Friday, May 20, 2011

Gold In A 4000-Year Bubble?

In the last of a series on gold on National Public Radio's "Money Planet" blog, Jacob Goldstein and David Kestenbaum ask if gold is in a bubble. For their answer, they refer to economic experiments done with simple virtual stocks. One experiment featured a stock that paid out a one (virtual) dollar dividend at the end of each round, and expired worthless at the end of ten rounds. Despite the simplicity of calculating the fundamental value, it still traded above that value at times and even went into a bubble. When that fact was pointed out to the student participants, the stock went up even more! As virtual stock-marker experiments show, bubbles are frequent.
One explanation for bubbles is the greater fool theory. People figure they can sell the stock to some greater fool, who will pay more for it.

Another thing that can cause bubbles: People don't always have great information about what's going on. So they just follow the crowd.

And once bubbles start, it can be hard to put the brakes on. If you think home prices are going up, you can buy a house, or two houses. But it's hard for the average investor to bet the other way — that home prices are going to fall.

So for all these reasons, we see bubbles and crashes, in the lab and in the real world. The people in Williams' experiments sometimes buy stock for more than it could ever pay out. This gives us a definition of a bubble: When the price of something rises way above its fundamental value.

That definition, though leaves one in somewhat of a quandary when it's applied to gold. Since there's no way to calculate gold's fundamental value, it's conservative in the accountant's sense to assume that gold has none because it pays no interest and dividends. Thus, a conservative accountant would have to conclude that gold has been in a bubble for at least four thousand years.

Clearly, this line of reasoning is a reductio ad absurdum. The definition of "value" is clearly too narrow, as can be seen when it's applied to any valuable that doesn't generate a return or stream of services. Yes, this includes money: it too pays no interest or dividends. The same criterion used by narrow-minded stock jocks to claim that gold has "no intrinsic value" can be used to claim that any money, fiat or no, is worthless. Exactly the same line of reasoning: just substitute any currency for gold and run through to the answer.

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