The Shine Is Off

Gold bars are seen at the Czech Central Bank on September 05, 2011, in Prague.

Photo by Michal Chizek/AFP/Getty Images

The run-up in gold prices in recent years?from $800 an ounce in early 2009 to above $1,900 in the fall of 2011?had all the features of a bubble. And now, like all asset-price surges that are divorced from the fundamentals of supply and demand, the gold bubble is deflating.

At the peak, gold bugs?a combination of paranoid investors and others with a fear-based political agenda?were happily predicting gold prices going to $2,000, $3,000, and even to $5,000 in a matter of years. But prices have moved mostly downward since then. In April, gold was selling for close to $1,300 per ounce?and the price is still hovering below $1,400, an almost 30 percent drop from the 2011 high.

There are many reasons why the bubble has burst, and why gold prices are likely to move much lower, toward $1,000 by 2015.

First, gold prices tend to spike when there are serious economic, financial, and geopolitical risks in the global economy. During the global financial crisis, even the safety of bank deposits and government bonds was in doubt for some investors. If you worry about financial Armageddon, it is indeed metaphorically the time to stock your bunker with guns, ammunition, canned food, and gold bars.

But, even in that dire scenario, gold might be a poor investment. Indeed, at the peak of the global financial crisis in 2008 and 2009, gold prices fell sharply a few times. In an extreme credit crunch, leveraged purchases of gold cause forced sales, because any price correction triggers margin calls. As a result, gold can be very volatile?upward and downward?at the peak of a crisis.

Second, gold performs best when there is a risk of high inflation, as its popularity as a store of value increases. But, despite very aggressive monetary policy by many central banks?successive rounds of ?quantitative easing? have doubled, or even tripled, the money supply in most advanced economies?global inflation is actually low and falling further.

The reason is simple: While base money is soaring, the velocity of money has collapsed, with banks hoarding the liquidity in the form of excess reserves. Ongoing private and public debt deleveraging has kept global demand growth below that of supply.

Thus, firms have little pricing power, owing to excess capacity, while workers? bargaining power is low, owing to high unemployment. Moreover, trade unions continue to weaken, while globalization has led to cheap production of labor-intensive goods in China and other emerging markets, depressing the wages and job prospects of unskilled workers in advanced economies.

With little wage inflation, high goods inflation is unlikely. If anything, inflation is now falling further globally as commodity prices adjust downward in response to weak global growth. And gold is following the fall in actual and expected inflation.

Third, unlike other assets, gold does not provide any income. Whereas equities have dividends, bonds have coupons, and homes provide rents, gold is solely a play on capital appreciation. Now that the global economy is recovering, other assets?equities or even revived real estate?thus provide higher returns. Indeed, U.S. and global equities have vastly outperformed gold since the sharp rise in gold prices in early 2009.

Source: http://www.slate.com/articles/business/project_syndicate/2013/06/gold_bubble_paranoid_investors_pushed_gold_to_1_900_an_ounce_in_2011_but.html

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