In ancient times, a gold nugget was just a pretty rock. People soon noticed that you could shape that pretty rock in all sorts of interesting ways–gold is malleable, ductile, etc, etc. So gold was used for jewelry because it could be shaped so easily.
Then people started using gold as a key good. In a pure barter system, if you have baskets but want chickens, you have to find a guy who has chickens but wants baskets. A tedious process. But what if you have baskes, and you trade them to someone for cowrie shells. Then you take the cowrie shells to the chicken farmer and trade him cowrie shells for chickens. Cowrie shells are therefore a key good. Yes, they can be used for decoration and such, but people accept trades of cowrie shells even when they don’t want cowrie shells, because they know they can trade the cowrie shells anytime for they goods they do want.
And these key goods are the first type of money. Everyone has heard of cigarettes being used as money in prisons. Other key goods used as money are cacao beans, cattle, cloth, whiskey, and so on.
And gold and silver turn out to be very useful key goods. They aren’t easily destroyed, they are divisible into any size wanted, they are portable, and so on.
So gold has an ancient connection with money, because it could be used as money across continents. You could take gold ingots, and walk all the from Venice to Beijing, and find people willing to trade you useful goods for those lumps of gold.
And you find during the Spanish conquest of the Americas vast amounts of gold were shipped from the conquered lands back to Europe, and the Spanish imagined they were literally importing money. But of course, gold isn’t money, it is just a good that can be used as money. So when you import vast amounts of a particular good, supply and demand should tell you that the price of that good will fall dramatically. And so the value of gold in Spain fell like a rock. Another way to look at it–if you take the notion that the value of gold is fixed–was that there was tremendous inflation, and the price of every good in Spain (except gold) rose dramatically. And so the importation of vast amounts of looted gold didn’t make Spain permanently rich, because the more gold they looted the less gold was worth.
So, back to the notion of “investing” in gold. Thing is, investing in gold is just like investing in pork bellies or frozen concentrated orange juice. You look at the price of the commodity, guess whether the price of the commodity will be higher or lower at some point in the future, and bet accordingly. Doesn’t anyone watch “Trading Places” anymore? So if gold is at $1000/oz, and you think the price of gold will increase, you can buy gold to sell at a later date. Or you can sell the gold now, and arrange to actually deliver it later, when you think you can buy it for less.
This is how people make money on commodities. But for every buyer who thinks the value will increase, there’s a seller who must think the value will decrease, otherwise why are they selling?
So if a company that sells gold is telling you that buying gold today from them at $1000 is such a good investment, why are they selling you the gold instead of keeping it and selling it later? Of course, there are plenty of people buying gold right now who don’t think gold is particularly more valuable today than yesterday, but they think that other people think gold is more valuable. So they buy gold even though they think the gold is priced very high, because they think the greter fool will buy gold tomorrow at very very very high prices.
And this is what is known as a speculative bubble. The price of the commodity rises and rises, and people buy in because there’s this dramatic rise in prices which leads them to think they can sell tomorrow at even higher prices. And eventually it all comes crashing down, and the people who bought at the top lose everything, depending on how the purchases were made. Lots of times these purchases are made with borrowed money. If you buy gold at $1000/oz, and tomorrow it crashes to $500/oz, you’ve lost half your money. But if you borrow money to buy the gold, then you could lose everything and more.
It seems to me that the current run up in gold prices is a classic speculative bubble, that will collapse at some point. That means if you buy gold today–as an investment–you have to plan on selling it before the collapse if you want to make money. But when will the collapse happen? No one knows, and it seems to me that the top of the bubble market is impossible to predict, even for insiders. Since we know (or think we know) the bubble will collapse at some point, that means that gold is not an investment but rather a gamble.
And if your strategy is to buy and hold the commodity, thinking that gold will just continue to rise and rise and rise forever, well, that doesn’t make much sense either. When are you planning on selling the gold? If you aren’t planning on buying low and selling high, then you aren’t investing. You’re collecting. Nothing wrong with collecting gold, but if you’re a gold collector you might not want to increase your collection at a time when gold prices are rising like crazy–you want to buy when gold prices are low.
Of course, all this depends on the notion that gold is in a bubble. If you disagree, if you think that the price of gold will permanently increase, then feel free to buy gold now while you still can.
But why would gold be worth so much more now than it was a year or two ago? The global financial crises? But that doesn’t mean that gold is more valuable, only that certain assets are worth less, like stocks of companies that are going to go bankrupt. Even if you think currencies like the dollar or the euro are going to worth much less in the future, that doesn’t mean exchanging your dollars for gold is a good idea, since there are any number of other goods that you can exchange your dollars for. You shouldn’t look at the expected value of gold compared to the 2011 dollar, you should look at the value of that gold compared to any other good you could buy today. Maybe gold will be priced at $10,000 an ounce, but another way to look at that is just that the value of the dollar collapsed by 90%. If gold increases price by a factor of 10, but other goods increase in price by a factor of 11 or 12 or 13, then the value of gold has actually fallen. In other words, if you expect inflation to wipe out the value of the dollar, don’t hold dollars. But that doesn’t mean holding gold is a good idea either.