Recently, Willem Buiter, an economist employed by Citigroup, wrote a research note on gold which essentially concluded that its pricing was not, and had never been, rational (a ‘6,000-year old bubble’ is how he describes the gold price).
There appears to be one surefire way of irritating an economist, and that is to begin praising gold, or an investment in gold. For some reason, to which I seem immune, it drives them mad. Thus, as one might expect, the recent proposal for the Swiss National Bank to hold 20 per cent of its reserves in gold has driven Buiter – an experienced, outstanding and well-regarded economist – to pick up his pen and attack gold.
In this essay, I want to critique Buiter’s note as a way of demonstrating how one might begin a critical appraisal of an argument, even one for which you have little knowledge of the subject area. I’ll ignore his discussion of the correctness or otherwise of the ‘Swiss National Bank’ proposal, and will instead concentrate on his more interesting discussion of the financial nature of gold.
A constant refrain that I hear, when making an argument critical of a consensus view or piece of ‘conventional wisdom’, is that ‘you have no qualifications in this area, therefore you are not entitled to disagree with the experts/consensus’.
This is completely wrong. All arguments, whether scientific or social or personal, are logical constructs. Therefore it is possible for a person who is aware of the nature of sound reasoning, and who can spot formal and informal fallacies in reasoning, to critique those arguments. Scientific knowledge gives one expertise in the special knowledge of a particular subject, however it does not lift an argument above critique, nor above the need for the expert to adhere to the rules of sound reasoning.
Before joining Citigroup, Buiter wrote a column for the Financial Times. As an economist myself, I enjoyed reading it. In fact his latest research note is almost entirely taken from a note that he prepared for his Maverecon blog on the Financial Times website five years back in 2009, and which I remember reading at the time (the comments are well worth reading). However, sound reasoning is no respecter of persons – nullius in verba ought to be the motto of all who endeavour to think critically. And therefore we will dare to climb into the ring with this formidable intellectual opponent.
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After discussing ‘Swiss National Bank proposal’, and the stocks and flows of gold, Buiter writes:
John Maynard Keynes once described the Gold Standard as a “barbarous relic”.11 From a social perspective, gold held by central banks as part of their foreign exchange reserves merits the same label, in our view. The same holds for gold held idle in private vaults as a store of value. The cost and waste involved in getting the gold out of the ground only to put it back under ground in secure vaults is considerable. Mining the ore is environmentally damaging, especially if it involves open pit mining. Refining the gold causes further environmental risks. Historically, gold was extracted from its ores by using mercury, a toxic heavy metal, much of which was released into the atmosphere. Today, cyanide is used instead. While cyanide, another toxic substance, is broken down in the environment, cyanide spills (which occur regularly) can wipe out life in the affected bodies of water. Runoff from the mine or tailing piles can occur long after mining has ceased.
Is the cost of mining gold ore, and processing it into refined gold, really so significant? After all, if it was prohibitively high relative to the price people were willing to pay for it, miners wouldn’t mine for it – supply would simply shut down. This is true for all commodities. So no matter how high the cost, many people still think it is worthwhile to continue digging out the ore and processing it for sale, just as they do for iron ore and the non-ferrous ores such as nickel, copper, tin, tungsten, lead etc.
Buiter also introduces the argument that gold mining and processing produces many negative externalities for the environment – release of mercury into the atmosphere, release of cyanide into waterways – the costs of which are not captured in the cost of the metal. But isn’t this true for many if not all industrial processes? And if so, surely it is a simple matter for governments to introduce legislation regulating the emissions of these chemicals and punishing those who pollute the environment with them?
What we have here is a case of Buiter seeking to tarnish the reputation of gold by referring to problems associated with its production. None of which are in the nature of gold per se, but are more the fault of unscrupulous producers and inattentive governments. An ad hominem argument, if one can say that about an argument made against a metal.
As for digging the stuff up only to put it back in the ground, why should we concerned about this? Do we show similar concern for the iron ore, dug up at great expense, which is refined, also at great expense, and then immersed in seawater for use as the hulls of ships, not to be seen again until the breaking-up of the craft? Or the disappearance of the steel and cement used in building the foundations of great structures – also never to be seen again until demolition? Or the shaping of great amounts of steel into sophisticated car engines, only to have them hidden from view under car bonnets?
Some metals and other products find their use in ways which cause them to disappear from view. It seems that monetary gold – that used for the purposes of central banking – is used in such a way. You might say that, under the gold standard, its being locked underground in vaults provided the ballast which ensured the stable operation of the world’s monetary systems.
Modern technology has done away with the need for central banks to store their reserves of monetary gold underground. It’s quite possible for a central bank to build a structure where their gold bullion could be stacked in piles in an area accessible to the public, with the gold protected by thick reinforced glass, and the whole area monitored by security cameras and security personnel. This would allow hoi polloi to wander around their nation’s gold stocks, admiring them and, if they felt inclined, taking reassurance from the wealth there displayed. We don’t actually need to store gold in underground vaults anymore.
But why should it matter if we do? Surely the more important consideration is not the underground storage, but the effect of the stored gold on the operation and stability of a country’s monetary and financial systems? You would think an economist would ‘get’ this, and not seek to include in his argument facile and weak points about where a country stores its monetary gold.
After some other paragraphs, Buiter writes:
Gold is very close therefore to the stone money of the Isle of Yap. This stone money, known as Rai, consists of large doughnut-shaped, carved disks, consisting usually of calcite, that can be up to 4 m (12 ft.) in diameter, although most are much smaller. Apparently, the total stock of Rai cannot be augmented any further. It also depreciates very slowly. This intrinsically useless form of money in the Isle of Yap is in all essential respects equivalent to gold today in the wider world. Another example would be pet rocks, as long as the rock in question is rare and costly to get into its final shape. Another is Bitcoin, a fiat virtual currency.
There is no reason at all for Buiter to criticize the Yap people’s choice of currency as being intrinsically useless. From a disinterested point of view, the Yap people at some point faced a social problem – what to use as a common means of payment and store of value – and they lighted on the Rai as a solution to their problem. Obviously it worked for them to some degree, otherwise they wouldn’t have used it. And its use most likely occasioned an improvement in economic efficiency and social life. What Buiter dismisses as being a useless form of money may have meant the difference between life and death for the Yap people.
The fact that the stock of Rai cannot be augmented, and that they depreciate slowly, makes them ideal forms of currency – far from being intrinsically useless, they in fact ‘fit the bill’ for a means of exchange and a store of value. The Yap people knew what made for a good currency many years before Buiter opened his first economics textbook.
Buiter goes on:
Gold has become a fiat commodity or a fiat commodity currency, just as the US dollar, the euro, the pound sterling and the yen (and a couple of hundred other currencies) are fiat paper currencies and as Bitcoin is a fiat virtual currency. The main differences between them are that gold, like Bitcoin, is very costly to produce, while the production of additional paper money has an extremely low marginal cost. If we count the deposits of commercial banks with the central banks, which together with currency in circulation make up the monetary base, as fiat money, then the incremental cost of fiat base money creation is zero.
Buiter’s highly original (and quite unorthodox) use of the phrase fiat commodity currency is quite strange. The idea behind a fiat currency is that the authority which creates the currency states that it has a given face value which it will accept as payment, and which those using it in transactions must also accept – that is the fiat (‘let it be’) in fiat currency. However Buiter has tried to get around this definition with a feat of verbal gymnastics:
Because to a reasonable first approximation gold has no intrinsic value as a consumption good or a producer good, it is an example of what I call a fiat (physical) commodity. You will be familiar with fiat currency. Unlike what Wikipedia says on the subject, we argue that the essence of fiat money is not that it is money declared by a government to be legal tender. It need not derive its value from the government demanding it in payment of taxes or insisting it should be accepted within the national jurisdiction in settlement of debt. Instead the defining property of fiat money is that it has no intrinsic value; it derives any value it has only from the shared belief by a sufficient number of economic actors that it has that value.
The “let it be done” literal meaning of the Latin ‘fiat’ should be taken in the third sense given by the Online Dictionary: 1. official sanction; authoritative permission; 2. an arbitrary order or decree; 3. Chiefly literary any command, decision, or act of will that brings something about.
The act of will in question is the collective attribution of value to something without intrinsic value. Being declared legal tender by a government may help achieving that status, but it is neither necessary nor sufficient.
Now hang on! That’s not the case at all. As explained above, the act of will which the government makes with regard to fiat currency is ‘The public will trade the pieces of official paper/plastic/polymer that we distribute as currency at the face value which we ascribe to those pieces of paper’. Buiter is selecting a definition of fiat which, while it suits his purposes, is at odds with the way in which the term is used technically. This is unacceptable. We must reject Buiter’s definition.
Another problem we have is Buiter’s definition of his phrase intrinsic value. What on earth does he mean by the phrase ‘intrinsic value’?
Earlier, he has said:
We can therefore safely ignore the intrinsic value of gold as an industrial, medical or dentistry input and as a consumption item and treat it as a ‘fiat commodity’ – one that has value as an asset if and to the extent that enough people believe that is has value as an asset.
And from this sentence, together with the first sentence of the paragraphs regarding fiat currencies (‘Because to a reasonable first approximation gold has no intrinsic value as a consumption good or a producer good, it is an example of what I call a fiat (physical) commodity’) we guess that Buiter ascribes intrinsic value only to those commodities whose predominant role is in being used up in the productive process or in meeting final consumption.
Now, is this a correct ascription? All commodities, including gold, have a market value – a value arising from the interplay of supply and demand in a market. Does this market value differ at all from the intrinsic value which Buiter talks about? It must do so, in his formulation, because while gold has a market value, Buiter ascribes to it a zero intrinsic value. But what then determines intrinsic value, if not the market? And how can Buiter know that these commodities have intrinsic value if this value cannot be observed?
Worse, what happens to those commodities whose place in the order of production and consumption has been superseded – goods such as flint, whale-oil and wax? On Buiter’s definition, they once must have commanded a very high intrinsic value, but what is that intrinsic value now that their market-value has fallen to zero? Do they retain their intrinsic value despite having zero market value?
Let’s escape this epistemological trap which Buiter has created. Commodities have values in a market because, on the demand side, their scarcity requires that they be rationed among buyers, and, on the supply side, meeting this demand requires producers to incur costs. Freely available goods, such as air, have no cost of supply and therefore no market value. Goods such as whale-oil, for which there is zero demand, command no price, despite the costs associated with their production.
There is no reason why the price that consumers are willing to pay for a commodity need be exactly the same as the cost of production – the two can differ quite markedly, and in fact almost always do.
Industrial and consumer commodities have value because they are demanded by many consumers, and because they are costly to produce.
Fiat paper currencies have a low cost of production relative to their face value. Because of this, it is only the fiat giving effect to their face value which makes them valuable – what else would you do with an Australian $20 note, if you couldn’t exchange it for goods and services? It would be near worthless. The difference between the production cost of a currency note and its face value is called seniorage, and it is through seniorage that central banks fund their operations.
Gold has a market value expressed as a price per ounce. The price serves to ration supply among those wishing to hold it or use it to create goods (such as jewellery or cutlery), and to either encourage or discourage further supply (depending as whether the price is high or low relative to production costs). There is nothing fiat about it in the least, especially in a world of paper currencies which float freely against one another.
But, for the sake of argument, let’s assume that Buiter’s idea of intrinsic value has merit. Why should we restrict intrinsic value only to those commodities which play a role in production or which are consumed? Why not extend the concept to those commodities which play a role in finance? Finance is a necessary part of modern society, and a functioning, stable currency is essential to the operation of finance in providing the means by which real productive activity can occur. One need only read about the situation in Weimar Germany post World War I to know what happens when a currency fails in its role.
Can we then say that this currency has intrinsic value arising from its role as an input to the financial process? I can’t see why not. If the marker of intrinsic value is that a commodity has a use, then certainly currency has a use. It seems that Buiter has deliberately restricted his definition of intrinsic value so as to exclude currencies and gold. This is a form of the formal fallacy of moving the goalposts, one variation of which is the no true Scotsman argument.
Gold is no longer the predominant form of currency used to settle transactions and store value. But it is still used for this purpose by some people and institutions. And given that they would have to use something for those operations, some form of commodity which is mutually acceptable to all parties involved in the transaction, there’s nothing wrong with using gold, no matter what Buiter or anyone else says. To the extent that gold serves a social purpose, and makes social and productive processes more efficient, it has some value to society. The extraordinary thing about gold is that it is an acceptable form of money in all societies, and has been so at all times – it is truly an international and timeless form of money. This is a remarkable fact and we ought not dismiss it lightly simply because it doesn’t suit our worldview, as Buiter does.
Why gold might be seen as a desirable medium of exchange and store of wealth is openly suggested by Buiter a little further on:
The great advantage to investors of gold is that, although it is not intrinsically valuable, it is very costly to increase its stock. The tap can be opened at the drop of a hat for fiat paper and electronic currency. The tap produces never more than a trickle in the case of gold.
Well, quite. Buiter doesn’t let this fact, which is one of the reasons why people have long seen gold as a sound store of value, get in the way of his story, though.
So if gold has positive, albeit wildly fluctuating value, it is because we are in a benign bubble for gold. Likewise, Bitcoin’s positive value represents a benign Bitcoin bubble. The gold bubble is, of course, pretty impressive. Intrinsically useless gold has positive value. It has had positive value for nigh-on 6,000 years. That must make it the longest-lasting bubble in human history.
Well, no. ‘Bubbles’ – such a beautiful name for such chaotic and painful financial episodes – are increases in asset prices which are not justified by the fundamentals which usually determine those prices (such as historical returns on investment, or expected returns from plans for future investment), and they tend to arise from investors seeking returns from extraordinary capital gains rather than a combination of ‘normal’ capital gains plus earnings from operations. When charted, they tend to show a marked upswing (which may last from a few weeks to a number of years) followed by a marked fall (which again may vary in duration).
Gold shows none of these characteristics. While there have been periods of marked upswings, they have been followed by marked falls, and have been punctuated by long periods of stability. This indicates that, while gold prices have displayed ‘bubble’ tendencies at times, they for the most part have reflected fundamental pressures arising from supply and demand. You might think the gold price is too high, you might think it is too low and destined to rise sharply. What cannot be justified is the statement that gold prices have been in a bubble for 6,000 years.
This last point indicates the extent of Buiter’s delusion. No bubble lasts for 6,000 years. Should you ever think this, it should lead you to question your assumptions and your argument, because it strongly indicates that somewhere, somehow, you’ve made an error. But, in this instance, Buiter lacks this self-reflection.
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- nullius in verba: do not take the arguments and conclusions of the experts at face value – they can be wrong, they have been wrong in the past, they will be wrong in the future;
- study the principles of sound reasoning, learn the common formal and informal fallacies so as to identify when arguments go wrong, and apply your knowledge to questions that are important for you and your society;
- outrageous or ridiculous conclusions (‘It has had positive value for nigh-on 6,000 years. That must make it the longest-lasting bubble in human history) are strong indicators that someone’s reasoning has gone wrong, and that you ought not to trust these conclusions until you have examined them yourself.