Thursday, October 7, 2010

On the Value of Gold

I've been a gold bull for a while now (see my post Ready to Ride the Golden Bubble from March 2009), but my rationale was more behavioral in nature. But now, Crossing Wall Street has a fascinating post on a possible model (or at least a framework) for the price of gold, which indicates we are nowhere near the peak.

I highly recommend reading the full post as it provides a nice background for why the model may work, but to the magic formula:

Whenever the dollar’s real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It’s my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

Now here’s the kicker: there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.
I wanted to see for myself, so I took Eddy's model and updated real T-Bill rates with historical T-Bills rates and historical CPI figures going back to 1950, then sized it so the output matched the current price of gold.

And while he is not trying to explain 100% of gold's movement, but rather the factors that drive that movement... the result in itself is rather impressive to say the least.

Log Scale

His six takeaways (summarized):
  1. Gold isn’t tied to inflation, but rather tied to low real rates (not always one in the same)
  2. When real rates are low, the price of gold can rise very, very rapidly
  3. When real rates are high, gold can fall very, very quickly
  4. Gold should not (and does not) have a long-term relationship with equities
  5. Low rates are likely to last for a long period of time
  6. Gold price is political; central bankers can crush the price if desired (i.e. raise rates)
This last point intrigues me. There is so much capital wasted (i.e. invested) in gold that my question is what would happen if central bankers did just that and raised rates?

The common thought (mine included) is that would kill the economy as we do live in a "credit economy" (i.e. there are lots of assets that are priced based on cheap credit, such as housing). But what if that forced capital away from gold and into goods and/or services that actually benefitted someone / something in the economy?

Data Source: Measuring Worth
Model Data (column K): Google Docs


  1. "There is so much capital wasted (i.e. invested) in gold that my question is what would happen if central bankers did just that and raised rates?...what if that forced capital away from gold and into goods and/or services that actually benefitted someone / something in the economy?"

    Worldwide private investment in gold bullion is estimated to be 27,300 tonnes, or $1.25 trillion at $1300/oz. (non-central bank, non-jewelry, non-industrial) (fn1)

    Total worldwide gold stocks, at $1300/oz, are $7.5 trillion.

    That compares to an about $150 trillion for global 'investment' assets (tradeable assets, real estate, financial instruments, public & private debt & equity, not public infrastructure). $50 trillion of that is public equities, turning over once a year or more.

    $1.25 trillion in global private investment in gold. In perspective, U.S. banks increased their excess reserves at the Fed (excess 'cash' from customer demand deposits) by $1 trillion since Fall 2008.

    And the U.S. and the world currently have an economic output gap, meaning too much unused productive capacity (people and hard assets). Lack of demand is the main problem, not lack of capital.

    So, I'm not sure that goosing capital from gold back into...what-stocks & bonds?...would be in significant amounts, or be effective economic stimulus.

    fn1: source:

  2. And that brings to the point of economic data. Once we get some sort of positive surprise (which BLS-I call it department of BS- would love to do tomorrow), gold probably would get kill short term as QE V2.0 would get less likely which in term would also kill equity?

  3. Steve- why does it have to go to financial assets or business investment rather than goods / services? Not necessarily needed in the US (we consume a lot), but global investors in gold...

  4. About this money "in" gold... Where is it, exactly? When one invests capital in the gold market, exactly how does it get "tied up?" I always thought that when somebody buys $10000 worth of gold, somebody else is selling the exact same amount. Gold and money both move around, but to ask how much capital is tied up in the gold market makes about as much sense as asking how much gold is tied up in the currency markets. And since both are just different ways of saying the same thing, I'm pretty sure both are completely incoherent ways of looking at a market.

  5. Jonathan- very Austrian of you. Long term, I agree. Short term, I couldn't possibly disagree more as economic decisions (capital / labor flows) are changed (in my view for the worse) due to all this focus on gold, let alone what I feel is the huge socioeconomic impact (the rich will get richer, the poor poorer) due to this whole reflation phenomenon.

    Let me try to get back to this with a broader post rather than an incoherent reply now, hopefully sooner than later.

  6. Great topic!

    I am a bit with Steve that the amounts are "small" and more so non of it belongs to the average guy to stimultae demand. I look forward to more!

  7. Jake, could you give a bit more detail about just what you did? Did you use the 3-month bill rate, and convert the Fed numbers to a monthly rate? Calculating a one-month percent change in CPI, or folding inflation in in some other way?

  8. I'm not sure what you mean by "focus" on gold, but to the extent that it is a true distraction, whatever that means, it has absolutely nothing inherently to do with the price of gold or the total cost of all the gold bullion. The price is, by definition, that price which clears the market. If it's high, that just means sentiment is such that we need a high price for people with gold to be convinced to stop being "distracted" by it in equal amounts to those who are diverting capital to it. For each dollar "distracted" by gold there is a dollar of gold that has just been divested by a person who is no longer distracted by gold and now has cash to invest in something we can safely assume will not be gold.

    I just don't see how somebody as smart as you can't get the idea that, neglecting investment in mining (which I assume you're not talking about as its neglible to the gold market) a market is completely symmetric. You're focussing on all the people buying gold, and forgetting that for all the money going into gold, there is an equal and opposite divestment of gold. When you talk about the massive amount of money going "into" gold, you realize that you would be equally right to talk about the massive amount of money going "out of" gold, right?

    So, to the extent that there is a massive transfer of money "into gold" what you really should be saying is that there is a massive transfer of money from people who are late to gold to people who already had some. Now, the real question is "what do the people who used to have gold want to invest in?"

    It's seems to me that one cannot assume where that transferred capital will go except to say that it won't go back into gold. Maybe it will go into all the investments you're worried are being ignored. Maybe it will go into hole digging. Maybe it will just sit in money market funds.

    So, what's your point?

  9. Jim- I emailed you the spreadsheet..

    Jonathan- I really wanted to wait to explain, but I've had one too many watching the evil Yanks win yet another playoff game (Lance Berkman?), so will try to give you some high level thoughts (note - I am not at my finest without charts).

    Assume instead of gold, the Euro all of a sudden became insanely expensive... literally became 6x stronger overnight (this is meant to be an exaggeration, but does match the run up in gold).

    Would there be a misallocation of capital as a result? In my opinion... of course.

    With the insanely strong Euro (Europe became literally 6x richer overnight) those that owned Euro do not need to be productive to earn goods /service, but can instead purchase these goods / services with their newfound rich piece of paper.

    Did anyone lose out? If you view this as a zero sum game per your comment, then someone on the other side received something for that rich currency when a transaction occurred, so all good.

    But... you would literally have a continent not needing to work (or at least those with enough Euros that a 6x multiplying of their wealth would not need to work [i.e. the rich – hence my statement that the rich are better off]), not needing to work.

    The result is a continent not producing because in the short run people are turning a piece of paper into a good.

    The argument that gold is too small is justified, but when an economy is struggling as it is today, I view all marginal impacts as substantial.

  10. Ok, I see what you're saying. You're essentially saying the price of gold changing changes behaviors, and I completely agree on that. What I was trying to say is that you can't make a priori statements about WHAT that means for the allocation of capital. You seemed to be assuming that any capital that goes into gold isn't going into something else. I hope you agree with me that, if you really meant that, it is wrong and fundamentally different from saying the bull market in gold MIGHT change capital allocation because it changes WHO has the capital.

    I take your point that it would change behavior if the Euro doubled, for instance. But your use of that example proves my original point, I think. If the Euro goes up, nobody would say it results in a misallocation of capital because that capital is "flowing into Euros". They would have to think a little further about it, and wonder how this capital flow to people who hold Euros will result in those newly capitalized people changing their behavior.

    Likewise, when you look at the gold bull, you can't say that's capital flowing away from other investments "into gold". The only thing you can implicitly say is that it's a transfer of money from one group to another, in this case long term gold owners. You then have to wonder if those people will do something different with that capital than those who previously held it. I think it's fair to assume they would, but it's not because money is flowing into gold that capital allocations changes, it's because money is flowing into people or groups that will allocate it differently from the people who spent their money on gold. People selling gold obviously have a different view of the world than those buying it, sure, but that doesn't tell us much.

    So, when I said "what's your point" I wasn't meaning that to be as rude as I think it sounded. I meant "why do you think former gold owners will allocate the cash involved radically differently than those who decided to stop allocating cash and sit on gold?"

  11. Hello Jake,
    very interesting and valuable job, would it be possible to play with your hypothesis using your spreadsheet ?

    thanks in advance


  12. "You seemed to be assuming that any capital that goes into gold isn't going into something else."

    I agree... which is why I agree with that comment that in the long-run, none of this likely matters (unless the short-term misallocation of capital has long run implication).

  13. pascal - i'll try to post the data online later this weekend

  14. I think it would be valuable for all to read Jim Fickett's post at regarding the gold model presented.