"Wading neck deep in a swamp, your revolver is neither use nor ornament until you have had time to clean it" Mary H. Kingsley (1897)

Golden Dreams

Behind the new gold rush

T. Balakrishnan

The price of gold has gone up from $256 an ounce in 2001 to $1,424. Meanwhile, price levels have struggled or crashed with respect to almost all other asset classes. Central banks have slashed interest rates. Yet, gold prices, it has been predicted, may go up and up. The many reasons for this renewed love are convincing. Interestingly, not long ago pundits had predicted the end of gold as the world’s default asset class and were clubbing it with commodities. It appears that the yellow metal is making a comeback to reassert the pre-eminence it has enjoyed for 5,000 years of history.

Its supply is falling. No new mines have been discovered. The existing ones are getting exhausted, and miners are digging as deep as 5 km. Gold content in ore has come down from almost 12 gm a tonne to 2 gm. And it costs more and more to take that out.

Environmental concerns have also contributed to mine-owners’ problems. The wages of miners are going up; so is the cost of providing them safety and security.

Emerging economies such as China and India are accumulating gold in order to reduce their dependence on the dollar. While the U.S. has a reserve of 9,200 tonnes of gold, China has 1,054 tonnes and India 565 tonnes. No wonder, as emerging economic superpowers China and India want to add to their reserves. Industrial use of gold is on the rise the world over. With the U.S. economy still drifting with the threat of the dollar losing its undisputed position of reserve currency, the rush to gold is increasing. The zero-interest regime in the U.S. is driving more private individuals to go for gold.

Added to all this is the rekindled investor-preference to gold. Money is moving away from mutual funds and equities and the once fashionable and often discredited hedge funds are also getting into gold. Exchange traded funds (ETFs) are channeling ever more funds to gold. Some pension funds are increasing the proportion of gold in their basket of assets. Given all this, gold can go nowhere but up. That is the consensus.

Everyone seems to be joining the new gold rush. But is everything well with gold? Or is it a bubble building up?

Consider the conventional wisdom. Money generally gets distributed, though not in any fixed proportion, among assets such as real estate, stocks, cash, government securities, gold, commodities, and in new investments in factories and machinery. There is no state of equilibrium in a global economy. Money gets transferred across geographical boundaries and asset classes based on anticipated gains. As long as the flow is reasonable and generally in line with the increase in returns, this works well. But when everyone rushes to the same destination, we are looking for trouble. Excess demand, though often artificial, creates excess supply, as in the case of real estate. Excess supply leads to price crashes. But in the case of gold, the argument is that excess demand cannot create excess supply as the total world supply is limited. People have a short memory and the Black Septembers, dot-com busts, currency crashes and real estate collapses are forgotten. Everyone, as usual, rushes to the next mass destination, creating another bubble. In all these collapses and crashes, those who are early to get in and get out, make big money — and the last ones are left holding the baby.

Is something similar happening in gold? The general consensus is ‘no.’ Gold is different. It has never let anyone down in 5,000 years. It is indestructible. Its supply is limited. But this time it is different. Is it really so? Gold has also gone up and down in the past. It was $424 an ounce in 1990 before crashing to $255 in 2001. Still, it moves only within a range and huge fluctuations are not possible in gold, argue some people. Actually, gold gave much better returns in the 1980s, only to stagnate and lose those gains in the 1990s.

What can spoil the party? U.S. interest rates? Can the U.S. hold on forever to a near-zero per cent interest regime as Japan has done for almost two decades? Can the U.S. avoid the inflationary pressures created by all those green notes printed in the last few years and the money blown up in Iraq and Afghanistan? Is gold the permanent safe bet, as we are led to believe?

In real estate, it was Japan’s turn first. Throughout the 1980s, prices kept climbing on the back of a booming economy and stock market. The arguments were sound. Japan is short of land. Nobody makes land anymore! The Japanese need bigger buildings. The economy is booming and will continue to do so. Well, naturally the prices kept going up — till the crash occurred. That happened in the early-1990s, and prices are still half of what they were during the boom.

The story was slightly different in South-East Asia in the late-1990s, but the outcome was not. We heard it again in 2008. Housing is the backbone of society. The U.S. is made up of house-owning families. The U.S. is not Japan. Well, there are millions of houses looking for new owners in the U.S. even now.

It was different in Dubai. Dubai was not building for locals and expatriates alone. It was not for Emiratis alone, and not just for Arabia. It was for the whole world. Dubai cannot crash! Well, it did, and very badly.

What about the stock market? Nikkei was almost 40,000 in 1989. It is around 10,000 in 2010. The Dow Jones was already 10,000 in 1999 and the brokers were predicting it would go to 40,000. What happened to all the pension funds, trust money, 401k savings that went into the stock market at their peak in the U.S.? We are in 2010, and the Dow is still around 10,000. Oil was $40 a barrel in 1973 before crashing to $13. It went up to $140 and was speculating to go to $200 before someone punched the barrel. It is still around $90.

A crash of gold prices could be the ultimate crash, nothing like we have seen. No one has managed to discredit the yellow metal in 5,000 years. But it appears that for the first time in history the ETFs, the hedge funds and the governments are about to do the undoable.

The fact that it has not already happened is no guarantee that it will not happen. Look at all the easy money coming into gold. All those who have shifted money from real estate, mutual funds, pension funds, hedge funds and stocks are pouring it into gold. Gold ETFs are the fastest growing investment vehicles today. This is all real quick money, but can evaporate at the click of a key. Of course, governments such as China and India are also betting on gold and increasing their reserves. But then, whoever said governments can make no mistakes?

The intrinsic value of gold has not gone up from $255 to $1,424 in 10 years. Gold is not consumed heavily like oil or grain. Industrial use of gold is limited. Gold is the most recycled commodity. Of the annual production of 2,500 tonnes, about 50 per cent goes to make jewellery and it is almost entirely recycled. The rest goes to industrial and other uses, and even here the recycling rate is high. In other words, all that demand is artificial and can be deflated in no time. There is no need to have excess supply to lead to a price crash, unlike other products. The sheer fact that gold is only a hedge instrument and does not serve any practical use by itself, will negate the ‘there-is-no-new-supply’ theory. Someone somewhere is watching for the perfect moment to disgorge the hoard, to create sudden panic and buy up following a crash. We have heard the script before.

There is no sign that a crash is going to come tomorrow, or for that matter next year or the year after. It may still go up for two or five or even 10 years. But crash it will, if we are to go by the economic history of boom and bust. And the higher it goes and the longer it stays there, the more painful the crash is going to be, especially for India.

Indians sit on an estimated 18,000 tonnes. India has always had the largest gold reserve with individuals. Imagine what will happen to millions of Indians if gold were to crash. A crash of gold will be the crash of the Indian economy.

Never have we had so much idle money chasing so little gold. Gold is losing its respect as the default and fail-safe asset class and becoming a speculative instrument. Mass hysteria is being built up. This shift of gold from being an item of passive wealth to an instrument of speculation is dangerous. It could be the beginning of the end of the faith in the last bastion of indestructible wealth. Gold is being talked up by crafty speculators and unsuspecting governments. Should not someone be worrying, especially in India?

(T. Balakrishnan is Additional Chief Secretary to the Government of Kerala. The views expressed here are his personal ones.)

Published: December 28, 2010 23:15 IST | Updated: December 28, 2010 23:15 IST

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