The Real Reason Gold's Above $1,000

Guest writer Tyler Cowen is a professor of economics at George Mason University and director of the Mercatus Center. He is also co-author of economics blog "Marginal Revolution" and the author of several books, including, most recently, Create Your Own Economy: The Path to Prosperity in a Disordered World.

Gold has risen and stayed at well over $1,000 an ounce. Although we've gotten used to this new level, investors are asking what it means and whether it will last.

To add to the puzzle, gold is high and rising when the dollar is weak and falling. This runs against the traditional pattern of both gold and the U.S. dollar being viewed as hedges against bad times and thus rising together. You might think that high gold and a low dollar mean the American economy has finally met its end. Over the same period of time, however, it hasn't been just gold stocks like Yamana Gold (NYSE: AUY  ) , Goldcorp (NYSE: GG  ) , and Barrick Gold (NYSE: ABX  ) that have risen; the stock market as a whole put on one of its biggest rallies ever, regaining a lot of the ground it lost during the crash. The pieces just don't seem to add up.

Why gold is so pricey
To understand the high price of gold, I suggest we look to a neglected economic thinker from the early 20th century, namely Frank Knight. One of Knight's essential contributions was to outline the difference between quantifiable "risk" and unquantifiable "uncertainty." If you wish, you can think of Knight as an early theorist of the Black Swan hypothesis.

When risk is quantifiable, you hedge it with something concrete, such as an options or futures transaction related to the specific market of concern. It will be more or less clear which kind of trade you should make. When risk is less easily quantified, people will put their responses to that risk into an arbitrary market, in this case gold, which has been the historic all-purpose hedge.

The price of gold is high because people are afraid, but it's more than that: To an unusual degree, they also don't know what exactly to be afraid of. I call this the new Knightian uncertainty, namely a general sense of fear, not necessarily based in anything particular.

Sometimes the fear is simply the expectation that many other people will remain in a state of fear as well. As you can see, this kind of expectation can be collectively self-validating.

A place called vertigo
The major economic variables today seem subject to much higher than average levels of uncertainty. For instance one big uncertainty concerns the course of inflation over the next five years. The Fed, in its efforts to fight out the financial crisis, pumped an unprecedented amount of reserves into the U.S. banking system. Normally this would be inflationary, but was it this time? It's not so simple. For one thing, the Fed has started paying interest on reserves, which makes banks more inclined to hold on to money rather than lending it out and expanding broader measures of the money supply. For another, the Fed has pledged to drain these newly created reserves out of the banking system when recovery is under way.

Frankly, I am skeptical about the ability of the Fed to thread the needle and succeed with its "exit strategy." But in which direction will the error occur? Will we have too much inflation, or too little inflation and perhaps a deflation and then a double-dip recession? No one knows and also a lot of people know that they don't know. The market, as evidenced by the TIPS spread, expects only moderate inflation, but that average forecast is hiding a lot of uncertainty about the variance of what can happen.

So here's a big risk -- namely about future inflation, output, and stability -- and that risk creates a more general sense of fear. Not all of that fear can be hedged by futures and options and thus we see the premium on gold.

You could march through a lot of other variables which today are more uncertain than usual, yet in vague or hard-to-forecast ways. That includes unemployment, fragile Chinese economic growth, the commercial real estate bust, rising health-care costs, sovereign debt problems, nuclear proliferation, climate change, problems in Pakistan, an Israeli attack on Iran, oil or commodity price shocks, and terrorism. 

A lot of people I know wonder if we haven't entered a new period of global chaos and that our current peace and comfort are a bit analogous to how the world looked in 1910. I've repeatedly heard the phrase "the vertigo years," in reference to Philipp Blom's recent book about the period leading up to World War I.

The outlook for gold, the dollar, and stocks
Now let's go back to the puzzle of our three asset prices.

Gold is high because generic uncertainty is especially high. Since the United States has just had an especially bad decade, from 9/11 onwards, the dollar is not strong as a hedge against bad times. It's not that everyone is so bearish on the U.S., we just don't seem invulnerable anymore. At the same time, the current economy, despite its high level of risk, has real long-term potential. The Internet holds the promise of becoming a second industrial revolution and many of the jobless will at some point be absorbed into new productive ventures. That's hardly an overwhelming case for optimism, but it is way better than things looked a year ago, and thus equities have recovered somewhat.

What about going forward? Uncertainty about uncertainty is especially hard to predict, but the core lesson is this. When you have people who are both wealthy and spooked, and the idea of a total collapse is suddenly on their radar screens, they want to buy real insurance against it. It may take us quite some time for the global economy to evolve away from this new and higher gold price.

In the meantime, let us know what you think in the comments box below. Is gold a good investment right now?

Tyler Cowen does not own shares of any of the companies mentioned in this article. The Motley Fool has a disclosure policy.


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  • Report this Comment On December 23, 2009, at 1:19 PM, SteamedCrab wrote:

    Great article!

  • Report this Comment On December 23, 2009, at 1:36 PM, Viking70 wrote:

    Thank you for this article.

    And $0.10 for the kids.

  • Report this Comment On December 23, 2009, at 2:05 PM, mitleg wrote:

    Wonderful article. I think it does capture the public mood quite well.

  • Report this Comment On December 23, 2009, at 2:30 PM, globalsailor wrote:

    I am actually impressed by this one too. It's making me reconsider my portfolio.

  • Report this Comment On December 23, 2009, at 4:43 PM, eddietheinvestor wrote:

    This article doesn't make sense. Why does Cowen fail to realize why investors are scared? The federal deficit has tripled to 1.42 trillion as of three months ago--a deficit that is rising constantly and is clearly out of control, the US is fighting two wars that it can't win, Congress is about to pass a health care bill that will dramatically increase the deficit, interest rates will have to rise and taxes will have to increase a lot to help limit the out of control deficit, inflation will probably result from the rise in interest rates; and all of these things could cause the stock market to collapse. Yet Cowen says that people are afraid yet they don't know what they are afraid of. He seems uninformed. People know why they are scared. It's all over the news: unsustainable federal deficit, cities and the state of California going bankrupt, recession, Congress and Obama spending money and then printing more and more without thinking of the future, a huge debt that our children will have to pay back if it's possible to repay such a debt. China is clearly skeptical of the US's ability to pay its debts, and now the health care bill will add to the deficit.

  • Report this Comment On December 23, 2009, at 4:44 PM, oldengineer wrote:

    I thought the article stated the obvious - people are nervous about the future of the economy, so they buy gold. I read the article looking for a prediction about the future price of gold and instead there was a wishy-washy "it may take some time to evolve away ......" So, if it may take time then it may not take time. Will it evolve away to a higher price or to a lower one? Reading this article was a waste of time.

    Old Engineer

    No disrespect intended. I just didn't think the article was worth reading.

  • Report this Comment On December 23, 2009, at 5:26 PM, QuandoInQuando wrote:

    Overall, not too bad. There is some reasoning that I hadn't heard before. But I would like to have a few more questions answered by someone with Professor Cowen's credentials.

    First, have we already mined almost all of the world's "easy" gold? If so, then the supply and demand law is in play.

    Second, are the developing nations really increasing their gold cache? It seems to me that a government would like to have a gold reserve just as soon as they could afford it.

  • Report this Comment On December 23, 2009, at 5:27 PM, plange01 wrote:

    foolish people have the newest technology in computers and smart phones then talk about gold which has been useless as a currency since the civil wall and in reality worthless...

  • Report this Comment On December 23, 2009, at 6:57 PM, xetn wrote:

    Just ask yourself what real value there is in a piece of paper? The only reason that fiat paper money has any value is because it is legal tender. If there were not a legal tender law in the US (and most other countries) no paper money would exist because the currency would not be worth the paper it is written on.

    Gold and other commodities have real intrinsic value because they have other uses and, in the case of gold, became real money (a unit of exchange) over many years based on that intrinsic value.

    Gold has been used as money (a unit of exchange) for over 5000 years. How long has paper been used, without the convertibility provision? Since 1971 when Nixon closed the gold window and took the US off Bretton Woods. Since then, it now takes over $534.00 to purchase what $100.00 would in 1971.

  • Report this Comment On December 23, 2009, at 8:09 PM, QuandoInQuando wrote:

    Those computers and smart phones use gold in their construction, as do almost all modern electronic devices. Gold's electrical and physical properities account for its intrinsic value. It's scarcity accounts for it's monetary value.

    As a currency, gold only has the value that people place on it. Folks like gold, and it is not plentiful, thus we say that gold is valuable. If gold were as easy to get as let's say aluminum, then we would price it accordingly.

    The gold in Fort Knox has no more intrinsic value than the gold at the bottom of some mine yet to be discovered. The gold in either place doesn't DO anything. Gold has value when it is used in such a way as to make our lives better [then they would be without it].

  • Report this Comment On December 23, 2009, at 8:14 PM, Centerline75 wrote:

    +1 on what estrlin and +2 on oldengineer.

    Duh! Folks can see the paper being printed by the wackos of D.C. as if there were no tomorrow.

    Gotta be some reason India and China have bought a few tons of gold lately and that China is telling its 1.5 BILLION citizens to load up on silver and gold.

    On a similar "vein", google JP Morgan Silver short positions...... hint, short squeeze to occur at some point.

    Like they said, article was a waste of time..... did that same econ professor or whatever who wrote the article forsee the global market meltdown this past year??

  • Report this Comment On December 23, 2009, at 8:32 PM, plange01 wrote:

    gold prices...stupidity! people think they are living during the civil war while talking on their blackberrys!!

  • Report this Comment On December 23, 2009, at 9:42 PM, jerryguru69 wrote:

    '...the Fed has started paying interest on reserves, which makes banks more inclined to hold on to money rather than lending it out and expanding broader measures of the money supply.'

    I wonder how many investors have taken this into account. I occasionally read a story that mentions in passing that there are $T's on ice by banks at the Fed and ECB. Will it stay there? What happens when it does start to move out into the banking system? When?

  • Report this Comment On December 24, 2009, at 1:00 AM, goalie37 wrote:

    Fear is good. The sheep are usually wrong.

  • Report this Comment On December 24, 2009, at 8:49 AM, XMFSinchiruna wrote:

    Please read Myth #2 in The 5 Biggest Myths About Gold:

    http://www.fool.com/investing/general/2009/06/09/the-5-bigge...

    Uncertainty has zero to do with my own rationale for holding gold and silver ... let alone some generic sense of uncertainty that I can't place a finger on. There are specific and identifiable fundamental drivers underlying the gold price, and no discussion of investor psychology will ever suffice to fully understand what is driving the price of gold.

    http://www.fool.com/investing/general/2009/06/02/the-top-10-...

    http://www.fool.com/investing/general/2009/09/04/the-untold-...

    Additionally, the market for gold is not presently driven by the retail investor and his/her state of mind. The market is driven by professional participants, including hedge funds and central banks, who again have a clear understanding of gold's outlook in relation to that of the U.S. dollar. There is no puzzle about the impact of U.S. dollar weakness upon the price of gold.

    The dollar and other leading fiat currencies, in fact, are fundamentally impaired by a failing global derivatives market that is hundreds of trillions of dollars in scale ... far outweighing global GDP. There is no mystery here. Gold is money, and the sooner people understand the enduring nature of gold as the only currency that can not be encumbered by such toxic malfeasance, the sooner they will protect their own assets from the inevitable continuation of the dollar's loathsome devaluation and further challenges to its hegemony as the primary reserve currency of the world.

    Happy holidays. Fool on!

  • Report this Comment On December 24, 2009, at 5:23 PM, Fool wrote:

    We are headed for a boom because the 24-year economic cycle repeats itself. The Kondrotiev cycle is reliable as it goes back to the beginning of the Industrial revolution with repetitive highs and lows. Not to be fooled. The new boom will be "cloud computing."

  • Report this Comment On December 25, 2009, at 6:39 PM, Gorm wrote:

    Great article! Makes total sense!

    Consider the "illusion" that the Fed / Treasury / Administration wants the Fed to keep interest rates low in the traditional sense that low rates serve as a stimulus for borrowing, ie Americans don't save, they borrow and also the threshold for investment is much lower when funding costs are low.

    BUT what if the the reality is twofold: 1) capital starved financials sitting on tons of toxic assets are enabled to amass no risk earnings and 2) all this buys precious time!!

  • Report this Comment On December 25, 2009, at 6:43 PM, Gorm wrote:

    If gold is a store of value that fluctuates with uncertainty and alternative solutions will avail themselves once the "risk" is better identified / defined, would you want to be sitting on a store of $300 gold purchased at today's prices?

  • Report this Comment On December 26, 2009, at 4:18 PM, Bigstu52 wrote:

    I like the Motley Fool Website. But while reading the Posts like this one about gold I am dismayed. Why write this trash to try to lure me to buy one of their subscription services. I would rather put up with some advertising on the sides or bottom than to waste my time like this.

  • Report this Comment On December 29, 2009, at 3:06 PM, Webuchadnezzar wrote:

    Eddietheinvestor's response was excellent, and far more on target than the original article.

    This author, a supposed professor of economics, JUST DOESN'T GET IT. Gold is high in dollar terms because of the govts irrsponsible and reckless deficit spending. It is printing billions upon billions of new dollars as fast as it can. Our currency is rapidly heading toward being worthless. What part of that does he not understand?

  • Report this Comment On December 30, 2009, at 12:59 AM, MalibuRon wrote:

    Gold went up when Central Banks in various countries like India decided this year that with the dollar weaker than normal, a temporary thing to be corrected when interest rates come back up from zero - the central banks diversified their foreign exchange holdings to include a temporarily more stable holding (gold). Central banks like in India are responsible for a lot of the strength this year in the price of gold.

    When the dollar strengthens, Central Banks will stop buying gold (if they haven't already) for their ForEx reserves; gold is not a currency, it is a commodity with quite limited production. The ForEx accounts will go back to Dollars.

    Furthermore, if gold starts to fall in price, Central Banks will look at the dollar and say: "Is the dollar getting stronger? Yes? Okay, gold's going down, lets sell gold before it goes lower, and buy dollars which are appreciating."

    AND GUESS WHAT FOLKS THAT'S WHAT'S HAPPENING. The dollar is strengthening.

    AND GOLD HAS SOLD OFF 10% in about 3 weeks.

    AND GOLD HAS BEEN TRADING BELOW ITS 50 day moving average (of $1116) for many days now (see http://stockcharts.com/h-sc/ui?s=$GOLD&p=D&b=5&g.... Closed at $1094 today.

    So, you goldbugs out there -- if spot gold keeps falling through its 200 day moving average of $991, just 100 points from its close today -- keeping in mind gold's fallen over 120 points in the past 3.5 weeks -- this *may* indicate that: CENTRAL BANKS, the most recent and *largest* buyers of gold, HAVE DECIDED NOT TO SUPPORT THE PRICE OF GOLD, they will not keep buying more gold to prop up its price.

    And if that is the case -- MAY BE A GOOD SHORTING OPPORTUNITY.

  • Report this Comment On December 30, 2009, at 1:00 AM, MalibuRon wrote:

    Gold went up when Central Banks in various countries like India decided this year that with the dollar weaker than normal, a temporary thing to be corrected when interest rates come back up from zero - the central banks diversified their foreign exchange holdings to include a temporarily more stable holding (gold). Central banks like in India are responsible for a lot of the strength this year in the price of gold.

    When the dollar strengthens, Central Banks will stop buying gold (if they haven't already) for their ForEx reserves; gold is not a currency, it is a commodity with quite limited production. The ForEx accounts will go back to Dollars.

    Furthermore, if gold starts to fall in price, Central Banks will look at the dollar and say: "Is the dollar getting stronger? Yes? Okay, gold's going down, lets sell gold before it goes lower, and buy dollars which are appreciating."

    AND GUESS WHAT FOLKS THAT'S WHAT'S HAPPENING. The dollar is strengthening.

    AND GOLD HAS SOLD OFF 10% in about 3 weeks.

    AND GOLD HAS BEEN TRADING BELOW ITS 50 day moving average (of $1116) for many days now (see http://stockcharts.com/h-sc/ui?s=$GOLD&p=D&b=5&g.... Closed at $1094 today.

    So, you goldbugs out there -- if spot gold keeps falling through its 200 day moving average of $991, just 100 points from its close today -- keeping in mind gold's fallen over 120 points in the past 3.5 weeks -- this *may* indicate that: CENTRAL BANKS, the most recent and *largest* buyers of gold, HAVE DECIDED NOT TO SUPPORT THE PRICE OF GOLD, they will not keep buying more gold to prop up its price.

    And if that is the case -- MAY BE A GOOD SHORTING OPPORTUNITY.

  • Report this Comment On December 30, 2009, at 4:34 PM, sprooz wrote:

    Since a market crash will occur around march-june 2010 as forecasted by a technology called ssrforecast, gold can only reach new highs.

    http://ssrforecast.bloguez.com/

  • Report this Comment On December 30, 2009, at 8:53 PM, GirlScoutDad wrote:

    I am quite impressed by the deluge of mass marketing advertising in print, TV, and internet media urging average guys like me to own gold.

    If millions of sheep like me start buy gold (as I have), then I imagine that a significant new demand for the metal is being generated, which should drive up price of course.

    BTW, does anyone know how much gold there is in the world? If so, then I could multiply the amount by the price and get an idea of the size of the total gold market.

  • Report this Comment On December 30, 2009, at 9:24 PM, Fool wrote:

    Fear is good. This country has been living for far to long beyond it's means. U don't have to look any further than your mail box. Everyone is living on credit and it was great, but like all good things it ended. Now as Americans we need to look back to our grandparents or parents at what they did after ww 2. They paid cash and saved their money. It's about time we wake up and start living more responsible we can't sustain our daily lives on credit or home equity lines. Wake up people things aren't gonna get better till we take responsibility for our overspending. This means u to Obama Pelosi and Reed wake up.

  • Report this Comment On December 31, 2009, at 2:29 PM, steveballmer wrote:
  • Report this Comment On January 01, 2010, at 10:05 AM, billriddeldallas wrote:

    On December 23, 2009, at 4:44 PM, oldengineer wrote

    YES!!! thank you OLD ENGINEER for stopping my ulcer from forming. This better encapsulates the entire article instead of the "confusion" of the american people.

    Most Ceo's and politicians should be in prison albeit a white collar prison much less running other peoples money. Unfortunately, if your way out of risk is hoping an intrinsic only value block of gold that cost 16,000 a pound will go up to 50,000 a pound and tell them they can sell a worthless lump of metal for 200,000 a pound......... well, one day its going to be a funny little scene on the malleable shiny fun metal called gold.

    lets all get gold teeth to increase the actual USE of gold.. !!! .

  • Report this Comment On January 01, 2010, at 2:19 PM, kolateepee wrote:

    I totally agree with this article and yes it is common sense stuff. I am one of the uncertain people and maybe I wouldn't be so uncertain if I could be given a reasonable explanation of how we are going to handle the huge commercial real estate debt problem and the slide of the consumer who is the support for most everything.

  • Report this Comment On January 01, 2010, at 3:01 PM, automaticaev wrote:

    I think when gold goes high enough people will want to sell it.

  • Report this Comment On January 02, 2010, at 4:35 PM, degel wrote:

    Umm, actually, it's not that gold has gone up. Rather the dollar has gone down.

    While gold has risen against all major currencies over the last few years, it has risen MUCH more against the dollar than against the Euro and other major currencies.

    During 2009, the price of gold fluctuated by ~10% or less, measured against most other currencies.

    We live in a global market. Viewing prices only in dollar terms is like wearing blinders -- it hides much of the full story.

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