THE increase in the gold price in recent years — from $800/oz in early 2009 to more than $1,900/oz in 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 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. The price is still hovering at less than $1,400, an almost 30% drop from the 2011 high. There are many reasons the bubble has burst and why the gold price is likely to move much lower, toward $1,000, by 2015.
First, the gold price tends to spike when there are serious 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. But gold might be a poor investment. Indeed, at the peak of the crisis in 2008 and 2009, the gold price 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 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 aggressive monetary policy by many central banks, global inflation is low and falling. 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. Private-and public-debt deleveraging has kept global demand growth below supply. Thus, firms have little pricing power, owing to excess capacity, while workers’ bargaining power is low, owing to high unemployment. Moreover, trade unions weaken, while globalisation has led to the cheap production of goods in China and other emerging markets, depressing the wages and prospects of 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 provide higher returns.
Fourth, gold prices rose sharply when real 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, central banks will stop quantitative easing and zero-policy rates, which means real rates will rise, rather than fall.
Fifth, some have argued that highly indebted countries will push investors into gold as government bonds become more risky. But the opposite is happening now. Many of these highly indebted governments have large stocks of gold, which they may dump to reduce their debts. Indeed, a report that Cyprus might sell a small fraction of its gold reserves triggered a 13% fall in gold prices in April.
Sixth, some extreme political conservatives 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 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. Nor is it a unit of account. 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.
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.
© Project Syndicate, 2013.
• Roubini is economics professor at New York University’s Stern School of Business.