From Paper Money Collapse, 23 May 2011.
The widely-read Lex column in today’s Financial Times ran an article on gold ETFs (exchange-traded funds) that regurgitates a couple of assumptions on gold that are popular in the mainstream media and financial market circles. They are: 1) gold must be in a bubble and 2) this bubble must soon pop.
As Lex put it:
“Predicting the top of the gold bubble is foolhardy. It is safer to predict that the bubble’s popping will be especially nasty.”
In order for gold to be in a bubble I would suggest that two conditions have to be met: First, some erroneous but popular belief as to the merit of and ongoing demand for this asset has to capture the general public. (“On the national level, house prices in the United States never go down.” “All dot.com stocks will have market caps of billions of dollars.” “Those tulips will always be in demand.” “Governments can and will always pay debt in their own currency.”) Second, the bubble has to be inflated with easy money. I would even argue that this second condition is the more important one. If you pump enough new money into the economy and provide enough cheap credit, some irrational belief will soon emerge and bubbles will get inflated.
There is obviously plenty of easy money around – and it is certainly the reason for the gold rally, but not in the way that cheap credit created the housing bubble or stock market bubble. Gold is not rallying because it is so easy to buy gold on credit and because banks are falling over one-another to put it on their balance sheets or use it as collateral for their fractional-reserve lending business. Indeed, a key message of the Lex article seems to be that gold ETFs are – contrary to some reports – indeed solidly gold-backed and thus pretty much as good as direct bullion investment. This means they are not over-inflated derivative structures around some small core gold holding, or in any other form the result of financial trickery. Whether this is indeed the case or not is a different topic. I do not want to comment on it here other than to point out that I personally still prefer direct investment in physical gold. Be that as it may, gold appears not to be rallying in response to financial leverage in the gold market, and that is an important difference to all other recent bubbles (such as real estate in the U.S. pre 2007, in Japan pre 1989, or in China today).
What I do find interesting, however, is that the Lex-writer uses the ETF story to argue that gold must still be in a bubble. The rationale seems to be as follows: ETFs have lowered the barriers to entry for gold investing. ETFs constitute a fairly low cost, liquid, and easily accessible way to bet on a rising gold price and thus have drawn a new set of investors to this precious metal. The new demand caused the price to rise, and the rising price has continued to attract ever more buyers. The rally is now feeding on itself. The latter point is not dissimilar to the one used by Warren Buffett to dismiss the gold rally when he
“…tells shareholders that he understands why rising prices can create excitement and draw in buyers, but it’s not the way to create lasting wealth.” (CNBC)
So according to this narrative, gold is not rising because of financial leverage but because of a fashion for ETFs. That fashion shows signs of petering out as – according to Lex – evidenced by the data from the World Gold Council that shows outflows from these instruments.
Yeah? So what?
According to the World Gold Council, in Q1 of 2011 outflows from ETFs and similar products totalled 56 tonnes.
At the same time, inflows into bullion and coins totalled —366.4 tonnes. That is a 52% year-on-year increase in physical demand and almost a doubling of demand if measured in rapidly declining paper dollars.
Continue reading at Paper Money Collapse