Charlie Munger recently declared that “civilized people don’t buy gold, they invest in productive businesses.” This poke at gold investors comes at a time when gold prices have been lazily mucking around between $1500 and $1900. We figured that now was a good time to interrupt all the navel gazing and explore two fundamental theories for why people hold gold as an investment – a monetary theory and a real theory. Most gold bugs are familiar with the monetary theory but not the real theory. Understanding both might help both the civi- lized and uncivilized investor determine when and in which direction gold will eventually break out of its range.
The monetary theory is so well-known that it hardly needs to be described. It says that gold prices are driven by changes in the market’s perception of future inflation. If the market suddenly expects that inflation will increase more than originally anticipated or, put differently, if money’s purchasing power is now expected to fall at a faster rate than before, then the gold price will be driven higher. Fixed-income investments, on the other hand, will fall in value. Gold, therefore, is held as an inflation hedge. If today’s investor is pretty sure that future inflation will come in higher than what the market expects, buying gold now at $1550 or so should provide a good return. Mind you, Munger would probably remind us that buying a productive business will provide a decent hedge against inflation as well, a proposition we wouldn’t disagree with.
The heyday of monetary theory #1’s explanatory power was in the 1970s. Inflation consistently rose above people’s expectations and the gold price galloped from $35 to $800.
The real theory of the gold price is less well-known. It assumes that there is an economy-wide risk-free rate of return on capital. Economists call this the natural interest rate. When that rate falls below zero, investors are indicating that an investment today is expected to provide a negative return upon maturity. This sort of extreme pessimism about the future characterizes recessions, depressions, and various doomsday scenarios. Instead of investing at a negative return, rational investors can hold some already- produced, storable item – like an ounce of gold – over the same period of time and still end up with that exact ounce of gold. They need only pay the cost of storing that gold over the interim.
Put differently, if returns on capital are expected to be below zero, investors will rationally prefer to own a durable asset that yields nothing and is (nearly) costless to store than an asset that provides a negative return, like a stock. Perhaps what Munger meant to say is not that holding gold is uncivilized but, rather, that it is uncivilized to bet on a long-term decline in society’s fortune. We won’t argue with that, since an investment based on the expectation of negative real returns is by definition predicated on the possibility of society regressing, or moving away from a state of civilization.
The real theory can be applied to a number of periods. Relative to most assets, gold performed quite well during the Great Depression. It did so too during the 1970s, a decade that was largely characterized by negative returns on capital. Investors today who are sure that the current pessimism will only get worse should consider buying gold as the real theory predicts a stronger gold price.
Since 2000 the gold price has increased from $250 or so to as high as $1950. The monetary theory can only explain part of the rise. In general, world inflation has consistently registered at lower levels than expected over this period. In the US, for instance, inflation expectations have hovered around 2% be- tween 2003 and now whereas gold has been increasing at around 20% a year (see chart, opposite). Indeed, since 2008, a number of nations have experienced periods of negative inflation. Our favourite price index (compiled by the Billion Prices Project, which collects daily prices from online retail stores) is up only 5% since June 2008, whereas gold has doubled. There is another paradox. If higher inflation expectations were indeed the explanation for higher gold prices, fixed-income prices should have collapsed. Yet in general, and particularly since 2008, safe bond prices, both sovereign and corporate, have risen along with the gold price.
The real theory does a good job of filling in for the monetary theory in explaining gold prices since 2000, especially prices since 2008. Expected returns on capital have remained subdued over that period, even negative. Investors in 5-year US real return bonds, for instance, have been content to earn a negative return on their investment since early 2010. If it costs just a few beeps to store gold, one can see why investors have been flocking to buy zero-interest gold ounces rather than being penalized for holding claims on real capital.
The real effect can be seen in China as well, where returns on fixed-income investments are kept artificially low by the gov- ernment. As a result, individuals who have chosen to keep their money in a bank or have invested in bonds have been earning a negative real return for much of the last decade. Storable assets with long lives provide a way to escape from this negative return jail; thus one observes phenomena in China like apartment speculation and warehouses filled with copper. Buying gold and silver has no doubt also been a popular way for the Chinese to avoid the burden of negative returns, and this has added to gold’s upward trajectory.
Lastly, central bank gold purchasing and selling decisions are of- ten guided by the prospect for real returns. In the early 1990s central bankers increasingly realized they could swap or sell their zero-yield gold for cash and invest in safe debt instruments, thereby earning a much higher return. Central bank gold flooded the world and helped contribute to the miserable 1990s gold bear market. Declining real interest rates rendered this trade less profitable in the 2000s, and central banks – content again to hold zero-yielding gold – began to unwind their swaps (and even bought the metal), thereby drawing gold out of the market and helping to push prices higher.
In sum, as gold coils between $1500 and $1900, investors might find it useful to combine the monetary theory, the gold investment crowd’s workhorse theory for the gold price, with the less well-known real theory, which has probably been responsible for a large share of gold’s price appreciation over the last few years. The best of times for gold are when both theories’ predictions coincide when inflation is progressively accelerating and falling confidence drives down real returns.
1. See, for instance, Larry Summers and Robert Barsky, 1988.
We haven’t seen this conjunction since the 1970s. The worst of times for gold are when inflation expectations are becoming more benign and buoyant confidence is pushing up real returns. This was the 1980s and 1990s. So in response to Munger: while it may not always be civilized to hold gold rather than stocks, it is surely not irrational to hold it given any likelihood of sustained negative returns on capital and high inflation.
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