Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 14 March 2012

Gold – Bug squashing time?

Goldbugs have a simple narrative: Fiat currencies are being debauched systematically by the central banks and therefore the only store of value left is gold. As gold prices have risen higher and higher, this has become more accepted as a fact than an opinion. Since nothing catches the public’s attention like a parabolic rise in prices, investors, both large and small, have rushed in to participate in the latest gold rush. Thus expectations of a price rise have become self-fulfilling.

The investment banking machine recognised the potential of goldbug propaganda and swung into action. There are more than 600 listed ETFs linked to gold available to ‘invest’ one’s hard earned money. Although no prospectus states that “It is an undertaking of great advantage but no one to know what it is”, but given the actual dynamics of some funds it would not be wholly inaccurate.  

Warren Buffett tried to sober up the party in his annual letter to shareholders (excerpt below) to no avail.
The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.
This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.
The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Buffett’s focus on the unproductive nature of gold for rejecting it as an investment does not directly counter the goldbug argument of it being a store of value. In the post-credit crunch bleak economic environment where deleveraging is the norm and sovereign defaults inevitable, clinging to a known store of value is a natural and intelligent investment decision. Unfortunately, gold’s attraction as an investment has more to do behavioural quirks than rational decision making. In the language of neuroscience, investor's brain is using the limbic system (used for automatic emotion-driven decisions) rather than the pre-frontal cortex (used for deliberative and reason-driven decisions). 

Behavioural follies are injurious to one’s wealth. Therefore the main goldbug argument has to be deconstructed to determine the investment decision. The first assertion is that gold is a store of value since the economic environment will continue to be bleak. The second related assertion is that western central banks will continue to debauch fiat currencies to re-start economic growth. In light of better than expected US economic data and resumption of growth there, the argument starts failing at the first assertion itself. Pointing to anaemic growth to support the argument is not enough since such a slow recovery is expected after a huge housing crash (as Reinhart and Rogoff have pointed out in their seminal work). The European situation may be dire but it will impact Euro’s purchasing power not gold’s price in dollars. The second assertion is on stronger footing. Despite tough words, central bank actions have been to debauch their currencies. However, as recent Fed actions have demonstrated, resumption of economic growth will make it a moot point.

The third assertion implicit in the goldbug argument is that gold will continue to be a store of value in a scenario of economic collapse. Even this does not stand up to scrutiny. Wealth is a derivative of power. It does not exist independently and it cannot exist in opposition to the established power. A desperate government will confiscate its citizen’s wealth one way or another. If fiat currencies are deemed to be losing legitimacy against gold then gold will either be confiscated (Roosevelt’s 1933 order is a case in point) or trade in it will be regulated. It is true that a black market can exist where gold is a medium of exchange. However, in the event of an economic collapse, the value of gold with respect to basic necessities will decline. At the moment an ounce of gold can buy hundreds of tins of canned beans but it certainly won’t in the dystopic goldbug worldview. And it most definitely won't if everyone holds gold and very few hold canned beans.

The fourth assertion in the argument is sponsored by the friendly neighbourhood investment banking team. Their claim is that financial contracts linked to gold are as good as gold. Since buying and storing physical gold is a drag, financial contracts ease the burden of sagacious investing. In these egalitarian times no one need fear that they are missing out on a "hot" investment. Not only is the legitimacy of contract law in an economic emergency questionable (as EU has demonstrated to Greek bondholders) but also the ‘links’ are sometimes tenuous and come with other hidden risks (counterparty risk for example). Financial contracts are a speculative instrument sold as an investment product to the masses. This has resulted in a wave of money flooding into gold and the consequent parabolic rise in price.

Upon reflection, gold’s sheen is wearing off. As Buffett sagely noted, gold makes no sense as a fundamental investment. And now even the technicals seem to be going against the goldbugs as gold trades below it 200, 100 and 50-day moving averages (see graph).

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