Gold Bubbles and Fiat Currency: Our Make-Believe Economy

Gold Bubbles and Fiat Currency: Our Make-Believe Economy

Why, when it comes down to it, we're all riding a make-believe train.

     A "bubble" in econo-speak, is a period of trading in commodities whose prices are significantly inflated form their intrinsic (see: actual) values." We've all heard of the 'housing bubble' of 2007, and probably remember the 'dot-com bubble' of 2001. Essentially, people buy stocks, commodities, etc., then attempt to sell when demand grows and costs increase. However, a bubble occurs when the costs continue to increase past the actual value of those stocks, and most people attempt to buy so that they can then turn a profit by selling at these inflated rates. Economists don't know why bubbles happen (though they have several theories) but we all know that bubbles eventually burst. When they do, they can have devastating effects.

     Amid the current economic recession there has been a lot of popular hype about gold, and small storefronts have popped up all over the country to buy people's gold. With the hype, comes increased investment and the danger that a new economic bubble might be forming; could gold be in a bubble? NPR's Money Market addressed this question, and the ultimate meaning of money in our culture, in their series "Gold: The 4,000 Year Old Bubble". Not only did the show test it buy purchasing some gold and selling it later (actually losing some money in the process due to commission and taxes), but they reported on an economist at Indiana University and some students that attempted to set up a simple stock-market meant to create an economic bubble.

     The students were made investors in a small market that only traded in one stock. They used real money, but in small amounts, and over time were given information (like actual traders) on the ebb and flow of the market, natural variations that occur in all economies. The stock paid a dividend of $1 on average, and would only be traded for 10 rounds, thus only ever making, on average, $10 for its traders. Alrington Williams, the economist that devised this experiment, expected a bubble to form very infrequently. However, what he found were that bubbles were the rule rather than the exception, forming about 90% of the time, and would inevitably crash before the end of the trial. Most of the time the students traded at prices well above what the stock could possibly be worth. At one point Williams even pointed out the insanity of their trades, and the price of teh stock went up even faster.

     It may not be possible correlate this experiment to the larger, infinitely more complex markets in the real world, but it's certainly a telling experiment in how people view money and speculative trading. The only stability that markets have is in their intrinsic real-world value. Once prices have increased beyond that value, they are no longer stable and will continue to grow until they eventually crash. As for gold, one of the economists on the show characterized gold as exising in a 4,000 year old bubble. Why? Gold isn't inherently worth anything. It's become universally agreed that gold, this soft shiny yellow metal, should be valuable. It's not particularly useful for anything, other than as an electrical conductor. It's not the rarest metal out there. It's certainly too heavy and too soft for a lot of practical purposes. There's no rhyme or reason as to why other than it just always has been valuable.

     In fact, so culturally institutionalized is the value of gold throughout the world, that there is a "gold standard", or a value at which a nation's currency (usually paper or coins of some common metal) is attached to its stores of gold. The "gold standard" leant nations currencies value because, supposedly, every cent of it was backed by an equal amount of value in gold (which isn't, in and of itself, worth anything). However, it was a standard of some kind, and for the purposes of continuing civilization,  it seemed to work.

     In 1971, the United States took itself off the gold standard. It no longer had the stores of gold to back the amount of printed currency it was creating, and the U.S. entered the age of fiat currency (fake money) and a new era of market instability. Now the dollar was valued simply because it was a dollar, and there was a run of commodities bubbles in things like oil and gold. Eventually the Fed stepped in and straightened things out by raising federal interest rates. However, in 2000-2004 the Fed lowered interest rates, which some economists believe increased the housing bubble.

     Now I'd like to return to a previous point...all of these things have value simply because we've agreed that they do. Gold, money, stock trades and dividends are all valuable because there is an unstated social contract that says they have value. Houses have real value, as does food, oil, automobiles, Juicy Fruit and cue-tips. However, the currency that allows all of these products, commodities, and services to be traded, bought, and sold does not. Essentially, we've created a finance system and an economical model of such incredible complexity that we don't even know how it works anymore. Even the experts (if you haven't figured this out yet) are taking best-guess shots at the problem of market stability and speculation.

     However, instead of pulling the reigns and maybe taking another look at that social contract item, we layer on the complexities. Money now exists as quadrillions of digits in a data stream being moved from server to server across thousands of global networks. It's not even tangible anymore, but digital. Even that isn't entirely true because now we have speculative currency, or money that can be used to buy that doesn't even exist because it isn't money we actually have yet. We have aeronautics engineers pulled out of R&D firms just to write speculative stock-trading algorithms to predict trends in the market which are then plugged into computers that make hundreds, even thousands of trades per minute for fractions-of-a-cent profits.

     This is a mind-bogglingly complex creature that we've created. it's a fantasy of human endeavor and yet it guides everything. We're all riding a make-believe train right now; it's traveling way too fast to jump off and it's being driven by a hedge-fund manager.

 

www.npr.org

www.economist.com

Photo from scripophily.com