The Gold Bubble and the Gold Bugs

NEW YORK – Gold prices have been rising sharply, breaching the $1,000 barrier and in recent weeks rising towards $1,200 an ounce and above. Today’s “gold bugs” argue that the price could top $2,000. But the recent price surge looks suspiciously like a bubble, with the increase only partly justified by economic fundamentals.

Gold prices rise sharply only in two situations: when inflation is high and rising, gold becomes a hedge against inflation; and when there is a risk of a near depression and investors fear for the security of their bank deposits, gold becomes a safe haven.

The last two years fit this pattern. Gold prices started to rise sharply in the first half of 2008, when emerging markets were overheating, commodity prices were rising, and there was concern about rising inflation in high-growth emerging markets. Even that rise was partly a bubble, which collapsed in the second half of 2008, when – after oil reached $145, killing global growth –the world economy fell into recession. As concerns about deflation replaced fear of inflation, gold prices started to fall with the correction in commodity prices.

The second price spike occurred when Lehman Brothers collapsed, leaving investors scared about the safety of their financial assets – including bank deposits. That scare was contained when the G-7 committed to increase guarantees of bank deposits and to backstop the financial system. With panic subsiding towards the end of 2008, gold prices resumed their downward movement. By that time, with the global economy spinning into near-depression, commercial and industrial gold use, and even luxury demand, took a further dive.