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Is the gold price a 'bubble'?


Over the last ten years gold has risen from $270 an ounce to over $1200 an ounce. This has fueled fears of another asset price bubble like those in equities in the late 1990's and property in this decade. Both of those asset classes suffered severe price falls subsequently, and housing is still falling in real and nominal terms and stocks have fallen consistently in value in real terms and sporadically in nominal terms in the last decade. A Dow Jones Index hovering around 10000 today does not have the same value as a 10000 level in the year 2000 (because the dollar's value is so much less today).

So could gold be on the same boom/bust trajectory? To answer that question it's important to consider the cause of the price rises in all of these different asset classes. Stocks rose for a multitude of reasons including excess liquidity in the system generated by high volumes of dollars being printed annually by the Federal Reserve, depressed savings rates due to very low interest rates directed funds into stocks, a moral hazard generated by the markets believing the Federal Reserve would bail them out if there was a sudden market fall. Overall the US economy of the 1990's was high on cheap and easy credit provided by the Federal Reserve.

When the Internet bubble popped at the start of this decade the US went into a brief recession. If the free market had been allowed to run its course this recession would have been deeper and harder than it was and it corrected many of the imbalances which had developed during the boom years of the 1990's. Instead the Federal Reserve intervened again and aborted the recession by printing more dollar mountains and dramatically increasing the money supply while supporting dollar demand by reducing interest rates even further. At this point the US economy was like a heroin addict who had just scored another high. So inevitably another bubble blew up - this time in property. By this stage gold had already begun its unheralded move upwards, but all eyes were firmly on the property markets across the globe.

In looking at the causes of the bubbles in equites and property we see that both bubbles had a lot to do with the actions of the Federal Reserve. They were underpinned by bad policies and weak currency management. Since the US dollar is the world's reserve currency the bad policies in practice in the US monetary system affected the entire world, it wasn't just stocks and property in the US that blew up, but stocks and property throughout the western world and even developing countries and Asia were effected.

This brings us to the current gold bull market. What is driving this asset class to all time nominal highs? The dollar is key. At the present moment the dollar occupies a place in the global monetary system historically occupied by gold. That is, the dollar is the global reserve currency and the global measure of value today and has been alone in that role since 1971. In 1971 the dollar peg to gold established under Bretton Woods after World War 2, was dissolved by Nixon. In effect this was a declaration that the US government would be a better guardian of the global financial system than gold had been in the previous centuries whenever and wherever a gold standard was in operation.

At the time, the suggestion was that gold would lose its 'monetary premium' and be traded henceforth as a straighforward commodity as about 7 dollars an ounce. Looking at the gold price bull market that ensued in the 1970's ending in 1980 at $850 we can see what a nonsense the idea that gold would lose its premium really was. Instead the US government generated massive inflation by printing dollars like there was no tommorrow. But this surge in the gold price did come to an end. How was that surge in gold halted? The answer is Ronald Reagan and his Federal Reserve Chairman Paul Volcker. Reagan was a hard money advocate who wanted to re-introduce the gold standard and defeat the inflationary nightmare that America was then enduring. Volcker was a monetarist and believed that the correct way to manage inflation and the dollar was through the currency supply management.  

In Autumn 1979, Volcker told Congress that the economy would grow faster than anticipated in 1980 and thus the Federal Reserve would print additional dollars to facilitate that growth. The market's confidence in the dollar collapsed. Dollar demand dropped so steeply that gold shot from an average price of $392 an ounce in 1979 to $850 an ounce in January 1980. This is incorrectly viewed as a mania for gold. Rather, it was a collapse in dollar demand and confidence. But monetarism ultimately was a failure and Volcker deserted that approach in October 1982 when he announced that he was no longer targeting the monetary aggregates. Monetarism doesn't specifically include gold as a key component of any monetary system. This was it achilles heel. A combination of Volcker's efforts to control the increase in the money supply and Reagan's tax cuts did arrest the slide in the dollar and drive up demand. This was the beginning of a 20 year bull market in stocks.

What lessons can we take from the events of the 1970's and 1980's? Well its clear that looking at the money supply in isolation won't tell us very much on it's own. During the 1970's base money was increased approximately 8.13% per year which is 119% over the entire decade but at the same time the dollar fell from $35 an ounce to $850 an ounce. This shows that it was a collapse in dollar demand which was the primary driver in the currency's fall. This drop in demand was a function of very poor currency management. Notably, in the 1980's base money grew at an average of 7.52%, and in this period the dollar strenghtened against gold. But this was against a background of increased economic growth underpinned by Reagan's tax cutting, less regulation and better currency management. Today the dollar has been losing value for 10 years without a break. In order to end the gold bull the US would need to create confidence in the dollar through lower taxes (pro growth), less regulatory complexity, and a real commitment to a stronger dollar through reductions in the supply of base money. Failure to address these three areas will leave gold on an unchecked upward trajectory. The current Obama administration prioritises additional spending on social security, healthcare, unemployment benefits etc. Swathes of new financial regulations are being implemented. And taxes, particularly for business and the wealthy seem set on an upward trajectory, defying historical experience, which shows consistently that tax reductions result in more real revenue flowing into government coffers.

If history is any guide whatsoever, there seems no  prospect of an end to this gold bull market under an Obama administration He is making errors in all three keys areas of taxes, regulation and sound money.
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