How to deflate gold price bubble

As with past booms in housing prices and Internet stocks, the four-year surge in gold prices raises the same fundamental questions for market regulators. How should they react? Should they react at all? How do they even know if a bubble exists?

It is clear that speculation has been driving gold’s rise. People are buying gold as either a hedge against inflation or economic calamity or solely because they think the price will rise. As evidence of this speculation, the World Gold Council reports that demand for gold bullion bars more than doubled from 2009, to about 850 metric tons a year. This is largely gold that is bought and sits there as people wait for price increases. Indeed, demand for gold in industry and for jewelry has actually declined by 18 percent from 2004, to about 2,500 metric tons a year, according to the World Gold Council.

This speculation is aided by the financial revolution. Previously, gold could be bought by retail investors only through dealers and street shops. Now anyone can go on the Internet, click and buy gold in the market through exchange traded funds. These funds will buy gold on the investor’s behalf, and now hold about 2,250 metric tons of gold, or nearly a year’s worth of output. Speculation alone doesn’t necessarily mean that gold is in a bubble. Gold is historically viewed as a protection against inflation and tumultuous economic times. It is a way to diversify a portfolio and hedge these risks. The price rise can be explained by people rationally betting that these events will occur. This is particularly true in light of the heightened risks to the economy because of events in Europe and the still lingering effects from the financial crisis in the United States.

But like paper money, gold is only worth what people believe it’s worth, and because of this, it is sometimes referred to as the barbarous relic. You can’t eat gold. Its industrial uses are limited. If someone else doesn’t assign the same value to gold that you do, you are out of luck. For those who predict it will be valuable if society completely collapses, guns and canned goods might come in handier. Gold’s relative uselessness has helped spur talk of a bubble. The problem for regulators is whether this speculation is natural, prudent hedging or people irrationally piling ever more into a bubbly asset.

After all, former Federal Reserve chairman Alan Greenspan speculated that the stock market might be “irrationally exuberant” in 1996, well before the actual bubble took hold. Like the Internet bubble, we will only know if a bubble truly existed if and when gold falls.

In his book “Irrational Exuberance”, Robert J Shiller of Yale University tried to set forth a test for spotting bubbles. Bubbles are created when people buy in to the next great thing. They accept that this is a game-changing asset, like housing or the Internet, which cannot fail. As more people buy the asset, the speculation and frenzy increase. According to Shiller, a crucial driver of a bubble in today’s modern age is the Internet and media.

If you watch cable television, it would certainly appear that gold is in a bubble.
Commercials abound for buying gold. Commentators on CNBC talk about gold hitting $2,400 an ounce, which would be a genuine record (the previous high of $850 in 1980 would be about $2,300 today, adjusted for inflation). In fairness, other CNBC commentators have said this is foolish and that gold prices are too high. Still, the marketing of gold to the masses is an ominous sign.

Even after the downturn in prices last week, it is not clear if gold has hit its peak. Is gold still being driven by fundamentals or is it a speculators’ delight?

Because of this uncertainty, regulators have acted as hesitantly as they did in the case of the Internet and housing bubbles. The Chicago Mercantile Exchange recently raised margin requirements for gold, the amount of money you can borrow to buy gold. The Singapore exchange also raised margin requirements last week. Other exchanges in other countries have not acted similarly, leading to differences that will drive gold trading to those markets.

The Commodity Futures Trading Commission, the primary regulator of the gold market in the United States, does not appear to want to act. The agency is following form as it also refused to act forcefully when oil jumped to more than $145 a barrel in 2008. It seems hesitant to quash speculation.

The commodities regulator, though, could force American exchanges to further raise margin requirements, reducing leverage and the ability of investors to buy more gold. The agency woul d also have to act to limit the gold acquired individually and by the ETFs. All of these measures would have to be coordinated and put into effect on a global basis.

Those would also be very aggressive acts to attack a problem that some say doesn’t even exist. This analysis could be applied to other commodities that have had huge run-ups in the past years, including oil, food and other metals like silver.

In other words, not only is it hard to spot a bubble, the measures to fight it, restrictions on leverage and holdings, are hard and controversial to put into effect. Limiting the type of media barrages we see is also impossible in a free society.

Yet if regulators are going to stop the next bubble, they will need to act aggressively. Of course, they shouldn’t act in every circumstance, but when we see the type of volatility and speculation as in the case of gold, acting to curb  these forces through limiting leverage in cooperation with international regulators would be a prudent course.

This would ensure that if a crash does come, it does not have aftereffects on banks and other institutions. Even if the Commodity Futures Trading Commission is hesitant to take such steps, it could take to the media to try to “talk down” the speculation as an initial foray.

Otherwise, we’re left hoping, without much basis, that people have learned that this time will not be different, something not much in evidence in the case of gold.