Here’s a perfect sentence to draw the ire of gold bugs: “But like paper money, gold is worth only what people believe it is worth, and because of this, it is sometimes referred to as the barbarous relic.” Look at all the buttons it presses: comparing gold to paper money! Saying that its value is just as much a convention – or, if you prefer, a “Ponzi scheme” – as that of fiat money! Using “barbarous relic” non-ironically!
That gem comes from a column last night by the Times’s Deal Professor Steven Davidoff, who set out to comprehensively annoy the Ron Paul crowd by arguing that U.S. regulators and exchanges should act to restrict leverage and limit holdings of gold because the metal is in a speculative bubble. The evidence for this includes that hedge-and-speculation demand has doubled in the last two years while industrial-and-jewelry demand is actually down, suggesting that gold is not so much trading on fundamentals. The recommendations:
Yet if regulators are going to stop the next bubble, they will need to act aggressively. Of course, they shouldn’t act in every circumstance, but when we see volatility and speculation as is the case of gold, acting to curb these forces through limiting leverage in cooperation with international regulators would be a prudent course. This would ensure that if a crash does come, it does not have aftereffects on banks and other institutions. Even if the Commodity Futures Trading Commission is hesitant to take such steps, it could, as an initial foray, take to the media to try to “talk down” the speculation.
For our own safety we’re not going to weigh in on whether gold is overpriced or underpriced, or on whether current gold demand is driven by (1) sensible concerns about inflation on the part of savvy investors or (2) Glenn-Beck-driven survivalist freakouts by financially illiterate retail buyers.* We’ll just point out that, if you’re going to have a bubble, this is a really sweet one to have.
Think of our last big bubble, in housing, and the slow-burn current one in European sovereign debt. Here are some bad things that come from bubbles bursting:
Systemic effects when the buyers of the bubble are banks . Or investment banks, money funds, or other quasi-banks. When those things lose lots of money, that’s really bad: financial systems freeze up, real-economy companies can’t borrow or access their cash deposits, and earthquakes and hurricanes and plagues of locust cover the face of the earth.
When Glenn Beck viewers lose their day-trading money, not so much. Gold bugs, as Davidoff points out, skew retail. GLD and PHYS holders are a mix of retail investors, mutual funds, and hedge funds who for the most part are hedging uncorrelated trades. It’s hard to find gold-investor literature that doesn’t sound rugged-invidual-survivalist. When individual investors lose their investing capital, it’s bad for them – but the systemic risks are a lot lower than in a bank-driven bubble.
Overuse of leverage. Banks that held AAA rated subprime or Greek bonds were levered 10, 20 or 30 to 1, with opaque balance sheets that allowed them to defer raising capital when market values for their securities sank. Layering of CDOs allowed further leverage into the system.
The gold ETFs – which are a big piece of whatever retail-driven bubble there is – are U.S. traded stocks subject to fairly conservative margin rules. CME futures leverage is much higher – around 18:1 – but still has daily maintenance, in cash, based on liquid market levels. There are no gold CDOs. There is leverage in the gold bubble/non-bubble, but it’s relatively modest and transparent. A crash would wipe out equity but would not leave a lot of holders owing money.
Overinvestment in debt claims. If you financed housing in 2005-2007, you were driving up housing prices; if you bought Greek bonds in the last few years, you were propping up Greek spending. When those bubbles crashed not only did your asset values fall, but the borrowers still owe you money and are underwater. They have houses worth less than their mortgages, or they have a tax base that is less productive than required to pay back their bonds. That’s a long-term drain as borrowers have to pay back their loans to lenders who can’t afford to write them down. Both sides of the trade are hosed, and for a long time.
But a bubble in shiny yellow metal? If you buy gold and it collapses, no one else is left on the other side of the trade trying to sort things out. You’ve just got some less valuable metal. Go make yourself some cufflinks.
Is gold a bubble? Maybe! But of all the candidates we've seen for the Next Big Thing in financial crises - student loans, social media stocks, U.S. treasuries - gold looks like a pretty weak contender.
* In unrelated news a CNBC poll today asks if the U.S. should return to the gold standard. Right now 63% say yes.