Gold is not merely at an all time high;

It has gotten there extraordinarily rapidly, a typical attribute of bubbles. That said, bubbles are very difficult to identify. Wall St. jokes aside, there are some very bright people who did not identify either the tech bubble or the housing bubble in time to avoid major losses.

If gold is in a bubble, why is it in a bubble and what would cause the bubble to burst? Historically, bubbles are caused by easy credit policies; many people with easy access to lots of money, all suddenly chasing the same asset. Does that describe the tech bubble? Check. The housing bubble? Check.

Does it currently describe gold? The Fed’s balance sheet has certainly exploded. Clearly the Fed’s intent is to keep avenues of credit open. However, as Meredith Whitney (sorry, I don’t have the appropriate link) has pointed out, credit for the average borrower has shrunken rapidly over the last 18 months, and gives all appearances of continuing to do so.

More than 125 banks have folded during 2009, and many more are likely to do so in the next year. When banks fold, the money supply contracts. Money supply contractions cause rapid deflation. Rapid deflation, as Milton Friedman and Anna Schwartz described in their classic study “A Monetary History of the United States,” caused the Great Depression. As a scholar, Ben Bernanke’s area of expertise was the causes of the Great Depression. He has prepared his entire life to deal with preventing a liquidity crisis from becoming a Great Depression, and as Friedman repeatedly pointed out, the Fed’s great failure during the depression was not turning on the spigots to the money supply. Bernanke will not make that mistake. His easy credit policies are intended to keep bank closures to a minimum, and avoid the escalation of deflation.

However, as the French discovered after building the Maginot Line, wars evolve. Bernanke has prepared to fight the Great Depression, and seeing a liquidity crisis, he is fighting it using all the tools that should have been used 80 years ago. Unfortunately, he is not fighting the same villain. The money supply has been expanding rapidly for years. There was plenty of money. The problem was that banks’ ledgers held assets that had suddenly become illiquid — assets whose valuations suddenly went from par to zero — not because they were necessarily worth zero, but because their value had suddenly become completely uncertain. If banks were forced to value these assets at the prices they could sell them for, then suddenly all banks were insolvent. Would you give credit to an entity you feared might be insolvent? All banking came to a screeching halt, credit dried up and it looked a lot like a liquidity crisis. Bernanke opened the spigots and kept interest rates low to forestall a non-existent liquidity crisis.

Meanwhile, over at Treasury, the Bush Hold ‘Em team had been running huge deficits throughout their term, and now the Obama administration has seen their raise and gone all in. If you spend more money than you earn, you must borrow. So far, the world (read China, India, Saudi Arabia, and the like) has been happy to lend, because the world is awash in US dollars. China holds over a trillion dollars in US government debt, all bought with US dollars received as payment for Chinese exports to the US.

If the world decides at some point, that the mounting supply of US debt is risky, they will begin to withhold their purchases of that debt. If the US continues to spend in multi-trillion dollar deficits, and the world slows its willingness to finance that deficit spending, then Treasury will be forced to either pay much higher interest rates or have the Fed pick up the world’s slack by buying the newly issued debt with newly minted currency. If (and given the administration’s enthusiasm for deficit spending, it’s when, not if) that happens, the Fed will no longer need to worry excessively about deflation. Inflation will be the war being fought.

And finally we arrive back at the question, is gold in a bubble? Gold has few industrial purposes. Although gold is in demand by the jewelry industry, the laws of supply and demand have clearly prevailed. As the price of gold has risen due to excessive investment demand, the jewelry demand for gold has declined, as I understand to about half its peak level. Obviously the investment demand currently is significantly greater than the previous jewelry demand.

Since gold has so few utilitarian purposes, its only real value is in its traditional characteristic of being a widely accepted store of value. People the world over, throughout history, have been willing to accept gold in payment for goods and services. When fiat currencies are strong, when they are perceived to be safe and valuable, gold loses its demand. When people perceive that fiat currencies are being debased, when they determine that holding fiat currencies has unacceptable risks, they return to their roots and buy and hold gold.

The current increase in the price of and demand for gold is merely a reflection of people’s perception, the world over, that holding the US dollar is becoming increasingly risky. If the Fed monetizes the government’s debt, inflation will destroy the value of the dollar, and given the US government’s current path, many people and sovereign nations can see no other outcome.

The pragmatic capitalist is right; there is no current sign of inflation. However, that does not stop investors from looking downstream and seeing the potential for inflation, and in fact for seeing significantly more than potential, but the probability of inflation. If they are correct, then the only limit on the value of gold, as denominated in US dollars, is the extent to which the dollar will be debased. If you double or triple the money supply from here, you will likely double or triple the value of gold (although the price may go even higher).

So, if we continue to define a bubble as easy access to money all being invested in a single commodity, then yes, it is likely that gold is forming a bubble. But what would prick the bubble is a US policy decision to stomach the hard times that would go with a return to a sound money/strong dollar policy; increase interest rates, increase current savings and reduce or eliminate Federal deficits. As the price of gold reflects, the world is betting that won’t happen.

And just to add to the general uncertainty, it would appear to me that the increasing level of the US stock market also reflects a growing bubble. Unlike the issue with gold, any number of pins may be poised to prick that bubble. Adverse geopolitical events or domestic terror strikes aside, investors may lose their current optimism in the face of continuing and deepening unemployment or from a renewal of foreclosure activity from the slew of new mortgage resets about to occur, or from a concern that new Federal programs will impose daunting new tax levels, or from any number of factors. If (when?) the stock market bubble bursts, how many additional banks will be taken down and forced to close their doors? How much impact might that have in contracting the money supply?

In such an event, would the gold bubble also be burst? Or is it possible to live in a world of asset and price deflation and yet still have gold price inflation? It’s a brave new world, and our biggest mistake may be to believe we understand it, or that our economists can predict the outcome of billions of independent, intertwined decisions by millions of individual investors, or that our policymakers can manage the economy or anticipate a myriad of unintended consequences.

- NeilB

Related Posts:

• Federal Reserve’s powers are too broad and it’s policies have caused more problems than solutions.
• Echoes of another great crash — and the lessons we refuse to learn!
• “Excess Bank Reserves, Fed Balance Sheet Assets Skyrocket To Record High Levels”
• A Depression Never Ends (1929-2009)
• Why the Present Depression Will Be Deeper than the Great Crash of 1929 (June 2009)

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