Felix Salmon

The total amount of gold in the world, according to Thomson Reuters, is 171,300 metric tonnes, or 5.5 billion troy ounces. What that means is that every time the price of gold falls by $100 an ounce, as it did on Friday and it has done again today, the value of the world’s gold falls by more than $500 billion.

That doesn’t mean investors have lost $1 trillion in the space of two trading days. Some gold is used in industry or jewelry, and there’s a huge amount in central banks, which don’t mark to market and therefore aren’t really investors as we normally understand the term. Still, with a “market capitalization” at the end of 2012 of about $9 trillion, the gold market is not much smaller than the NYSE, is twice the size of the Nasdaq, and is almost three times the size of the Tokyo and London stock exchanges.

As a result, the falling price of gold is more important than simply being an opportunity for schadenfreude around the likes of Glenn Beck or John Paulson or Zero Hedge. At the end of 2012, for instance, Paulson owned 21.8 million shares of GLD. Those have sunk some 19%, or $30 per share, since then — a total loss of more than $650 million, for Paulson and his investors. But that’s just a drop in the bucket compared to the $1.6 trillion wiped off the value of gold more generally during the same period.

To put that number in context, the NYSE has risen 6.6% since the end of 2012, a rise in value of some $930 billion. Which means that the value of gold has been falling faster than the value of stocks has been rising. But gold is held in much more concentrated hands: most people have very little exposure to it, while a relatively small number of investors have huge allocations. As a result, the wealth effect from the fall in gold prices is likely to be felt quite acutely.

Gold is the classic zero-coupon perpetual bond: an asset whose industrial value is a tiny fraction of its cash value, and which represents, as Joe Weisenthal says, a costly failure of markets to efficiently allocate capital to where it is best invested. Goldbugs are by their nature defeatist and pessimistic; get enough of them together at the same time and they become self-fulfilling. (That’s why they tend to be so evangelical about their beliefs.)

So what does the fall of the gold price mean for the rest of us? The first thing to worry about is the wealth effect: if people have suddenly lost a trillion dollars, does that mean they’re going to spend less, and hurt the broader economy as a result?

I doubt that, somehow. About 2,500 tonnes of gold is tied up in gold ETFs. That’s about 80 million ounces, which translates to investor losses of about $16 billion in the past couple of days. On top of that, there have probably been about $3 billion of losses in the futures market. Those numbers — a proxy for the gold positions which are marked to market regularly — are relatively modest: they’re much smaller than the $100 billion or so that has been wiped off the valuation of Apple this year alone.

What’s more, very few investors have leveraged positions in gold, and when asset bubbles burst, it’s normally the leverage, more than the bursting bubble itself, which does the most damage.

Still, there will be pain — pain which is necessary to break the gold fever. It’s important that goldbugs are seen to not only have silly beliefs, but also to have lost a substantial amount of money. Gold is a fear trade rather than a greed trade — it’s defensive, and defensive investors are always particularly loss-averse. If you lose money betting on high-flying tech stocks, that’s much more likely to be money you can afford to lose than if you lose money after putting your life savings into precious metals. (Silver, as befits its status as the “B” share of gold, is also being hit badly today.)

The biggest problem in the markets right now is that they’re still far too risk-averse. Fear-based assets like gold, Treasury bonds, and cash are in high demand, while there isn’t enough money flowing through greed-based assets like stocks and bank loans and into the economy as a whole. Even if the stock market is expensive, the number of primary and secondary offerings remains low; similarly, banks are not expanding their loan books nearly fast enough.

What the system needs, then, is a stark reminder that fear-based assets can be just as risky as greed-based assets. Rising interest rates can eat away the value of your bond portfolio, inflation can erode your cash, and as for gold (or bitcoins, for that matter), well, it can plunge in value literally overnight.

My hope is that the price of gold will continue to fall, that goldbugs will look increasingly silly, and that as a result Americans with savings will conclude that the best thing to do with those savings is to put them to work in a productive manner, rather than self-defeatingly trying to protect what they have.

At the end of the 1990s, and again in the mid-2000s, we had greed bubbles. Both those bubbles burst, and the weird result was a fear bubble, which manifested itself in negative risk-free real interest rates and a soaring price of gold. Let’s hope that what we’re seeing right now is the fear bubble bursting. It’s what the world needs.

It worked! Kinda. I took Matthew Bishop’s challenge, and tried to spend a gram of gold like I would any other currency. And, frankly, didn’t have a lot of luck — until I managed to find a small business where the owner just happened to be standing around. In the end, I got three lobster rolls (and free drinks, too) for one gram of gold. Which were very tasty — thank you Snack Box!

So, what did I learn on my expedition in Times Square?

• When I tell the Snack Box owner that the gold is real and that “you can tell by how shiny it is”, I’m not kidding. Pure gold is really shiny.
• The most surprising people turn out to know how much a gram of gold is worth, with an astonishing level of accuracy.
• Gold is not a currency. I’m reasonably sure that Andrew, the guy behind the counter at Snack Box, would not have accepted my gram of gold unless his boss was telling him to.
• If you do want to spend gold, then try your luck with small businesses, and don’t expect a good implied exchange rate.
• Also, bringing a film crew along is unlikely to help you at any big chain store.

Most interestingly, however, at least to me, was how much it actually cost us to obtain that gram of gold. For the purposes of the video, I was using the value of one gram of gold based on its market price per ounce. But if you go out and attempt to buy a gold bar, you’ll never be able to find one for a mere $53. In fact, my producer wound up paying double that, in Manhattan. Even if you do a lot of searching online, you’ll be hard pressed to find one for less than $80. We didn’t try to sell the gold — we wound up getting a delicious lunch instead — but my guess is that in most cities the effective bid/offer is absolutely enormous. And much bigger than for any major global currency.

Still, it was a fun — and tasty — experiment. If you try it yourself, do let me know the results!

You don’t need to be a conspiracy theorist to find this worrying: a 1kg gold bar, certified as 99.98% pure by XRF (X-ray fluorescence) tests, turns out to have been drilled out and largely replaced with tungsten. This bar was discovered only because it was 2 grams lighter than it ought to have been: the forgers failed to add quite enough gold to the outside of the bar to make up for the weight lost when they replaced gold with tungsten. But if they’d gotten the weight right, it would probably still be circulating today.

Of course, there are means of testing gold bars beyond just weight and XRF. If you can weigh the bar accurately, then you can test for purity by essentially dropping it in a bucket of water and seeing how much the water level rises: a gold-covered tungsten bar will displace more water than a pure gold bar. Alternatively, for $3,000 or so you can buy a micro ohm meter, which is easily sensitive enough to tell the difference in conductivity between a pure gold bar and one which is largely tungsten.

But as far as I know, these tests are not particularly commonplace among gold dealers, and in any case only a minuscule fraction of the gold bars in the world are physically traded, changing hands from one owner to the next — the obvious point at which tests like these would be conducted. If you own gold — if you’re a central bank, say, or a physical-gold ETF, or even if you’re just a Ron Paul or Glenn Beck type with your own personal stash — then there’s no realistic chance at all that you’re going to go bar by bar through your own holdings, testing each one.

In the case of gold, then, what JK Galbraith famously called “the bezzle” — the amount of wealth that people think they have, which in fact they don’t have — could be truly enormous. If there are 1.3 million salted 400 oz bars in existence, and each one is 75% tungsten, then that makes 390 million ounces of gold which in truth isn’t there. At $1,660 per ounce, that’s over $600 billion which people think they own but don’t. To put that number in context, it’s roughly half the total quantity of subprime mortgages which had been issued at the height of the housing bubble.

On the other hand, it’s also possible that the number of salted 400 oz bars is zero, that the 1 kg bar recently discovered was an amateurish aberration, and that there’s nothing to worry about at all. But the economic incentives here are so enormous, for people looking to make a fortune in the fake-gold-bar industry, that I very much doubt no one has tried. And statistically speaking, if a bunch of people have tried, then some subset of those people will have succeeded.

So what to make of the fact that no salted 400 oz bars have yet been found? On the one hand, it can be viewed as very worrying — as being an indication that the gold markets are very bad at uncovering such things. On the other hand, you’d think they’d be good enough at it that they would have uncovered at least a small percentage of the salted bars outstanding — and if they’ve uncovered no such bars at all, then that can be taken as an indication there aren’t any salted bars outstanding.

In any case, there’s clearly now serious tail risk for anybody in the physical-gold market. And like most tail risks, measuring and/or insuring against it is extremely difficult. Any store of value has problems, be it fiat currency or sovereign debt or bitcoins. This latest discovery just goes to show that the problems with gold aren’t just the obvious ones surrounding things like the risk that the price of gold might plunge. There are non-obvious ones, too, which have the potential to be even bigger.

Update: Thanks to smart comments from BronSuchecki and Tim Worstall. I forgot that gold is actually used, once in a while, to make things like jewels — which means that bars are melted down pretty frequently. If there was a significant number of salted bars out there, we’d know about it, since you’d notice when one of them got melted down. Which isn’t to say that there are no salted bars at all, but it certainly does seem to imply that there’s nowhere near 1.3 million of them.

Ever since the news broke last week that Hugo Chávez wanted to transport 211 tons of physical gold from Europe to Caracas, I’ve been wondering how on earth he possibly intends to do such a thing.

There are 99 tons already being held at the Bank of England; according to the FT, the plan is to transfer other gold to the Bank of England from custodians such as Barclays, HSBC, and Standard Chartered; then, once it’s all in one place, um, well, nobody has a clue what might happen. Here’s the best guess from the FT:

Venezuela would need to transport the gold in several trips, traders said, since the high value of gold means it would be impossible to insure a single aircraft carrying 211 tonnes. It could take about 40 shipments to move the gold back to Caracas, traders estimated.

“It’s going to be quite a task. Logistically, I’m not sure if the central bank realises the magnitude of the task ahead of them,” said one senior gold banker.

I put the ever-resourceful Nick Rizzo on the task, but he came up with little more: the market in physical gold is tiny, and largely comprised of nutcases. The last (and only) known case of this kind of quantity of gold being transported across state lines took place almost exactly 75 years ago, in 1936, when the government of Spain removed 560 tons of gold from Madrid to Moscow as the armies of Francisco Franco approached. Most of the gold was exchanged for Russian weaponry, with the Soviet Union keeping 2.1% of the funds in the form of commissions and brokerage, and an additional 1.2% in the form of transport, deposit, melting, and refining expenses.

It’s not much of a precedent, but it’s the only precedent we’ve got; my gut feeling is that Venezuela would be do well to get away with paying 3.3% of the total value of the gold in total expenses. Given that the gold is worth some $12.3 billion, the cost of Chávez’s gesture politics might reasonably be put at $400 million or so.

It seems to me that Chávez has four main choices here. He can go the FT’s route, and just fly the gold to Caracas while insuring each shipment for its market value. He can go the Spanish route, and try to transport the gold himself, perhaps making use of the Venezuelan navy. He could attempt the mother of all repo transactions. Or he could get clever.

In the first instance, the main cost would be paid by Venezuela to a big insurance company. I have no idea how many insurers there are in the world who would be willing to take on this job, but it can’t be very many, and it might well be zero. If Venezuela wanted just one five-ton shipment flown to Caracas in conditions of great secrecy, that would be one thing. But Chávez’s intentions have been well telegraphed at this point, making secrecy all but impossible. And even if the insurer got the first shipment through intact, there would be another, and another, and another — each one surely the target of criminally-inclined elements both inside and outside the Venezuelan government. Gold is the perfect heist: anonymous, untraceable, hugely valuable. Successfully intercepting just one of the shipments would yield a haul of more than $300 million, making it one of the greatest robberies of all time. And you’d have 39 chances to repeat the feat.

Would any insurer voluntarily hang a “come get me” sign around its neck like that? They’d have to be very well paid to do so. So maybe Chávez intends to take matters into his own hands, and just sail the booty back to Venezuela on one of his own naval ships. Again, the theft risk is obvious — seamen can be greedy too — and this time there would be no insurance. Chávez is pretty crazy, but I don’t think he’d risk $12 billion that way.

Which leaves one final alternative. Gold is fungible, and people are actually willing to pay a premium to buy gold which is sitting in the Bank of England’s ultra-secure vaults. So why bother transporting that gold at all? Venezuela could enter into an intercontinental repo transaction, where it sells its gold in the Bank of England to some counterparty, and then promises to buy it all back at a modest discount, on condition that it’s physically delivered to the Venezuelan central bank in Caracas. It would then be up to the counterparty to work out how to get 211 tons of gold to Caracas by a certain date. That gold could be sourced anywhere in the world, and transported in any conceivable manner — being much less predictable and transparent, those shipments would also be much harder to hijack.

How much of a discount would a counterparty require to enter into this kind of transaction? Much more than 3.3%, is my guess. And again, it’s not entirely clear who would even be willing to entertain the idea. Glencore, perhaps?

But here’s one last idea: why doesn’t Chávez crowdsource the problem? He could simply open a gold window at the Banco Central de Venezuela, where anybody at all could deliver standard gold bars. In return, the central bank would transfer to that person an equal number of gold bars in the custody of the Bank of England, plus a modest bounty of say 2% — that’s over $15,000 per 400-ounce bar, at current rates.

It would take a little while, but eventually the gold would start trickling in: if you’re willing to pay a constant premium of 2% over the market price for a good, you can be sure that the good in question will ultimately find its way to your door. And the 2% cost of acquiring all that gold would surely be much lower than the cost of insuring and shipping it from England. It would be an elegant market-based solution to an artificial and ideologically-driven problem; I daresay Chávez might even chuckle at the irony of it. He’d just need to watch out for a rise in Andean banditry, as thieves tried to steal the bars on their disparate journeys into Venezuela.

Erin Arvedlund — yes, that Erin Arvedlund — has a pretty crazy column in the Philadelphia Inquirer, under the headline “Why buying gold may be better financially than buying a house.” It says pretty much what you’d expect: house prices are falling, gold prices are rising, and therefore before you go ahead and buy a house, you should probably consider whether you’d be better off buying gold instead.

Arvedlund talked to a bunch of people for this column, mostly rent-a-quote types like Barry Ritholtz and Peter Schiff, but the central conceit is all hers: none of the people she quotes is literally saying that people should make a speculative punt on gold rather than buy a home to live in. Indeed, Schiff comes out quite explicitly and says that homes are not an investment, they’re more of a consumption good. (He’s right.)

Arvedlund, here, has committed the journalistic equivalent of mixing toothpaste and orange juice. Either tastes fine on its own: it’s perfectly OK to pen a column pointing out that house prices might well continue to fall, or another one looking at gold as an investment and saying that it has a fair amount of possible upside. The really nasty taste comes when you combine the two.

To see just how crazy Arvedlund’s thesis is, look at how she presents it:

Maybe you’ve saved enough for a down payment. But should you bet your money on home prices, even with a tempting low-interest, fixed-rate mortgage? Or is it financially smarter to continue renting and invest the money in an asset that could appreciate for at least another few years?

By definition, money that has been painstakingly saved up for a down-payment on a house is not risk capital which can or should ever be applied to a highly speculative investment like gold. It might well be smart to continue to rent rather than buy a home. And indeed it might even be true that gold will rise in value over the next few years. But that doesn’t mean that anybody in their right mind should seriously consider taking their down-payment nest egg and investing it in gold.

Being “financially smart” is not the same as investing in whichever asset gives you the highest return over some given time horizon. If that were the case, then everybody should just go out and start selling lottery tickets without any downside protection. The fact is that nothing is a good or a bad investment in and of itself: you always have to look at it in the context of the specific risk profile of the investor in question. And if the investor is someone scraping together a down-payment on a house, then it’s trivially true that using some or all of the down-payment money to buy gold at $1,350 per ounce is downright bonkers.

Essentially, Arvedlund is proposing an exotic relative-value trade here: she’s saying that houses will underperform gold, or that the price of a house in gold is going to go down rather than up. Which brings us to this graph, which is the price of houses in gold:

Arvedlund’s trade has been a good one for a long time — pretty much since 2002. Over those nine years, whether house prices have been rising or falling, the price of a house in gold has gone down, and you would have been financially better off buying gold than taking that money and using it as a down-payment for a house. On the other hand, from 1980 to 2002, Arvedlund’s trade was an utterly atrocious one, which would probably have lost you money on both legs.

One look at this volatile time series tells you all you need to know about Arvedlund’s advice: it’s way too risky for her audience, and in fact, over the long term, it’s pretty likely that the price of a house in gold is going to revert to its long-term mean and go up rather than down.

Arvedlund is writing for the Philadelphia Inquirer here, not for Barron’s or for people with huge amounts of risk capital and disposable income. The last thing this audience needs is speculative advice about buying gold now and trying to time the market so that you sell it before the bubble bursts. But if I were a hedge fund manager, I would wonder whether this column marked some kind of a turning point. It’s entirely possible that  Arvedlund has hit the very moment at which gold starts to underperform house prices. Which isn’t to say, of course, that either of them are going up.

Is it a coincidence that the price of gold hit an all-time high just as David Cameron was becoming the prime minister of Britain? Yes. But it’s also indicative of the enormous amount of uncertainty that continues to pervade the market. If you’re just looking at the stock market, you’re not looking at the most sensitive barometer of fears about the global economy in general and the eurozone in particular. As Paul Krugman notes, the euro/dollar exchange rate is probably a better place to look, and that’s now back down below 1.27, after trading at 1.50 as recently as December. For what it’s worth, here’s the price of gold in euros:

It’s entirely conceivable that we could see gold at €1,000 an ounce pretty soon. Which, just as much as recent stock market volatility, is a pretty clear indication that there’s still a lot of worry out there, trillion-dollar eurozone bailout plans notwithstanding.

Courtney Comstock is absolutely right when she runs a story under the headline “You Know It’s Over When Esquire Magazine Is Telling Its Readers How To Invest In Gold Funds”. In a spectacularly silly article, Esquire’s Ken Kurson extolls the virtues of buying gold-denominated hedge funds, on the grounds that if the hedge fund doubles and gold doubles, then you’ll end up quadrupling your money! Genius.

But to appreciate the fuller expression of Kurson’s genius, it’s worth flicking through his archives. There’s the 2006 article where he says that everybody should invest in credit default swaps, specifically by buying stock in a company called GFI Group:

A few days after its January 2005 IPO, I bought a few hundred GFI shares (GFIG on Nasdaq) for just under 26, and I have since added a couple thousand, picking up more each time the stock dips below 50. (I should mention that GFI’s CEO, Mickey Gooch, has become a friend of mine.) In addition to my belief that this stock could very well become a tenbagger within ten years, there’s something very appealing about investing not just in a company but in a whole new industry.

Today, GFI Group is trading at $4.43 per share. Yes, that’s in the wake of a 4-for-1 stock split, but it’s still well below its IPO price, and Kurson, if he didn’t sell at the top of the market, is now sitting on substantial losses. Of course, that’s the problem with 99% of investment advice, not just Kurson’s: these people are very happy to tell you what to buy and when to buy it (now), but never tell you when you should exit your position.

Kurson also reckoned that the automakers were a screaming buy in 2005, saying that “GM is moving with stunning speed to address what ails its business, and that “the United States government will not allow Ford or General Motors to default on its debt”. How did that trade work out for you, Ken?

But if Kurson is not very good at telling you what to buy, maybe he’s good at telling you what to sell. Let’s see:

An investor should short as many shares of Apple as he can possibly borrow…

I’m short a bunch of AAPL at $65.

Oh well, never mind.

So when Kurson says that “$20,000 will barely buy in five years what $10,000 buys today”, it’s worth reading that in the context of his past predictions. And maybe staying away from the gold-denominated Superfund.

I was pleasantly surprised by the volume of email response I got to a passing reference to Kripkenstein on this blog — clearly quite a lot of you enjoy a bit of analytical philosophy! I went out to lunch today with a couple of philosophically-inclined finance types as a result, and, since I’m still high on Sichuan peppercorns and it seems to be something of a slow news day, I thought I’d put up a poll.

Remember this wonderful graph, from Paul Kedrosky, showing the price of gold in gold? Pay attention, there will be a quiz.

So here’s the question, for those of you who remember the analytic-synthetic distinction:

Or to put it another way: Can an analytic a priori statement be funny?

Update: With 125 votes cast, a clear majority of you (59%) are voting for the first option, analytic a priori. But you’re wrong, as dsquared explained to me in an email this morning — what happens to the graph if the price of gold goes to zero?

The assertion that the price of gold, in gold, is 1, is not analytic because it depends on the truth of at least one other proposition (that gold has a nonzero price) and is not a priori because there are possible worlds in which gold does not have a nonzero price.

Which just goes to prove, if nothing else, that philosophy is probably not best conducted by polling blog readers.

Update 2: Natecha defends the analytic-a-priori crew against dsquared, saying that the statement “x/x=1″ isn’t false when x=0, just undefined. He adds for good measure that “Daniel’s comment flies in the face of philosophical orthodoxy about analyticity and apriority”. Which is a statement I daresay Daniel would agree with.

For a while now, hedge funds have been creating share classes denominated in gold. By far the biggest fish in this pool is John Paulson, and as a result he’s been buying gold, literally, by the ton. (With gold at $1,050 an ounce, and 29,167 ounces per ton, Paulson’s $4.3 billion gold investment would buy him 140 tons of gold.)

I’m a little unclear on how these share classes work, but it seems similar to a portable-alpha strategy. The problem with gold is that while it fluctuates in value, it doesn’t generate any kind of returns unless and until you sell it. But with these share classes you get to have your cake and eat it: you’re essentially parking your money in gold, while at the same time investing it in obscure and wonderful trading and investment strategies across all manner of other asset classes.

Hillel Aron has a friend who was just at breakfast with John Paulson, being sold on investing in his funds:

His conclusion – not a shocker here – there will be a rush into Gold. Paulson personally has all his own assets in Gold and his funds own 5 different Gold Mining Stocks. By the way, Paulson notes, of the 200 Trillion dollars of investible assets in the world, only 800 Billion of that is Gold.

This means, I think, that Paulson’s own investments in his funds are all in the gold-denominated share classes. And I can see how a multi-billionaire would do something like that: when you have that much money, the only things which can wipe you out are hyperinflation or outright confiscation. Gold is a good way of protecting yourself from both eventualities.

For people with less dynastic amounts of money, however, I’m less keen on the gold-denominated share classes. For one thing, there are substantial hedge-management costs involved. But more to the point, if the price of gold falls, then you can end up in the very painful position where your investment loses money in dollar terms and you still have to pay a large 20% performance fee, since it could still have done well in gold terms. Ouch.

Izabella Kaminska has an interesting take on the record-high gold price, via Bedlam Asset Management: essentially, it’s rising because the big gold ETFs, like GLD, are so incredibly easy to buy and to speculate with. Gold is now something that individuals can easily trade in and out of daily — goldbugs are no longer just hold-it-until-you-die inflation hawks and eschatologically-inclined survivalists.

The implication, according to Bedlam, is that the whole swathes of ETF-linked commodities risk being dumped en masse, if and when the current wave of momentum fizzles out:

One or more of the smaller exotics will expire. Little notice will initially be taken. After a couple more, especially if in different sectors, there will be a rush to dump them all. The good and the bad will be forced sellers alike to meet redemptions. This will lead to an avalanche of physical gold, live hogs and cocoa being heavily sold into often thin markets, causing sharp price declines.

Remember: insofar as gold is being held by speculators, it isn’t safe. And GLD alone has more than $30 billion invested in it, much of that on margin. Where would gold be if even a fraction of that sum got sold at once? I don’t like to think.

Matthew Turner points me to this rather interesting datapoint from the IMF’s International Financial Statistics for Ecuador. The country’s has had 845,000 ounces of gold for as far back as the statistics go — until January 2009, when they jumped to 1.76 million ounces, and then February 2009, when they rose further to 1.93 million ounces. That’s an increase of 1.085 million ounces (or about 37 tons of gold) in the space of two months — which at present prices is worth almost exactly $1 billion.

Curiously, the national valuation of the gold reserves hasn’t risen much — from $734.7 million in December to just $804.2 million in February. Which implies that the huge jump in gold reserves might just be some kind of data-input error. But on the other hand, it coincides exactly with Ecuador’s decision to default on its foreign debt. Might the Ecuadorean central bank be trying to convert attachable assets into something it can safely store at home? And if the country’s gold reserves have soared this year, why hasn’t Ecuador’s valuation of those reserves increased proportionally? It’s all most peculiar.

Update: The IMF says that indeed this is “a simple data mistake that is being corrected”.