Gold – a six thousand year-old bubble

Gold is unlike any other commodity.  It is costly to extract from the earth and to refine to a reasonable degree of purity.  It is costly to store.  It has no remaining uses as a producer good – equivalent or superior alternatives exist for all its industrial uses.  It may have some value as a consumer good – somewhat surprisingly people like to attach it to their earlobes or nostrils or to hang it around their necks.  I have always considered it a rather vulgar metal, made for the Saturday Night Fever crowd, all shiny and in-your-face, as opposed to the much classier silver, but de gustibus… .

The total stock of ‘above-ground’ gold is about 160,000 metric tonnes (a metric ton is 2,204 lbs. or 35,264 oz, for those of a non-decimal mind-set).  About 50 percent of this existing stock of above-ground gold is kept as a pure store of value (for investment purposes), most likely somewhere below-ground, for security reasons. The other 50 percent exists as jewellery.  I would argue that most of this jewellery demand is simply small-scale store of value (investment) demand by households, rather than demand driven by aesthetic considerations or other intrinsic sources of joy associated with having gold hanging from your extremities.

From a social perspective, gold held by central banks as part of their foreign exchange reserves is a barbarous relic (Keynes used the expression to refer to the Gold Standard, but close enough is close enough).  The same holds for gold held idle in private vaults as a store of value.  The cost and waste involved in getting the gold out of the ground only to but it back under ground in secure vaults is considerable.  Mining the ore is environmentally damaging, especially if it involves open pit mining. Refining the gold causes further environmental risks.  Historically, gold was extracted from its ores by using mercury, a toxic heavy metal, much of which was released into the atmosphere.  Today, cyanide is used instead.  While cyanide, another toxic substance, is broken down in the environment, cyanide spills (which occur regularly) can wipe out life in the affected bodies of water.  Runoff from the mine or tailing piles can occur long after mining has ceased.

Even though, from a social efficiency perspective, the mining of new gold and the costly storage of existing gold for investment purposes are wasteful activities, they may be individually rational.  There is no invisible hand here (or elsewhere) to ensure that the aggregation of individually rational behaviour adds up to anything desirable or sensible.

Because to a reasonable first approximation gold has no intrinsic value as a consumption good or a producer good, it is an example of what I call a fiat (physical) commodity.  You will be familiar with fiat currency.  Unlike what Wikipedia says on the subject, the essence of fiat money is not that it is money declared by a government to be legal tender.  It need not derive its value from the government demanding it in payment of taxes or insisting it should be accepted within the national jurisdiction in settlement of debt. Instead the defining property of fiat money is that it has no intrinsic value and derives any value it has only from the shared belief by a sufficient number of economic actors that it has that value.

The “let it be done” literal meaning of the Latin ‘fiat’ should be taken in the third sense given by the Online Dictionary: 1. official sanction; authoritative permission; 2. an arbitrary order or decree; 3. Chiefly literary any command, decision, or act of will that brings something about.

The act of will in question is the collective attribution of value to something without intrinsic value.  Being declared legal tender by a government may help achieving that status, but it is neither necessary nor sufficient.

Gold is very close therefore to the stone money of the Isle of Yap.  This stone money, known as Rai, consists of large doughnut-shaped, carved disks, consisting usually of calcite, that can be up to 4 m (12 ft) in diameter, although most are much smaller. Apparently, the total stock of Rai cannot be augmented any further.  It also depreciates very slowly.  This intrinsically useless form of money in the Isle of Yap is in all essential respects equivalent to gold today in the wider world.  Another example would be pet rocks, as long as the rock in question is rare and costly to get into its final shape.

Gold has become a fiat commodity or a fiat commodity currency, just as the US $, the euro, the pound sterling and the yen (and a couple of hundred other currencies) are fiat paper currencies. The main differences between them are that gold is very costly to produce, while the production of additional paper money has an extremely low marginal cost.  If we count the deposits of commercial banks with the central banks, which together with currency in circulation make up the monetary base, as fiat money, then the incremental cost of fiat base money creation is zero.

The outstanding stock of physical gold, at 160,000 tonnes or thereabouts, is very large relative to the maximum amount of new gold that can be mined and refined during a year.  The short-run supply curve of new gold is steep and becomes vertical at a volume of production that is small relative to the oustanding stock (annual gold production has been declining from a peak of just over 2,500 tonnes in 2001 to 2330 tonnes in 2008 – only 1.5% of the outstanding stock).[1]

The good news for gold bugs

Since gold is a fiat commodity currency, its value will be determined largely by its attractiveness relative to other fiat currencies – the fiat paper currencies issued by central banks.  Gold should not be analysed as one of a set of intrinsically valuable commodities (silver, iron, lead, zinc, platinum, aluminium, titanium etc. etc.) but as part of a set of intrinsically useless and valueless fiat currencies – the US dollar, the yen, the yuan, the euro, sterling, the rupee, the rouble etc. etc.).  It is therefore in times that market participants are nervous about the future value of most other fiat currencies, that gold will be at its most attractive.

Such a time is what we are going through now.  Many systemically important central banks have expanded their base money stocks and balance sheets massively.  The Fed has doubled the size of its balance sheet.  The Bank of England has tripled the size of its balance sheet.  Many central banks have bought vast amounts of public debt.  In the UK, out of the initial £175 bn of quantitative easing, as much as £173 was spent on gilts.  The Fed has purchased only about €300 bn worth of Treasury securities, but has acquired a much larger amount of Treasury-guaranteed agency debt.

Although in most of the overdeveloped world (except the UK), deflation is the immediate threat, there is a medium and long-term threat of much higher inflation in all countries with enlarged central bank balance sheets and the prospect of large future fiscal deficits.  The great advantage to investors of gold is that, although it is not intrinsically valuable, it is very costly to increase its stock.  The tap can be opened at the drop of a hat for fiat paper and electronic currency.  The tap produces never more than a trickle in the case of gold.

So when fiscal incontinence threatens price stability in some of the main industrial countries (especially the US and the UK) because the central banks in these countries may be forced to monetise both the stock and large new net flows of public debt, the one fiat money whose quantity cannot be varied at will by a monetary authority will do well.  We see that with gold today.  We also see that, to a lesser degree, in the strength of the euro.  The ECB is by far the most independent of the leading central banks.  They also have a heavily asymmetric de-facto interpretation of price stability: inflation is unacceptable, deflation is OK.

So until the risk of serious inflation is removed from the medium-term outlook for the US, the UK and other fiat currencies, gold will be a relatively attractive store of value despite the cost of storing it.

The gold bug’s nightmare

An economy with fiat money can have many different equilibria.  To make the point as clearly and simply as possible, consider a stationary economy.  Population, endowments, technology, government spending, taxes and preferences are constant.  The government budget is balanced.  Prices are flexible.  There is a constant stock of fiat money (which could be paper money, gold, Rai or pet rocks.  This fiat money is perfectly durable and therefore can serve as a store of value.  It pays no interest.  Assume that, for whatever reason, society prefers it (or even has decided to require) it as a medium of exchange or means of payment.

With a bit of further work, such an economy will have an equilibrium with a positive, constant price of money (a constant general price level).  Economists call this the fundamental equilibrium.  This stationary economy will, however, also have many other (in fact infinitely many other) non-stationary equilibria, called (speculative) bubbles.  They always have equilibria in which the value of money starts at a positive value but falls steadily towards zero – the general price level rises without bound even though the quantity of money is constant.  The holders of money anticipate the future inflation and reduce the real stock of money balances they want to hold.  This further increases the actual and expected rate of inflation, and the real stock of money balances goes to zero: the general price level goes to infinity or the price of money goes to zero.  We have Zimbabwe.

What is often ignored is that this economy has an equilibrium that is even more ‘fundamental’ than the fundamental equilibrium.  That is the equilibrium in which the price of money is zero in every period, not just in the long run (as with the speculative inflationary bubble equilibria).  Remember, fiat money, including gold, is intrinsically useless.  It has value only because people believe it to have value.  If everyone expects that money will have no value in the next period, it will have no value this period, because no-one will be willing to take receipt of money to carry it into the next period where it will be valueless.  So fiat money with a zero value is always an (unfortunate) fundamental equilibrium.

I would actually call it the only fundamental equilibrium.  All other equilibria with a positive price of money – an asset with no intrinsic value – are benign (relatively speaking) bubbles.  The constant price of money (constant general price level) equilibrium is also a bubble, based entirely on belief and trust – a beneficial bootstrap equilibrium, lifting itself by its hair, like the Baron von Münchhausen.

In a world with multiple fiat moneys, the zero value of money equilibrium lurks for each of the fiat currencies, including gold.  Admittedly, as regards gold, so far so good.  Gold has positive value.  It has had positive value for nigh-on 6000 years.  That must make it the longest-lasting bubble in human history.

I don’t want to argue with a 6000-year old bubble.  It may well be good for another 6000 years.  Its value may go from $1,100 per fine ounce to $1,500 or $5,000 for all I know.  But I would not invest more than a sliver of my wealth into something without intrinsic value, something whose positive value is based on nothing more than a set of self-confirming beliefs.

[1] Since gold is very durable, it is reasonable to assume that virtually all the gold that was ever refined is still out there somewhere.  There is no gold ‘consumption’, just its transformation into jewellery and no significant depreciation of the stock.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website