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.