Gold may be set for speculative bubble

With the US and other countries monetizing budget deficits, the chance of rapid inflation has surged. The annual production of gold, the traditional hedge, is far below the world’s rate of monetary growth. An inflationary panic could thus bring an explosive gold price rise.

Gold has little intrinsic value; if it had never been coined its price would probably rest around the $250 per ounce of the late 1990s. However because of its history it is regarded as an inflation hedge and store of value, and that psychological association becomes tighter as inflation worsens and the gold price rises. Hence arguments about the irrationality of gold investment are wrong: in an inflation-prone environment belief in gold becomes self-reinforcing.

Alternative safe-haven stores of value, such as foreign currencies and US Treasuries, are falling away as the Swiss and Japanese authorities seek to weaken their exchange rates and the US runs ever-greater deficits.

In the stagflationary conditions of 1980, the gold price peaked at $875, the equivalent of $2,300 today. However the rise to 1980’s inflation levels was gradual; monetary policy in the 1970s was only moderately over-expansive and the US fiscal deficit was modest by current standards. Including the Fed’s March 18 announcement of further monetary stimulus, monetary and fiscal policies in the US and globally are far more inflationary than in the 1970s. Consequently, there’s a real threat that if inflation returns, it will do so violently.

Smart investors are hedging against this possibility through gold. Hedge fund tycoon John Paulson paid $1.28bn for 11.3% of AngloGold Ashanti. That company is unprofitable at present gold price levels, but would hugely benefit from a price rise.

Should other hedge funds turn to gold, its price could soar. At current prices, annual gold output is worth only $104bn and the global gold stock only $5.12 trillion. Central bank gold reserves total $895bn, a fifth of currency in circulation. Even a quintupling in the gold price, to $5,000 per ounce, would raise the value of annual gold production only to $500bn and the global gold stock to $25tn, just 20% above the world’s M1 money supply.

Recent bubbles in stocks, housing and commodities have been driven by easy credit. The ongoing US Treasury bond bubble is driven by desire for a safe haven. When it collapses, a gold bubble driven by inflationary concerns may be inevitable.