From time to time, there has been talk about introducing bills in a legislative session mandating that some of the state's savings be invested in gold or silver. Rumors have it such a bill is on its way this session again - I look forward to reading it - but before any such bill shows up I would like to make a couple of points on this matter.
An often-heard argument for investments in metals like gold and silver is that they outperform other equity over time. This tends to be true, although it depends on the period one chooses to look at. However, the return on investment should never be the guiding principle for the investment of taxpayers' money. Any investment where the performance of equity markets is relevant, will inevitably expose the investor to risk.
A better approach to portfolio-related legislation is to demand that taxpayers' money be safeguarded against losses. This is not the same as seeking high returns: a Treasury bond is safer from a risk perspective than other investments, but they are not ideal for investors seeking high returns.
Gold and silver can be good if the goal is to build in a stop-gap against losses in an investment portfolio. There is, of course, a point to be made about their return, but the most important variable to keep an eye on, especially in the investment of taxpayers' money, is liquidity.
There are four dimensions to liquidity that are relevant in this context. First, the liquidity of an asset depends on the immediacy of the asset. This is predominantly a matter of market institutions, referring to how fast a given trade can be executed. Secondly, there is the market breadth, which is defined as the "cost" of providing liquidity. This is a technical aspect of liquidity that is less relevant in terms of long-term management of taxpayers' portfolios. Third, and related to breadth, is market depth: how big of a trade can the market handle for any given "liquidity cost", or bid-ask spread?
The fourth dimension of liquidity is called "resiliency". It refers to the market impact that any single trade will have. If, for example, a seller of gold wants to cash in a big amount at a given point in time, and that sell drives down the price, then the resiliency of the market is the time it takes for the market to return to prices as they were before the trade.
This last dimension is the most important one given the quest to invest some of our state's money in gold and silver. While the term "resiliency" is often used as I defined it above, there is a broader aspect to it that is sometimes omitted from any analysis of market liquidity. The resiliency of, say, the gold market is not just a matter of individual trades, but of how the overall market performs over time. The real question about resiliency - and therefore the liquidity of a portfolio that has gold in it - is what the gold market will look like at a point in time when we may find it necessary to liquidate our gold or silver.
In other words: how resilient will the gold market be when our state reaches a crisis of sufficient dimensions?
This is the most important question to answer regarding investment mandates that include precious metals. The need to liquidate gold and silver would come about if our state was hit by a serious fiscal crisis. Suppose, for example, we invested 10-15 percent of the states' Legislative Stabilization Reserve Account in gold and silver. We would theoretically have to burn through 85-90 percent of LSRA before we had to dip into the metals. It would take a serious, but far from unimaginable, crisis in our state's finances before the legislature would be forced to dip so deep into the LSRA that it may have to consider liquidating gold and silver.
In fact, I have explained the conditions of such a crisis in a two-part paper for the Center for Freedom and Prosperity.
When considering the liquidity of investments in gold and silver, our question must be: what resiliency would the precious-metal markets have in that macroeconomic environment? Would many others try to liquidate their holdings, too? What does that mean for market resiliency?
This question is not an argument against investments in gold and silver, but raises an important policy question regarding the role of LSRA:
--Is it a last-resort funding opportunity, or
--Is it truly supposed to be a stabilization account?
If it is the former, a better solution is simply to hold the assets in the form that comes with the highest possible degree of liquidity. If, on the other hand, LSRA is truly supposed to be a stabilization account, then it makes sense to hold a portion of it in precious metals.
Anyone sponsoring a bill to suggest this change in portfolio management will be making a much stronger case for himself by considering these questions regarding the purpose of LSRA.
There is one more aspect of this worth keeping in mind. A bill that proposes gold and silver investments should always come with a statement of conservatism in investment strategy. The reason is, simply, that when investors add assets to their portfolio that are generally perceived to lower the exposure of the portfolio to risk, they do not change their overall investment strategy. Their aggregate risk profile remains, which means that a lowering of the actual risk profile of the portfolio allows the investor to re-invest other assets for a higher exposure to risk.
In other words, a bill requesting that gold and silver be added to the state's investments that does not also request a lower-risk profile of said investments, could actually result in increased exposure to risk, at least on the margin. Thereby, the bill would not have made a meaningful difference.
Again, it remains to be seen if any such bill is in the legislative pipeline, but given that this subject pops up from time to time, I expect it will this time around as well.