What’s Gold for?

Plus! Bitcoin, Flows, Autochthony; Digital Media, Distribution, Autochthony; Leaving “Little Taipei”; Scrap

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In this issue:

Programming Note: The Diff will be off on Thursday 11/26, in  recognition of the Thanksgiving holiday. The Diff will be back Friday  11/27, with a shorter issue, in recognition of the fact that the market  is open half-days on the Friday after Thanksgiving. A formative early  experience in my buy-side career was when a story came out the afternoon  before Thanksgiving, was widely ignored the next Friday, and caused the  stock in question to rise 10% or so on Monday once it was  widely reported.

What’s Gold For?

For reasons that have more to do with physics than finance, gold is  the asset class with the longest unbroken performance record. We have a  decent idea of what a given amount of gold bought in ancient Greece,  imperial Rome, renaissance Genoa, revolutionary France, and the modern  US. Other products have existed about as long; there are records of  loans going back to ancient Mesopotamia. But they’re a discontinuous  time series—we have those records because they were written on clay  tablets, which were then baked because the city they were in was razed  to the ground. This typically results in a default with no recovery for  the creditor. Gold, though, is durable; in general, the gold we have  will last indefinitely, barring extreme events.[1]

There are roughly three ways to think about gold, two of which are fairly crazy, one of which is boring but sometimes useful.

Crazy View #1: Gold is (the only kind of) Money

Money is gold, and nothing else.

Money is a slippery concept. It’s a general agreement to treat a  fungible category of goods as though they are worth much more than they  really are, and, importantly, to treat them as a legal way to settle a  debt. Humans have used many kinds of money in the past: gold and silver,  of course, but also immovable stones, cowry shells,  Bitcoin, paper money, ledgers representing theoretical rights to paper  money, ledgers representing theoretical rights to Bitcoin, and of course  packets of mackerel from the prison commissary ($, WSJ).

Something is a good form of money if it’s readily divisible, easy to  move around, and hard to make more of. It’s a better source of money if  it’s not used for some other purpose, or rarely so, because this means  that savings don’t reduce the availability of any real-world goods. Gold  satisfies all of these criteria. When people start hoarding gold,  something interesting happens: gold becomes a better way to store  wealth. If gold is less prone to inflation than a cowry shell and easier  to transfer than a Rai stone, it’s more likely to become the default.  And once it’s the default, you know it’s the default. You buy it,  because other people buy it. That sounds like participating in a bubble,  and it is; money is, possibly by definition, the bubble that never  pops.[2]

Unfortunately, it has some obvious problems: it’s quite valuable in  inconveniently small amounts, so it’s hard to use gold for everyday  spending. (A gold coin the weight of a penny would be worth $164.) And  the difficulty of finding new gold, which makes gold a very durable  medium of savings, also means that the money supply in a country that  uses gold is inflexible.

Inflexible money supplies can be very helpful under some  circumstances. When governments are untrustworthy, for example, the  inability to produce more currency acts as a brake on their spending.  But it’s less useful for an expanding economy, where the demand for  money expands, too. England was on a gold standard starting in 1717, but  the amount of ostensibly gold-backed paper currency circulating there  was far higher than the Bank of England’s gold stocks. For example,  during the Napoleonic Wars, the Bank of England dramatically increased  the English money supply, but backed less than half of it with gold  reserves.

When gold standards are universal, this kind of thing is  self-correcting over time. A well-run central bank can extend credit a  bit beyond its reserves. If that credit leads to good investments, the  loans get paid off and the country prospers. If it leads to consumption,  that requires imports, which have to be paid for with gold. As gold  leaves the country, extending further loans gets difficult, so the bank  shrinks available credit. This tends to cause a quick and painful  recession, but in economies with little net borrowing and lots of  agricultural jobs as a labor market backstop, recessions hit hard and  end quickly.

But one thing this means is that as economic growth accelerates, and  as the economy gets more complicated, a gold standard is, increasingly, a  constraint. The First World War significantly weakened the gold  standard, and by the end of the Second, most of the world had switched  to a strange top-down system: most currencies were convertible into  dollars (at fixed prices) and dollars were convertible to gold (also at a  fixed price). Since dollars earned interest and gold didn’t, countries  wanted to accumulate dollars. But as the dollars outstanding exceeded  the gold backing them, those dollar holders got increasingly nervous.  This led to a long period of diplomatic and economic acrobatics  (summarized in  this subscribers-only post), which ultimately ended when the US left the gold standard in 1971.

Gold had been at a fixed price from 1933 to 1971, and inflation was  high and accelerating. Cutting off the dollar’s connection to gold led  to a spectacular bull market. Gold started 1970 at $35/oz, and in  January of 1980 it hit $850/oz, for a 37% compounded return over ten  years.

It subsequently crashed, and underperformed relative to other assets  over an extended period. Perhaps the most striking comparison is that  the Dow was at 860 when gold was at $850. Today, the Dow is at 29,483,  and gold is at $1,866. Four decades after the peak of the great  inflationary gold bubble, a gold investor is enjoying capital  appreciation close to what an equity investor had clocked in 1986,  ignoring dividends.

It has gotten increasingly difficult to argue that gold is the only  kind of money. If money constitutes something that can be readily  exchanged for goods and services, then gold is emphatically not money; the merchants who accept gold as payment are the ones in the business of exchanging gold for currencies people actually spend.

Any thesis that makes sense based on first principles but doesn’t make a practical profit will lead to two responses:

  1. Some people will decide that some of their first principles were wrong; they’ll take their losses and lick their wounds.
  2. Other people will decide that the prices are wrong, and come up with increasingly elaborate theories as to why.

Goldbugs are very well-informed, and have some completely deranged  views about central bankers, the media, other insufficiently pure  goldbugs, whether or not stated gold reserves are fictitious, whether or not prices are being manipulated etc. There is a lot of information out there on  what’s happening with gold prices and why at any given moment, but some  of it is based on pretty conspiratorial assumptions. The goldbugs have  had great moments, but over long periods, gold has been a poor asset to  own.

Crazy View #2: Gold is Worthless

If we restore the gold standard, are we to return also to  the pre-war conceptions of bank-rate, allowing the tides of gold to  play what tricks they like with the internal price-level, and abandoning  the attempt to moderate the disastrous influence of the credit-cycle on  the stability of prices and employment? Or are we to continue and  develop the experimental innovations of our present policy, ignoring the  “bank ration” and, if necessary, allowing unmoved a piling up of gold  reserves far beyond our requirements or their depletion far below them?  In truth, the gold standard is already a barbarous relic.
It gets dug out of the ground in Africa, or someplace.  Then we melt it down, dig another hole, bury it again and pay people to  stand around guarding it. It has no utility. Anyone watching from Mars  would be scratching their head.

A realistic definition of insanity is that it involves behaviors that  don’t make sense given one’s goals. But sensibility is in the eye of  the beholder, and goals have a funny way of getting redefined after the  fact. So a good working definition is that anyone who a)  behaves differently from other people, and b) attributes this to the  fact that everyone but them is crazy, is crazy.

For everyday behavior, “everyone” means everyone. In financial  markets, though, “everyone” means a dollar-weighted average opinion of  buyers and sellers who are active in a given market. Some investors buy and sell entirely  based on an independent evaluation of companies' prospects, but most try  to articulate the view they’re betting against. It’s not enough to buy  something cheap; it’s important to explain why it’s cheap, and why that explanation is wrong.

The view that gold is nonsensical has to argue against several  millennia of human beings all thinking gold is quite valuable indeed.  They might all have been wrong, but every time a new generation  arrives and the price of gold doesn’t collapse to nearly zero, it’s  Bayesian evidence that gold has value for a reason.

Like many other social phenomena, gold’s value starts with a kernel  of irrationality—someone valuing a shiny metal because it looks good—and  then proceeds from there to the schelling point of gold as a vehicle  for savings. It’s possible to design a better monetary system on a blank  sheet of paper, but money evolves just like every other institution,  and it’s subject to selection pressure, too. A new system can be  designed, but implementing it while the old system is still running is a  daunting challenge. Keynes was a genius, he surrounded himself with other geniuses, and when he and his fellow economists designed the postwar financial system, they had the advantage that the US had most of the world’s gold and almost as much of its industrial output, as well as the world’s strongest military and only superweapon. It was the best time in history to escape a local maximum and build a better system—and it didn’t work.

The Sane, Boring View

After the first Gulf War, sanctions prevented the Iraqi government  from printing its old currency. The country printed some new notes, but the old ones kept circulating, and appreciated relative to the new currency.

Gold is basically an Old Iraqi Dinar without the Iraq: it’s less liquid  than a currency, but has the currency-like characteristic that people  use it as a vehicle for savings. It also has the Old Iraqi Dinar-like  characteristic that it’s a currency whose supply is predictable, and  that doesn’t produce interest.

Ultimately, currency moves are driven by expectations about relative  real returns. Those real return expectations, in turn, are driven by a)  interest rates in a given currency, and b) inflation expectations. The  naive theory would be that every currency should have exactly the same  value for interest rate plus expected inflation. If a few years ago you earned 2% in  dollars and experienced 2% inflation, then a 15% interest rate for Turkish Lira  implied 15% inflation for the Lira. In practice, this is not always so;  higher-yielding currencies historically produced excess returns, with a bit more risk of sudden depreciation,  although in the post-crisis environment this was less straightforward.

Some currencies move in response to disasters. The Yen, for example,  tends to rally during crises, because Japan’s overseas investors  repatriate funds. Gold, too, moves in response to crises: during the  first Gulf War, its price rose 7% in a few days after the invasion of  Kuwait. Gold was up 5.5% on 9/11. And the day AIG was forcibly  recapitalized in September 2008 was one of gold’s best days ever, up  11%.

This has given gold a reputation as the asset to buy during a  disaster, but that’s a side effect. Gold is, much more prosaically, a  carry trade: a currency issued by a theoretical, abstract central bank  that keeps the money supply growing at a roughly fixed, very low rate of  about 1.6% per year. This central bank maintains a resolute 0% interest rate  policy. Most of the time, this makes gold a terrible currency, but when  inflation is high and rates are low, it’s a competitive one:

(In the chart above, I’m using a log scale for gold to make long-term trends visible. The most important thing to note is that gold outperforms when real rates—10-year treasury yields minus inflation—are negative.)

When real yields are below zero, gold is a high-yield currency. Imagine, earning an almost-0% return after inflation on your savings!

There are good reasons to expect a negative real rates environment in the next few years. The Federal Reserve has promised to keep rates low for as long as it takes to achieve full employment, even tolerating higher inflation along the way. Unemployment is falling, but current stats also include a two point  reduction in the unemployment rate from people who have left the workforce,  and the pre-Covid economy was able to sustain surprisingly long gains  in employment. So that takes care of the  “rates” part.

The “real” part is  up to deferred consumption, fiscal policy, and vaccines: US  consumers have, since the start of the Covid Crisis, paid down credit  card debt and home equity loans, and saved money at all-time highs. Some  kinds of consumption have been voluntarily reduced, and other kinds are  impossible. But there’s clearly pent-up demand; every quarter, cruise  lines talk about how a) they are currently bleeding money, because they  still have expenses but can’t carry passengers due to plague, and b)  passengers are buying tickets for future sailings. Restaurants, bars,  theaters—all of them have immense pent-up demand. And that ignores the growing possibility of a CARES Act follow-up that would provide more immediate relief and increase the post-vaccine consumption boom.

If gold were a crisis asset, then vaccines and a spending bill would  be bad for gold. But since gold is a real-rates asset, it is, at the  moment, a bet on technocracy: a bet that governments will use fiscal  policy to aggressively manage the economy, that the Federal Reserve will  decide to reinterpret its own mandate, and of course that the  healthcare and logistics industries will get hundreds of millions of  vaccine doses delivered on time. It’s a bet that the world’s experts will go to extraordinary lengths to make life ordinary again for everyone else.

Does it make sense to be bullish on technocracy? I’d argue that it  does. The Trump administration widened the Overton Window with respect  to what the executive branch can claim it will do, but many of  those aggressive, norms-busting promises were not actually implemented.  How you explain this depends on your personal partisan alignment: on the  right, you might say that Trump was facing off against the Deep State;  on the left, you might say that he did not have a large enough group of  competent, institutionally-savvy civil servants who were willing to implement his  goals. From a non-partisan perspective, it’s crucial to point out that these are exactly the same critique:  a deep state can only thwart someone if it’s full of people who know  how a given department works, can make that department do what the  President says, and… don’t. Different connotation, same denotation.

In that model, a Biden administration has a wider range of options,  and is more likely to achieve its goals. One of those goals is to get  through the remainder of the Covid-19 epidemic with a minimal loss of a)  lives, and b) economic output. And the way to do that is to  combine more restrictions on potentially infectious behavior with more  transfer payments to offset the attendant loss of income.

Asset allocation is, among many other things, the art of teleporting  purchasing power into the future. Each asset class is a teleporter  with  different specs. Stocks are a better purchasing power teleportation  machine when growth is high and the timeline is long; bonds are best in  deflationary or at least disinflationary environments. And when rates  are low, but there’s accumulated spending to do, gold becomes the  purchasing-power teleporter of choice.

[1] The two historical big ones are 1) since gold is malleable, coins  that are in frequent use will wear down over the centuries, and 2)  Georgy de Hevesy dissolved two gold Nobel Prize medals in acid to hide them from the Nazis in 1940.

[2] This argument has been approximated in various places, but I first saw it made compellingly here.

Further reading: The Power of Gold is a good general history of gold and its obsessions, and the historical anecdotes above draw heavily on it. This essay  turned out to be wrong, at least so far, but has many provocative  ideas. “Money is the bubble that never pops” is useful in a variety of  contexts.

Disclosure: I’m long gold, and this post is not investment  advice. Please do your own research—as long as you promise to tell me  what I got wrong.

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Bitcoin, Flows, Autochthony

Bitcoin’s price movements are a mystery. It’s a volatile asset, and  there’s continuous demand for sensible explanations for any given price  movement. (The general explanation is that Bitcoin is a very  low-probability bet on a potential reserve asset, and since the odds of  it functioning as a reserve asset are positively correlated with price,  it’s prone to bubbles.) Sometimes, though, there’s a (relatively)  real-world explanation for why the price has risen. FT Alphaville compiles evidence  that the most recent run-up—Bitcoin is up 57% in the last month, and  close to an all-time high—is due to Paypal allowing users to purchase  Bitcoin.

This is an odd echo of Paypal’s early pitch, which was to create a  digital, inflation-proof currency that could be used to avoid  inflationary crises. The carrot of consumer demand and the stick of  regulation pushed Paypal into offering e-commerce payments instead of  insurgent savings accounts, but a few decades later they’ve returned to  form.

(Disclosure: I’m long Bitcoin.)

Digital Media, Distribution, Autochthony

Buzzfeed, whose founder and CEO previously co-founded HuffPo, has acquired HuffPo ($, WSJ). Buzzfeed’s Jonah Peretti has previously argued that digital media companies need to consolidate to survive, but the companies plan to operate independently for now, which will mute the economic benefits of consolidation, except on the ad sales side.  Consolidation among clickbait media companies is a similar phenomenon  to the roll-ups of Amazon third-party retailers: relying on a massive  external distribution platform like Facebook/Twitter/Google is a great  way to grow fast, but a terrible way to achieve any kind of stability,  so it’s optimal for any given media company to make diversified bets.

Leaving “Little Taipei”

If it didn’t involve the hypothetical risk of nuclear war, the  relationship between China and Taiwan would be the international  relations equivalent of a sitcom: China formally denies that Taiwan as a  country exists, but grew its economy through direct investment from  Taiwanese companies:

Today three of China’s 12 most popular consumer-goods  brands by revenue are Taiwanese. Chinese gobble up Master Kong instant  noodles, Want Want rice crackers and Uni-President juices. Apple’s three  biggest China-based suppliers—Foxconn, Pegatron and Wistron—are all  Taiwanese.

That relationship is fraying ($, Economist),  both because of that geopolitical risk and for more economic reasons.  This is part of a larger trend: as operating in China has gotten more  expensive, manufacturers who moved there for cost reasons are  considering where to move next. The timing isn’t urgent; profitability  is down, but not negative. Geopolitical risk, though, makes a “some time  in the next few years” decision more urgent.


In 2019, the cruise ship assembly business was booming, with a record-setting 117-ship backlog through 2027. This year, the cruise ship disassembly business is hot ($, WSJ):

Ten cruise ships were sent to recycling this year after nine were demolished over the previous two years combined.

Shipping in general is one of those frustratingly cyclical businesses  where capacity is ordered years in advance, so record increases in  capacity happen after peak demand. (This dynamic shows up in  other fields, too; petroleum engineering degrees granted usually peaks  about two years after oil prices in each cycle.) When cyclical companies  are undercapitalized, recoveries are slow; they can sell enough  capacity to service debts but not turn a profit, and that’s what they  do. What’s unique about the Covid recession is how abundant capital is;  cruise lines have enough access to funding that they can afford to ditch  their lowest-ROI ships, meaning that the industry can return to  supply-demand balance faster than in a typical recession.