It's the environment, stupid.

Jack Nicholson’s character in The Departed has a brilliant (albeit flawed) quote: “I don't want to be a product of my environment. I want my environment to be a product of me”.  The environment (as in the state of affairs of the world -not in a Greenpeace sense) is a critical component in understanding asset price bubbles: a shock to the environment might have a repercussion in the markets.  Let’s get a bit more technical and call this environmental shock “exogenous”.

An exogenous shock might be something like an epidemic sweeping through society; the bubonic plague appears to have been an important factor that contributed to the tulip mania in the Netherlands (Garber, 2000).  The exogenous shock of technological innovation – whether in the form of railways (Campbell and Turner, 2012) or the advent of the world wide web (Shiller, 2000) - has been identified as a critical factor in stock market bubbles of certain industries over the centuries.

Not this environment! (photograph permitted under the Creative
Commons Attribution Share - Alike 3.0 Unreported License)

What’s been happening in the world of gold then?  Take two rather basic but fundamental assumptions. First, recall that there is only a finite amount of gold on the planet, and this has to be mined.  We therefore have limited supply of this asset – Forbes notes the amount of gold could be filled into a couple of Olympic sized swimming pools (yes, that's right - just a couple of swimming pools!).  Gold is therefore seen as a nice hedge against inflation, given its supply is fixed (Ghosh, Levin, MacMilan, and Wright, 2004). 

Second, Gold has had the moniker of being a “safe haven” for when times are stormy in the global economy (Rogers, 2005, for example).  People flock to gold as a shelter from market turmoil or downturns.  Given today’s Eurozone GDP figures, it looks pretty bleak out in the real world.  Linked with these two points, in an attempt to trade their way out of recession, many countries appear to be embarking on a currency war to devalue their currency to aid the increase of exports (Stephanie Flanders from the BBC has a good introduction to this).

Might the fact that there is only a finite amount of gold, and the persistent global economic downturn be the requisite environmental exogenous shock that indicates a bubble is present in gold?  Hold that thought, as the next post considers what mechanism might translate this environmental exogenous shock into price movements of an asset.