Is There a Gold Bubble?
With all of the screaming and commotion I just had to look… In the summer of 2008 I was attending FEE’s summer seminar, and on my way back to my hotel room, I heard such an uproar I had to investigate. It was coming from the large ballroom and it was far too early for a wedding. It was a seminar of how to get rich by flipping houses in the real estate market! I remember it well because it was less than six weeks before the fall of Lehman Brothers, AIG and all the rest. The writing was on the wall and I wanted to run in there to tell them to get out, run away, save their money, and not to throw their retirement funds into a hole! Alas, it was a closed event, one had to pay a fee to get in and I respect property rights. I sincerely hope that no one followed the snake oil pitch.Hotel ballroom seminars are truly the last phase of an investment bubble before it bursts. Today the hot topic in the hotel ballroom seminar circuit is gold. There are gold parties where people bring their “unwanted” gold to a hotel, mall, or even someone’s house and they get cash for their jewelry, etc. The pitch is that gold is at an “all-time high.” A year ago, gold was around $680/oz. and recently peaked above $1180/oz on November 25th. Even on the radio, there are advertisements to put gold into your retirement portfolio.So why is there this run up and what does this signal to economists?First, we need to examine the reasons for the run up in the price of gold. Since the dollar went off the gold standard, gold has been used as a hedge against inflation. Austrian economists have long argued that a gold backed currency is far better than any sort of fiat currency. However, that endorsement should not be confused with a recommendation about investing one’s portfolio in gold assets (as was once advertised on radio and TV).Many investors are observing the following facts and expecting this scenario to play out.The U.S. Federal Government has been pumping dollars into the economy at a rate that has not been seen since the days of the Roosevelt administration. Within the last year there has been the passage of the TARP funds, the several series of bail-outs, the stimulus bill, etc. There has really been no reason to assume that this trend is going to change in the short or medium terms, especially with all of the talk coming from Washington about a new stimulus bill and universal health care programs.The Federal Government has expanded the national debt so fast that the U.S. Treasury is breaking all records in the amount of debt it is planning to sell in its auctions. The Federal Reserve has said that it will supply new dollars to the Federal Government and any failing banks. The result of the Fed’s actions over the past year has placed an incredible amount of new money in the reserves of the banking system. Each of these “unloaned” dollars is the source of concern. Today the banks are not lending them out. As the economy improves, the banks will start to lend these dollars. Through the magic of fractional reserve banking, these dollars will be multiplied over and over—about 9 times over. So each dollar sitting in reserve can potentially be expanded into 9 dollars in demand deposits.Fed chairman Ben Bernanke has promised that it will not be a problem to pull these funds out of the system before massive price inflation sets in. Investors disagree. Mainstream investors see Bernanke walking along a razor’s edge. This edge is that of pulling the money out too slowly, yielding large price increases, or pulling the money out too quickly, thus raising interest rates, killing the recovery and creating a double dip recession. Anyone reasonably plugged into the investment and political sectors knows that if the trade-off comes down to big inflation or a double dip recession, the choice will be to avoid the recession. That means there is a good chance of some big price inflation coming our way.To avoid the erosionary effects of inflation, gold has traditionally been a safe haven for investors. Today, investors are looking at their alternatives: dollars, euros, yen, pounds, etc. and have decided that the outlook for all of them is rather bleak. Thus as an attractive alternative, they are considering gold. As inflation fears rise, more flee to gold.After the dot.com bubble, investors moved into the real estate market. So this leads to the next question: With the collapse of the real estate bubble will investors now move into gold creating a new bubble? The price of gold is up over 74% since this time last year. New money is being flooded into the economy and has to go somewhere. That new money isn’t showing up in the real estate market or in manufacturing or even in retail, so where is it going? How much of it is flowing into the gold market? There is no accurate way to know, but my sense is that it is a significant amount.In 2000, the Fed prevented the dot.com bubble from fully collapsing by expanding the money supply. Again, the Fed is preventing the full liquidation of the economy’s built up malinvestments. New money has been rushed into the economy and flows into the areas of the economy that show the greatest return. The commodity markets have been spurred by inflation fear and fueled by monetary expansion. These factors are creating more bubbles, and this time, in particular, in the gold market. Investors are choosing gold to be used as this hedge against the dollar.A real concern is an inflating of a gold bubble. Supposing that there is a bubble in the gold market, will the consequences be as destructive as the dot.com bubble or the real estate bubble? I do not think so, but it certainly is possible. The consequence of an artificial boom is the build up of malinvestments. The malinvestments were most readily seen in the dot.com sectors and the real estate sectors, but they were wide spread in many other sectors of the economy. The pain of the recession comes about from the liquidation of the capital equipment that was mistakenly built during the artificial boom. The more heterogeneous and specific the capital equipment, the more difficult it will be to sell it off during a liquidation. This stickiness of capital determines the speed of the adjustment process back to full employment.If there is a gold bubble, then the initial focus of the malinvestment will be in a commodity futures market. There is little sticky capital built up in such markets. The danger comes from the second round effects, when the money starts to leave the gold market and enter into other areas of the economy. The initial build up in the dot.com and real estate sectors was compounded by the additional malinvestments in the other sectors of the economy. A dot.com executive buys a house and a fancy car, etc. The real estate builders and sellers place more orders and redirect tremendous resources into the earlier stages of production. Meanwhile, consumers are convinced not to save and instead spend on credit and financing.I think that there is a bubble forming in the gold market. I do not think that it is a problem; I think that it is a symptom of a much larger problem, namely the unchecked power of the Federal Reserve to create money out of nothingness. With an enabling Federal government, the outlook is that these business cycles will recur and become more destructive over time. Only the education of the population and the politicians that the path of easy money and credit is the path to destruction will enable us to avoid such a future.
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