After the Gold Rush

The run-up in gold prices in recent years – from $800 per ounce in early 2009 to above $1,900 in the fall of 2011 – had all the features of a bubble. And now, like all asset-price surges that are divorced from the fundamentals of supply and demand, the gold bubble is deflating.

At the peak, gold bugs – a combination of paranoid investors and others with a fear-based political agenda – were happily predicting gold prices going to $2,000, $3,000, and even to $5,000 in a matter of years. But prices have moved mostly downward since then. In April, gold was selling for close to $1,300 per ounce – and the price is still hovering below $1400, an almost 30% drop from the 2011 high.

There are many reasons why the bubble has burst, and why gold prices are likely to move much lower, toward $1,000 by 2015.

First, gold prices tend to spike when there are serious economic, financial, and geopolitical risks in the global economy. During the global financial crisis, even the safety of bank deposits and government bonds was in doubt for some investors. If you worry about financial Armageddon, it is indeed metaphorically the time to stock your bunker with guns, ammunition, canned food, and gold bars.

But, even in that dire scenario, gold might be a poor investment. Indeed, at the peak of the global financial crisis in 2008 and 2009, gold prices fell sharply a few times. In an extreme credit crunch, leveraged purchases of gold cause forced sales, because any price correction triggers margin calls. As a result, gold can be very volatile – upward and downward – at the peak of a crisis.

Second, gold performs best when there is a risk of high inflation, as its popularity as a store of value increases. But, despite very aggressive monetary policy by many central banks – successive rounds of “quantitative easing” have doubled, or even tripled, the money supply in most advanced economies – global inflation is actually low and falling further.

The reason is simple: while base money is soaring, the velocity of money has collapsed, with banks hoarding the liquidity in the form of excess reserves. Ongoing private and public debt deleveraging has kept global demand growth below that of supply.

Thus, firms have little pricing power, owing to excess capacity, while workers’ bargaining power is low, owing to high unemployment. Moreover, trade unions continue to weaken, while globalization has led to cheap production of labor-intensive goods in China and other emerging markets, depressing the wages and job prospects of unskilled workers in advanced economies.

With little wage inflation, high goods inflation is unlikely. If anything, inflation is now falling further globally as commodity prices adjust downward in response to weak global growth. And gold is following the fall in actual and expected inflation.

Third, unlike other assets, gold does not provide any income. Whereas equities have dividends, bonds have coupons, and homes provide rents, gold is solely a play on capital appreciation. Now that the global economy is recovering, other assets – equities or even revived real estate – thus provide higher returns. Indeed, US and global equities have vastly outperformed gold since the sharp rise in gold prices in early 2009.

Fourth, gold prices rose sharply when real (inflation-adjusted) interest rates became increasingly negative after successive rounds of quantitative easing. The time to buy gold is when the real returns on cash and bonds are negative and falling. But the more positive outlook about the US and the global economy implies that over time the Federal Reserve and other central banks will exit from quantitative easing and zero policy rates, which means that real rates will rise, rather than fall.

Fifth, some argued that highly indebted sovereigns would push investors into gold as government bonds became more risky. But the opposite is happening now. Many of these highly indebted governments have large stocks of gold, which they may decide to dump to reduce their debts. Indeed, a report that Cyprus might sell a small fraction – some €400 million ($520 million) – of its gold reserves triggered a 13% fall in gold prices in April. Countries like Italy, which has massive gold reserves (above $130 billion), could be similarly tempted, driving down prices further.

Sixth, some extreme political conservatives, especially in the United States, hyped gold in ways that ended up being counterproductive. For this far-right fringe, gold is the only hedge against the risk posed by the government’s conspiracy to expropriate private wealth. These fanatics also believe that a return to the gold standard is inevitable as hyperinflation ensues from central banks’ “debasement” of paper money. But, given the absence of any conspiracy, falling inflation, and the inability to use gold as a currency, such arguments cannot be sustained.

A currency serves three functions, providing a means of payment, a unit of account, and a store of value. Gold may be a store of value for wealth, but it is not a means of payment; you cannot pay for your groceries with it. Nor is it a unit of account; prices of goods and services, and of financial assets, are not denominated in gold terms.

So gold remains John Maynard Keynes’s “barbarous relic,” with no intrinsic value and used mainly as a hedge against mostly irrational fear and panic. Yes, all investors should have a very modest share of gold in their portfolios as a hedge against extreme tail risks. But other real assets can provide a similar hedge, and those tail risks – while not eliminated – are certainly lower today than at the peak of the global financial crisis.

While gold prices may temporarily move higher in the next few years, they will be very volatile and will trend lower over time as the global economy mends itself. The gold rush is over.

This piece is cross-posted from Project Syndicate with permission.

17 Responses to "After the Gold Rush"

  1. M. Siddique Ahmed   June 4, 2013 at 4:06 am

    The analysis given above is a nice one and will help me in trading gold

  2. Kaimu   June 4, 2013 at 6:16 am

    Aloha! I too appreciate this analysis and would like to understand from Nouriel how the price of gold increased from $265USD in 2001 to $1025USD in 2008 during a time when the Fed Funds Rate was over 5%. From 2001 to 2008 the gold price increased around $765USD during an economic boom with the housing market and unemployment was much lower. From 2001 to 2008 there was no QE. During the 2001 to 2008 time frame wages did not spiral either and official inflation was capped at <3%.. From 2008 to 2011, the post-TARP crisis where the Fed Funds Rate crashed from over 5% down to 0.50% the price of gold increased $850, not much more than the time period where the Fed Funds Rate was over 5% and we had economic prosperity and virtually no fear at all in the markets or the economy. Nearly the complete opposite of today. In 2001 US Debt was around $6TRIL and by 2006 was around $8.5TRIL, the prime housing market years and a period of robust economic growth with no fear. How is it the gold price increases in both of those extremely different monetary and economic and sovereign debt scenarios?

    • Sonny   June 4, 2013 at 7:05 am

      Maybe, that was the "volatility" he was talking about………………LOL.

    • CRO   June 11, 2013 at 2:44 am

      The answer should be obvious and is there for everybody to see: "So gold remains John Maynard Keynes’s “barbarous relic,” with no intrinsic value and used mainly as a hedge against mostly irrational fear and panic."

  3. hugo   June 4, 2013 at 8:31 am

    What will happen when the central banks will exit from the extreme quantitative easing and zero policy rates? Nobody knows. This is uncharted territory. OK, Interest rates will likely go up. But real interest rates? – As long as they are negative it’s positive for gold. What are the investment alternatives when bond prices AND stocks go down?
    And remember: Greece is still in the Euro zone ;)

    • Kaimu   June 4, 2013 at 11:38 am

      Aloha! From 2003 to 2006 the Fed Funds Rate(FFR) increased from 1% to 5.25% and nobody called 5.25% "negative real rates". In 2007 the FFR was at 4.75%. Still not negative. It was not until 2008 that the FFR dropped from 3.5% to 0.25%. In 2008 the gold price was flat, averaging $850USD. If you look at the actual historical evidence based on interest rates, which are set by the US FED you would concur that the gold price increases when rates rise. From 1976 to 1980 the Fed Funds Rate went from 4.5% to 19%. The gold price increased from $100USD in 1976 to $850 in 1980 when the FFR was 19%. I do not understand what the fundamental driver is for the gold price is. The post-TARP era has seen the price of gold increase and the pre-TARP era has seen the price of gold increase. What is the common denominator?

  4. Peter   June 4, 2013 at 9:02 am

    Eventually, all countries will be back on the gold standard. That is why the central banks are buying gold. That is why the price of gold will spike. The drop in the price of gold was manipulated in the paper market. Nobody is selling their gold. Yes, it is being redeemed in GLD by those that manipulated it in the first place.
    I am surprised that Roubini doesn't see that. It is the confiscation of gold just like back in 1933 but done in a different way. I am also surprised that he thinks inflation is low. Perhaps he has too much faith in the information coming from the government and he doesn't pay attention to real price increases due to increases in the money supply.

    • CRO   June 11, 2013 at 2:47 am

      You just read the article. Is this comment what psychologists call 'cognitive dissonance'…? ;-)

  5. yeh sure   June 4, 2013 at 10:11 am

    Roubini's excellent post which reiterates stupid conventional logic is marking the end of the pullback. Didn't he ever learn about Elliott waves? 5 waves up and then a 38.2% fib retracement is the norm before heading on the next wave up. And all this talk about there being no more risk, etc. is ridiculous. Just look at the debt vs gdp chart and you will see that it is taking exponentially more debt in order to maintain linear GDP growth. Nobody can maintain exponentially anything for very long so the the fed collapse will come sooner than anyone can believe, especially nouriel.

  6. Robert Patterson   June 4, 2013 at 11:44 am

    The shocking thing about the lack of a larger spike in the price of gold, is that it indicates that the deflationary atmospere of the last years was so great that the billions poured in to the economy did not cause any appeciable inflation. So some credit must be given to the seers of the Fed, who showed their skill.

  7. Deon Opperman   June 4, 2013 at 5:24 pm

    Forgive me, but I think this article is naive in the extreme. Are you suggesting that by some or other "it's different this time" logic that just because inflation is being suppressed by a number of mechanisms and variables, we shall happily continue with no inflationary repercussions from the trillions of funny money that has been created? Just 8 years ago pundits were claiming that the world had entered a state of perpetual prosperity. Hello?

  8. touretul   June 6, 2013 at 10:02 am

    this article is complete bullshit

  9. Tejas552   June 7, 2013 at 3:04 am

    Prof. Roubini's analysis is very interesting. However, I think he goes too far in deriding those who favor gold investments as "extremists" and "fanatics". Our current fiat monetary system is still an experiment. Since the 18th. century the US made several attempts at issuing paper money – all have failed save the latest one which is still ongoing. The current dollar has lost about 96% of its value since inception of the Fed – most of the value was lost since 1971, when the Nixon administration reneged on the US' promise to convert central bank claims in gold. Expressed in ounces of gold a typical house in the UK costs the same today as in 1930. A person born in Germany in 1920 and receiving a 20-Reichsmark gold coin for his baptism would today have the equivalent of about 350 euros. The same 20 Reichsmark in paper money (or bonds or stocks) would have been destroyed several times over.

  10. Tejas552   June 7, 2013 at 8:22 am

    I think Prof. Roubini is wrong when he says that gold has no intrinsic value. Gold is an extremely useful commodity. The range of its uses expands as the price falls. Indeed, in the past 6000 years of recorded human history, the value of gold has never even once fallen to zero or close to it. No nominal asset can match this.

  11. Tejas552   June 7, 2013 at 8:32 am

    Inflation is low and falling, according to Prof. Roubini. However, inflation is not about abstract price indices that are prone to manipulation. Inflation is about the purchasing power of money and this purchasing power is measured not only in CPIs and PPIs, but also in asset prices, commodity prices, wages and in prices of things that cannot be reproduced, such as original works of art, or real estate in prominent locations. Prices for the latter two categories have gone through the roof in recent years and we all know what is happening with asset prices too. Purchasing power is evaporating rapidly, depending of course on what sort of things you buy.

  12. BWilds   June 13, 2013 at 6:44 am

    What happens to the price and the value of gold if government confiscates it or makes it illegal to sell and own. And most of all unless it is in your possession, gold may be for many no more then a promise on paper or implied, remember if you own gold that is represented by a certificate, you own a piece of paper. As interest rates rise the carrying charge of owning gold will increase. All these factors make me question the value of everything, more about this in the post below,

  13. mary chang   June 29, 2013 at 8:12 am

    1. Economists keep saying: "THERE IS NO INFLATION…" But my grocery bills have tripled (approximately) in the past several years.
    2. Will someone please convince my grocer that he is out-or-touch with Economics?
    3. Or is he? (Out-of-touch with reality, I mean…)
    4. SOMEONE is clearly out-of-touch with GROCERY BILLS — either Grocers, or Economists. …