I wrote before that gold is a a poor inflation hedge. The myth has its origins in a big run up in the 80s that had as much to do with wild speculators cornering the precious metals markets as with a knee-jerk reaction to two continuous years of double digit inflation rates.

With gold hitting new “all time highs” it is time, again, to revisit how high gold actually is. The following chart shows gold yearly average prices since 1969 in an imaginary currency that adjusts only following yearly official inflation rates. The currency is based on the price of Borodium, and it uses base 1-1969, that is, it measures the prices of gold adjusted for inflation starting in 1969.

As you can see, the 1980 peak was B$ 4377, and the 2007 average was just B$ 2014. That should provide enough fodder for gold bulls to argue that gold is “cheap”. Regardless of the absurdity of valuating any good by the price in the past, that may become a convincing argument to feed an speculative frenzy.

If gold were to reach previous highs, the next yearly high average should be at $2196 in 2007 US dollars. Depending on how long it takes gold to reach that, the price could be much higher. I expect these arguments to start percolating into mainstream media (right now is mostly gold permabulls who make the argument), and stories about fortunes made in gold starting to circulate in cocktail parties.

Since the myth of the relationship between gold and inflation seems to be prevalent and the current and future administration policies will be highly inflationary, it is reasonable to think that a bubble may form around gold. The difference between a normal rise of the price of any good and a mania, is that during manias a number of illusory assumptions reinforce themselves until there is a sense of inevitability to increase of prices of the manic good.

As I said yesterday, gold may lend itself to become the instrument of such mania mainly for these reasons:

1. It is relatively easy to become a “gold expert”
2. It is massively available
3. We all can have the illusion we understand it
4. Most of us have some of it
5. It has a strong emotional history from where to drive examples to reinforce the mania
6. It is easy to trade
7. It has prestige
8. Buying it and holding it produces instant gratification
9. It has some utilitarian value
10. Who does not like bling!

Based on that, expect a lot of people starting to talk about $2200 gold and beyond. Again, the arguments will be that

1. By “historical measures” gold is cheap (of course they will ignore the fact that they are talking about a 1 year manic high)
2. Gold is real money
3. Since gold is real money, it is an inflation hedge

The strongest rational argument against such scenario is that if gold were to keep rising to reach those levels (we are talking about more than 200% from today’s prices), the current global economy would collapse in a global depression. To understand this you need to understand that the current global economy runs on slave labor from China and other 3rd World countries.

If the prices of commodities were to keep rising at these levels, the price of labor in those countries should rise accordingly, and added to the increase in the price of goods, it would create an increase in the price of final goods that would stop exporting deflation (as it does today) and it would start exporting inflation to an already overheated inflationary economy. In that scenario, you would not be able to buy at Walt Mart if you are a Walt Mart employee, and the economy will screech to a halt with high levels of unemployment, which would create a over production crisis in the manufacturing countries, which would make it necessary to destroy a large chunk of the means of production. And that would be just the beginning of it. If that were to happen, you would end up with an excess of gold at high prices.

However, if gold does become the object of the next bubble, rational arguments will be laughed at.

Originally published on 1/11/08 by Franklin

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