In a headline piece on roubini.com, Nouriel Roubini writes an extended article slamming both gold bugs, and the so-called gold bubble, which he believes is far too volatile, and which, contrary to ever increasing claims to the opposite, will likely not get to the mythical price of $2000/ounce, and instead will head lower. The argument presented, as is widely the case, boils down to the trifecta of i)gold having no industrial utility, ii) no intrinsic value (no associated cash flow streams) and iii) costing an arm and a leg to store. While Roubini's thesis is attractive on the surface (if somewhat Keynesian and thus often reiterated by mainstream Economists), we present some counter arguments to Roubini's thesis.
Roubini summarizes the current situation:
In the last nine months, concerns about a global depression have dissipated and the global economy is recovering from its worst recession in decade; deflation is still gripping the global economy as the slack in goods and labor markets persists at high levels. So why have gold prices started to rise sharply again in the last few months, in spite of no near-term risk of inflation or of depression? And could gold prices rapidly rise towards $2000?
On the one hand, the Doctor does see the pro-gold argument, which he highlights in five main points:
There are several reasons why gold prices are gradually rising, but they do not suggest a rapid rise toward $2000; at most they suggest a gradual rise with significant risks of downward correction.
- First, while we are still experiencing global deflation, there are rising concerns that inflation may reemerge forcefully in the medium term because of large monetized fiscal deficits.
- Second, a massive wall of liquidity—borne of easy monetary policy—is chasing assets. Some of those assets include commodities like oil and base metals—the rise of which could eventually become inflationary.
- Third, dollar funded carry trades and a more generalized portfolio allocation to non-dollar assets (especially EM assets) are pushing the U.S. dollar sharply down. There is an inverse relation between the value of the dollar and the dollar price of commodities: the lower the dollar the higher the dollar price of oil and other commodities, including gold. The rise of gold in euros has been much more muted.
- Fourth, the global supply of gold—both existing and newly produced—is limited, and demand is rising faster than supply over the medium term. The recovery of the global economy has started a revival of retail gold demand especially in India. Central banks looking to diversify their portfolios account for further demand—see for instance, the recent increase in gold holdings by emerging market central banks. Most of the increase in demand comes from private investors using gold as a hedge against low probability tail risks of high inflation and another near depression caused by a double dip recession. Inflation risk and the risk of a double-dip are both low, suggesting lower gold prices, but increasingly investors want to hedge against such risks early on. And given the inelastic supply of gold, it only takes a small shift in the portfolios of central banks and private investors to boost increase the price of gold significantly.
- Finally, as sovereign risk is rising—see Dubai, Greece and other emerging markets and advanced economies—the concern about sovereigns not being able to back stop too-big-to-save financial system could rise again.
On the other, Roubini, sticking to the Socratic method, lays out the counter argument for a quick drop in gold prices:
- First, the dollar carry trade may at some point unravel, popping the global asset bubble that this carry trade has fueled.
- Second, central banks will eventually need to exit quantitative easing and effectively zero policy rates, which will put downward pressure on risky assets including commodities.
- Third, bouts of global risk aversion may occur as the global recovery may turn fragile, anemic and subpar, thus leading to a rise in the U.S. dollar that would drive down prices of commodities and gold in dollar terms.
- Fourth, since the carry trade and the wall of liquidity are causing a global asset bubble, some of the recent rise of gold is also bubble driven by herding behavior and momentum trading, pushing gold higher and higher. But all bubbles eventually crash and the bigger the bubble the bigger the eventual crash.
- Fifth, the effect of rising sovereign risk on gold prices is ambiguous, as the events of recent weeks suggest. A risk in such risk could push up the price of gold if it leads to expectations that central banks will eventually monetize those fiscal problems. But in practice it has weighed on the price of gold because it has increased investors’ risk aversion and led to a rush into a different (and more liquid) asset than gold—e.g. the U.S. dollar—thus pushing gold prices down. In general, gold always competes with fiat currencies and anything that is dollar bullish—like repeated bouts of global risk aversion—tends to be gold bearish.
At the heart of Roubini's argument is a principle that is self-evident when one looks at the price dynamics of various asset classes today: that inflation is still in check. Of course the threshold between reserve accumulation by FR banks (which is now at ~$1.2 trillion) and all that excess money spilling over is all the stands between an environment of muted "disinflation" and runaway, spiraling and uncontrollable hyperinflation. And should the Fed lose control over a runaway monetary train, Gold at $2000 will be a distant memory. But more on that in a second. First, Roubini on why gold bugs' expectations will soon be dashed:
Thus, the gold bugs are wrong—or at least very, very premature—in justifying buying gold as an attack on fiat currency. The velocity of money is still low or falling—the opposite of a currency crisis or run on the dollar. As a further indication of the collapse of credit/money multipliers, indicators of expected inflation are subdued or falling, despite governments printing money (excess reserves). The high inflation scenario may be constrained even if/when easy money gains too much traction, as the yield curve would steepen sharply, raising the discount rate for risky private sector debt and for corporate equity, limiting the speed of the recovery and hence the ability of states to impose inflation surprises in the context of shortening average debt maturities.
Finally, let’s assume the global economy double dips and concerns about near depression and sharp deflation reemerge. Should investors hold gold in that world? In a true world of near depression, gold bars are pretty much useless. Keynes referred to gold as a “barbarous relic.” Unlike other commodities, it has little intrinsic value. Much like a fiat currency, gold’s value is based largely on the irrational beliefs of investors. In a depression or near depression, one would be better off stockpiling canned food and other commodities like oil that are useful for riding out Armageddon. You cannot eat gold or burn gold.
Investors should thus be wary of getting the gold bug and being stuck with this barbarous relic. The recent swings in gold price—up 10 percent one month, down 10 percent the next—prove the point that gold has little intrinsic value and that most of its price movements are based on beliefs and bubbles. As an insurance policy against the tail risk of eventual inflation, it may be useful to hold a small amount of gold in one’s portfolio, but stocking up portfolios with a fiat currency that has marginal practical use, a zero nominal interest rate, high storage costs, and the price of which is subject to volatile whims and bubbles is totally irrational. If you want to hedge against inflation, stock up on Spam or other canned food or buy futures on commodities that have more physical uses and consumer demand.
We disagree with the professor across a few key points. As Dr. Roubini himself will acknowledge, the primary reason for the rapid "improvement" in asset valuations, and the postponement of the double dip/next leg of the depression, is solely due to global central banks having themselves onboarded private sector asset exposure as the very last option to prevent an all out collapse of the financial system: individual sovereigns' taxpayers are now the owners of what used to be Merrill's toxic CRE loan bonanza. Whereas a year ago the collapse of Goldman would have been possible without it also involving an at least technical default by the US, we are now beyond such capitalist flights of fancy, courtesy of the Bernanke Put (let alone the discussion of what the MTM mismatch of the central bank balance sheet is - courtesy of increasingly more lax accounting standards, the spread between fair value and book value, as we have reported, keeps increasing and could potentially be a 20%+ delta). These assets need to produce cash flow, which they do not, or at least not to a point where the Fed's balance sheet is self-sustainable. Which explains the massive money printing, via QE, although as pointed out the actual cash does not hit circulating money, but merely ends up at the banks, earning 0.25% (why not: on $1.2 trillion it amounts to $3 billion a year in absolutely risk-free taxpayer subsidies). The main reason, as Zero Hedge will shortly show, why the dollar keeps getting pillaged versus its main counterpart, the euro, is that while the Eurozone balance sheet has stayed flat, courtesy of a mortgage bubble that never hit the ludicrous size of its US counterpart, the US Federal Reserve "assets" keep rising, and at a rate which is the inverse of incremental dollar devaluation.
In essence the only reason why gold has appreciated less in terms of Euros is thanks to US generosity to assimilate European toxic asset losses, via an osmotic, and nearly 1-to-1 increase in equity markets between America and Europe. In this way, even as the euro continues not devaluing, the implicit Eurozone inflation is still nonetheless occurring, courtesy of increasing equity values, which happen purely on a sympathetic reflex to what the S&P is doing in New York. Another interesting observation are the comparable rates of expansion of the balance sheets of China and US - once again China is taking advantage of not only the dollar peg, but of it having even less a vocal political system to keep the printer in check (i.e., the absence of its own version of Ron Paul allows it print its way to "9% GDP prosperity" every year). At the end of the day, the Fed can only carry the burden of importing global inflation so long before the need to tighten is the opportunity cost of the Fed Chairman's job (and the ruling party's continued majority in the House and the Senate). And this is precisely the day that gold bugs live for.
Mr. Roubini is wrong on one key argument: gold bug mania is not so much driven by the dream of fiat currency destruction (we all know the race to the bottom is on everywhere except in Europe which as discussed above has it own unique set of circumstances), but by the volatility in the actual reversal from expansion to contraction monetary phases. The Fed is in uncharted monetary policy territory, and way out of its comfort zone. If history is any indication, Greenspan, who was unable to control the runaway train of monetary glutting in the early 2000s, is a perfect case study of what will happen - why would Bernanke, who is Alan "Moral Hazard" Greenspan reincarnated, get it right? Especially, having demonstrated over the past month a complete lack of comprehension of asset bubble existence. And that particular bet explains why all the smartest money is currently accumulating it. Many pundits have said that the one who times the switch to inflationary policy by the Fed will be the richest man in 2010 (or 2012 if Goldman is right). Yet gold is a negative carry-free way to make just such a wager with the broadest possible time horizon: gold's lack of positive carry offsets precisely the theta bleed which one would incur if one was merely rolling S&P puts constantly waiting for the Nassim Taleb moment of six sigma plus singularity. Also, once purchased, there is no need to roll the gold contracts, especially in physical form. At the end of the day, if the monetary skeptics are right, and they most likely are, the Fed will not only be unable to rein in inflation but we will go straight to hyperinflation and not pass go. At that moment the price of gold will hit escape velocity. And as in hyperinflation traditional supply/demand mechanics collapse, especially for such industrial metals as copper, aluminum, and, yes, even silver, gold's lack of intrinsic value will be the main thing in its favor. Furthermore, with gold prices representing a nearly 80% discount on the global monetary base in simple value terms, in a scramble to a makeshift gold standard, the next resistance level will be not $2000, but $6000/oz.
Yet in all honesty, we do agree with Roubini, that at that point in the future, when all non-gold commodities are flatlining, spam will likely be just as valuable as gold. Unfortunately, lead will be in a league of its own. If that is the price to pay for the terminal proof of flawed-from-the-start Keynesian economics, and the failure of the Federal Reserve as the bastion of Wall Street's "second estate" interests, and the subsequent demise of both, it may just end up being worth it.