Gold as a hedge

If you thought gold was a sure-fire winner from loose monetary policy, the last few months have been a nasty surprise. Since early September, gold has lost over $200/oz – a fall of over 11 per cent. This has come despite the fact that the Bank of England and (in effect) ECB have been printing money, and despite the US Federal Reserve’s pledge to keep interest rates at nugatory levels for many months.

Paradoxically, though, this fall does not mean that gold is a lousy investment. Quite the opposite. It highlights a virtue of the metal.

Perhaps the biggest development since early September has been a decline in uncertainty. Back then, there was a possibility that the euro area’s debt crisis might have triggered another financial crisis of the sort we saw in 2008 when Lehmans’ collapsed. Investors flocked to gold as a safe haven against this danger. Since then, though, the danger is thought to have receded – and so safe haven demand for gold has fallen.

And here’s the key point. That possibility of a crisis was fundamentally unquantifiable. It was an example of heightened Knightian uncertainty or ambiguity – of what former US Defense Secretary Donald Rumsfeld called an “unknown unknown.”

In this sense, there is a sharp distinction between uncertainty and risk. The former cannot be quantified. The latter can; this is what the Vix index does.

And this is where gold’s merit lies. A new paper by Dirk Baur of the University of Technology, Sydney and Thomas McDermott of Trinity College, Dublin points out that gold is a safe haven not so much against risk – government bonds are that – but against uncertainty. For example, gold did well immediately after 9/11 and during the collapse of Lehmans – two events which generated large uncertainty.

There’s a reason for this. During times of genuine uncertainty, investors’ attention shifts to the worst-case scenario. And the worst case for gold is generally better than the worst case for equities or bonds. Individual shares can be wiped out completely. Bonds can suffer large default or currency losses. But gold’s worst case isn’t so disastrous – at least over shorter time horizons. Hence its appeal in times of crisis.

And hence its recent fall – because investors believe that uncertainty has receded.

But this is why gold is worth holding. There’s a danger – unquantifiable by definition – that some unpredictable event (so called “black swans”) will cause uncertainty to rise again. If it does, gold could win.

However, this justifies only quite small holdings of gold. This is partly because the danger of high uncertainty might be small; crises don’t happen very often. But it’s also because one such unpredictable event might be investors' further disillusionment with gold. As Messrs Baur and McDermott write: “a “bubble” in safe haven asset values, could turn out to be the next black swan event.”

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