Truly now is the golden age; the highest honour comes by means of gold; by gold love is procured.
Ovid, Ars Amatoria
As we stagger through the ruins of the global financial system, surveying the wreckage left by the bursting of the debt bubble, a new bubble is already being inflated - a gold bubble that could become as inflated and unsustainable as the pre-millennium dotcom madness, tulip mania or the South Sea bubble. On Friday 19 August, gold surged well above $1,850 per ounce, representing a 180 per cent rise in the four years since the start of the financial crisis.
While all other asset classes are slumping back towards the lows of the credit crash, the gold bubble is giving at least a handful of City boys something to cheer about. Commodities traders used to be viewed as the poor relations of the whizz-kids on the derivatives desks or the hedge-fund heroes. For the first half of the past decade, the gold price hovered between $200 and $500 per ounce, as investors poured money into equities, hedge funds and asset-backed securities. Only when the twin devils of recession and inflation reared their heads in late 2007 did gold begin to gleam once again.
Now, commodities traders are keeping their colleagues in Hermès ties, and suddenly every graduate aspires to a place on the commodities desk. This bubble will burst eventually but, for now, gold is the one asset glimmering in the otherwise moribund financial markets.
We are living through a second major crisis in three years, with European leaders dithering over Greece and the United States getting used to life on a credit rating below that of Johnson & Johnson and Microsoft. It used to be that, in times of panic, investors sold out of stocks and invested their money in the haven of government bonds. This time, however, it is government debt that is at the heart of the crisis. Investors are buying record amounts of gold to protect against inflation and hedge against currency devaluation - and, as with any other bubble, simply because everyone else is doing it.
In the wake of plummeting equity markets, investors have rushed to gold. Exchange-traded funds (ETFs), which give retail investors easy access to gold, have had record inflows. Gold's status alongside the Swiss franc and the yen as the only safe havens left in this latest rout has meant that everyone has been chasing bullion, from individuals wishing to protect their pension pots to banks' proprietary trading desks and sovereign wealth funds.
Investment bank analysts are scrambling to upgrade their forecasts for the price of gold: JPMorgan believes it could reach $2,500 by the end of the year; Goldman Sachs, in a note suggesting a "one-in-three chance" of another US recession in the next six months, claims that gold remains "underbought".
What everyone agrees is that the relatively smooth rise in gold prices since the beginning of the year will not continue. It will enter a period of volatility as commodity exchanges increase their margin requirements (the CME Group, the world's largest commodity exchange, raised margin requirements steeply on 11 August), as investors are forced to sell gold to meet margin calls or cover losses in other parts of their portfolio and, most importantly, as traders recognise that gold has reached bubble territory and try to call the top of the market.
Bulls and bears
There is a science to investing in bubbles. George Soros has built a career and an extraordinary fortune on the back of his "theory of reflexivity", which identifies bubbles before they inflate and which, crucially, tells him when to get out. As early as the Davos conference in January 2010, Soros had dubbed gold the "ultimate bubble". Over the course of 2010, he continued to buy gold, both physically and through ETFs such as the iShares and SPDR gold trusts. He rode the price up from below $1,100 per ounce to $1,400 per ounce in the first quarter of 2011. Then he began to sell.
Exactly how much and when he sold is unclear (his fund isn't required to make its portfolio public), but reports suggest that Soros dumped the vast bulk of his gold holdings earlier this year. This means he missed out on the rise in price of $450 per ounce between April and August. That would not have worried him unduly. Central to his theory of investing in bubbles is the need to get out while they're still inflating - you don't want to be one of those rushing for the exit as the bubble bursts.
John Paulson, the hedge-fund manager who correctly predicted the real-estate bubble and who now holds most of his personal wealth in bullion, believes that gold prices will reach $2,000 per ounce imminently and may rise as high as $4,000 per ounce over the next few years. The market is torn between two of its great sages - Soros of the gold bears and Paulson of the gold bulls.
In the long term, I'm with Soros. The gold bubble will burst, and when it does - as with all bubbles - we will look back on these days of $1,850 per ounce as a kind of collective madness. Gold lends itself to fetishism and the recent price rise is almost entirely attributable to that fetish status. Gold underpinned our currencies for such a long period of history that, like children running to the safety of our mothers' skirts, we rush to gold when panic strikes.
In 1821, with the introduction of the gold sovereign, Britain became the first leading nation to adopt the gold standard. Over the course of the 19th century, gold came to underpin the global currency markets, giving tangible value to the fiction of paper money. Citizens could request that their banknotes be converted into gold at a predefined rate. Only in times of financial crisis or warfare was this right suspended. Thus, as crises approached, investors would rush to convert their currency into gold to pre-empt any suspension of the standard.
In the 20th century, with the cost of world wars, rapid technological change and the Great Depression, it became clear that the gold standard was too inflexible a system for the modern financial markets, contributing to rampant inflation and prolonging the economic slump in the United States. The Bretton Woods Agreement of 1944 established an international currency market based on a US dollar that was convertible into gold. Even this last link between the precious metal and paper money was severed with the "Nixon shock" of 1971, when the dollar became a fiat currency - one based solely on the government's promise to redeem it at its face value.
Though formally gold may no longer stand behind paper currency, it has not lost its appeal. Like any promissory system - from banking to insurance - the currency markets depend on a kind of communal suspension of doubt. When people begin to lose faith in a system (as they did with the banking system in 2007 and 2008), they rush to procure tangible evidence of the promises that underpin it. For the banks, this was hard cash from their accounts; for currencies, the evidence of the money myth remains gold.
When the financial storm subsides, we will see gold again for what it is - a pretty, expensive, rather useless metal. Just as it was a return to old-fashioned financial analysis that showed us that the loss-making tech stocks we had bid up to ridiculous levels in the late 1990s were worthless, it is only when we divest gold of its cultural and historical baggage that it will return to fair value. Let us attempt to strip gold of its aura with some cold facts.
Commodities traders watch the relationship between the prices of precious metals closely. On 8 August, the price of gold rose above the price of platinum for the first time since late 2008. On that last occasion, the situation reversed swiftly as traders bought platinum and sold gold, seeing the inversion as a sure sign that the gold price had reached its peak. The price of platinum, though this is nominally a precious metal, is driven by industrial demand: it is used in the manufacture of catalytic converters, for instance. Platinum is rarer than gold and has infinitely more uses than its yellow cousin. A combination of market panic, pessimism over global auto sales and more general double-dip depression, however, has pushed gold up while dampening demand for platinum.
Gold has few industrial uses and silver - currently around $40 per ounce - can be substituted in almost every circumstance. Apart from those who treat gold as a financial asset class, the main demand comes from the jewellery market, particularly in India. Just as financial market speculation in wheat futures in 2008 led to food riots across developing nations, this latest spike in gold prices has had unexpected real-world consequences, with Kolkata jewellers reporting the quietest wedding season in many years. Ordinary buyers of gold are being priced out of the market by financial speculators. Whenever this happens, whether in oil, wheat or cocoa, a crash is imminent. Financial speculation alone cannot sustain a market for long.
There are also negative signals for gold prices coming from the supply side. While gold production fell between 2006 and 2008, 2009 and 2010 brought a surge in supply, driven by the astonishing rise of China as the world's largest miner of gold. In 2010, China extracted 341 tonnes, up almost 9 per cent year on year, overtaking other major producers such as Australia and South Africa. With the latest price rises driving further Chinese investment in gold mining, the conventional scarcity of the metal may soon be a thing of the past.
Some economists predict that deflation following the second dip of recession will cause the gold bubble to burst. I think this is unlikely. Even in a deflationary environment, people will need somewhere to park their cash and, given the likely background of tumbling equity and property prices, the safe harbour of gold will be sought even more keenly. It is more likely that a sharp rise in interest rates, driven by governments' inflationary tactics to tackle the debt crisis, will pop the gold bubble. At the moment, because of the very low interest rates, we perhaps don't notice that gold doesn't pay interest or a dividend - that it is an asset that costs money (in margins and storage charges) to hold. But interest rates will rise and, when they do, gold will fall.
While investors have their cash tied up in gold, the financial markets are starved of their capital. We won't grow our way out of this slump with money stalled in gold. The bursting of this bubble - while it will hurt the unwise - will be a sign that we are emerging from the darkest economic days in almost a century.
Warren Buffett, that champion of American ingenuity and enterprise, is another gold bear. In an interview last October with CNN, he noted wryly: "You could take all the gold that's ever been mined and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all - not some - all of the farmland in the United States. Plus, you could buy ten ExxonMobils; plus, have $1trn of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?"
Due to the fall in the equity markets, major corporations, hives of innovation that still generate enormous profits, are trading at bargain levels. Gold cannot be responsive. It cannot shift strategy to deal with a swiftly altering economic landscape. It cannot reinvent itself.
Gold bulls point out that current price levels are still far away from the 1980 record, once adjustments for inflation are taken into account. In January 1980, gold spiked at $850 - around $2,200 in today's money. This, however, was against a background of double-digit inflation, soaring equity markets, Soviet intervention in Afghanistan and the Iranian Revolution. Both economically and politically, the drivers of that gold spike were very different from those of the present crisis, as was the path that prices took to their peak. The rise was precipitous, moving higher with oil in late 1978 and surging briefly to its peak, before plunging back over the course of 1980 and 1981.
Let the good times roll
The biggest threat to the gold price is the economic crisis. It may be the case that governments, and not traders, will be the ones that identify and burst this bubble. With prices at such elevated levels, it makes sense for the treasuries of debt-burdened nations to sell down their gold reserves. Italy, one of the countries at the centre of the crisis, is the world's fourth-largest holder of gold. German politicians have already lobbied for making liquidation of Italian reserves one of the conditions of any bailout package.
France and the US are also major holders of gold that might be thinking about taking profits on their positions - but it is the International Monetary Fund (IMF) that everyone will be watching. The IMF is the world's third-largest holder, with almost 3,000 tonnes of gold, even after the organisation bowed to pressure from the G20 and liquidated more than 400 tonnes in late 2010. China and India have called for further sales to be carried out and, with a new crisis to tackle, the IMF would be foolish not to consider dumping more of the precious metal on a ravenous market.
Gold will inflate to still more ridiculous levels in the coming months, as the pink papers carry ever gloomier headlines and politicians bicker and delay. JPMorgan's $2,500 an ounce is likely and even Paulson's $4,000 an ounce isn't out of the question when the bubble reaches its final, overinflated phase.
Yet a bubble it is and, like all bubbles, it will burst. The smart traders - such as Soros and Buffett - are already long gone. The unwary retail investors who, too late, have jumped on the gold bandwagon will be hurt when the crash comes. Mining stocks such as Randgold - bid up from $20 a share in 2007 to over $100 a share now - will also suffer badly, as will those investors who have used these stocks as a proxy for the metal. ETFs that specialise in gold will experience outflows to rival the record inflows of August 2011. But, unlike previous bubbles, the bursting of the gold bubble will leave relatively few victims and will signal better times ahead.
The history of this latest phase in the global financial crisis is written in gold. Only when the metal begins its fall will we know that sanity has returned to the markets and we are on the path to recovery.