OK, I vote 'B'

Macro Man feels safe in assuming that most measures of risk appetite will slide into risk aversion as of c.o.b. today. This will necessitate some trading tomorrow; Macro Man will provide a post mortem when he has some time away from the real job.
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February 27, 2007 at 8:48 PM ×

Very interesting action in gold today, holding its own while the futures market was open then succumbing to a bout of tape-painting - or risk contagion, depending on who you believe - after hours.

Gold loves to hear that monetary authorities have their hands tied and more dilution is a certainty. The "die" side of "inflate or die." But gold hates to see itself sold to meet margin calls... irresistible force, meet immovable object.

Macro Man
February 27, 2007 at 8:53 PM ×

Yes...my theory was that gold, having acted as a risky asset on the way up, would act as a risky asset on the way down.

Intraday price action was interesting. Down 10 bucks by London midday, rallies back to nearly unched as the dollar legs down again, then craters along with the SPX, yen crosses, etc.

I suspect that all of a sudden, there are quite a few people wishing their were more dilution!

February 27, 2007 at 9:51 PM ×

There will be more dilution. But probably not today! And if you need the money today... doh.

But there is a difference between gold and the Turkish lira, which is that only one of them has had six zeroes liposucked off its ass.

The big unanswered question is: when the Chinese retail public figures out that a stock market is not and cannot be converted into a hard currency, where do they put all those yuan the PBOC is printing?

Because of their political mission, monetary authorities cannot sustain a rise in the price of money relative to other assets. Too much economic activity is driven by equity extraction - aka dilution. Stabilization of the global money supply is simply not a credible long-term threat.

So the important thing to watch in gold is the price of gold not relative to currencies, but relative to other assets that attract savings. By that standard, despite tanking on the Access market (and Access tape-painting is really, really common) gold looked like a very different animal on today's volatility spike than on last May's.

Historically, the end of an inflationary period is always defined by a "terminal bubble" in which the market for savings chooses a new monetary standard. The terminal bubble is the bubble that does not pop, but runs to completion. But, by definition, no market signal can distinguish a terminal bubble from one that is doomed to pop.

For example, equities (hello, South Sea) cannot become a currency because they have no intrinsic scarcity - rising prices generate new supply. The fact that this is true of equities and not of gold cannot be inferred by looking at the charts for either. It demands logic. For example, if gold at $2000 could be profitably extracted from seawater, it would not be a terminal bubble candidate. But market data will not inform you of this until the price actually hits $2000 and salty gold begins to appear in London.

The challenge of monetary managers is to disguise this fact, keep the supply of savings sloshing around between bubbles that are nonterminal, and (ideally) keep the dilution pressure down so that no bubbles at all appear. At present I would say they are doing an adequate, but unimpressive, job of this. But the long-term trend is not good.

Macro Man
February 27, 2007 at 10:14 PM ×

But isn't the intrinsic scarcity of gold one of the things that prevents its widespread use as a store of value amongst institutions controlling vast sums of capital, i.e. reserve managers.

I mean, there just isn't enough gold out there to make it viable for China, Russia, and India to convert 1/2 of their fiat dollar holdings into gold. To do so would drive the price of gold so insanely high (in dollar terms) that they would effectively debase the remainder of their reserves (and in all likelihood, the value of other fiat currencies) to a degree that the exercise would be more trouble than it is worth.

As for what what is being bought with Chinese money/liquidity growth...a lot of it is going into economic 'stuff'. Nominal GDP growth of 15% requires a fair old amount of money growth to keep the engines humming (and the farmers employed.)

Moreover...why gold? Why not silver, copper, palladium, platinum, or moon dust? Obviously, societies all over the world have venerated gold throughout history...but a lot of 'em were enthusiastic practitioners of slavery or enforced indentured service too, and you don't hear people clamoring to bring those institutions back, even though that's the way it was 'always done in the past.'

I ask that not to be provocative, but out of genuine curiosity...

February 27, 2007 at 10:50 PM ×

Morons on CNBC claimed the carry trade was unwinding blah blah blah, but unless somebody was borrowing cheap in China, they were wrong. Whatever the local cause, there's likely to be a larger effect, because all of us have been plotting and waiting and polishing our daggers for quite some time.

February 27, 2007 at 11:05 PM ×


These are exactly the right questions.

The answer is that monetary standardization is a coordination game and gold is its Schelling point.

Why do we have money? We have money because people want to transfer wealth across time. This creates a demand for saveable goods that is qualitatively distinct from the intrinsic demand for those goods. Ceteris paribus, this tends to jack up their price.

(One obvious but common error is to think that savers want to "preserve the purchasing power" of the nonsavable goods (suppose your saver is, for example, a fisherman) that they exchange for savables. Their goal is not to preserve but to maximize, subject to their risk-reward function.)

This is a coordination game because, as a saver, you have to guess what goods other savers like you will choose in order to solve the same problem. In theory, you can expect the game to converge on a Nash equilibrium, which is a strategy from which no individual deviation is advantageous.

Only one good needs to serve as a repository of savings and be overvalued in this way. If two goods are used, as in the gold-silver bimetallic standard of the 19th century, the game is unstable, and whichever good starts to win will keep on winning. In the 19th century it was silver that got punked, but it could just as easily have been gold. All goods but the monetary winner end up demanded only by direct users, and will be priced by the normal commodity mechanisms.

Because there are multiple goods with the same general scarcity profile as gold, such as silver, platinum, moondust, etc, this game has multiple equilibria. Thus the need for a Schelling point.

Gold is a Schelling point (a) for simple cultural reasons, and (b) because it has been overvalued (relative to its price if the only demand for gold was direct demand from users) for quite some time, and we therefore have sound geological reasons to expect higher supply inelasticity than for, say, iridium.

Now, this is an abstract model. It is not the real world. The real world is much more complicated. It includes an enormous number of frictional effects, reality distortion fields, and so on.

And in particular, the central banks with their massive gold hoards hover over the whole market. In the CB game, buying gold counts as defecting - the fact that ECB banks failed for the first time to meet their gold sales quota last year, and the fact that IMF gold sales have popped up on the radar again, are very likely to be related. I would never expect the CBs to lead a gold melt-up panic. The only plausible scenario is that they try to fight it and are forced to follow it. I'd bet, for example, that the ECBs will be trying to dishoard gold and drive the market down this week.

What's interesting about this analysis is that it works if and only if people understand it. If the above is an accurate description of the game, and if Alan Greenspan were to go on CNBC tomorrow and explain it, game over. The story of Francis Place is also interesting (search for "gold"). Needless to say, viral transmission over the Internet is a nontrivial possibility.

I think Benn Steil has, at least to some extent, figured this out. When I saw that article my jaw hit the floor so hard I was picking up teeth for a week. The CFR of all places! So much for omerta...