Gold is a funny asset class to handle. For most asset classes, they say that when your taxi driver starts telling you to buy that asset, its time to sell. Gold is the only asset class I can think of where even the (Indian) taxi driver has been a buyer - and not just now, but since a long time.
And yet the sharp rise & corrections in Gold prices raise the B-word (bubble) in our minds.
In the context of analyzing Gold prices, it is useful to look at Money. We can think of Money as a good with some special characteristics.
We may have studied at some point of time about the basic functions of money. It is used to denominate the value of goods & services, it acts as a store of that value and it is used as a medium of exchange.
Often, we say that Money has no intrinsic value. I don't entirely agree. Money, so long as it's credible money, has value in terms of the functions that it provides. In particular, the most useful functions that it provides are the storage of value and the elimination of the need for double coincidence of wants. It's a very big convenience. In the absence of money, suppose you wanted to eat an apple and you had oranges to pay the apple seller, but he wanted shoes (which you don't have). You would need to run around till you found someone who had shoes and needed oranges. Money derives its value from the fact that it eliminates this running around. In this sense, its a good.
However, it has some special characteristics. Firstly, in most countries, Money is a monopoly. The supply is controlled by the Government through the Central Bank. No one else is allowed the right to produce Money. Secondly on the demand side, the citizens have an obligation (not just a right but an obligation) to use only that Money and nothing else.
Now, the single most important hypothesis on which gold buying has been predicated is the fear that modern monetary systems will get replaced.
Such replacement can be voluntary or forced.
Voluntary replacement is, to put it mildly, out of the question. The modern monetary system is an outcome of over 40 years of expanding economic activity. Global GDP now is around 70 trillion USD, give or take a few trillion. The world's stock of financial assets, if assumed to be roughly 2.5 times this, would be around 175 trillion USD. I have no handle on the world's stock of real assets (which are not tied to financial claims), but it should be a few hundred trillion I guess. All of this would need to be denominated in Gold.
The world's supply of Gold is simply not enough to meet this. The annual physical market turnover of Gold at today's prices would be very roughly around USD 250 billion. The outstanding stock of Gold in the world is estimated to be around USD 8.5 trillion to 9 trillion. That's less than 15% of Global GDP. For the world's economic claims to be denominated in Gold, Gold prices will need to increase at least 40 to 50 times. In it's sterling rise so far (No pun on the Bank of England which sold Gold at 300 dollars an ounce) Gold prices have increased around 6 times in slightly over a decade. The increase would be much less when you consider the ratio of the value of Gold outstanding to that of the GDP or to that of Financial Assets outstanding.
Monetary replacement can be a forced one. Such a forced replacement, however, will happen after a severe, severe disruption. It will happen when people no longer have the faith in the currencies issued by Governments. It will happen in the total collapse of law and order. It will happen when people no longer want to denominate their claims in the Government's currency.
That can be a time for gold to really really shine. However, even under such a scenario, I do not imagine Gold being the only medium of exchange. It will be too expensive and inconvenient to do that. Try buying a loaf of bread with Gold. You will need to literally have it in particle form. Hence, each person will have a basket of goods - food grains, clothes, cattle etc which he will try to exchange. Gold will be one of them, albeit the most prized one. This is because among physical assets, Gold is the most efficient one in eliminating the need for double coincidence of wants and as a store of value.
Money has value only when money preserves value. If it doesn't preserve value, it loses value. It will start losing value when people lose faith in it. And the warning indicator that people are losing faith, is hyperinflation. I don't know exactly at what point inflation becomes hyperinflation, but basically it is the point when people start selling a currency due to lack of trust and start buying anything else that they can lay their hands on.
Do we see hyperinflation yet? Hardly. Headline inflation in the UK, Europe & US is between 3% to 5%. India is at 10% (high, but not hyper). China is around 5%. Asset markets such as Equities, Housing & Commodities have been declining in value. Government Bonds have rallied.
Clearly, there's a dissonance. Interest Rates are still low in the US, UK, Europe and Japan. Fiscal dynamics are horrible. And yet there is no hyperinflation. Do people by and large still seem to have enough faith in the currencies of their respective Governments? That's what developments so far seem to be telling us.
One reason why this is happening could be the mismatch between the global financial markets and global economic activity. Mismatch, in terms of financial markets being most developed in those countries which have the least economic growth taking place, and vice versa. For example, China & India present growth opportunities, but their financial markets lack depth and are not developed enough. Consequently, investors in the Developed World are forced to put money in Government Bonds & Cash, due to a lack of options. And its not about China & India presenting growth opportunities alone. The point is whether they have enough institutional development to allow such returns to be gained with less risk. That is not the case yet.
Greater institutional development in Emerging Countries will increase the decline in value of Developed World currencies. But such development is far from being a given. And even if it happens, it will happen over a long period of time.
Another reason, which I think is important, is that faith in a currency is not a function of monetary and fiscal dynamics alone. It is a function of many other things, such as the faith in the maintenance of law and order by the Government, its efficiency in promoting economic equality, it's ability to handle external threats and so on. Looking at monetary and fiscal dynamics alone and saying that faith in currencies will evaporate is too narrow a view. The Government derives its faith in the currency from a number of reasons. In a world which is inherently uncertain and volatile, status quo is at a premium. As long as Governments can deliver status quo, faith in currencies will be preserved. And the upside to Gold will be capped.
Is Gold in bubble territory? I frankly don't know. What I do know is that we see several elements common across bubbles, which can be seen in Gold as well (Think IT, Housing etc etc):
1) Low-Short Term Interest Rates For Funding Positions
2) Lack of Visible Cash Flows From The Asset (Investment Hypothesis Based Solely On Capital Appreciation)
3) Unquestioned "Long Term Buy" (Bigger Fool Theory?)
4) Herd Mentality: Its Now or Never; Buy Now Or You Will Never Get To Buy It! (This One's Almost A Clincher)
5) Initially, a Tendency to Buy Even After Violent Corrections
6) Ok, Even If Its a Bubble I Will Be Smart Enough To Exit Before Anyone Else (Ex-SuperBoss called this the Jallianwala Bagh situation)
Faites Vous Jeux...
And yet the sharp rise & corrections in Gold prices raise the B-word (bubble) in our minds.
In the context of analyzing Gold prices, it is useful to look at Money. We can think of Money as a good with some special characteristics.
We may have studied at some point of time about the basic functions of money. It is used to denominate the value of goods & services, it acts as a store of that value and it is used as a medium of exchange.
Often, we say that Money has no intrinsic value. I don't entirely agree. Money, so long as it's credible money, has value in terms of the functions that it provides. In particular, the most useful functions that it provides are the storage of value and the elimination of the need for double coincidence of wants. It's a very big convenience. In the absence of money, suppose you wanted to eat an apple and you had oranges to pay the apple seller, but he wanted shoes (which you don't have). You would need to run around till you found someone who had shoes and needed oranges. Money derives its value from the fact that it eliminates this running around. In this sense, its a good.
However, it has some special characteristics. Firstly, in most countries, Money is a monopoly. The supply is controlled by the Government through the Central Bank. No one else is allowed the right to produce Money. Secondly on the demand side, the citizens have an obligation (not just a right but an obligation) to use only that Money and nothing else.
Now, the single most important hypothesis on which gold buying has been predicated is the fear that modern monetary systems will get replaced.
Such replacement can be voluntary or forced.
Voluntary replacement is, to put it mildly, out of the question. The modern monetary system is an outcome of over 40 years of expanding economic activity. Global GDP now is around 70 trillion USD, give or take a few trillion. The world's stock of financial assets, if assumed to be roughly 2.5 times this, would be around 175 trillion USD. I have no handle on the world's stock of real assets (which are not tied to financial claims), but it should be a few hundred trillion I guess. All of this would need to be denominated in Gold.
The world's supply of Gold is simply not enough to meet this. The annual physical market turnover of Gold at today's prices would be very roughly around USD 250 billion. The outstanding stock of Gold in the world is estimated to be around USD 8.5 trillion to 9 trillion. That's less than 15% of Global GDP. For the world's economic claims to be denominated in Gold, Gold prices will need to increase at least 40 to 50 times. In it's sterling rise so far (No pun on the Bank of England which sold Gold at 300 dollars an ounce) Gold prices have increased around 6 times in slightly over a decade. The increase would be much less when you consider the ratio of the value of Gold outstanding to that of the GDP or to that of Financial Assets outstanding.
Monetary replacement can be a forced one. Such a forced replacement, however, will happen after a severe, severe disruption. It will happen when people no longer have the faith in the currencies issued by Governments. It will happen in the total collapse of law and order. It will happen when people no longer want to denominate their claims in the Government's currency.
That can be a time for gold to really really shine. However, even under such a scenario, I do not imagine Gold being the only medium of exchange. It will be too expensive and inconvenient to do that. Try buying a loaf of bread with Gold. You will need to literally have it in particle form. Hence, each person will have a basket of goods - food grains, clothes, cattle etc which he will try to exchange. Gold will be one of them, albeit the most prized one. This is because among physical assets, Gold is the most efficient one in eliminating the need for double coincidence of wants and as a store of value.
Money has value only when money preserves value. If it doesn't preserve value, it loses value. It will start losing value when people lose faith in it. And the warning indicator that people are losing faith, is hyperinflation. I don't know exactly at what point inflation becomes hyperinflation, but basically it is the point when people start selling a currency due to lack of trust and start buying anything else that they can lay their hands on.
Do we see hyperinflation yet? Hardly. Headline inflation in the UK, Europe & US is between 3% to 5%. India is at 10% (high, but not hyper). China is around 5%. Asset markets such as Equities, Housing & Commodities have been declining in value. Government Bonds have rallied.
Clearly, there's a dissonance. Interest Rates are still low in the US, UK, Europe and Japan. Fiscal dynamics are horrible. And yet there is no hyperinflation. Do people by and large still seem to have enough faith in the currencies of their respective Governments? That's what developments so far seem to be telling us.
One reason why this is happening could be the mismatch between the global financial markets and global economic activity. Mismatch, in terms of financial markets being most developed in those countries which have the least economic growth taking place, and vice versa. For example, China & India present growth opportunities, but their financial markets lack depth and are not developed enough. Consequently, investors in the Developed World are forced to put money in Government Bonds & Cash, due to a lack of options. And its not about China & India presenting growth opportunities alone. The point is whether they have enough institutional development to allow such returns to be gained with less risk. That is not the case yet.
Greater institutional development in Emerging Countries will increase the decline in value of Developed World currencies. But such development is far from being a given. And even if it happens, it will happen over a long period of time.
Another reason, which I think is important, is that faith in a currency is not a function of monetary and fiscal dynamics alone. It is a function of many other things, such as the faith in the maintenance of law and order by the Government, its efficiency in promoting economic equality, it's ability to handle external threats and so on. Looking at monetary and fiscal dynamics alone and saying that faith in currencies will evaporate is too narrow a view. The Government derives its faith in the currency from a number of reasons. In a world which is inherently uncertain and volatile, status quo is at a premium. As long as Governments can deliver status quo, faith in currencies will be preserved. And the upside to Gold will be capped.
Is Gold in bubble territory? I frankly don't know. What I do know is that we see several elements common across bubbles, which can be seen in Gold as well (Think IT, Housing etc etc):
1) Low-Short Term Interest Rates For Funding Positions
2) Lack of Visible Cash Flows From The Asset (Investment Hypothesis Based Solely On Capital Appreciation)
3) Unquestioned "Long Term Buy" (Bigger Fool Theory?)
4) Herd Mentality: Its Now or Never; Buy Now Or You Will Never Get To Buy It! (This One's Almost A Clincher)
5) Initially, a Tendency to Buy Even After Violent Corrections
6) Ok, Even If Its a Bubble I Will Be Smart Enough To Exit Before Anyone Else (Ex-SuperBoss called this the Jallianwala Bagh situation)
Faites Vous Jeux...
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Very informative. Not that I understood every word of it :P
ReplyDeleteI believe the statement that 'Money has no intrinsic value' refers to the fact that in absence of any other good, money has no value. Which is not true for say apples. Interestingly, it is not even true for gold, at least in India.
When I look at the gold buying pattern in my family, which is not unlike many in India, the decisions are rarely based on the price. Hence, gold is not treated *just* as store of value. It has an intrinsic value in form jewelry etc.; an asset that is a source of pride, comfort, security and even happiness. And this would be true for cultures where gold is an integral part of the customs and traditions.
The fact that internationally gold has trumped other precious non perishables such as say diamonds, platinum etc., to be store of value in difficult times gives rise to a very peculiar situation in context of India. One that I cannot fully comprehend, but is somehow reassuring.
Hehe...Agreed Ameya...Thanks :)
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