"A man writes because he doubts, because he is tormented."

Friday, February 10, 2012

An Inquiry of Gold Fuss

This is quite wonkish. With all the fuss to invest and hold in gold (even the talks in my office and my diploma 3 taxation class of 2008 Facebook group, for Christ’s sakes), I think I have to set things straight.

First of all, gold is not a good choice of investment (albeit good for hedging, but that’s another story.) As what Warren Buffet also noted, with the world’s 170,000 metric tons of total supply of gold valuated at approximately $9.6 trillion, choosing to invest to this asset that isn’t capable of producing anything (unlike investing in companies that can give you dividends or interest revenues, or managing a farmland that can produce commodities) is not wise. Secondly, despite its limited supply, its price can be shaken up by market condition of other financial products like bonds, stocks, etc. Its volatility can be shown during 1980. The gold price went from $560 per ounce to $850 over three short weeks in January 1980. After that gold became much less precious as it hit back to below $600 and plunged to bearish market. It never crossed $850 and above again until January 2008

So what drives the hike of gold price currently? We don’t know for sure. Perhaps Krugman was right that the increase of gold price is driven by deflation and/or the falling of expected return of other investments, following the Hotelling rule. Perhaps he was wrong as there is no sign of deflation (for instance, average global inflation rate is projected to reach 3.4% in 2012 and bond rates of PIIGS are high,) and this chart shows (courtesy of Lior Cohen) that the spike in gold price (at least in US) came after the recent two quantitative easing plans from The Fed in 2008 (QE1) and 2010 (QE2.)





That means, instead of being driven by deflation, it’s driven by inflation expectation or depreciation of dollar against other currencies. And it is exacerbated by the negative elasticity of gold price: because of the expensive cost of gold mining, when the gold price rises in the short run, the miners tend to mine the poorer quality veins of gold first in order to maximize profitability in short and medium term; and that pushes the price of better quality gold used for investment further.

That being said, we still don’t have a good grasp of what causes the gold price to soar. Maybe its price goes up because of people are buying it, and people are buying it because its price goes up, some sort of self-fulfilling prophecy. And since more people are buying it, it attracts more people to buy it because of the herd mentality (surprise, surprise: bubble!) But if you ask me whether I want to invest in gold, I’d say: nope. I’d rather invest in Microsoft or Google’s stocks and probably hedge it with emerging markets’ bonds. Just saying.

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