WASHINGTON, July 27, 2011—As the price of gold shot past $1,600 per ounce last week, mainstream experts bandied around the word “bubble” once again. We have heard such talk ever since bullion broke through the $400 mark. That was almost eight years ago.
Gold has had a massive bull run, which began in late 2001. It has risen nearly six-fold since. And despite the gains, the underlying fundamentals do not suggest that gold is in a bubble.
Asset bubbles occur when there is frenzied buying on a mass scale.
We saw such a bubble a few years ago in real estate. Almost everyone then seemed to be buying a second or a third or a fourth house as a speculative investment. People thought that the way to become rich was to take out a few mortgages and then sit back and watch real estate prices go through the roof.
We know there is a bubble when people act like that. During the real estate frenzy, housing prices rose dramatically in a few years.
What we have seen with gold is a steady increase in price over an extended period of time. Some corrections happened along the way – as one would expect – but the long-term trend has been a steady climb.
To understand the forces behind gold’s rise, we must understand one basic thing about gold: Gold is money. Throughout much of history gold has functioned as money. It has served this function because it possesses a set of characteristics that make it uniquely suited as a means of exchange and a store of value.
In the last eight decades or so, governments around the globe have sought to deprive gold of its monetary function via legal tender laws and their equivalents. These laws criminalize the use of gold as a means of exchange.
But government laws cannot suppress the natural order of things. Despite the best efforts of politicians, gold has retained its function as money. The laws have only made gold go underground, so to speak. Even though it is not openly used as a means of exchange, it still functions as shadow money.
Gold price reflects the strength of government-mandated currencies, mainly the dollar, which has taken gold’s place as the de-facto reserve currency of the world.
The weaker the dollar, the higher gold.
Since late 2001 the US government has weakened the dollar in unprecedented fashion. It has done this in three primary ways:
1. Unduly low interest rates;
2. Excessive government debt;
3. Unwarranted expansion of the money supply.
This process was set it in motion when the government started lowering interest rates in response to the dot.com collapse and 9/11. Low interest rates gave rise to the housing bubble as Americans kept taking out cheap mortgages to buy properties.
When the Federal Reserve began jacking up interest rates in the effort to stem rising inflation, the housing bubble burst and wreaked havoc throughout the economy. The government responded by bailouts and various forms of monetary stimuli that ballooned its debt. To make things worse, the Fed slashed interest rates to the point where real rates are now negative.
Since 2001, the dollar has suffered continual debasement. Hence the rising price of gold.
Gold’s bull run is not the result of a bubble. It has been driven by government policies that have had a debasing effect on the dollar. As long as the government continues to debase the dollar, the price of gold will keep going up.
Gold will go through inevitable corrections and some of them may be quite sharp and dramatic. But the underlying fiscal dynamics are pressuring upward. This will not change until government puts its fiscal house in order. The chances of this happening, however, appear to be very remote at this point.
As any asset, gold, too, can go into a bubble. This will happen when people start panic-buying bullion in order to get rid off their dollars.
You will know that gold is in a bubble when your “experts” on TV urge you to buy at $8000 or more per ounce. Then you will know it’s time to offload.
Until then, hold onto your gold.
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