Gold Class Animal Spirits

In his 1936 book ‘The General Theory of Employment Interest and Money’ John Maynard Keynes outlined how rather than being independently rational, investors were often prone to erratic herd-like behaviour. He argued that macroeconomic stability is inherently vulnerable to the ‘animal spirits’ of speculators. The recent deflation of the post Global Financial Crisis (GFC) gold price bubble is a prime example of this phenomenon.

After the GFC of 2007/2008, gold became hot property for investors. This is known as the ‘retreat to safety’. In uncertain times, investors look to gold as it offers protection against inflation. They moved away from cash deposits that at the time, seemed likely to erode in purchasing power. With stocks volatile and most bonds out of the question, gold was the safe haven from the loose monetary policy that followed the GFC. Faced with uncertainty and seeking safety, investors formed a herd and the bubble was born.

The post GFC quantitative easing by the US Federal Reserve did not significantly dilute the US dollar as many anticipated it would, and it now seems that these threats of high inflation were somewhat overblown. The safe haven of gold offered protection against a threat that never materialised. This year on April 10^th, investment bank Goldman Sachs put a ‘sell’ on gold, helping spark a frenzy[1]. The ‘retreat from the retreat to safety’ accelerated and in a matter of days, gold went from being hot property to deadwood.

From the 14^th to the 16^th of April the gold price fell 14% to $US1360 an ounce, including a fall of 9.2% on the 15^th alone. This was the largest one day fall since 1980 and the first time in 20 months that it has been below $US1500. The immediate knock-on effect was some aggressive dumping of gold-mining company stock – Mexican giants Fresnillo fell 15% and the ASX-listed Kingsgate Consolidated fell 15.2%[2].

On face value, an optimist may hope that this means that the ‘retreat to safety’ is over, and investors are reallocating their money back into the productive securities of bonds and stocks. However on the 15^th of April, the Dow Jones Industrial Average suffered its biggest fall since November of 1.8% and the S&P/ASX 200 Index lost 0.9%. This was mostly on the back of a general lack of confidence in the future of commodities based companies, having much to do with China’s annual GDP growth for the January to March quarter being announced as 7.7%, rather than the predicted 8% and a fall from the previous quarters 7.8%.

Many analysts suggest that gold still has further to slide. It seems the only way back to its lofty over-valuation is some credible threats of high inflation, something that could surely not rear its head now if it has resisted the last five years of ‘easy money’ policies.

The gold bubble was triggered by probabilistic forecasts about what the future may hold, and the bust was no different. Two specific expectations elicited the price plunge. Firstly, there is an expectation that the US Federal Reserve will tighten monetary policy. An end to quantitative easing would help to dispel the exaggerated fear of inflation eating away at cash, and thus the safety of gold is recognised as no longer required. Secondly, there is growing speculation that Italy and Spain could sell off its gold stocks to help their financial woes, which could lead to a surplus of supply. Both of which are expectations, not actual events.

The panic selling is tantamount to the ‘animal spirits’ Keynes spoke of. After almost five years of artificially high growth, the market was infected by a collective yet false sense of safety and over-confidence. With the bull market having been built on misguided forecasts, it was inevitable that at some point a bear market would be triggered by something less than circumspect.

So what exactly does this say about speculator behaviour and market rationality? It suggests that inherent in some dynamics of capitalism is a flaw that can transform the rational into irrational. While for the individual investor, joining the bubble and panic selling when the bust comes seem like the rational things to do at those particular times, the emergent effect of collective ‘animal spirits’ is destabilising and irrational. Sometimes, what is true of the part is not necessarily true of the whole.