Why gold is not in a bubble

The price of gold may have hit new highs recently, but there is still little real evidence of a bubble, says Merryn Somerset Webb. Here, she explains why.

You probably think gold is in a bubble. After all, it hit new highs in dollars, pounds and euros this week and has pretty much quintupled since its lows of 2001.

What's more, everyone from Germany to China is still nuts for it. Earlier in the week, the FT reported that the Germans have been snapping up coins and gold bars faster than they did even in the aftermath of the Lehman Brothers' collapse. In the UAE, you can buy bars direct from a vending machine. At Harrods, you can pick up a variety of gold coins over the counter. And as the gold bears are keen to point out you can see ads for the purchase of gold all over TV.

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But look at the actual price of gold and it is hard to see real evidence of a bubble. Gold may have hit new highs in nominal terms, but it hasn't come close to hitting its old highs in real terms. Adjust the 1980 high of $850 for US inflation and you get a price of around $2,400 a level only the most bullish are predicting even now.

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But hasn't there been a transformational global event that has changed the case for gold, too? Back when gold's bull run kicked off, there were precious few gold bugs and we tended to make the case for the metal based on likely demand for "bling" from the new middle classes of emerging markets. We only mentioned in passing the fast rising US national debt and the nagging fear that fiat currencies might not be all they were cracked up to be.

Today, however, gold has reverted to its historical role as the global currency of the last resort. You no longer buy it because you think the Chinese and Russians are likely to increase their consumption of gold-plated mobile phones. You buy it because you think there is a chance that governments, caught in a debt trap from which there is no honourable escape, will eventually think they have no choice but to print their way out of it. And the risk of hyperinflation is a transformational event for gold, it being the only global currency that can't be printed on the whim of a central bank.

All that said, there is a strong chance that we might see a short-term fall-off in the gold price. Why? Partly because high prices are putting off India's jewellery buyers. Partly because there is likely to be a short hiatus in new investor buyers coming to the market if you haven't panicked yet, you will need a new crisis before you do. But mostly because, after the mini-inflation scare following the ECB's bailout plans for Europe, we seem to be having a deflation scare. Prices may be stubbornly rising in the UK, but Spain is now in outright deflation (exclude energy and food, and prices are falling) and core inflation across Europe and the US is very low.

The endless money-printing across the world has not yet brought us proper inflation simply because the mechanism for passing it on isn't working very well: the banks are too busy repairing their balance sheets to lend it out. But there is nothing like deflation to bring on hyperinflation: governments desperate to prop up prices and economies, despite being broke, print reams of money money that eventually enters the market in a rush, flipping deflation to inflation.

If you can get a copy of Adam Ferguson's 1975 book When Money Dies (soon to be republished), you will find an excellent account of how this happened in the Weimar Republic. It might not happen again but, at this point, it would surely be foolhardy to discount it entirely.

Finally, a word on the ads for gold on TV. There is much muttering about them being a sign of the top. But that is to misunderstand the direction of the flow. The ads aren't selling gold to willing punters, they are persuading them to sell their gold at a discount to the spot rate. That's a very different thing more suggestive of awareness of gold beginning to enter the public mind than of a bubble. Either way, I'd ignore the ads. If you have gold, you should hang on to it. If you haven't, you should use the pull-back in price to get some.

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I've written here before about the Blackrock Gold & General Fund and gold ETFs but another fund that might be worth holding is Junior Mining, which specialises in smaller mining companies..

This article was first published in the Financial Times

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