The key word here is 'uncertainty.' The thing about political uncertainty is that it cannot be quantified. Whereas we can, roughly, assign a probability to the danger of share prices falling, we cannot assign probabilities to political uncertainty. What will happen to the US fiscal cliff? Will euro area governments take the measures needed to create a fiscal union that saves the euro for good? We can tell stories here - or construct scenarios - but it's not obvious that it's sensible to assign numerical probabilities to them.
What we have here is a distinction between risk - what Donald Rumsfeld famously called "known unknowns" - and uncertainty, or unknown unknowns. This matters, because the old cliché that investors hate uncertainty is very true, and it matters for asset prices.
The way it does so was first expressed formally in 1961 by Daniel Ellsberg, then at the Rand Corporation. When there's just risk and no uncertainty, he said, we simply try to maximise risk-adjusted returns. But as uncertainty increases, we supplement this rule by the minimax principle - we try to minimize the maximum possible loss. And this helps justify the popularity of gold.
Take the US's fiscal cliff. The worst outcome for equities here is that fiscal policy does tighten, plunging the economy into recession. The worst outcome for bonds is that Congress agrees to prolong the tax cuts, which would extend budget deficits into the distant future; with such deficits being partly monetised by QE, this could be inflationary. But what’s the worst outcome for gold? It’s much less obvious. The minimax rule thus suggests avoiding bonds and equities but holding gold.
Or consider the euro crisis. The worst case for equities is that popular opposition to austerity in southern Europe leads to some countries leaving the euro, which would impose huge losses onto banks, thus clobbering the economy and stock markets. The worst outcome for northern European bonds is that governments agree to a fiscal union involving a German fiscal expansion and a guarantee of southern European debt. This would force down bund prices as they lose their scarcity value. But again, it's not easy to see gold being clobbered, and so the minimax rule recommends gold ahead of bonds or shares.
This thinking suggests another way in which quantitative easing is good for gold. For equities, the worst case here is that QE fails to boost the economy, either because it is a mere 'asset swap', an exchange of cash for close substitutes, or because it isn't powerful enough to combat the forces depressing economic growth. For bonds, the worst-case is that these sell off either because QE does prove inflationary, or because it succeeds in bolstering economic growth which leads investors to sell bonds to buy equities. Again, though, it's not obvious how gold can lose heavily, so it is attractive to investors seeking a maximin asset.
Uncertainty - as distinct from risk - is therefore good for gold. It is a minimax asset, as it offers protection from worst-case outcomes. Of course, this is not the only reason why gold is so high - but it is another one.
This is nothing new. Dirk Baur of the University of Technology, Sydney points out that gold has benefited in the past from outbreaks of uncertainty, such as in the immediate aftermath of the 9/11 attacks and the collapse of Lehman Brothers.
Herein lies both a justification for holding gold and two dangers. The justification is that gold deserves a bigger place in portfolios than conventional mean-variance analysis gives it because it offers protection against increases in uncertainty which raise demand for a minimax asset. And such increases are inherently unpredictable, as they often arise from 'black swan'-type events.
Normally, however, insurance comes at a price. Economic theory tells us this price is low returns; safe haven assets should offer lower returns than riskier ones. There's a danger that this could be especially true in coming months. If uncertainty recedes - and the question of the US’s fiscal cliff should be resolved within the next four months - then (ceteris paribus) gold could fall as maximin demand for it declines.
