A different kind of bubble

Gold is a commodity, and you are a conspiracy theorist.

Did you know that you are a conspiracy theorist? Well I hope you are, because anyone who has ever held a hypothesis on a conspiracy is self-evidently a conspiracy theorist, and if you do not have the wits to consider alternative ideas, then you have no place in the market nor in reading SJS.
Did you agree with the 911 commission’s findings? They consisted of a conspiracy hypothesis – a theory on a conspiracy of bad people.
Have you ever had an idea that something might be rigged on purpose? Not even Enron? Then I am sorry for you because you would have been the perfect client of B. Madoff.  Spotting too many irregular, potentially dangerous patterns is a useful evolutionary characteristic – when stakes are high then a few false alarms are better than excess gullibility.

Popular wisdom tells you that each and every conspiracy must be a hoax. But what about the manufactured evidence prior to the second gulf war? Is the government not in a conspiracy to rig the price of commodities such as corn, the price of labor, and even the price of money itself through artificial interest rates, creating fake markets for bonds and everything that is based on them? What does OPEC do? How about government incentives for cheap housing? Are they hoaxes? No. They all sound pretty much like conspiracies. Your mind will now start resisting this argument by saying that a confederation of price manipulators is not a conspiracy if it is not somehow concealed. Are you really on that level of resistance – “if I can’t see it it’s not there”? What species of trusting bumpkin credits every producer, speculator, and middleman with having your best interests at heart?

“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
Adam Smith

Now that we have established that you have nothing to fear from looking at conspiracies straight in the eye, we can label you as a lousy fear-spreading conspiracy theorist, and move on.

Smarter readers will have already guessed that the reason for this long preamble has been an introduction to the subject of Gold. Gold is topical at the time of writing – what is it used for? Jewelry? Why pay for something you need to then guard as storage?

Gold used to be money. Now it is a commodity. But money itself is a commodity.  Don’t take my word for it, ask Mr. Morgan, perhaps the biggest fat banker that ever lived. Before the suspension of gold convertibility, in 1971, you could get gold in exchange for your paper money. This gave people faith that the paper money they were using, and the credit supported by it, was limited in supply. This also created somewhat regular inflation-deflation cycles. Nowadays, of course, there is no limit to the amount of money in the world. Any central bank can simultaneously “create” (i.e. write into an accounting ledger) a huge asset in the form of money and a matching theoretical liability, and then use the money as if they had earned it. And, of course, we live amongst gigantic bubbles and busts. This lack of limitation means that eventually there will be more dollars and pounds and yen per physical object, and the value of your held cash will go down.  The only question is “how fast?” The answer to this primarily depends on something called “credit creation” – when banks lend money they increase the amount of dollars in existence, because they make more loans than they have deposits, and because the money from the loan can be used in the same way as money from your employer. At the moment this is not happening as fast as the central banks would like. They would like to increase the volume of lending and borrowing to increase economic activity, similarly to the way that Japan kept its economy on life support following its gigantic bubble and the way that china prevented a calamity in 2009 by forcing banks to lend for investment projects – the bigger the better – without much regard to what the projects were for. Would that be good now? It would create more work in the short term, but would probably be damaging after a couple of years, as China is currently finding out with an economy dependent on demand from building buildings for the purpose of investment (i.e. expected demand for buildings).

But we are not here to judge. We just want to figure out what might happen. And the central banks can cause prices to change, as long as they are not encumbered in some important way due to limited reserves and fixed exchange rates. The US, Japan, the UK, and the EU do not have this problem – they can make adjustments with the side-effects of changing the value of their respective currencies, which they want to do anyway. If the central bank of Japan wanted to, it could just create enough money to buy out all the bonds against the Japanese government, and it is already a good way towards doing just that. These powerful entities will keep on conspiring to manipulate prices for a long time, resulting in an eventual decline in the value of cash, just as they want. In the short term there may be an unwillingness to spend and borrow, which will make the amount of money in circulation go down, but over time people will respond to the incentive to borrow at low rates and invest in things like buildings instead of keeping money on deposit.

The bank of Japan has been trying to do this for over a decade, so why is this suddenly going to work?

It might not. It is more likely than ever to work now, because retirees spend money, taking it out of the bond market, and because the Japanese central bank is now doing this inflating on a much bigger scale that is likely to change people’s behavior once it gets triggered by, say greed over rising investment asset prices.

But today we are talking about gold, which mainly responds to the activity of the much bigger US central bank.

The purpose of gold is not just to look pretty. It is not necessary under normal conditions – the kind of conditions you read about in economics textbooks. However, if there is excess money in an economy and it has nowhere else to go, then it will flow into gold, as well as into any kind of rent-seeking activity.

But there is one other important aspect. And that is the game theory site to gold. Everyone who has ever commented on gold, apart from the tiny minority of “gold bugs”, says that there is no way to value gold. That is exactly the point – it is worth whatever somebody else is willing to pay for it. Now, as long as everybody else ignores gold, then its price ought to be just high enough to satisfy incremental jewellery demand, which is a price to produce a volume of that jewellery. However, what if certain countries start to accumulate gold? Other countries will notice, and they will get in on the act too, fearing that they will be left holding ever-deleting claims on nothing in particular (remember, the US Treasuries are “I owe you nothing” and Eurobonds are “who owes you nothing?”)

There are some people calling gold a bubble that has burst. The price at which gold mines starts to be unprofitable to investment in at least around 1200, and if you look at the cashflow statements of producers you will see that it is probably much higher. This is a similar metric to net current asset value for a stock, because it is a real valuation baseline. Oil traded well below its cost of production in 2009, and the same could happen to gold if there was sufficiently low demand and high supply. Unlike oil, gold can be held off the market for more than a short period of time, and anecdotal evidence suggests that there is a lot of buying of physical metal (inventories are low too).

So why the drop? I believe there is either a conspiracy, or (less likely) a default by a highly leveraged player. The amount of gold sold on Friday was apparently greater than a year of global mine production, and apparently twenty billion dollars of futures contracts was sold in an hour. Who has that kind of money invested in gold futures? Whoever it was, it was not a stream of ordinary investors such as hedge fund holders of gold – unless they acted in concert, or conspiracy. It could not have been a producer. Even if there was a private entity out there with $20 b of gold to sell, do you think they would empty it onto the market In such a short time, guaranteed to crash the price on themselves?

No. If anything, there is a bubble in gold negativity. Try to find a positive article about gold in the FT, BBerg, etc. You can’t find one.

When I was bullish on Japanese stocks, starting in 2009, there was nobody interested in them. Every article had the tone of “oh dear, you poor losers”. The same is true of gold and gold stocks today. I do have to caveat that gold stocks are mostly terrible, terrible businesses. But as my readers already know, it’s not how good something is, it’s the goodness relative to the price that counts.

There is one obvious bubble right under everyone’s nose – that is, of course, lending the government money at a guaranteed loss.

Meanwhile, who is buying gold now? Mainly the central banks of countries with lots of depreciating dollars – notably excluding japan, the yes-man of the US. I believe that if there was a conspiracy to crash gold, and I find it difficult to understand who would be behind the recent antics if it was not a planned event (note also many coincidental encouragements to sell gold for no particular reason in the week beforehand – Goldman, Soc Gen, false Cyprus gold sale rumor, etc. and the unusually high short interest prior to the crash), then there could only have been futures sold, because that amount of physical gold is just not available (except for through a central bank, who would not sell in one go on the futures market in one hour). That means that it was maybe a gigantic liquidation (although you would have heard about it by now, and that theory is not consistent with the volume and rapidity), or a short sale (which is consistent with those two factors). If it was a short sale it was very clever, because it killed lots of small speculators who got margin calls and were forced to sell, presumably into the covering (margins were, unusually, raised on the Comex – this is consistent with a short sale conspiracy). But that would also mean that there are no leveraged longs left in the speculative market, which in turn means that it can go little lower in the short term without additional shorting. As to who could have been the seller, I will leave that to your imagination.

I encourage you to send me hate mail on this post, stating:

Gold is used for nothing (i.e. it is a currency)

Gold is no more than jewelry (i.e. it is not a currency)

Gold is a relic (tell that to the people who conspire to rig the price of money)

You’re a conspiracy theorist (thank you for your in depth argument)

The economy is recovering and central banks will raise rates (Ha ha ha ha ha! Ha ha ha ha ha! Ha ha ha ha ha ha ha ha ha!)

It can’t be a safe haven if it only goes down (please buy what is going up to calm your nerves)