Tag Archive for 'Gold'

Warren Buffet on gold

This is a week or so old by now, but it’s so good I wanted to make sure it was permanently on my blog.

From his latest letter to shareholders in Berkshire Hathaway, the Sage of Omaha‘s opinion on gold as an investment:

The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Brilliant stuff.


Update 11 September 2014: My views on digital currencies, including Bitcoin, have evolved somewhat since this post. Interested readers might care to read two new Bank of England articles on the topic. I was a co-author on both.

Original post is below …

Discussion of it is everywhere at the moment.

The Economist has a recent — and excellent — write-up on the idea.  My opinion, informed in no small part by Tyler Cowen’s views (herehere and here) is this:

  • Technically, it’s magnificent.  It overcomes some technical difficulties that used to be thought insurmountable.
  • As a medium of exchange, it’s an improvement over previous currencies (through the anonymity) for at least some transactions
  • As a store of value (i.e. as a store of wealth), it offers nothing [see below]
  • There are already many, many well-established assets that represent excellent stores of value, whatever your opinion on inflation and other artefacts of government policy
  • Therefore people will, at best, store their wealth in other assets and change them into bitcoins purely for the purpose of conducting transactions
  • As a result, the fundamental value of a bitcoin rests only in the superiority of its transactional system; for all other purposes, its value is zero
  • For 99.999% of all transactions by all people everywhere, the transaction anonymity is in no way superior to handing over physical cash or doing a recorded electronic transfer
  • Therefore, as a first approximation, bitcoin has a fundamental value of zero to almost everybody and of only slightly more than zero to some people

This thing is only ever going to be interesting or useful to drug dealers and crypto-fetishists.  Of those, I believe that drug dealers will ultimately lose interest because of a lack of liquidity in getting their “money” out of bitcoins and into hard cash.  That only leaves one group …

A note on money as a store-of-value:  When an asset pays out nothing as a flow profit (e.g. cash, gold, bitcoin), then that asset’s value as a store-of-value [1][2] is ultimately based on a) the surety that it’ll still exist in the future and b) your ability to convert it in the future to stuff you want to consume.  Requirement a) means that bread is a terrible store of value — it’ll all rot in a week.  Requirement b) means that a good store of value must be expected to have strong liquidity in the future.  In other words, there must be expected future demand for the stuff.  If you think your government’s policies are going to create inflation, putting your wealth in, say, iron ore, will be an excellent store of value because the economy at large will (pretty much) always generate demand for the stuff.

That makes gold an interesting case.  Since there isn’t really that much real economic demand for gold, using it as a store of value in period T must be based on a belief that people in period T+1 will believe that it will be a good store of value then.  But since we already know that it has very little intrinsic value to the economy, that implies that the T+1 people will have to believe that people in period T+2 will consider it a store of value, too.  The whole thing becomes an infinite recursion, with the value of gold as a store-of-value being based on a collective belief that it will continue to be a good store-of-value forever.

Bitcoin faces the same problem as gold.  For it to be a decent store-of-value, it will require that everybody believe that it will continue to be a decent store-of-value, and that everybody believe that everybody else believes it, and so on.  The world already has gold for that purpose (and gold has at least some real-economy demand to keep the expectation chain anchored).  I’m not at all sure that we can sustain two such assets.

[1] All currencies are assets.  They’re just don’t pay a return.  Then again, neither does gold.

[2] Yes, yes.  Saying that it’s “value as a store-of-value” is cumbersome.  It’s a definitional confusion analogous to free (as in beer) versus free (as in speech).

Gold vs. US Treasuries

John Hempton writes:

We live in a strange world – the 10 year US Treasury is trading with a 2.63 percent yield.  The market is presuming that there will not be much inflation in those ten years.  However if there is deflation (as per Japan) then the 10 year will wind up being a very good investment (see my blog post on Japanese bond yields from the perspective of a Japanese household).

At the same time gold is appreciating very sharply – from $950 per oz to $1250 in the past year – and from $800 two years ago or $450 five years ago.  On the face of it the gold price is predicting inflation.

Try as I may – I can’t see any reason why both those prices are correct.  I have long held the view that prices are mostly sort-of-rational … [s]o either there is a theoretical way in which both these prices can be correct or even my weak version of the efficient market hypothesis is spectacularly wrong.

and then asks

My first question thus is can anyone tell me why these prices could possibly be consistent?  Is there a rational reason why the bond market is pricing low inflation and the gold market seemingly pricing high inflation?  Does anybody have the ingenious world view in which both these prices are correct?

Since Blogger rejected my comment over at John’s site as being too long, I may as well reproduce it here. I don’t know about “correct” and I’m no finance guy, so my first point is that  I have no freakin’ clue.  Nevertheless, here are five, somewhat contradictory ideas, three of which might fit in a weak EMH world …

Idea #1) Yes, yes, your whole post was predicated on some weak version of the EMH. However … Treasuries, despite what the arch-conservatives are saying, are unlikely to be in a bubble (see idea #4 below).  It might (and only might!) even be impossible for them to be in a bubble.  On the other hand, gold can experience a bubble (to the extent that you concede that bubbles can exist at all).  Just because it can doesn’t mean that it currently is in one, but if it is and treasuries are not, that would partially resolve your dilemma.

Idea #2) Gold, as a commodity, is a affected by global phenomena, whereas US treasuries, while obviously still influenced by global pressures, are more sensitive to the US economy than is gold.  This statement will become more true over time as the US economy shrinks as a share of global GDP.  Therefore, perhaps you should deduce that markets are predicting low inflation or deflation for America, but quite high inflation for the world as a whole.

Idea #3) Gold, as a commodity, partially co-moves with other commodities, many of which are seeing price increases because of real, observable events in their markets (Chinese construction, Russian drought, etc).  Perhaps it is being dragged up by those (this augments idea #2).

Idea #4) In the broad market for USD-denominated investment-grade bonds, there has, I believe, been a net contraction in supply despite the surge in US government borrowing.  This is the private-sector balance-sheet correction.  One might argue, from something of a monetarist point of view, that (disin|de)flation is occurring in the US precisely because the US government is not expanding its borrowing fast enough to replace the private-sector contraction.  I mentioned this briefly the other day.

Idea #5) Another non-EMH idea, I’m afraid:  Both the USD and gold enjoy safe-haven status.  An increase in generalised fear (Knightian uncertainty, unknown unknowns, etc) will shift out the demand for both at all price levels.  To the extent that such a dynamic exists, I suspect that it ebbs away only slowly and, while elevated, is susceptible to rapid increases in response to events that would, in normal times, not affect people so much.

Update 11 Oct 2010:

James Hamilton on essentially the same topic.