DAVID KESTENBAUM, HOST:
Is there someone here who can tell us if gold is in a bubble or not?
JOHN DOODY: Gold is not in a bubble until everybody owns it, and that's a long way away.
KESTENBAUM: What about this though? Look at that? It's going up, up, up, up.
DOODY: So what? Look at that.
KESTENBAUM: What would be too high? When would you say it was a bubble?
DOODY: I don't know. It will never cease to be too high as long as you continue to - hey, listen, I'm the guy with a place in Saint Bart. Where do you live?
(SOUNDBITE OF SONG, "KING OF DIAMONDS")
MOTOPONY: (Singing) I've been looking for the king of diamonds, but I guess the queen will do.
JACOB GOLDSTEIN, HOST:
Hello, and welcome to PLANET MONEY. I'm Jacob Goldstein.
KESTENBAUM: And I'm David Kestenbaum. Today is Tuesday, May 17. At the top there, I was talking to John Doody, editor of Gold Stock Analyst newsletter. Just to answer his question, I live in a one-bedroom walkup in Brooklyn.
GOLDSTEIN: But, David, Saint Bart may be in our future. Today on the podcast, we sell that gold coin we bought last fall and we find out how much money we made.
KESTENBAUM: Or lost. And on the way, we learn a lot about bubbles.
GOLDSTEIN: But first, David, let me give you the indicator.
KESTENBAUM: All right.
GOLDSTEIN: Today's PLANET MONEY indicator - 6.6 billion. The state of California, it's going to bring in $6.6 billion more in taxes than it originally thought.
KESTENBAUM: Woo hoo.
GOLDSTEIN: You're very excited today. I like that.
GOLDSTEIN: Yeah. So that's a new estimate out from the governor's office this week. And we're sort of hearing that from around the country, actually. Just today, there's this report out of New Jersey, there's another new one out of Michigan that both states are on track to bring in more in taxes than they expected.
KESTENBAUM: All right. I got two questions for you. One is that unemployment in this country's still really high. That hasn't really budged. Those people aren't now just starting to pay income tax. So where's the money coming from?
GOLDSTEIN: Basically, it's coming from rich people. In particular, it's coming from capital gains tax. So what that is is when you have an investment, like, say a stock. You buy a stock, the price goes up and you sell it. You make a profit on your investment. You have to pay capital gains tax. And that tends to be disproportionately rich people who pay that. So when the stock market goes down, people aren't making money on their investments, states get totally hammered. And that is what happened during the crisis. But now the stock market is coming back. So states are seeing their tax revenues, largely, capital gains tax revenues coming back.
KESTENBAUM: All right. Question two. You said $6.6 billion in additional revenue for California. That sounds like a lot of money. But California's a huge state. It is in huge budget trouble. I can't imagine this is going to fix the problem.
GOLDSTEIN: No, that's true. It's still in budget trouble. It's, like, slightly less horrible than they thought it was going to be. And this too is broadly true around the country. I dug up this report that's pretty useful. It's from the National Conference of State Legislatures. And basically, what it said is 21 states are actually on track this year to bring in more income tax revenues than they predicted. Only three are on track to bring in less in taxes. But at the same time, states are still not back to where they were before the recession several years ago. According to that same report, only two states expect their tax collections to return to the peak levels this year. Everybody else is still playing catch up.
KESTENBAUM: Thanks very much.
KESTENBAUM: So today, we have the final installment of our gold series. And just a recap for a second, we decided to buy gold, a gold coin after our toxic asset investment. We spent $1,000 of our own money on a toxic asset. We lost half of the money. And then, you, Jacob, pitched this new project to the PLANET MONEY team. Previously, on PLANET MONEY.
(SOUNDBITE OF ARCHIVED BROADCAST)
GOLDSTEIN: So look, I have a proposition, basically. I want you to take that money right now put it in my hand because I have what for all of history has been the very definition of a sound investment, gold.
UNIDENTIFIED PERSON: Gold?
GOLDSTEIN: One word.
UNIDENTIFIED PERSON: And you're going to bring in gold? We're going to see the gold?
GOLDSTEIN: We're going to have what you call a gold.
UNIDENTIFIED PERSON: And - wait. So gold is at incredibly, unusually high rates right now. What likelihood is there that it will increase above these incredibly high bubble-like rates?
GOLDSTEIN: You know, to tell you the truth, that's what me and Kestenbaum want to figure out.
KESTENBAUM: So that is the question we're going to tackle today before we say goodbye to our small shiny beautiful very expensive coin. Is gold in a bubble? You know, we talk about bubbles all the time. You know, the dot com bubble, the housing bubble.
GOLDSTEIN: Right. But when you start to look at sort of basic economic theory you see this really weird thing. It essentially says bubbles are impossible. They should not happen. We talked about this issue with Tim Harford. He's an author and an economist.
TIM HARFORD: The basic idea is why would you have a bubble because why would anybody buy an asset whose price was obviously overinflated? And even if you did buy an asset whose price was overinflated, then you're obviously an idiot. And idiots are not likely to have a lot of money for a long time. Whereas, the smart people who realize the asset is - has an inflated price. They're going to sell it to you, they're going to make lots of money.
So in the end, even if some people are idiots in the first place, pretty soon the idiots will be out of the market. And the market will be full of smart people with lots of money. And you won't have any bubbles. Now clearly, we seem to have bubbles. But that's the basic story that economists tell. And that's why it's a little surprising that we have bubbles.
GOLDSTEIN: So you're saying if we assume, as economists tend to do, that the world is rational, bubbles basically shouldn't exist or they shouldn't be very big. They should go away really fast if they start to exist.
HARFORD: Yeah, they shouldn't exist. They should go away fast. And even if people aren't rational, you would expect the more rational people to have more money. So it's called the weight of money argument, I think.
KESTENBAUM: So this is a problem. Theory says bubbles should not exist. It seems pretty clear something like a bubble exists.
GOLDSTEIN: (Laughter) Right, there is the word bubble.
KESTENBAUM: We do have a word, so we're clearly implying that we mean something by the word, right?
GOLDSTEIN: It feels right.
KESTENBAUM: It feels right. But we really need a definition for a bubble, right? And we've been asking this kind of simple, kind of deep question, you know, what is a bubble? But turns out defining it is really tough.
RICHARD THALER: Actually, let me give you a story that ends with a definition of a bubble.
GOLDSTEIN: This is Richard Thaler. He's an economist at the University of Chicago. And his specialty is behavioral economics which is a part of economics that's particularly relevant here.
THALER: I periodically give talks to groups of finance practitioners. So during the '90s - the late '90s when I was asked to give one of those talks I had a standard question. I said here's a list of five internet stocks Amazon, eBay, AOL.
GOLDSTEIN: This is in the middle of the dot-com bubble and Thaler says to these finance experts, if I give you $1,000 and you invest that money in these tech stocks, how much value do you think you've got for your $1,000?
THALER: Well, the median answer was 50 cents on the dollar. They thought they were getting $500 worth of value for their $1,000 investment in these internet stocks. Then I'd ask a second question which is what do you think is going to happen to that portfolio over the next six months. And the average answer was up 20 percent. That is a bubble. (Laughter) So to be clear, when most market participants think we have an asset that's selling for twice as much as it should but we expect it to go up, that's a bubble.
GOLDSTEIN: And you can see why a lot of people might be skeptical that bubbles could form in the first place. If everyone thinks Internet stocks are already overvalued, why do they think they're going to keep going up?
KESTENBAUM: It turns out there are researchers trying to figure out what's going on in bubbles like this. Trying to recreate bubbles without destroying the global economy, trying to do it in a safe environment, a university using students as traders and real money.
ARLINGTON WILLIAMS: So I've got a big wad of about $400 in cash in my satchel. And I hope to give it to these traders in about - probably in about three and a half hours from now.
GOLDSTEIN: This is Arly Williams. He's an economist at Indiana University. And he helped run one of the first of these experiments back in the 1980s.
KESTENBAUM: Going in was it like, oh, we're going to be able to do this or...
WILLIAMS: Our thinking going in was we might be able to do it. I thought we would see bubbles but very infrequently.
KESTENBAUM: So in the lab they set up the world's simplest stock market. There's just one stock to trade and it's pretty easy to figure out what the right price for it should be. At the end of every trading round, the stock pays a dividend. And it's randomly going to be either say $0 or $2. So you know that on average it's going to give you $1. So if there are 10 rounds left in game the stock should be worth about $10.
And this may sound like a lot to keep in your head. But in the lab, they make it super easy. There's a computer screen that says clearly, this stock should be worth $10 or this stock should be worth $5 or whatever. And yet, they get bubbles. The stock will shoot up way over the rational value, sometimes beyond what it could possibly even be worth. And then, it crashes. And Arly says it doesn't just happen occasionally.
WILLIAMS: Probably 90 percent of the time when you take people and put them in one of these markets for the first time, you will see a speculative bubble and crash relative to this kind of well-defined notion of the underlying dividend value of a share of the stock.
GOLDSTEIN: In fact, sometimes in class in the middle of one of these experiments in the middle of a bubble, he'll stop and point out to students the insanity of what they're doing.
WILLIAMS: Say, OK. Now right now, the fundamental dividend value of the share is $8. And look at this graph. You know, you're trading shares right now at $14. What do you think about this?
WILLIAMS: And, you know, the first time I ran this with a big class there - it was a double-decker auditorium. And, you know, I had this digital projection of the actual price of the shares of stock versus the theoretic price. And I thought this is going to just destroy this market. I mean, it's going to crash back down to fundamental value instantly. And then went back to my office and fired up my computer and went in to see what was going on. And the price for the next two trading rounds and trading rounds there lasted three and a half days. But for the next two trading rounds, prices went up even farther.
WILLIAMS: And so showing people basically that the market was in a price bubble just fueled the price bubble even more.
KESTENBAUM: So basically with that class you said, hey, look, there's this huge bubble. And rationally, what should happen then is the bubble should burst, that should be the end of it. But instead, everybody's just like, oh, my God, there's a bubble. I've got to get in on it. Buy, buy, buy.
WILLIAMS: That's precisely what happens.
KESTENBAUM: I asked Arly what is going on in their heads. You've got the students there, ask them. He says asking the students is not much help.
WILLIAMS: They are typically unable to in any concise way articulate what it is that they're doing.
WILLIAMS: Now, I - you know, I'm not sure - that may hearken back to the sophistication of the traders. But they'll just say things, like, you know, it seemed to me the last round the price went up. And, you know, the dividends probably going to be pretty high. So I thought I'd buy some shares.
GOLDSTEIN: The first experiments they did were with undergrads, but then they went on to MBA students. They even tried it once with actual traders in Chicago. And again and again, they saw the same thing. A bubble and a crash. But just like in the real world, it's really hard to predict what the bubble is going to do or when it's going to crash.
WILLIAMS: So I see the bubble start. And I go, OK. Here we go. But I really don't understand how big the bubble is going to be and how long it's going to last.
GOLDSTEIN: Now obviously, these are experiments in a lab. People aren't using their own money. And it turns out if you play the game a bunch of times with the same people, they figure it out. The bubbles start to go away. But still all these experiments do seem to capture this basic fact. We see bubbles in the real world even though they don't make any sense. So why is that?
KESTENBAUM: One explanation is something called the Greater Fool Theory. Basically, people are buying not because they think the stock is worth what it's being sold but because the price has been going up and up and up. And they figure they can sell it to someone, some greater fool for more money. You can also call this momentum trading. People who try to ride the bubble sell at the peak and make money from it before it pops.
GOLDSTEIN: And then on top of that, in the real world, there are lots of things that can feed into bubbles. One is people don't always have great information. So if they see a stock going up they figure, hey, all those people who are buying, they must know something. And, you know, often you can come up with some kind of good story for why prices should be higher, for why maybe this is not a bubble.
KESTENBAUM: And another thing in the real world that can keep bubbles going is that it's hard to put the brakes on. If you think housing is going to go up you can buy a house or two houses. But if you think the housing market is going to crash and you want to put your money where your mouth is you have to find a way to bet that it will go down. But shorting the housing market is difficult to do. Shorting is risky, and it is really unpopular with your neighbors.
GOLDSTEIN: So all these things taken together, they do make a pretty compelling picture. We've got now an explanation for how bubbles can form. And remember from Thaler, we got a pretty good definition of a bubble. It's when the price of something is far above what you might call its fundamental value.
KESTENBAUM: Which means we can finally return to our initial question, is gold in a bubble? Here's Tim Harford.
HARFORD: Gold is a tricky one, and here's why. Remember, we said bubbles should be defined in terms of fundamental values. Your - the price of your house, you should be looking at the future stream of income from rents. The price of corporate stock should be looking at future profits. And you need to make your best judgment on what that would be. But the price of gold. So what is the stream of value that comes out of gold? It's really not clear to me.
Clearly, some people hold gold because they like the jewelry. And that's fine. And that's perfectly legitimate. But most people hold gold because, well, they think it's going to be worth more or it's going to retain its value. Governments hold gold for that reason. We've got Fort Knox. You've got people like you, who invest in these gold coins as an inflation-proofing store of value. And, you know, sometimes it's been a very good investment. But it's just it's just not clear what the fundamental value of gold is. I mean, it's worth something because people have always thought it's worth something. And that's really weird because what that really tells you is well gold's in a 4,000-year-old bubble. And if it's lasted 4,000 years, maybe it'll last another 4,000 years. Who am I to say?
GOLDSTEIN: It seems like there's always this problem with bubbles to some extent, which is even if you can say with, you know, a high degree of confidence there is a bubble, you probably cannot say you know when it's going to pop. It might be tomorrow or it might be in five years or 4,000 years in the case of gold.
HARFORD: Yeah. You never know. And it can cost you an awful lot of money to find out. There's this famous saying - the market can stay stupid longer than you can stay solvent.
KESTENBAUM: Jacob, when we started this project, we said that we were not going to try to time the market. We were going to sell in six months no matter what.
GOLDSTEIN: And that's what we did. Six months to the day after we bought our shiny, tiny, little gold coin, we went back to the diamond district a few blocks from our offices to sell it back to Hank Mendelson (ph), the guy we bought it from.
HANK MENDELSON: How are you guys, by the way?
GOLDSTEIN: Good. The price of gold went up since we bought our quarter-ounce gold coin. When we bought, gold was trading for just over $1,300 an ounce. On this day, it's over $1,400 an ounce. But Hank tells us that in the end, we're going to lose money. We wound up getting hit in a few ways. For one thing, Hank charged us a premium when he sold us the coin, an extra fee. That fee's how he makes his living. So even though the price of gold went up, it didn't go up enough to make up for the fee. All right. So we lost $9.
MENDELSON: Nine dollars - not terrible.
GOLDSTEIN: Not terrible, he says. But the price of gold went up and we lost $9.
KESTENBAUM: Not only that, when we bought, because our coin was so small, it didn't count as an investment. So we had to pay sales tax.
MENDELSON: One ounce, you made money. The quarter ounce you didn't make money because it was too small a denomination.
GOLDSTEIN: So you're telling me we got killed by sales tax.
KESTENBAUM: All right. Count it out.
GOLDSTEIN: One, two, three, 310, 320, 30, 40, 50. So, David, I will say this, if gold is in a bubble, we at PLANET MONEY, Planet Money Investment Advisers, we discovered a way to buy on the way up, get out before the bubble burst and still lose money.
(SOUNDBITE OF SONG, "KING OF DIAMONDS")
MOTOPONY: (Singing) You've got everything I needed. That's why I'm loving you so much.
KESTENBAUM: So the PLANET MONEY Investment Fund - we started out with $1,000. It now has $406.06 left.
GOLDSTEIN: We'd love to hear your ideas for what we should invest in next. You can email us at firstname.lastname@example.org or leave us your comments on our blog at npr.org/money.
KESTENBAUM: I'm David Kestenbaum.
GOLDSTEIN: And I'm Jacob Goldstein.
KESTENBAUM: Thanks for listening.
(SOUNDBITE OF SONG, "KING OF DIAMONDS")
MOTOPONY: (Singing) I've been looking for the king of diamonds until the dealer made you mine.
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