Friday, April 20, 2012

Gold commentators get it wrong.

Another post over at Zero Hedge about gold and silver prices seems to miss the point. Barring it being declared contraband The price doesn't really matter. Holding physical metals is not a portfolio price hedge, it is a risk hedge. Think the kinds of things people keep in cottages and farmhouses in case of extreme weather events, a fairly common occurrence in which they may not be able to rely on the trappings and accoutrements of society for brief periods. In a city it seems like the end of the world, but in the country, that's just winter...

Like insurance, it is more valuable to some people than others. Hurricane coverage is pretty valuable in Florida, not so much in Wisconsin. Consider how you would price an insurance premium on a variety of political and financial perils facing your personal wealth, then whatever the premiums would be, that is how much you can accept paying (or losing) as the prices of physical metals oscillate. Politically, holding physical metals like gold and silver is sensitive because it is essentially an insurance policy against a variety of general actions that a state will take against wealth holders. In this sense, there is a taint of an anti-social attitude associated with it in some circles.

Anecdotaly, I do not know anyone who professes progressive or left'ish politics who would say they have a "stack" of physical metal, and I do not think this is just a matter of discretion either. I think it's more of an expression of faith in government and society, and in particular that they will remain political influentials or coalition members in the event of a crisis. Rural people and some urban ones who would consider themselves traditionally conservative have implied they would (or do) keep at least some around for an emergency. As a result, I think gold has a future as a political wedge issue.

With a small spread and relative to currency fluctuations, gold is pretty much the same price everywhere, and therefore it must be overpriced in some places and underpriced in others. Demand for it is not uniform. In countries like Greece, Italy and Spain, gold is a hedge against some plausible circumstances - like national governments swapping domestic euro bank deposits for returns to the Drachma, Lire and the Paseta, respectively. As mentioned in an earlier post, it is also a way to transfer wealth out of a country, and is more welcome at its destination than briefcases full of foreign cash.

Like cash, it hedges against sudden account seizures or "bank holidays" forced by authorities (closing banks as a tactic to prevent or slow bank runs) in a volatile political environment. These are all extreme events, but ones which occur in different places around the world suddenly, and with surprising frequency. There may not be one in a given country for decades, even centuries, but then they happen.

Issues like this are more relevant in Euro area crisis countries than in say, Australia or Canada. Cynically, I would bet that bank runs in the US are probably less likely than some prophets of doom would foretell, as any prediction of a bank run presumes that people actually have the savings to withdraw.

The question about whether metals are over or under priced is secondary to the likelihood of the financial perils that holders are using it to insure against. Trading in gold is just trading one risk for another, and oddly, trading it for more dollars (e.g. one of the risks it is intended as a hedge against) may increase a trader's short term purchasing power or leverage, but - adjusted for risk - not necessarily his wealth.

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