Well, I normally do not follow the price of gold or other precious metals but an email from a former student of mind has piqued my curiousity. My former student is studying medicine rather than economics but has a consuming interest in economics and markets and forwarded me a newsletter on the price of gold and a "model" linking the price to real interest rates.
In essence, there is a critical value of 2 percent – if real interest rates are below this, then the price of gold will soar. The newsletter also has a reference to discussions that the price of gold may soar to $5,000 or even $10,000 an ounce – quick frankly this is all starting to sound like the Dow 30000 talk and we all know what happened to the stock market not that long after.
A link to interest rates for the price of gold is not a bad story but it is part of a bigger portfolio picture. In the wake of the tech stock crash at the end of the 1990s boom and the potential for recession, interest rates were lowered. This led to money pouring into real estate and fueled the mortgage bubble that has led to the current financial crisis. With rates still low and the returns to real estate now depressed, money poured for a while back into the stock market (with yet another crash in 2008) but this was also combined with a search for another asset – hence gold. With returns depressed on real estate and other financial assets and the market crashing again, money is now pouring into gold. To my mind, this is another speculative bubble much like the housing market and is being fueled by the search for quick speculative returns as much as any view of gold as a "safe asset" or as some type of alternate international currency. The price of gold was under 400 dollars an ounce for most of the late 1980s and 1990s and only starts its recent ascent after 2000 – coinciding with the 21st century's first decade of turmoil in stock and real estate markets. It is now pushing 1800 dollars an ounce but for how long? If you look at a graph of gold prices since 2000 it reminds me of what happens to a population of fruit flies sealed in a glass aquarium with a fixed supply of food. The population explodes and population increases exponentially until the supply of sugar is exhausted and then the population collapses. Replace fruit flies with gold prices and replace food supply with cheap money and you have what I think is a nice metaphor for the current gold price story. As long as it remains cheap to borrow and other asset prices are depressed, one can expect gold prices to remain high. Is a real interest of 2 percent the critical value? Who knows. At some point, the boom will end. As we have seen to date. All booms comes to an end. The real question is not if but when which is indeed the hardest question to answer. Of course, having cycled through the stock market, real estate, then the stock market again and now gold – where will speculative investment money flow next?
Worthwhile Canadian Initiative 
This makes me think of Samuelson’s 1958(?) “Exact Consumption Loan Model”, where the natural rate of interest is below the real growth rate of the economy. The real growth rate of the world economy (population + productivity) will be/has been somewhere around that 2%. If the natural rate is below the growth rate, the economy “needs” some sort of bubble asset. Samuelson called it “money” in his model, but it wasn’t really (or didn’t have to be). It could be gold, or land (and the house price rise was really a housing land price rise), or anything in relatively inelastic supply. But as you say, bubbles are unstable. Even if the economy “needs” a bubble, it could be one asset, or another. So sentiment could suddenly switch from land, to gold, to Tbills, to whatever. And one bubble could collapse, as another one grows.
It’s not a bubble, it’s a response to central banks around the world engaging in inflationary stimulus. The gold bubble will only pop once central banks raise interest rates, which doesn’t seem like it’s going to happen anytime soon.
“If the natural rate is below the growth rate, the economy “needs” some sort of bubble asset.”
Nick, could you elaborate? Are you saying that an asset bubble somehow equilibrates the real and natural rates?
“As long as it remains cheap to borrow and other asset prices are depressed, one can expect gold prices to remain high”
Livio, banks certainly aren’t borrowing at the short rate to buy gold. Do you think investors are borrowing to buy gold? That would be insane, moreover, is there any evidence of this actually happening?
JP, try this old post from Nick, ‘Do We Need a Bubble‘
RSJ:
Its not necessarily that investors are borrowing to buy gold – that may be happening but I have no evidence. Its just that investors often have cash balances they wish to invest and with stock market returns low, interest rates on investments low, the temptation is certainly to put it in gold and reap a speculative return. That is quite risky if the price drops suddenly but this pattern has occurred before.
Thanks Declan. That’s the one.
The empirical fit on that post Livio links to looks pretty good to me. I think it has also performed quite well out of sample too.
Why would low real interest rates cause a bubble in gold prices as opposed to some other asset. (Real estate? Patents? Swiss Francs? Silver? etc.)
The gold market is primarily buying from consumers in India, in China and Central Banks. Cheap money has very little to do with any of these markets. However, I expect that cheap money will soon find gold. That should make things interesting.
Having a finance background, the nature of the discussion of gold always surprises me. Why not start with the nature of the asset in question, and from there figure out how it behaves in alternate “states of the world”?
Every asset is a claim on a set of cash flows. The timing of those cash flows defines an asset’s duration. Gold is a claim on the cash flows from leasing it: mostly for jewelry use. These cash flows continue in perpetuity. Therefore, gold is the longest duration asset available in the economy.
Does the above correctly describe the claim represented by the asset? In what states of the world will that claim do well? Why should one of those (the only one?) be the observed correlation with negative real interest rates?
An even better way to frame the question:
If you were to construct a claim on a set of cash flows that rises in value when real interest rates fall below zero, what would that claim look like?
Nick, RSJ, thanks for that link.
Nick, what about this post?
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/could-the-natural-rate-of-interest-really-be-negative.html
“If you don’t like beans: try clothes, furniture, towels, landscaping, wine, scotch, copper, insulation, tobacco, dentistry, cutlery, steel, bricks, canoes, lumber, art, education, books, guitars,…., whatever. At negative real interest rates, why wait? Why not buy them now?”
Does this describe the same process as the bubbles in Lucas and what Livio is referring to?
Why does nobody consider the fact that some gold investors — myself included — consider gold to be a real currency. It is, in fact, traded as a currency by all major currency traders, under the currency code XAU. And as a matter of real fact, gold is actually used in international settlements believe it or not.
Could it be that golds intrinsic value is that of a common currency market for which there is no central manipulator for holders of the underlying asset can use to discover prices against other assets without the risk of policy imposed inflation or policy induced hyper-inflation?
No, no… that couldn’t be it. What silliness. People trading gold in the settlement of debts. Hahahahaha… who’d ever do that? http://en.wikipedia.org/wiki/Metal_as_money
Many people are concerned that trillions of dollars of fraudulent derivatives will cause a financial meltdown and collapse of the monetary system. Owning gold and silver has to be looked upon as a form of insurance against monetary collapse.
Why gold? Why not canned goods?