The word ‘Bubble’ is brought to you by the letter ‘B’.
These are the words of an anonymous critic on my facebook stream, confident that gold is in a bubble destined for collapse. I have taken to occasionally posting the spot gold price to keep it in my readers’ consciousness. My most recent post drew criticism for expressing continued support for gold despite its $375, 20% tumble of late September, 2011. My critic continued:
Havent you learned your bubble 101 from the 08 collapse? … Not quite sure your metal motivation, but it is obviously a freight train that cannot be stopped.
My critic studied business, works in finance, and follows the stock market. I studied mathematics and I’m a lawyer. I have no formal training in either economics or finance. I do not follow the stock market. Yet, I have positioned myself so that I must justify my continued support for gold. Have I learned my bubble 101 from the 2008 collapse? You tell me.
My critic’s subsequent lesson to me on economic bubbles originally consisted of one word: speculation. He later elaborated:
You are a true gold pumper, just like those penny stock pumpers.
I had no idea what a “penny stock pumper” was, but I imagine this fun video from StockJock-e at HotStockMarket.com explains it well enough:
I understand this behavior because I’ve observed a few iterations of it since I bought my first gold coin back in 2007. Jan Harvey with Reuters refreshes our recollection in Analysis: Hard-hit gold bulls not yet out for the count (9/26/2011):
Gold’s toppling from record highs, culminating in Monday’s unprecedented $120 price plunge, has investors asking whether a decade-long bull run is over. History would suggest that while gold has taken a beating, it is far from down and out.
Monday’s tumble to around $1,535 an ounce dragged prices 20 percent below the record $1,920 reached this month. But since its rise from just over $250 in early 2001, gold has bounced back from bigger drops, having fallen 25 percent between May and June 2006, and 27 percent in October 2008.
The headline “Gold falls on profit-taking“ is as common as cold fronts on the evening weather report. Some days are warm, some days are cool. Speculation may burn some people in the short term (Peter Schiff, CEO of Euro-Pacific Capital, calls it “speculative froth“), but gold bounces back. Like a penny stock pumper? Really? Comparing gold to last week’s dicey business venture seems to be a bit short-sighted. Nonetheless, my critic offered some further reading: Gold: Bubble or Not? (8/28/2011), by Marc Schindler of Forbes.com, to which I shall return.
Why does gold bounce back? Recall that I am not formally trained on these matters, so perhaps take my opinions on them with a grain of salt. Everything I know about economics, I learned from Mises Institute Media. I have been a regular listener since a colleague recommended that I buy gold as early as 2004. One of this collection’s greater influences on me has been Jeff Riggenbach’s audiobook reading of Murray Rothbard’s What Has Government Done To Our Money?, which left me with what I feel is a working knowledge of what money is and how it works. Other Mises Institute lectures offered a layman’s guide to economic bubbles. The most memorable and concise of those has been Thomas E. Woods, Jr.’s retelling of the Austrian theory of the business cycle and Ludwig von Mises’s parable of the master builder, from Woods’s lecture Why You’ve Never Heard of the Great Depression of 1920 (4/5/2009). Although I recommend watching the full 49-minute video, the excerpt beginning at 29:26 and continuing about seven minutes through 36:20 is required viewing for understanding my perspective on economic bubbles:
Optional viewing to promote a deeper understanding would include Peter Schiff’s lecture: Why The Meltdown Should Have Surprised No One (3/13/2009).
The lesson of these videos, for me, was that speculation alone does not cause bubbles that burst. To create a bubble that bursts, an additional element is necessary: The thing people are speculating over has to be a dud. It has to be a rotten egg. At the very least, it must be overvalued. If the thing people are speculating over is actually valuable, then you’ll get spikes and you’ll get dips but you won’t get a bubble that bursts. The gold is not in a bubble because gold is valuable.
Gold is valuable because it is useful asset. Anyone who tells you otherwise is suffering a disconnect to from reality. Marvel, for example, at the delusions of Marc Schindler, author of : Gold: Bubble or Not? (8/28/2011):
Gold is an useless asset. It does not produce earnings, it does not pay dividends or interest, and it has few industrial uses. The only things it does well is look pretty. … We plotted the ratio of the gold price to the value of the S&P 500, to the GDP, to an index tracing industrial metals (i.e. those that are useful rather than just pretty), and to the median family income. …
Rarely do I encounter statements of such profound ignorance. Gold has two major uses aside from its relatively minor industrial uses. First, gold is used to make ornaments that rich people use to decorate their bodies and that regular people use to make themselves look like rich people. A multi-billion dollar industry, called the jewelry industry, developed a few millennia ago to satisfy demand for these ornaments. This industry still exists today. When Schindler opines, “the only thing it does well is look pretty,” he means to say, “the only thing it does well is form the foundation of the timeless, multi-billion dollar jewelry industry.”
I assume that Marc Schindler is at least aware of the jewelry industry. His error is not one of staggering obliviousness. Rather, he has erroneously imposed his his personal values on other people. Value is subjective. That he, personally, does not recognize the value of gold jewelry does not render gold “an useless asset”. It is useful to those who find value in such things. Golds recognized usefulness in making the consumer goods commonly known as jewelry induces gold’s second use.
Gold is useful as a store of wealth and as a medium of exchange. In addition to those who drape themselves in gold ornaments, rub gold on their faces, and swim in pools of gold, gold is valued by anyone who understands that other people in society will accept gold in trade. Not everyone who accepts gold in trade intends to use it for jewelry. They accept it in trade because, historically, there has never been a shortage of people who do use it for jewelry. Gold stores wealth and especially well because it has all the properties of a sound money. In addition to being fungible, it is durable, divisible, portable, and scarce. I believe that in the coming years, as economic conditions deteriorate, this use of gold will become much more popular, causing demand, and therefore prices, to climb. Thomas E. Woods, Jr. explained above why the economic outlook for the coming years. Let’s revisit the thought experiment.
We saw above how speculation can cause spikes and how it can ruin a rotten-egg penny stock here and there, but ruining the whole economy with the burst of one giant, resonating economic bubble requires an additional feat of economic magic: You have to convince countless people across the economy all to begin speculating on countless rotten eggs all at the same time. I know that some people are greedy and some people are fools some of the time, but that doesn’t destroy an entire economy. Entirely destroying a free and diverse economy requires a serious coordinated effort. For that you need monetary central planners.
Although I did take a class in banking a few years ago in law school, I can not profess an intimate knowledge of the details of the Federal Reserve system. I can say this: The Federal Reserve, through a couple different mechanisms, sets the interest rates at which banks borrow money. This is a form of price-fixing, as interest rates represent the price of borrowing money.
Prices communicate important information to investors. In a free market, interest rates would be a function of national savings. As people leave more money at their banks, their banks have more money to lend to entrepreneurs and investors. The price of borrowing money therefore would drop. Low interest rates, in a free market, would communicate to investors that the time is right to invest in long-term projects. As those projects come to fruition, those who had been saving their money will be ready to consume the fruits of those long-term investment projects. In a free market, interest rates would naturally coordinate present savings and future consumption. Interest rates mean something.
America’s economy is not a free market. The Federal Reserve commands and controls America’s monetary system from the top down. Rather than allowing consumers to indicate their preferences for deferring consumption, Alan Greenspan’s Federal Reserve commandeered interest rates and used them to drive the economy during the 2000s. The result was that investors were misled into investing while consumers were not saving. Houses were built, and that put people to work. That was the boom time. Once the houses were built, however, nobody had any money to live in them. Mortgages defaulted. The housing bubble burst, and the economy collapsed. Ten years later, Ben Bernanke’s Federal Reserve is doing the same thing all over again: it is forcing interest rates down to near zero to spur long-term investment that should not take place. Any investments that are based on the false signals conveyed by the Federal Reserve’s price-fixing will be rotten eggs. They are destined to fail all across the economy. The question is when.
Therein lies the value of gold as a store of wealth and as a medium of exchange. As our government’s fiscal and monetary policies become more reckless and irresponsible, people are going to want a to save some of their wealth outside of risky investments and inflating fiat paper money. Gold will be there for them as it has been for thousands of years. People will flock to it not to get rich quick, but rather to save what they have. As they flock, the price will rise.
This has been the sense among the gold-bug and hard money websites that I have frequented since I became interested in gold, which include Kitco.com, Coinflation.com, the writings of “Mogambo Guru,” Richard Daughty at DailyReckoning.com, The American Advisor radio show (at least back in the Joe Battaglia days, when I had more time to listen), among others. The pitch for gold has never been that you can get rich quick on the stuff if you buy it and take profits. The pitch has always been that you should buy the stuff and hold onto it because the people running our country are irresponsible, and their policies will drive our economy to ruin. “Speculative froth” may come and go, but protection against economic disaster has been the base of the market for gold as an investment for at least as long as I’ve observed. As long as our government and monetary central planners continue to act recklessly with their deficit spending and their interest rate manipulations, protection against economic disaster will continue to carry the gold market.
It is obviously a freight train that can not be stopped.
Will anything change my mind about gold? Yes. If any one of the following events occur, I will change my mind about gold.
- After 4000 years of consistent popularity, gold jewelry goes out of style as a fashion accessory. When people stop using gold, its price will plummet. This is not completely unprecedented. Ad man Rory Sutherland tells us of the wealthy Prussians, who were persuaded to donate their gold jewelry to help the war effort of 1813 against the French, and who were given in return replica jewelry made of cast iron the popularity of which lasted fifty years hence. Perhaps one day gold really will be “an useless asset”. Not impossible, but unlikely.
- Alchemy is vindicated as a science. When scientists figure out how to extract gold from more common materials, the price of gold will plummet. This phenomenon has a precedent in aluminum, which was originally rare and precious, but became common when a method of extracting it from ore was perfected. Those who invested fortunes in aluminum in the late 18th century were all wearing sad faces by the early 20th century. Could it happen to gold? Not any time soon, I don’t think. Apparently, not even Star Trek replicators could create the stuff. (On the other hand, I think the Enterprise crew used iPads. We may be closer than you think.)
- The government ends its reckless and wrongheaded fiscal, monetary, and economic policies and adopts a program of austerity. As I type, our government is 14,790,340,328,557.15, or about 40% of GDP, in debt. That’s a lot of beans. With a deficit national deficit currently at about $1,300,000,000,000, or 8.5% of GDP, and a Federal Reserve that is still having its way with interest rates, the trend of recklessness does not seem to be even slowing, let alone reversing. This is despite all the lip service we have been hearing lately about the debt ceiling, etc. The government may default outright, leaving creditors empty handed and disgruntled, or the government may pay the debt. The government may pay the debt by either sucking huge amounts of resources out of the private sector or by printing the money it needs, thereby destroying the value of the dollar. All of these outcomes will wreak havoc on the economy in future. I don’t think politicians can change the course. I think their time preferences are too short and their incentives are too perverted. If they did manage to change course, through some miracle, I think our nation would emerge from this recession prosperous, and less in need of a store of wealth.
Someone convinces me that the government’s current economic policy will not bring about future economic decline. I can’t discount the possibility that maybe everyone hasn’t lost their marbles. Maybe the only one who has lost his marbles is me. I try to be fair. I may not be very good at it, but I try. I seek differing opposing opinions, but there simply aren’t many to be had. A telling case study is the one-sided “rivalry” between the Austrian economists at the Ludwig von Mises Institute, especially Robert P. Murphy, and mainstream economist Paul Krugman.
Notice the volume of articles at Mises.org under the tag “Krugman“. Just about any time Krugman scribes any noteworthy oracle from his blog at the New York Times, the Mises Institute is right there with a plausible response. Krugman rarely responds in kind. When he does, his responses are usually dismissive, cryptic, laden with invective, and/or bereft of any serious economic analysis whatsoever. On those rare occasions when Krugman does take the time to respond reasonably to a Mises article, someone from the Mises Institute, often Murphy, immediately pounces with a reasonable response of his own. Last year, Murphy gave an hour long lecture in which he addressed the few criticisms that were floating about at the time.
Murphy has offered to debate Paul Krugman, and has attempted to induce Krugman’s acceptance with a pledge drive that at the time of this writing has received $69,010, all to be delivered to the Food Bank of New York City if and when Krugman accepts the challenge. The pot sits unclaimed.
I would like for mainstream economists to take the Austrian theory of the business cycle, as explained above by Thomas E. Woods, Jr., more seriously. They should recognize that, from the layman’s perspective, the theory is intuitively attractive and worthy of a more complete response. If they do provide one, and convince me that government stimulus will fix the economy, then I will change my long-term opinion about gold. So long as they continue to ignore and dismiss the Austrians, I will be more inclined to believe the guys who not only make sense on their own, but who also diligently answer their challengers.
Enjoy these videos of Austrian-inspired policiy-makers and investors making plain sense:
That, my friends, is why I believe gold is here to stay and a run-down of the sort of things that will change my mind. This list is not inclusive. If you can convince me to change my mind about gold, I’d love to hear from you!