Thursday, February 19, 2009

Why gold is a good reference point

The late Jude Wanniski in 1995 wrote a classic piece on why gold is so important, titled "A Gold Polaris." As this chart shows, gold holds its value relative to other things over time, so that it can be used as a reference point to measure all other things. Oil is currently becoming cheap relative to gold, since an ounce of gold today buys almost 25 barrels of oil. Just a few months ago, an ounce of gold would only buy you about 9 barrels of oil.

To give my own analogy for why gold is important and provides a unique reference point for all other prices: I remember many years ago coming into Grand Central Station on a train from Stamford. As I looked out the windows of each side of the train I suddenly became disoriented. I momentarily lost the ability to judge whether my train was moving forward or stopped, and which of the other trains were entering or leaving the station. I had lost a fixed reference point. Gold can provide a fixed reference point in a world where all currencies float up and down against each other, and prices for commodities and real estate rise and fall by significant amounts.

The action in the gold market today is telling us that all the world's currencies, with the significant exception of the Japanese yen, are declining in value. That would presumably follow from the observation that all central banks, with the exception of the Bank of Japan, are taking extraordinary measures to relax monetary policy in order to keep their price levels from falling. By offering to supply more currency than the world wants, the values of their currencies are falling. This is a precursor for the values of all things denominated in those currencies to rise, which is another way of saying that rising gold prices presage rising inflation in most countries around the world. The lag between gold rising and the prices of all other things rising is difficult to know, of course, and it can be variable, but a strongly rising gold price is a good sign that the price level will be rising in the future.


brodero said...

Scott if you could show a chart of
how much is in Money market assets vs. say the capitalization of S&P 500 or Wilshire that would be great.

Scott Grannis said...

Before doing it, I can say with confidence that MMFs have increased hugely relative to the value of the stock market. But all that will say is to reiterate what we already know: there is more money out there than ever before, and stocks have fallen by 50%. If people can recover their confidence then there is lots of upside potential.