Warren Buffett: What’s So Great About Gold?

Gold coins and ingotsWarren Buffett, in a recent article in Fortune (“Warren Buffett: Why stocks beat gold and bonds,” 9 Feb 2012), identifies three major categories of investments — currency-based investments, sterile assets, and productive assets.

In his article, Buffett makes some comments about gold that are sure to be controversial. He classifies gold under the category of sterile assets — “assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future.” (Photo: Linked from Buy Silver Gold)

Then he goes on to write,

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth — for a while.

He then goes on to draw a contrast between the investment value of today’s $9.6 trillion of gold and an equivalent amount of truly productive assets. With that same $9.6 trillion, he says, “we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge)” — a set of investments much more likely to produce value in the future than that big block of gold.

I’m certain there are good arguments against it, but I find his reasoning sensible and interesting. He also refers to the 17th-century tulip bubble, which I have written about previously — see “The ‘Tulip Mania’ Economic Bubble: Source of a Myth?

AB — 10 February 2012

The Astonishing $600 Trillion Interest-Rate Derivatives Market

A post from April 21, 2010 on Washington’s Blog calls derivatives “the world’s largest market, dwarfing the size of the bond market and world’s real economy” and says that the derivatives market “is currently at around $600 trillion or so (in gross nominal value).” — See “Are Interest Rate Derivatives a Ticking Time Bomb?

In contrast, Washington says that the worldwide bond market in 2009 was $82.2 trillion and the world economy was $58.07 trillion.

The most popular derivative, he says, are interest rate derivatives, in which “the underlying asset is the right to pay or receive a notional amount of money at a given interest rate,” according to the Wikipedia definition of interest rate derivative.

Washington quotes various economists to demonstrate why such derivatives have the potential to seriously destabilize the world economy (which we all know is so solid right now). He includes a long quote from portfolio manager Doug Noland, who compares interest rate derivatives with the so-called “portfolio insurance” that played a role in the stock-market crash of 1987.

One proponent of portfolio insurance is cited as making this breathtaking statement in 1985:

[I]t doesn’t matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost.

About interest rate derivatives,Washington believes:

[N]o one – even the people that design, sell or write about the various interest rate derivatives – really knows how much of a danger they do or don’t pose to the overall economy. In addition to all of the other complexities of the instruments, the very size of the market is unprecedented.

AB — 22 April 2010

Defining Asset Bubbles

Here is an interesting interview with Jeremy Grantham of investment firm GMO, discussing asset bubbles, what they are, and how they should affect investment decisions.

Economist Edward Harrison at Naked Capitalism adds some analysis and explanation in his post “Jeremy Grantham on Bubbles.” Harrison’s “informal working definition of a bubble is “a price rise that is at least two standard deviations above trend.” He says that

Above two-standard deviations the psychology of prior price movements starts to dominate price activity and a bubble forms in which power law characteristics come into play.

In “power law” relationships, a quantity varies more than you should expect. It kind of refers to the “tall head” part of a distribution graph, the opposite of the “long tail.”

AB — 21 April 2010

‘Life Inc.’ author Douglas Rushkoff on Colbert Report

Douglas Rushkoff, who writes about media and popular culture, appeared July 15, 2009, on The Colbert Report. Rushkoff is currently promoting his new book, Life Inc.: How the World Became a Corporation and How to Take it Back.

Rushkoff does a great job explaining the premise of his book, which is that corporations are only happy when individuals are contributing to the GDP, which is why they are always bugging us to do something productive rather than something useless like, for example, going out and watching birds.

As always, Colbert does a great job of helping Rushkoff explain his book by pretending not to like it. Here’s a link to the video — it’s a great six minutes.

AB — 17 July 2009

Do happy faces cause dumb investments?

Could an investor be prompted to make a more risky financial decision when exposed to positive, optimistic stimuli, such as a smile on the face of someone recommending or selling an investment?

That’s the implication of research by Julie L. Hall, a doctoral student in personality and social psychology in the Cognitive Science & Cognitive Neuroscience Program at the University of Michigan.

Hall and colleagues studied investment decisions made by 24 research subjects during a market simulation game. Some choices were high-risk and some were low-risk. Participants were shown pictures of happy, angry, or neutral faces before they carried out investment decison-making tasks.

Researchers also used fMRI (functional magnetic resonance imaging) during the tasks to see which areas of the brain “lit up” while participants were deciding which investments to follow.

Writing for New Scientist, Peter Aldhous describes how the game was set up (“Cheery Traders May Encourage Risk Taking,” April 7, 2009):

For every round of the game, the bond paid out $3. One of the stocks paid out $5 half of the time, while the other lost $5 at the same rate. At the start of the game, the players were told the rules but didn’t know which of the stocks was good and which was bad: that only emerged as the game unfolded. As with real-world investments, the good stock became bad at certain points during the game, and vice versa.

As Hall and colleagues anticipated, the positive stimuli caused increased activity in areas of the brain associated with anticipation of a reward and correlated with risky decision-making.

In introductory material to her March 23, 2009, presentation at the annual meeting of the Cognitive Neuroscience Society (“Put Your Money Where Your Heart Is: An fMRI Investigation of Affective Influences on Financial Investment Decisions,” Julie L. Hall, Richard Gonzalez, Oliver C. Schultheiss, Cognitive Neuroscience Society Annual Meeting Program 2009):

As predicted, participants showed greater NAcc activation and were more likely to make risky investment decisions after happy versus neutral face primes in both the subliminal and supraliminal presentation conditions. In addition, participants also showed greater anterior insula activation and made slightly less risky investment decisions after angry versus neutral face primes during supraliminal presentation conditions.

Hall concludes that

… facial expressions of emotion, even when they are not consciously perceived, can influence investment decisions and suggest that the inclusion of affect may lead to more accurate models of economic decision making, which better explain irrational financial behavior. They also suggest that affective states during pre-choice stages of the decision making process may alter the perception of benefits relative to costs, leading to changes in financial risk taking depending on whether the affective state is positive or negative.

Brian Knutson, a psychologist at Stanford University, has done similar research. He acknowledges, writes Aldhous, that “it is hard to determine the extent to which real financial markets are driven by similar emotional factors.”

However, Knutson has found that “the nucleus accumbens,” the brain area associated with risky investment decisions, “is activated when we are anticipating a reward.” For example, “showing men erotic pictures leads to similarly risky investment decisions.”

This fits with the Bubbleconomics proposition that infectious optimism contributes to economic bubbles and to the disastrous results.

Hall tells Adhous,

When risk-taking is a good thing, it’s good to be in a positive mood. When risk-taking is a bad thing, it’s not good.

AB — 7 April 2009

The “Tulip Mania” Economic Bubble: Source of a Myth?

One often-cited historical example of an economic bubble is the “Tulip Mania” phenomenon of the 1600s, famous especially for the problems it created in Holland. The story goes that in the 16th century, tulips were introduced to Europe from Turkey andover time  become the object of a speculative bubble that collapsed in 1637, ruining many people in the process.

The Wikipedia entry on Tulip mania says that “the modern discussion of tulip mania began with the book Extraordinary Popular Delusions and the Madness of Crowds, published in 1841 by the Scottish journalist Charles Mackay.”

The Wikipedia article calls McKay’s account “popular but flawed” and says that “since the 1980s economists have debunked many aspects of his account.” McKay’s account traces back to a 1797 book by Johann Beckmann, A History of Inventions, Discoveries, and Origins.

The article says that both Beckmann and McKay’s accounts are “primarily sourced to three anonymous pamphlets published in 1637 with an anti-speculative agenda.”

The chapter on “Tulipomania” from McKay’s Extraordinary Popular Delusions and the Madness of Crowds can be found at this link on the online text archive Project Gutenberg.

Speaking of the tulip bubble, McKay writes that:

In 1634, the rage among the Dutch to possess [tulip bulbs] was so great that the ordinary industry of the country was neglected, and the population, even to its lowest dregs, embarked in the tulip trade. As the mania increased, prices augmented, until, in the year 1635, many persons were known to invest a fortune of 100,000 florins [guilders] in the purchase of forty roots.

In modern terms, it’s a little hard to judge the extent of the bubble described here, but McKay does present a list of items and their values in florins that were supposedly exchanged for just one root of the rare Viceroy tulip species:

Two lasts of wheat — 448
Four lasts of rye — 558
Four fat oxen — 480
Eight fat swine — 240
Twelve fat sheep — 120
Two hogsheads of wine — 70
Four tuns of beer — 32
Two tuns of butter — 192
One thousand lbs. of cheese — 120
A complete bed — 100
A suit of clothes — 80
A silver drinking-cup — 60

Total: 2500 florins

Rampant speculation on the value of rare tulip species resulted in the establishment of formal markets for their sale, says McKay:

The tulip-jobbers speculated in the rise and fall of the tulip stocks, and made large profits by buying when prices fell, and selling out when they rose. Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and one after the other, they rushed to the tulip-marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them.

Speculation also took hold among the laity:

Nobles, citizens, farmers, mechanics, sea-men, footmen, maid-servants, even chimney-sweeps and old clothes-women, dabbled in tulips. People of all grades converted their property into cash, and invested it in flowers. Houses and lands were offered for sale at ruinously low prices, or assigned in payment of bargains made at the tulip-mart. Foreigners became smitten with the same frenzy, and money poured into Holland from all directions.

When the bubble finally collapsed in 1637, McKay writes, “prices fell, and never rose again. Confidence was destroyed, and a universal panic seized upon the dealers.”

In the light of recent revelations about the perverse compensation system in today’s financial services industry (see “Should banking execs get paid a lot?”), it’s interesting to note what McKay says about the way in which some speculators managed to walk away unscathed while many suffered ruin:

Hundreds who, a few months previously, had begun to doubt that there was such a thing as poverty in the land, suddenly found themselves the possessors of a few bulbs, which nobody would buy, even though they offered them at one quarter of the sums they had paid for them. The cry of distress resounded every where, and each man accused his neighbour. The few who had contrived to enrich themselves hid their wealth from the knowledge of their fellow-citizens, and invested it in the English or other funds. [Italics ours.] Many who, for a brief season, had emerged from the humbler walks of life, were cast back into their original obscurity. Substantial merchants were reduced almost to beggary, and many a representative of a noble line saw the fortunes of his house ruined beyond redemption.

As mentioned above, modern scholarship has revealed some deficiencies in the received version of the Tulip Mania case study. We will plan on taking a closer look at those criticisms in future posts.

AB — 2 April 2009

The Market Religion

A recent article by Time columnist James Poniewozik highlights “The Market” as the focus of ideology, especially as expressed by commentators on financial cable network CNBC. (See CNBC Under Fire: Sticking Up for the Big Guy?):


… CNBC looks at everything, particularly politics, in terms of how it will affect “the Market.” The commentators on CNBC murmur about the Market as if it were the Island on Lost: a mystic force that must be placated, lest it become angry and punish us. “The Market doesn’t like …” “What the Market wants to see is …”

And, oooh, is the Market cranky at Obama! The Market doesn’t like raising taxes on the wealthy (even if [Warren] Buffett does). The Market doesn’t like government health-care reform or cap-and-trade environmental policy or big budgets or limiting bonuses at bailed-out banks. And don’t get the Market started on bank nationalization. That ticks the Market off!

From the Bubbleconomics point of view, I would suggest that this kind of religious fervor about markets plays a role in the formation of economic bubbles at all levels. It reminds me of one of the oversimplifications that come up in discussions of intelligent design: A given condition exists, therefore the believer thinks God must have made it.

But simply because markets can offer certain benefits in some circumstances, it doesn’t follow that they should be trusted blindly as if they were one of the marvelous creations of the Deity. The greater Market is just a function or outgrowth of the human civilization we live in. While it is true that the whole is greater than the sum of its parts, that doesn’t mean that the whole is somehow naturally virtuous.

AB — 23 March 2009