Thursday, February 12, 2009

The message of gold

Judy Shelton has a good article about the virtues of a gold standard in today's WSJ, so I thought I would add my chart on real gold prices to the discussion. As this chart shows, real gold prices are not far from the highs they reached in the inflationary heydays of the early 1980s. As Judy notes in her article, when monetary policy is tied to a gold or commodity standard, inflation tends to be low. Allowing monetary policy to be guided by human discretion almost always leads to higher inflation. Discretionary monetary policy in our recent past has undoubtedly contributed to volatile inflation, as well as real estate and commodity speculation. The rise in gold prices in both real and nominal terms since the early 2000s—right around the time that the Fed started easing in order to cushion the economy's decline in the during the 2001 recession—has now reached levels that are undeniably worrisome, since they are a clear sign of rising inflationary pressures.

As Judy explains, and as I've discussed before, easy money and rising inflation sap an economy's strength by diverting resources away from productive activities and towards speculative activities. We see living proof every day of the destructive impact of the housing price bubble, in which speculative demand for housing, fueled by cheap money, drove prices to unsustainable levels and resulted in excessive housing construction, only to be followed by a major collapse. We've also witnessed extreme volatility in energy and commodity prices this past year that have wreaked havoc among emerging economies around the world.

If I were Obama's advisor, I would be telling him that $1000 gold is a lot more troubling than the current recession. I would give him a copy of P.J. O'Rourke's article that channels Adam Smith on the solution for our housing crisis (clue: just let prices fall). Smith told us long ago that housing can never be a source of wealth for an economy, regardless of whether housing prices rise or fall. The problem comes from over-building, which is inevitably followed by a construction bust and the need to redistribute the economy's energies. Housing construction collapsed long ago, and prices are rapidly returning to more reasonable levels, so what remains of this bursting bubble is more akin to a tempest in a teapot than a threat to modern civilization as we know it.

Late last month I highlighted a significant new trend in the TIPS market, in which investors' expectations of deflation were rapidly fading. The next chapter in this story could be how yesterday's fading deflation fears are gradually replaced by tomorrow's rising inflation fears. We're on a monetary roller coaster, folks.

The world seems to be ignoring inflation risk these days, out of concerns that collapsing housing and commodity markets, coupled with a significant decline in economic activity, will keep central banks' desperate attempts to boost money supply from igniting inflation. The message of gold is that these concerns could be wildly misplaced. This is a message that applies to all investors around the world, because all major currencies today are rapidly losing value against gold, the traditional standard of value.

I still believe the U.S. economy will recover from this recession sooner than most people think, but as I've said before, the recovery is likely to be be sub-par for quite some time. The economy will be bogged down for years by rising inflation pressures—which will probably show up in another asset price bubble somewhere—and by a significant expansion of government influence in the economy, thanks to the hugely bloated faux-stimulus bill that will probably be passed this week.

I must add that it was refreshing to see the news just a short while ago that Judd Gregg was withdrawing his name from the nomination to the Commerce Secretary post. It would appear that there are still some men of principle in Washington. And it's one more sign that Obama could really use some better advice when it comes to economic policy.

Full disclosure: I am long TIP at the time of this writing.


M Miller said...

Or, could we be seeing a bubble in gold just like in commodities. Many friends are buying gold via GLD. All the headlines are saying to buy gold. Many brokers are telling their clients to buy gold funds and GLD. That to me is the biggest sign it could just be a speculative move of money.

I agree with all your comments on gold, but I see on the ground (I'm an investment advisor to high net worth families) that massive amounts of money are moving into gold (just like they moved into commodity index funds and natural resource funds over the last several years until the bust).

Again, I concur with your reasoning. Good reasoning often sets the stage for a crowded, blind-folded trade by the masses, lead by the brokers looking for the next story to tell their clients (and keep them "in the game").

We shall see. Thanks again for your investment of time Scott.

Mark A. Sadowski said...

I lied when I told people three months ago I was imminently selling my gold (thanks to my father I have a fairly large amount). Truthfully I was uncertain. But now I'm thinking now may finally be the time to sell. I just don't see gold going much higher. I have yet to see a convincing case that it can go any higher.

Daniel said...

I love GLD, but at the end of the day the only safe way to buy gold is to buy physical gold.

I see 1200 being the bubble, and the collapse occurring when the equities rebound.

just my $.02

Mark A. Sadowski said...

Is there an alternative to physical gold (just kidding)? I'm looking at 18th century gold coins that are a part of my collection. I'll miss them but I'm also not a fool.

Daniel said...

i like my 20th century maple leafs & American Eagles. i couldn't imagine letting go of some 18th century bullion.

Scott Grannis said...

There's a theory about how to interpret the gold price which makes sense to me, but nobody has proven it. Rising gold prices mean that monetary policy is effectively supplying more liquidity to the market on the margin. With gold approaching $1000, this means the Fed is REALLY oversupplying liquidity. When there are more dollars in the world than the world wants, that is the basis of a monetary inflation. Monetary inflation shows up first in the gold price, then in other prices (the value of the dollar, real estate, commodities, energy prices, etc.). The last place it shows up is in the CPI. So gold at these levels is a sign that measured inflation will be rising in the future. The lags are "long and variable" and things don't always work perfectly (e.g., real estate rose then fell, even as gold continued to rise). No hard and fast rules.

I try to avoid forecasting gold and instead use it, in conjunction with what I see happening in other parts of the market, to judge whether the Fed is inflationary or not.

In a few years gold might well be lower than it is today, but if that happened I would have to believe that the Fed did something to tighten policy in the interim. In the absence of any overt tightening, my inclination is to see gold continue to rise. It is not yet at any extreme level, so I don't see any natural impediment to higher prices.

Tighter monetary policy would mean higher interest rates, and at some point those interest rates start to exert downward pressure on gold because bonds become more attractive relative to gold. With interest rates now very low and likely to remain low for "some time" gold doesn't have much competition from bonds, so it seems to me that it is likely to continue rising.

Nevertheless, you have to be cautious at these levels, because gold is clearly "rich" relative to its average real value over time (which I guess is about $450 or so in today's dollars).

Mark A. Sadowski said...

Thanks Scott,
I'm nervous about selling but I'm confident that gold is near the top. But if my nostalgia is your concern, know the following. My brother is buying my gold from me. I can always buy the same coins back after the price of gold dives. It's all in the family, and I think I've been following the markets a lot better than he has. (Yes, I know, he's something of a dolt.)

Cabodog said...


There sure seemed to be much more money around in 2005 (due to all the lax lending) and all that money was chasing fewer goods, like real estate, gold and even oil.

I realize that the money supply wasn't coming directly from the government, but it was being created from the velocity of money and lax lending -- it still meant more money in circulation at the time.

So, with the absence of lending now (ie, securitization), is there more money now than in 2005?

I do like your explanation of gold vs. bonds -- that makes a lot of sense. One of the penalties associated with owning gold has been its zero return and in some cases, insurance and storage costs, essentially creating a negative return.

Judging from the recent shortage of gold bullion coins, it would appear that the "little guy" is buying gold (large buyers just buy bullion). And, it's been my experience that when the "little guy" rushes to buy something, be it gold, silver, houses or mutual funds, it usually marks a top in the market for the particular item. Likewise, when the little guy gets out, it usually marks a bottom (mutual fund outflows in October/November for example, fingers crossed).

Interested in your thoughts about money supply in 2005 vs. now.

As always, thanks for the interesting commentary and lessons in economics.

Scott Grannis said...

I think it just seemed like there was more money then, because it circulated faster and found its way into all the nooks and crannies of the economy, thanks to securitization, etc. Things were more efficient than they are now is another way of putting it. So it's not that there's a shortage of credit overall, it's that some people are having difficulty getting access to the credit. Plus, there is lots of money that people are just sitting on, because they are afraid of counterparty risk.

There's a lot more money now than there was in 2005, but it circulates and recycles at a much slower rate. That can improve as confidence improves.

People are piling into gold, not surprisingly given its relatively high price, but I don't sense that it is getting to the point of absurdity yet.

Donny Baseball said...

Excellent as always. Like others I love the logic but have never taken a shine to gold. My inflation play, porkulus or no (but especially with it), is TBT, an ETF that returns 200% of the inverse of 20 yr Treasuries.

Scott Grannis said...

Donny: I also own TBT