes and at prices that are well above near term historical averages:


Keep in mind the chart above isn't adjusted for inflation.  But nonetheless, there has been a marked rise in the price of gold the past ten years.  So the question on every one's mind is: How will this investment cycle end?  Nothing increases in value at such a high rate in a relatively short period of time without a subsequent reversion to the mean... that is, a significant correction, a drop in price.

But what is gold?  Is it a commodity or is it money?  I guess the answer depends on who you ask.  A jewelry designer looks at gold as a commodity.  Whereas a Central Bank may deride gold, yet monitors its price and the reserves the Central Bank maintains.  Quite the dichotomy, no?

So why do governments continue to maintain gold reserves?  After 1971, gold was effectively demonetized.  The world began to function on a fiat paper standard when the world reserve currency, the US Dollar, was no longer redeemable in gold.  When central banks accumulate foreign reserves, they do not sit on those reserves, they put them to use.  For example, China runs a large trade surplus with the US.  What can it do with that surplus?  It invests it in such a way to receive a return , i.e.government debt, agency debt. It puts that money to use.

Gold pays no dividend, no interest, nothing,  It sits there and its price rises and falls with the market.  Yet governments still hold onto it.

From ancient times to 1971, trade in the global economy was conducted using precious metals (coins) or commodities.  Occasionally some countries experimented with a fiat paper standard, but it always ended in collapse.  Weimar Germany, France under John Law's experiment, etc...  Nonetheless, when a nation experimented with a fiat paper standard, most of the rest of the world still used commodities or precious metals.  Today, that is not the case.  And when one looks at the broad sweep of global economic history, one has to realize that our times are truly unique.  They are far from the historical norm.

So did mankind finally figure it out?  Did mankind find a new wonderful monetary system that couldn't be restrained by a commodity or metal supply?  Would this new system continue for the next few thousand years as the old system did?  No one knows the answers to those questions.  Not even governments or central banks.  And that's why they hold gold.  Because you never know when this grand fiat paper experiment goes to hell, so to speak.

So ask yourself.  How is paper fiat functioning today?  What are the odds of a dollar world reserve currency crisis?  What is the US's fiscal condition?  What is the fiscal condition of many other countries?

Which leads me to the title of this post: Gold Will Be A Bubble Until It Isn't

What do I mean by that?  Well, if the current fiat paper dollar-based global monetary system meets its end - and historically speaking, all national currencies that function as global reserve currencies eventually lose that global role.  And if you believe that all the major nations can cooperatively and peacefully agree on a new paper system such as the IMF's SDR to replace the US Dollar's global role, then gold has no long term investment value and it is in a bubble.

But if the end of the current global monetary system is chaotic, and distrust grows not just with the US Dollar, but in all paper currencies, and all nations begin to distrust the stewardship of other nations' currencies, then gold is the only thing left they can deploy.  Gold must back their currencies.  It strengthens, once again, what we call "money."

And you know what else?  When this global monetary event transpires, gold's price may not go down.  When this event transpires, nations will have to look at their money supply, and their gold reserves, and determine - do they want to peg their currency at a gold price that is at the going price, below market, or above the market.  If they peg their currency at a price below the going gold price - they are choosing deflation.  If they choose above the price - they are choosing inflation.

What do nations prefer?  Governments always prefer inflation to deflation. So there you have it. 

Gold will be a bubble until it isn't. 

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