In today’s Financial Times Mark Williams argues that the recent correction in gold means the gold “bubble” is finally bursting. Unfortunately, he does not provide a single reason for why the 10-year bull market in the precious metal constitutes a “bubble”, nor why this rally must end now.
According to the narrative of this article, investing in gold must have always been quite an irrational endeavour. Such folly was simply made easier with the advent of liquid ETFs (exchange-traded funds), which made the gold market more accessible to the small investor and trader. From than on, an irrational rally must have just fed on itself. Quote Mr. Williams:
“By 2005, more and more investors tried to rationalise why gold was no longer a fringe investment. It was a hedge against a weak dollar, global turmoil, incompetent central bankers and inflation. As trust in the financial system declined, gold would naturally rise, they reasoned.”
How silly! How could they believe that?
So according to Mr. Williams, gold has been going up because….it had been going up before. The investors simply rationalized it with hindsight. But gold recently went down, and down quite hard. Measured in US dollars, gold is down 16% from its peak on September 5. And now it has to go down further, so reasons Mr. Williams. If people bought it because it was going up, they must now sell it because it is going down.
Toward the end of his article we get the usual bon mot – by now repeated ad nauseam by Warren Buffett – that gold does not produce anything, does not create jobs, and does not pay a dividend. Yawn.
Gold is money
To compare gold with investment goods is wrong. Gold is money. It is the market’s chosen monetary asset. It has been the world’s foremost monetary asset for thousands of years. It has been remonetised over the past 10 years as the global fiat money system has been check-mating itself into an ever more intractable crisis. Faith in paper money as a store of value is diminishing rapidly. That is why people rush into gold. It doesn’t replace corporate equity or productive capital. It replaces paper money.
At every point in time you can break down your total wealth into three categories: consumption goods, investment goods and money. If you buy gold as jewellery, it is mostly a consumption good. If you buy gold as an industrial metal to be used in production processes, it is mostly an investment good. However, most people buy gold today as a monetary asset, as a store of value that is neither a consumption good nor an investment good. Therefore, you have to compare it with paper money. That is the alternative asset.
NOT Paul Volcker (Photo by U.S. Federal Reserve)
The paper dollars and electronic dollars that Mr. Bernanke can create at zero cost and without limit, simply by pressing a button, equally do not produce anything, do not create jobs, and do not pay dividends either. Although, sadly, the reflationists and advocates of more and more quantitative easing – many of them writing for the FT – seem to think that this is what paper money does. Alas, it doesn’t. It only fools the public into believing that lots of savings exist that need to be invested, or that enormous real demand exists for financial and other assets. Expanding money is a trick that is beginning to lose its magic.
The dollars in your pockets do not generate a dividend, neither does the gold in your vault or your ETF. So why do you even hold money?
Because of uncertainty. You want to stay on the sidelines but want to maintain your purchasing power without spending it on consumption and investment goods in the present environment and at current prices.
Stocks, bonds and real estate have been boosted for decades by persistent fiat money expansion. Now that the credit boom has turned into a bust it is little wonder that people are reluctant to buy more of these inflated assets. (Some real estate and some stock markets are currently already deflating, which is urgently needed. But bonds are not. If there is a “bubble” at all, it is in government bonds, although that bubble seems to begin to deflate as well — one European sovereign at a time.)
People want to preserve spending power for when the bizarrely inflated debt edifice has finally been liquidated and things are cheap again. But policymakers and their economic advisors do not want that to happen (“Oh no, that dreadful deflation! No! Anything but a drop in prices!”) and they are using the printing press to avoid, or better postpone the inevitable at all cost, even at the cost of destroying their own paper money in the process. And that is why you cannot hold paper money and have to revert to eternal money: gold.
Gold versus paper money
Mr. Williams quotes the market value of the world’s largest gold ETF, GLD, at $65 billion at present, apparently considering this already proof of how mad things have become in the world of gold investing. Well, consider this: in just the first 8 months of the year 2011, Bernanke created $640 billion – out of thin air – and handed it to the banks. Since the collapse of Lehman Brothers, the Fed has created reserve dollars to the tune of $1,800 billion, or more than twice as much as the Fed had created from its inception in 1913 up to the Lehman collapse in 2008. Or, if you like, 27 GLDs at present market value. The money supply in the M2 definition has gone up also by $1,750 billion since Lehman. Mr. Williams, why is anybody still holding these absurd amounts of paper cash? Isn’t that the more interesting question rather than the tiny amounts that they hold in the form of physical gold?
The biggest owner of gold is allegedly the United States government. I say ‘allegedly’ because they have not done a proper audit for a while. Supposedly, the U.S. has 261 million ounces of gold in their vaults at Fort Knox. At current market price that is a market value of $423 billion. Bernanke created more paper money between last Christmas and last Easter!
And those who, like Mr. Buffett, feel like joking that the entire stock of gold fits under the Eiffel tower – ha! ha! ha! – let they be reminded that the trillions that Mr. Bernanke created fit on the SIM cards in their mobile phones. It is all electronic money – and when Mr. B turns into a monetary Dr. Strangelove and goes bonkers with those nuclear buttons, there will be much more fiat money around.
NOT Ben Bernanke!
Let me be clear on this point: the fact that money today consists of paper or is even immaterial money and consists of no substance at all is, no pun intended, immaterial to me. It doesn’t matter. As an Austrian School economist, the concept of “intrinsic value” that some gold bugs cite in defence of gold money is meaningless to me. Money does not need a substance to be money. The problem with modern money is not its lack of substance but its perfectly elastic supply. The privileged money producers create – for political reasons – ever more of it. That is the problem. And that is why the market remonetises gold. Nobody can produce it at will.
Here is Mr. Bernanke again:
“The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost…We conclude that under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
But to Mr. Williams, paper dollars are now a safer bet than gold:
“Fears of a Greek default and eurozone turmoil are now prompting investors to buy US dollars – which many are starting to see as a safer bet than the euro or volatile gold.”
Hmmm. Safer? Are you sure?
What’s next for gold?
Mr. Williams may, of course, be right in predicting that the gold price may go down from here. For that to happen the faith in paper money has to be restored, at least to some degree. The printing presses have to stop and liquidation must be allowed to proceed. And that is precisely what happened under Fed chairman Volcker in 1979. That is what caused the previous correction in the gold “bubble”.
The question is this: How likely is this now?
In my view the present sell-off in gold is the result of the market going through another deflationary liquidation phase, yet at the same time the central bankers seem reluctant to throw more money at the problem. The ECB is buying unloved Italian sovereign bonds rather joylessly at present, and Bernanke seems for the time being happy to reorganize his bond portfolio rather than to print more money. Alas, I don’t think it will last. I am fairly confident it won’t last. They won’t have the stomach to sit tight.
Pressure is already building everywhere for more quantitative easing. Ironically, on the very same page of the FT, on which Mr. Williams argues that the gold bubble has burst, Harvard economist Kenneth Rogoff presents his case that this time is not so different, and that we can simply kick the can down the road once more by easing monetary policy, just as we have done for decades. In China, in Europe, everywhere, just print more money. And I already made ample references to Martin “Bring-out-the-bazooka” Wolf, who desperately urges the central banks to print more money.
Will the central bankers ignore these calls, as they should? I don’t think so. Remember, the dislocations are now astronomically larger than they were in 1979. The system is more leveraged and much more dependent on cheap credit. In the next proper liquidation, sovereign states and banks will default – no central banker will be able or willing to sit on his hands when that happens. But in order to postpone it (they won’t avoid it) they need to print ever more ever faster.
We are in a gold bull market for a reason, and a very good reason indeed. Unless the underlying fundamentals change (or policy changes fundamentally), I consider this sell-off in gold rather a buying opportunity.
8 Responses to Gold “bubble” bursting? – I don’t think so
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{ Hello Jamie, I don't want to pile on. This is important stuff and there is... } – May 17, 3:57 PM
{ Hi Detlev, I recently bought and read your book. Wanted to start reading it again... } – May 17, 3:42 PM
{ Jamie, I do take that into account. Every week the US government has to borrow... } – May 17, 10:35 AM
{ Hi Detlev, Thanks for your detailed response. Obviously we have a difference of opinion on... } – May 17, 9:01 AM
“The paper dollars and electronic dollars that Mr. Bernanke can create * * * do not pay dividends either.”
Well, actually (thanks to inflation) they pay a negative dividend.
“As an Austrian School economist, the concept of “intrinsic value” that some gold bugs cite in defence of gold money is meaningless to me. Money does not need a substance to be money. The problem with modern money is not its lack of substance but its perfectly elastic supply.”
I was quite shocked to read this, in particular the claim that Austrian economics back up your position. I recommend Jorg Guido Hulsmann’s excellent recent work ‘The ethics of money production’ as well as the Hoppe lecture linked to at the bottom of this post.
Gold is useful as a money for a number of reasons: it is fungible, doesn’t degrade easily, is hard to counterfeit convincingly, is easily divisable into weights and measures and can be fairly cheaply re-melted and coined in case of damage. However, all this would mean diddly squat if gold did not also have value as a commodity. There is no way in a free market that people will ever use anything as a money that does not have value as a commodity. The only way to make them do so is through legal tender laws, making the given money the sole item accepted for taxes, etc.
The consequence of your position, namely that the problem with fiat money is its elasticity, is that the ideal system would be a fiat money system set up in such a way that the money supply could not be expanded or contracted for political or private economic gain. If we ignore ‘intrinsic value’ and consider money to be only an exchange standard, paper money has many advantages to gold i.e. ease and cheapness of production and replaceability. If we could solve the elasticity problem, fiat money would be the best money. This is, in fact, precisely the conclusion that Ricardo came to, only wih the caveat that such an event is unfeasible. Now we can agree with him, but the way is left open for Friedmanites and others to argue that paper money would be just dandy, if only we could solve the institutional problems associated with it.
Again, this is quite false. Only commodity money will ever be used in a free market and so it is, by definition, the best currency. It may be gold, or a mix of gold or silver, jade, or something quite different entirely.
In general, I am disturbed that what you seem to be advocating is a return to the gold standard. Whilst this would represent a vast improvement on the current mess, it is not what we want at all: namely a free market in money (just as we do not want some absurdity like a ‘coal standard’, but a free market in fuel). The gold standard was, historically, the first step taken towards fiat money, produced by massive and illicit government interference driving silver out of circulation, it is not at all some sort of Austrian economic ideal. In addition, advocating it allows the defenders of paper money to point to the very imperfect historical reality of the gold standard and its theoretical absurdities.
Further, I would point out that the gold supply is elastic and we should expect any free market money to expand and contract in rhythm with market mechanisms. A gold standard is as elastic as its administrators want it to be.
In short, you are too much of a goldbug and not enough. On the one hand, a necessary (though not sufficient) condition for gold to be money is the ‘intrinsic value’ you scornfully refer to, on the other, you focus too much on gold when the proper aim is not to support any particular form of money, but to allow the free market to decide what is used.
With regards
Concerned fan
http://www.youtube.com/watch?v=pBI1fv8YrzU
I think there are certain things on which we can readily agree:
Gold is uniquely qualified to function as money and it is the best form of money we presently have. Gold can fulfill all monetary functions adequately and satisfactorily, and there is no need to replace it with anything else.
I use the term “gold standard” as code for a gold-based monetary system. I would prefer such a system to be entirely free-market based, that is, it should be without any involvement of the state. All gold is held privately, and entirely private institutions (“banks” for lack of a better term) which are at full risk of bankruptcy offer the service of storing it and then use it as a basis for an entirely private global payment system. This would be a better system than the Classical Gold Standard of 1880-1914, although that system was undoubtedly better than anything that came after it, and if we restored it it would still be a better system than what we have today.
Here is what we disagree on:
Gold makes such good money because it has “intrinsic value”. This is an untenable statement. Why? First of all, as an Austrian you should never use the term “intrinsic value” (nowhere to be found in Mises). The term goes against the very foundation of Austrian methodology, which has the concept of subjective value at its core. That is why we Austrians don’t fall for such things as the “productivity theory of real interest rate” or the “labor theory of value”, which are both based on the notion that there is some “real” or “intrinsic” value to things. As Austrians we know that any value that is assigned to anything at any moment in time is simple the result of a subjective act of valuing in that very instance. If you use gold as a monetary asset, you assign a value to it as a medium of exchange, a value as money. For this act of valuation it does not matter one bit that the gold also has some industrial application and therefore has – to somebody else and in an entirely different context – some value as an industrial commodity. Or, to be more precise, it only mattered once: when gold was first used as money, when it made the transition from pure industrial commodity to being money.
This confusion is the result of a misunderstanding – I believe – of Mises’ regression theory. Mises addressed the following problem: if I use money today, how can I know, at least roughly, how much it is worth, what its exchange-value is? Answer: by knowing what its purchasing power was yesterday, or the last time money was used. The previous transaction is always a point of reference for the money user in order for him to have some idea of what his cash holdings can buy. If we now trace back the use of a particular monetary asset step by step through time, from transaction to transaction, we must arrive at the point at which the monetary asset became money, the point at which it was first used as money. But in this very first transaction at which it was used as a medium of exchange and not as an industrial commodity, how did people determine its value then? Answer: they used its value as a commodity. That was, for the very first monetary transaction, the point of reference for the new monetary asset’s purchasing power was its price as a pure commodity.
This theory explains that money came into existence spontaneously (rather than as an act of state legislation, as alleged by the state theory of money) but that such a process of spontaneous money creation can only occur with a commodity. Free market money is always commodity-based money, not because of the residual industrial application of the monetary asset (some funny concept of “intrinsic value”) but because it could not have become money in the first place without also being a commodity. But once a monetary asset has been born and its use as money spreads, its remaining use in industry becomes less and less important in the act of valuing it. It will then increasingly be valued as money.
Gold has a paper-dollar price of $1600. How much of that is its “intrinsic value” as an industrial commodity? $100, $500, $1,000? We don’t know of course. But I think it would be wrong – and be in outright conflict with everything Austrian theory has to say about value – to say that people only use gold as a monetary asset with a purchasing power of 1,600 paper dollars because it also has some residual industrial application from which it derives a fraction of its value. No, it is being valued so highly because it is being used as money (at least as store of purchasing power), and its use as money is what determines its price. When the paper dollar gets completely devalued, gold will go up to $10,000 or $20,000 an ounce without any of its “intrinsic value” having changed. Gold’s remaining use as an industrial commodity is meaningless for its use as money.
Money came about as free-market “gold money”, then it was taken under state control and became state-managed “gold money”. And now the state has transitioned it to state-controlled fiat money, which is where we are today. Obviously, we are no longer facing the “reference point” problem today. That the free market would never have taken us to this point I accept (see Hoppe). But there is no rational reason why people should not use state fiat money now. In fact, Austrian theory can – because of its subjective value approach – explain the widespread use of state fiat money toady better than any other economic school. Once something is used as money it derives its value entirely from that use, and it doesn’t matter that it may have no other use whatsoever.
The idea that people would stop using fiat money if the state dropped the legal tender laws is simply nonsense. As a matter of fact, I live in the UK (you, too, I assume) and the Royal Mint here still produces gold sovereigns, which are legal tender and you can buy without VAT. This is an entirely legitimate alternative to paper pounds. Why are not more Brits using gold sovereigns? The law does not stop them. Utah has just made gold and silver coins legal tender in the sate. Of course, this will NOT drive out the paper dollar (I still applaud Utah’s move but for other reasons.)
The problem with paper money is not that it could not have come into existence without the state (that is history– water under the bridge) or that it is not “backed by anything”, but that its supply is fully elastic and constantly expanded under the false notion that this will help the economy grow faster (of course, it is also being expanded to fund the state, bail out the banks and for other purposes, but I am being charitable and just assume the highest goals of monetary policy according to current mainstream economics). The inherent elasticity is its Achilles heel – and this is what must ultimately undermine the system and lead to its collapse.
I explain this in more detail in my book.
The honesty of Bernanke is quite scary – there really is nothing from stopping the Fed or any other central bank from creating utter disaster if they so wished. Of course, they’ve already caused enough problems as it is!
I just have one question. When this money is printed (or electronically created) where does the interest that is required to pay it back come from? It seems to me that the whole system is flawed (due to a great amount of greed by just a few men). In the past, there have been groups of people that have made usury illegal in their trading world probably because of this basic flaw in this type of system. This system creates a void. It creates lack and enslavement. Not abundance. Perhaps this is the reason why so many loans are in default. The money to pay the interest back DOES NOT EXIST and it has caught up with us finally. I suppose that prices dropping (as bubbles burst) in real estate and other goods work towards correcting this issue but it seems to me a fundamental problem. We are in a closed system. Just create a closed system in your mind… you are the banker… you have 1000 people to loan money to that do various things – butchers, candle-makers, computer sellers, doctors, plumbers, etc. You place money out in this system… loan money to them… they trade among each other. But they must pay back the money… with interest to the banker. Someone is going to get cut short. WHERE DOES THE INTEREST COME FROM? I know I am over simplifying. But maybe it is more simple than we think. Maybe it will all fall apart and we will go back to a barter system. In that case, you better have real tradable marketable skills and/or goods to trade.
Please remember that an economy does not need more money to produce more goods and services and to create real wealth. I explain this in more detail in my book. To say that we have too little money to pay interest is therefore not quite correct. I would therefore describe the phenomenon that you allude to somewhat differently. In a paper money system privileged money producers exist that can create money out of thin air and inject it into the economy. In our system the banks can do this to some degree and the state central bank without limit. The new money is injected into the economy via the loan market – it is lent to non-banks. These non-banks cannot print money. When the loans get repaid to the banks and the central bank, and the “new” money returns to its creators, so to speak, it does so with interest. That interest represents real resources that the non-banks have produced in the meantime and that they give to the money creators in return for the temporary use of the printed money. The money creators can create money without producing goods and services but they end up obtaining real wealth – that is a privilege that is unique to any money producer. Everybody else in the economy can only obtain more wealth by participating in the production of goods and services. Money producers obtain real wealth simply by printing money. That is not a surprising conclusion if you think of counterfeiting. Our monetary system therefore contains an process of constant redistribution from the producers of goods and services to the printers of money.
You may say that this is amoral and anti-capitalist (which it is) but is that enough to conclude that this process is also unsustainable, that this system must collapse? I think to argue that conclusively you also have to show that this process leads to growing imbalances in the economy via the persistent mis-allocation of resources. That is what I do with my book.
Hi Detlev,
One question please. Helabe raises a good point – where does the inteest come from? Suppose we have a simple thre person economy. You are the bank. You lend me $1000 and I am supposed to pay you 0% interest,$1100. But there is only $1000 in circultion! Where would the other $100 come from? I jut wouldn’t be able to repay you no matter how much I create, because the money does not exist. You, the bank, are the only persn capable of creating this money. But you do so through lending, and every dollar you create has to be paid back with interest, In a huge system you have a great many plyers so you can push out the event horizon when default finally sets in, but eventually the basic fact that monetary liabiities exceed monetary assets will catch up. Could that be what is happening now?
I was interested to read areport in the FT last week regarding the increasing acceptability of gold as collateral instead of cash at various commodity and financial clearing houses:
http://www.ft.com/cms/s/0/362f211e-f00b-11e0-bc9d-00144feab49a.html#axzz1aOMrsWJA
I imagine this is a huge potential market and is arguably a further pointer towards the increasing monetisation of gold, as the crisis proceeds,