Friday, October 8, 2010

Kenneth Rogoff On Gold

Via Greg Mankiw’s blog (excerpts):

$10,000 Gold?
Kenneth Rogoff

SAN FRANCISCO – It has never been easy to have a rational conversation about the value of gold. Lately, with gold prices up more than 300% over the last decade, it is harder than ever. Just last December, fellow economists Martin Feldstein and Nouriel Roubini each penned op-eds bravely questioning bullish market sentiment, sensibly pointing out gold’s risks...

...Admittedly, getting to a much higher price for gold is not quite the leap of imagination that it seems. After adjusting for inflation, today’s price is nowhere near the all-time high of January 1980…At $1,300, today’s price is probably more than double very long-term, inflation-adjusted, average gold prices. So what could justify another huge increase in gold prices from here?

One answer, of course, is a complete collapse of the US dollar... And if you are really worried about that, gold might indeed be the most reliable hedge...

...Even so, the fact that very high inflation is possible does not make it probable, so one should be cautious in arguing that higher gold prices are being driven by inflation expectations. Some have argued instead that gold’s long upward march has been partly driven by the development of new financial instruments that make it easier to trade and speculate in gold…

…In my view, the most powerful argument to justify today’s high price of gold is the dramatic emergence of Asia, Latin America, and the Middle East into the global economy. As legions of new consumers gain purchasing power, demand inevitably rises, driving up the price of scarce commodities…

...Indeed, another critical fundamental factor that has been sustaining high gold prices might prove far more ephemeral than globalization. Gold prices are extremely sensitive to global interest-rate movements…Today, with interest rates near or at record lows in many countries, it is relatively cheap to speculate in gold instead of investing in bonds. But if real interest rates rise significantly, as well they might someday, gold prices could plummet...

...If you are a high-net-worth investor, a sovereign wealth fund, or a central bank, it makes perfect sense to hold a modest proportion of your portfolio in gold as a hedge against extreme events. But, despite gold’s heightened allure in the wake of an extraordinary run-up in its price, it remains a very risky bet for most of us.

Of course, such considerations might have little influence on prices. What was true for the alchemists of yore remains true today: gold and reason are often difficult to reconcile.

Apart from the long term fundamental increase in gold demand (which has in fact levelled off last year), Rogoff makes the point that new financial instruments may have made speculating in gold easier – Gold ETF’s, a proliferation in gold bullion companies for example – but his point about interest rates is what I want to focus on. On that basis, with interest rates in developed economies likely to remain low, the price of gold is likely to remain elevated for some time, despite being in Rogoff’s estimation double it’s long term fundamental value.

But that doesn’t mean an investment in gold makes sense, if your base currency is outside the USD/EUR bloc, as I’ve tried to show.

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