Is Gold in a Bubble? Well… was the Rise in the Paper Mark Price of Gold a Bubble?
As I have mentioned previously, the financial services industry is becoming increasingly populated with avid ‘bubble-watchers’. After having missed TMT in 2000, Real Estate in 2006 and just about everything in 2008, they’re determined to catch the next one. Alas, I admire this new found skepticism and respect the desire to be prudent. However, as always, group-thinking is the antithesis of good thinking when it comes to financial markets. Any group enterprise based on a conviction about the future course of prices is bound to fail. Here, I contend that gold is not in an exuberant bubble (yet!). Moreover, I liken the recent up-trend to the up-trend in the paper mark price of gold during the Weimar hyperinflation. [Full disclosure, we buy gold online very regularly.]
The Essence of a Bubble:
A bubble is characterized by an enormous rise and then a sudden fall in an asset’s money price. Usually, the majority of the gains made on the way up are given back on the concomitant price decline. It is this reversal of fortunes that strikes fear into the heart of investors when it comes to gold. The investor that considers gold to be in a bubble fears that a downward twist may wipe out any potential gains on the upside.
The Typical Environment in which Bubbles take Place:
The upswings of speculative bubbles are typically accompanied by large increases in the stock of money, whereas the downward twists are typically accompanied by falls in money growth and/or outright monetary contraction. In other words, money becomes increasingly abundant on the way up, and suddenly scarce on the way down.
Examples of this type of environment can be seen when looking at speculative bubbles over the past 300 years:
- During the Tulip bubble (1634-37), there were forces that tended to augment the money supply. The establishment of the Bank of Amsterdam, the practice of ‘free coinage‘ and large discoveries of precious metals in the Americas tended to channel money into Amsterdam. As Doug French wrote in Early Speculative Bubbles & Increases in the Money Supply: “Upon close inspection it appears that from the year 1633 to 1638 deposits grew from five million florins to eight million florins, a 60 percent increase!”. The subsequent ‘scarcity of money’ is demonstrable by the fall in the total mint output of the South Netherlands – from about 17 million guilders in 1633-1635 and 23 million guilders in 1636-1638 it fell to 11 million in 1639-1641.
- During John Law’s Mississippi Bubble (1716-20) a similar pattern can be observed. In May 1716, the first Bank of France was established; on the way up, the stock of banknotes famously increased well beyond the specie backing them, and on the way down, the redemption demands on that specie grew to intolerable proportions. Indeed, so intolerable were these redemption requests that every attempt was made to stop people from redeeming. As Doug French wrote (again, in Early Speculative Bubbles & Increases in the Money Supply): “On January 20, 1720, a decree was passed authorizing the search of all homes for concealed coins. Eight days later it was decreed that banknotes were currency throughout the kingdom. The company was then allowed to search all buildings, with any specie seized benefiting the informer… Those who still dared to hold on to the coin lived in constant fear, and Law did not stop there. On February 4th, it was announced that the wearing of any type of precious stone was to be prohibited after the first of March, the penalty being confiscation and a hefty, 10’000 livre fine.”
- The South Sea bubble, being very similar to the Mississippi bubble, exhibited these characteristics.
- Likewise, the bubble in American stocks preceding the Great Depression exhibited these same characteristics. According to Murray Rothbard in America’s Great Depression, the money supply increased by more than 60% from June 1921 to June 1929. Moreover, the deflationary forces accompanying the stock market crash and economic contraction were deemed so unpalatable that President Roosevelt notoriously banned gold ownership in the US.
Gold during the Hyperinflation of the Weimar Republic:
As I often reiterate here on greshams-law.com; in order for a currency to be a viable and well-functioning currency, there must be a profit-motive in owning it. In fact, the market is constantly engaged in finding that profit-motive. In my mind, the idea that killed the paper mark was that the market’s attempt to find a profit-motive in owning the paper mark was continually thwarted by the central planners of money. Every time the paper mark price of gold rose, more money printing was deemed to be necessary. Hence, by 1923, one had to give up 1’000’000’000’000 paper marks in order to acquire one gold mark (see chart below):
The pertinent questions are; why didn’t the market give back most of that rise as with all bubbles? Why – instead – was currency reform instituted (with the establishment of the Rentenmark)? What made this rise not a bubble?
For me, the answer is clear: the rising supply of money during the hyperinflation was not ‘extinguishable’ by the private sector. In contrast, during the bubbles mentioned, the inflated money supply was ‘extinguishable‘ by the private sector (e.g. by bank-runs). During the Weimar hyperinflation, the paper mark was – essentially – a fiat currency. Every increase in the stock of paper marks (brought about by liberal discounting of treasury bills at the Reichsbank) necessitated a rise in the paper mark price of gold. This is because the market sought a profit-motive in owning the paper mark – every increase in the stock of paper marks implied that each existing paper mark was backed by less gold (at the Reichsbank). The market continually fought for a gold price that entailed that the entirety of the gold at the Reichsbank could not be bought by the entire stock of paper marks (at market prices). As any such rise in the paper mark price of gold was deemed to necessitate further printing, the parabolic (but non-retraceable) price chart seen above was drawn out. The important point to note is that if the ‘hyperinflation premise’ had been abandoned sooner, the paper mark price of gold could have simply stabilized (i.e. not collapsed like a popping bubble).
How this Applies to Gold Today:
First of all, let me say that I’m not predicting a modern hyperinflation any time soon – that was not the intention of the above paragraph. In fact, as I mentioned here and here, I consider the opposite to be more likely. Rather, I mentioned the above to articulate the importance of differentiating between extinguishable ‘IOU money’ an more ‘sticky’ Federal Reserve notes and Reserve Balances.
Gold is on the balance sheet of the Federal Reserve. So, as fiat currencies trade ‘at discounts from par‘ (i.e. prices reflect that dollars are at most ‘good for’ what they’re backed by), any expansion in the balance sheet of the Fed is dilutive for the dollar. That is, continued balance sheet expansions are likely to bring about rises in the prices of the Federal Reserve’s assets. If one believes that the Federal Reserve will continually expand its balance sheet to attempt to preserve the existing stock of ‘IOU money’ (as I do), then this gives rise to a bullish case for gold.
I should note that this doesn’t mean that gold will not turn into a bubble. Rather, as people get drawn to its bull trend, it probably means that it will. However, I contend that it will only really be subject to a bubble-like collapse when its price level is signifiantly dependent on the prevailing mass of ‘IOU money’. As Marc Faber recently pointed out, it is unlikely that we have reached that stage (see chart below):
Gold is a kind of hedge against monetary base expansions. Therefore – unless you believe that the monetary base will decline sharply – one shouldn’t be fearful of a bubble-like collapse (yet!). Should gold become exuberantly over-owned (and therefore highly dependent on the mass of ‘IOU money’), then such a bubble-like collapse would have the platform to take hold.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012