The Myth of a Gold Bubble

Recently, as gold has notched up new all time record after new all time record, there has been a flurry of articles claiming that gold is in a bubble. This is nothing short of ridiculous but not at all surprising. It is not surprising because humans have a habit of not recognizing what is the root cause of a change.

For example, the mother of little Johnny will tell you that the clothes she bought for Little Johnny last summer "have gotten too small for him". In reality the clothes haven't changed in size at all but Little Johnny got too big for them. You will often hear people say something like "since getting my new job the days just fly by". In reality the speed of rotation of the earth does not get affected by someone landing a new job! Another example is the pensioner who claims "I had to move to an apartment because the stairs in my old house had become too difficult for me to climb". In reality the stairs hadn't changed a bit but the pensioner had become too frail to climb them.

In the same vein the prognostications about the gold market being in a bubble are completely the inverse of what they should be. The real consideration is the purchasing power of the dollar. Figure 1 shows how many milligrams of gold the dollar could buy from 2001 through to today (10/1/2010). In April 2001 one US dollar could buy 125 mg of gold while today it will only buy 24.3 mg. The purchasing power or the dollar with respect to gold is on a well defined exponential decay, as shown by the black curve match. Is this decline in purchasing power because gold became more scarce? In terms of real physical gold the answer is "no" because the real physical gold stock of the world grows by about 1.3% each year due to new mine supply, but we will discuss this further below. What about the dollar, did it become more abundant? It sure did! In 2001 the money supply as measured by M3 was $6 trillion while today it is approximately $14 trillion.

Figure 1: Purchasing power of one US dollar expressed in milligrams of gold.

Asking if gold is in a bubble is akin to wondering how little Johnny's clothes became too small. Instead one has to ask how the dollar could have been so mismanaged such that its promiscuous rate of production has set it on a path to certain destruction defined as zero purchasing power with respect to gold. It can clearly be seen in Figure 1 that is where the dollar is headed.

I have written several articles about how the supply of gold has been artificially increased by the supply of "paper gold". The main culprits are the bullion banks operating on the London Bullion Market Association over the counter gold market. These banks sell just ledger entries of gold to their customers who hold "unallocated" accounts and have, by my estimates, less than 3% gold reserves to back those sales.

One of the biggest casualties of the financial crisis is that trust in the banks has completely evaporated. As a consequence more and more customers are asking to take delivery of their unallocated gold. This was confirmed recently by UBS, which is itself a bullion bank. In a GATA dispatch on Aug. 2 a UBS report was quoted that stated "a new trend in 2010 is the movement toward fully allocated physical gold. In H2 and 2011, we expect this type of gold exposure will deepen as new and existing investors diversify a portion of their gold reserves to purely allocated form. Quite simply, such customers are limiting their weight of paper gold exposure."

As investors shun paper gold there will be a growing shortage of physical metal to meet demand which will drive down further the purchasing power of the US dollar (and all fiat currencies) with respect to gold. Furthermore, the Federal Reserve in its September FOMC announcement said that it would now not simply be trying to avoid deflation but to actually create inflation. These two factors together guarantee high inflation and most likely hyperinflation.

Figure 2 shows a chart of a hypothetical gold price evolution against time. I am sure that many anti-gold analysts would claim that such a chart would represent a highly unstable bubble in gold. But this would not be true.

Figure 2: Hypothetical gold price.

Figure 3 shows that this rapidly climbing gold price is generated simply from fiat currency destruction. Figure 2 is just the reciprocal of the dollar purchasing power of figure 3. This is not a bubble in gold but a destruction of the paper currency. Such currency destruction has always happened throughout history of which the most famous examples are Weimar Germany and Zimbabwe.

Figure 3: Hypothetical purchasing power of the US dollar.

Gold is not in a bubble; it is instead fiat currencies that are in their death throes as governments globally engage in competitive currency debasement and "paper gold" becomes unacceptable to investors creating a run on the bullion banks meager stocks of real physical gold.

Adrian Douglas is editor of the Market Force Analysis newsletter and a member of the Gold Anti-Trust Action Committee's (GATA) board of directors.

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