Regulators, Bubbles

And the Price of Gold

By STEVEN M. DAVIDOFF

Gold is caught in a frenzy.

Its price reached a record high of $1,917.90 at one point in August, not adjusted for inflation, then plummeted by about $120 an ounce. The volatile trading is spurring claims that gold is in a bubble, one that will pop badly.

As with past booms in housing prices and Internet stocks, the four-year surge in gold prices raises the same fundamental questions for market regulators.

How should they react?

Should they react at all?

How do they even know if a bubble exists?

It is clear that speculation has been driving gold’s rise. People are buying gold as either a hedge against inflation or economic calamity or solely because they think the price will rise. As evidence of this speculation, the World Gold Council reports that demand for gold bullion bars more than doubled from 2009, to about 850 metric tons a year. This is largely gold that is bought and sits there as people wait for price increases. Indeed, demand for gold in industry and for jewelry has actually declined by 18 percent from 2004.

This speculation is aided by the financial revolution. Previously, gold could be bought by retail investors only through dealers and street shops. Now anyone can go on the Internet, click and buy gold in the market through exchange traded funds, which now hold about 2,250 metric tons of gold — or nearly a year’s worth of output.

Speculation alone doesn’t necessarily mean that gold is in a bubble.

Gold is historically viewed as a protection against inflation and tumultuous economic times. But like paper money, gold is worth only what people believe it is worth, and because of this, it is sometimes referred to as the barbarous relic. You can’t eat gold. Its industrial uses are limited. If someone else doesn’t assign the same value to gold that you do, you are out of luck.

Gold’s relative uselessness has helped spur talk of a bubble. The problem for regulators is whether this speculation is prudent hedging or people irrationally piling ever more into a bubbly asset.

As with the Internet bubble that burst in 2000, we will know if a bubble truly existed only if and when gold falls. In his book “Irrational Exuberance” ,Robert J. Shiller of Yale University notes that bubbles are created when people buy into the next great thing. They accept that this is a game-changing asset — like housing or the Internet — that cannot fail.

According to Professor Shiller, a crucial driver of a bubble in today’s modern age is the Internet and media. Commercials abound for buying gold right now. TV commentators talk about gold hitting $2,400 an ounce, which would be a genuine record (the previous high of $850 in 1980 would be about $2,300 today, adjusted for inflation).

But REGULATORS have acted as hesitantly as they did in the case of the Internet and housing bubbles.

REGULATORS NOT REGULATING  ? ? ? ?

The Chicago Mercantile Exchange recently raised margin requirements for gold, the amount of money you can borrow to buy gold.

The Singapore exchange also raised margin requirements last week.

Other exchanges in other countries have not acted similarly, leading to differences that will drive gold trading to those markets.

Not only is it hard to spot a bubble, but the measures to fight it, like forcing exchanges to further raise margin requirements, are hard and controversial to put into effect.

Yet if regulators are going to stop the next bubble, they need to act aggressively.

Of course, they shouldn’t act in every circumstance, but when we see volatility and speculation as is the case of gold, acting to curb these forces in cooperation with international regulators would be a prudent course, limiting the effects of a crash.

Even if the Commodity Futures Trading Commission, the primary regulator of the gold market in the United States, is hesitant to take such steps, it could, as an initial foray, take to the media to try to talk down” the speculation.