The gold bubble and the gold bugs
Gold prices have been rising sharply, breaching the $1,000 barrier and in recent weeks rising towards $1,200 an ounce and above. Today's "gold bugs" argue that the price could top $2,000. But the recent price surge looks suspiciously like a bubble, with the increase only partly justified by economic fundamentals.
Gold prices rise sharply only in two situations: when inflation is high and rising, gold becomes a hedge against inflation; and when there is a risk of a near depression and investors fear for the security of their bank deposits, gold becomes a safe haven.
The last two years fit this pattern. Gold prices started to rise sharply in the first half of 2008, when emerging markets were overheating, commodity prices were rising, and there was concern about rising inflation in high-growth emerging markets. Even that rise was partly a bubble, which collapsed in the second half of 2008, when - after oil reached $145, killing global growth - the world economy fell into recession. As concerns about deflation replaced fear of inflation, gold prices started to fall with the correction in commodity prices. The second price spike occurred when Lehman Brothers collapsed, leaving investors scared about the safety of their financial assets - including bank deposits.
That scare was contained when the G-7 committed to increase guarantees of bank deposits and to backstop the financial system. With panic subsiding towards the end of 2008, gold prices resumed their downward movement. By that time, with the global economy spinning into near-depression, commercial and industrial gold use, and even luxury demand, took a further dive.
Gold rose above $1,000 again in February-March 2009, when it looked like most of the financial system in the United State and Europe might be near insolvency, and that many governments could not guarantee deposits and backstop the financial system, because banks that were too big to fail were also too big to be saved.
That panic subsided - and gold prices started to drift down again - after US banks were subjected to "stress tests," America's Troubled Asset Relief Program further backstopped the financial system by removing bad assets from banks' balance sheets, and the global economy gradually bottomed out.
So, with no near-term risk of inflation or depression, why have gold prices started to rise sharply again in the last few months?
There are several reasons why gold prices are rising, but they suggest a gradual rise with significant risks of a downward correction, rather than a rapid rise towards $2,000, as today's gold bugs claim.
First, while we are still in a world of global deflation, large, monetized fiscal deficits are fueling concerns over medium-term inflation. Second, a massive wave of liquidity, via easy monetary policy, is chasing assets, including commodities, which may eventually stoke inflation further. Third, dollar-funded carry trades are pushing the US dollar sharply down, and there is an inverse relation between the value of the dollar and the dollar price of commodities: the lower the dollar, the higher the dollar price of oil, energy, and other commodities - including gold.
Fourth, the global supply of gold - both existing and newly produced - is limited, and demand is rising faster than it can be met. Some of this demand is coming from central banks, such as those of India, China, and South Korea. And some of it is coming from private investors, who are using gold as a hedge against what remain low-probability "tail" risks (high inflation and another near-depression caused by a double-dip recession). Indeed, investors increasingly want to hedge against such risks early on. Given the inelastic supply of gold, even a small shift in the portfolios of central banks and private investors towards gold increases its price significantly.
Finally, sovereign risk is rising - consider the troubles faced by investors in Dubai, Greece, and other emerging markets and advanced economies. This has revived concerns that governments may be unable to backstop a too-big-to-save financial system.
But, since gold has no intrinsic value, there are significant risks of a downward correction. Eventually, central banks will need to exit quantitative easing and zero-interest rates, putting downward pressure on risky assets, including commodities. Or the global recovery may turn out to be fragile and anemic, leading to a rise in bearish sentiment on commodities - and in bullishness about the US dollar.
The recent rise in gold prices is only partially justified by fundamentals. Nor is it clear why investors should stock up on gold if the global economy dips into recession again and concerns about a near depression and rampant deflation rise sharply. If you truly fear a global economic meltdown, you should stock up on guns, canned food, and other commodities that you can actually use in your log cabin.
The author is professor of economics at the Stern School of Business, NYU, and chairman of Roubini Global Economics.
© Project Syndicate, 2009, www.project-syndicate.org.