Gold: The 4,000-Year-Old Bubble

May 20, 2011

Last fall, we bought a quarter-ounce gold coin. A few weeks ago, we sold it. The price of gold rose while we owned the coin. But because we had to pay a commission and sales tax when we bought it, we wound up losing a little money in the end.

In this story — the last in our series on gold and the meaning of money — we try to answer one final question: Is gold in a bubble?

To understand bubbles, some economists are trying to recreate them — without destroying the global economy. They do it at universities, using real money and student volunteers as traders.

Arlington Williams, an economist at Indiana University, helped run one of the first experiments trying to create a bubble in the lab, back in the 1980s.

"I thought would see bubbles infrequently," he says. But over the years, Williams and his fellow researchers have found that bubbles — and crashes — occur in the vast majority of their experiments.

In the lab, they set up the world's simplest stock market. There's one stock that the students can trade. At the end of every round of trading, the stock pays a small dividend — an average of $1, say. At the end of the game, the stock is worth nothing. So if there are 10 rounds left in the game, the stock should be worth $10.

They make this very simple for the students, who have computer screens that tell them exactly how much the stock should be worth.

But the price of the stock still almost always shoots way up over the expected value. Then, at some point before the end of the experiment, it crashes.

One time, in the middle of a bubble, Williams pointed out the apparent insanity of what the students were doing. That made the stock price go up faster.

"Showing people that the market was in a price bubble just fueled the price bubble even more," he says.

One explanation for bubbles is the greater fool theory. People figure they can sell the stock to some greater fool, who will pay more for it.

Another thing that can cause bubbles: People don't always have great information about what's going on. So they just follow the crowd.

And once bubbles start, it can be hard to put the brakes on. If you think home prices are going up, you can buy a house, or two houses. But it's hard for the average investor to bet the other way — that home prices are going to fall.

So for all these reasons, we see bubbles and crashes, in the lab and in the real world. The people in Williams' experiments sometimes buy stock for more than it could ever pay out. This gives us a definition of a bubble: When the price of something rises way above its fundamental value.

So if that's the definition, is gold in a bubble? We asked Tim Harford, an economist and author. Here's what he said:

Gold is a tricky one, and here's why. ... bubbles should be defined in terms of fundamental values. For the price of corporate stock, we should be looking at future profits, and you need to make your best judgment for what that should be. But ... it's just not clear what the fundamental value of gold is. It's worth something because people have always thought it's worth something. And that's really weird, because what it tells you is gold is in a 4,000-year-old bubble. And if it's lasted 4,000 years, maybe it will last another 4,000 years. Who am I to say?

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