21 April 2008

Why Gold is Not in a Bubble

A nicely done analysis by Paul Krugman, economist of Princeton, in The New York Times.

What Paul does fail to mention is the significant decline of the dollar tends to inflate the prices of all commodities and products not produced in domestic US or sold openly in world markets, and that commodities are significantly and increasingly the case, a triumph of the service economy. Further, the inputs to costs of extracting/producing those commodities are soaring because of the general inflation of energy products.

So even if the price had increased while the supply remained steady, or even increased, a case could be made for commodities priced in dollars that they are still not in a bubble because the US dollar is in a bubble of supply.

However, this brings us to the interesting anomaly. Why is metals production not increasing with the dramatic increases in prices?

Some say that gold and silver were actively priced suppressed by the paper markets in NY and Chicago for many years, with huge short positions keeping the benefits of adding sources of supply artificially low. So now we are paying the price, since it takes years to bring new supply, new mines, into production.

But that's Moral Hazard and Unintended Consequences, and we are told to ignore them, as Josef Goebbels told the German people to disregard the bombs falling on Berlin. And for now, we listen, and go forward into the night.

Moral Hazard: A dilemma that arises when government officials take steps to bail out countries or businesses that are in serious financial trouble. Although the action may help prevent widespread financial turmoil, thereby protecting innocent parties, it creates an expectation that governments will always come to the aid of failing countries and companies, potentially increasing risky behavior because there is no penalty. Webster's Dictionary

Since free markets and capitalism are based on the principle of discovering price and managing risk, the greatest hazard ultimately is that we will lose our free markets, and essentially lose that which we think we have based our market economy upon, until of course we hit the wall and collapse, in our markets or as a republic.

Commodities and speculation: metallic (and other) evidence
by Paul Krugman
April 20, 2008, 9:49 am
The NY Times

We’ve had a huge runup in commodity prices — fuels, food, metals. But why? Broadly, the debate is between those who see it as a speculative phenomenon, driven by some combination of low interest rates and irrational exuberance, and those who see it as a collision of rapidly growing demand with constrained supply.

My problem with the speculative stories is that they all depend on something that holds production — or at least potential production — off the market. The key point is that the spot price equalizes the demand and supply of a commodity; speculation can drive up the futures price, but the spot price will only follow if the higher futures prices somehow reduces the quantity available for final consumers. The usual channel for this is an increase in inventories, as investors hoard the stuff in expectation of a higher price down the road. If this doesn’t happen — if the spot price doesn’t follow the futures price — then futures will presumably come down, as it turns out that buying futures produces losses.

Which brings me to this chart, from the IMF’s World Economic Outlook:

Bubble, bubble, where’ the bubble?

As far as I can see, this creates real problems for any claim that high metal prices are speculatively driven. Food inventories are also historically low. I just don’t see how a low-interest-rate or bubble story works here.

Paul Krugman in the NY Times