TCS Daily


The Financial Paradox of Our Time?

By Jerry Bowyer - July 7, 2006 12:00 AM

My friend Rich Karlgaard, the omnivorous and 'air-apatetic' publisher of Forbes magazine has declared that the simultaneous existence of a flat (and, sometime, inverted) yield curve and high gold prices is "the financial question of our time." I agree. Supply side economists who have lived in blissful peace with one another (at least as far as economic issues are concerned) are now split. They have fundamentally different views on the state of our economy, and what the Fed should be doing. Since the days of Ronald Reagan the supply-siders have been driving the policy debate and have, generally, forecast the pants off of the Keynesian establishment. But now they're forecasting different things. Some of those think you should focus on the gold market and some put more emphasis on others markets; bonds, for instance.

In the past it hasn't really mattered whether you are a gold watcher or a bond watcher, because these markets have been saying pretty much the same thing, but lately they haven't.

For the past year or so, the different indicators have signaled different things. Gold and other commodity prices have soared, a sign of high inflation. Interest rates and the yield curve (the difference between long term and short term rates) have been more low and flat, a sign of modest inflation. This is the paradox, and it's not just theory. It directly challenges the Fed's ability to know whether to tighten more (as they did again recently), or stop. Forbes, Brian Wesbury, the Wall Street Journal Editorial Page and the New York Sun have tended to side with gold. Arthur Laffer, David Malpass, Larry Kudlow, Alan Reynolds and TCS Daily's Jim Glassman have been more reluctant to depend exclusively on this price signal, and have been much less alarmed about inflation. Some of these guys have been doing some shifting around lately too.

I recently talked to the Council of Economic Advisors Chairman Ed Lazear, and he told me that because of interest rates the Administration's inflation forecast will also remain modest. His view is that interest rates are the more inclusive indicator. They know about gold prices and that goes into the mix with a lot of other things and what comes out is a manageable inflation level. This puts the administration closer to the second camp.

The good guys are disagreeing with one another for a good reason: the data are mixed. What a pity! For two decades we had markets that spoke clearly and a Fed chairman that didn't. Now we have a Fed Chairman who speaks clearly and markets that don't.

Aside from theory, here's what's been happening in the real-world economy:

A theologian once said that a paradox is not a contradiction; contradictions can't be resolved. A paradox can. It is a charley horse between the ears. Resolving an apparent contradiction (like "the last shall be first and the first shall be last") is a very powerful mode of learning, because it drives us back to first principles and gets us asking fundamental questions.

Here's a good fundamental question: why gold? The point of a gold standard currency is to keep governments from cheating their citizens. This goes all the way back to Moses: "a just weight and measure thou shalt keep." Paper can be produced in nearly infinite supply, electrons even more so, but gold is scarce. The basic case for gold is that we get better at producing it at about the same pace that we get better at producing everything else. In other words, our gold output usually grows at about the same rate as our everything-else output. There's the rub: usually. However, sometimes gold -- and other commodities -- grow at different rates than the rest of the economy.

From the 16th century to the 18th century, gold came flooding into Europe from North America. Explorers discovered the Western Hemisphere, plundered the Indians' gold supplies, and shipped boatloads of the stuff back to Europe. Because of exploration and (then) modern shipbuilding, the European economy got much more efficient at gold 'production' than at everything else. So, even countries with a gold-based monetary system were hit with many years of inflation. Their money supply grew more quickly than their economies.

I think that we currently face the opposite scenario. We're not much better at getting gold out of the ground than we were last century, but we're much better at getting wealth out of electrons. Our economy can now grow at a faster pace, by far, than the mining industry can. Our economy now grows faster than our gold supply. This means that gold prices, reflecting gold scarcity, will be an imperfect messenger.

Think of it this way: imagine two economies. One is made up entirely of jewelry stores. The other is made up entirely of iPods. Gold and silver prices would be a great inflation predictor in the jewelry-world. The price of metals would translate fairly directly into rings and chains. Gold would be a terrible predictor of inflation in iPod-world.

To the degree that we are moving from jewelry-world (or even auto world) to iPod-world, the link between commodities prices and overall prices is weakened.

Productivity and Globalization become the new big factors. We're trading with one another more than ever. This creates a hyper competitive environment, which keeps costs down, even when the government prints a little too much money. Even more important is the fact that we are now undergoing a productivity revolution in all sectors. The cost of each unit of everything we produce (movies, songs, software, cars, MRIs) is much less dependent on underlying commodity costs. We're using technology to handle the new pressures of this hypercompetitive environment.

If this is true, it means that the further we get away from commodity costs and the closer we get to an end product, the less inflation we'll see. It also means that we'll see even lower inflation rates in things that can be traded across oceans (food and durable goods) than in things that can't (haircuts and roller-coaster rides).


Let's say for a moment that the Fed has been printing too much money, but that globalization and productivity were countering much of the effect of this excess liquidity. If this were the case then Commodity indices like CRB (which measure raw materials) would be higher than Producer Price indices (which measure the input costs of our economy), which would be higher than CPI (which measures end product prices, but does it badly), which would be higher than the Implicit Price Deflator (which measures end product prices better), which would be higher than the cost of exports (which are, by definition, tradable across national borders). As the above chart shows, that this is exactly what is happening.

The Fed did pump too much money in the economy; remember that when the current rash of tightening began the Fed Funds target rate was only 1%. The excess liquidity went to gold and then to the rest of the commodities, but at each point in the production cycle after that, more and more of the commodity inflation has been getting 'squeezed out' of the system.

This is how commodity-focused inflation indicators, like gold, could be sending out high inflation signals while more broadly-focused inflation indicators, like yield curves, could be sending out more modest inflation signals. This is how good guys, with terrific track records could be saying such different things. They're both telling the truth, one about raw materials, the other about end products.

Jerry Bowyer is Economic Advisor for Independence Portfolio Partners.

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16 Comments

The Market
Gold is increasingly attractive and demanded in final goods production, especially electronics. Gold will only become more scarce (on Earth) as time goes on. It was officially abandoned as a monetary standard decades ago.

MARKET prices, interest rates and productivity are the key to inflation monitoring and policy.

No Subject
Bowyer produced the best analysis I have read in a long time.

What do you mean by "final goods?" The percentage of gold used in electronics is very small. Most is used for decoration.

prices
Whenever the price of something goes up, we humans are pretty good at finding ways to get more, or to make existing stocks go further. In other words, higher prices make more difuse gold deposits economical to mine. Higher prices also make it worthwhile to be more efficient at recycling.

I agree that market prices are something to watch, but the question is, which market prices. Do we watch all prices, and average them? Certain prices vary tremendously, without any regard to underlying inflation. Do we ignore these items? If so, how do we determine these items?

Watch "market prices" is one of those things that is easy to say, hard to do. That's why gold has been so popular in the past.

If the author is right, and at least superficially, his arguments make sense, then it is time to abandon gold as a primary inflation indicator.

Ignore commodities, especially gold, at your own peril
Let me say that I do not own gold (at least as an investment, there is some jewelry lying around the house and the few flakes I panned for a couple of years ago in a little vile), but it is still a very important economic indicator. In this age of such diverse economic drivers, it is now just one of many that need attention; but you ignore it at your own, very significant, risk.

2006 is going to prove to be a much higher than recent average inflation year. This will be due, largely, to the incrreased price of energy and it's effect on everything else. Probably a 4-5% hike in the consumer price index and closer to 6+% in the true cost of living index. But, at present, this is looking like a small blip that will probably relax back to the 2-4% range, and possibly even less, all-around in 2007.

This increase would have happened in 2005 if energy prices would have gone up in late 04 or the early months of 05. It is simply an industrail lag that is now catching up a bit.

Volatility
Volatility is a measure of risk. Where the dollar supply remains steady, dollar trades will drive the price of dollars up and attract loss-averse (volatility sensitive) surplus capital away from other assets, such as gold. But where the dollar supply increases ahead of dollar trades, other assets will attract loss-averse surplus capital away from dollars. The mortgage lending boom as well as the Fed's printing money to settle state debts have caused the dollar supply to increase ahead of dollar trades, which implies the dollar supply has increased ahead of the produced value it stores, causing inflation.

Note that loss-averse surplus capital moves between dollars and other low-volatility assets and not capital encumbered by current claims. The latter experiences currency and commodity volatility as a production risk. Of course, gold & other commodities are also production inputs, but precious metals experience additional demand volatility as perceived low-volatility assets equavalent to currency. This is the margin that's interesting.

Enter hedging. Derivatives enable owners of capital subject to current claims to fix future prices within a range of volatilaty acceptable to the derivatives' counterparties. But speculative second-hand trading of derivatives introduces additional volatility into the prices of assets underlying derivatives, thereby muddling the effect of additional demand for these assets created by surplus capital fleeing inflation-caused currency volatility.

In sum, speculative derivative trading is volatile and lends to noisy prices, thereby drowning out the useful information regarding currencies the prices the underlying low-volatility assets would have conveyed but for the additional volatility.

Commodities
What intrinsic value does gold have?

Its great for IR mirrors and electronics and makes pretty jewelry. But to buy a bar, stick it in a safe and hope someone will buy it back if I need to sell it?

Moly, copper, Pt all have significant industrial uses and would seem to be a better economic investment for growing economies.

As the global, and eventually solar sytem economy develops, how much value will gold have if it does not find an industrial use? Especially if an asteroid of pure gold is found.



A Few Thoughts

1)Bond interest rates are not just a function of inflation, but also of the attainable *real* rates of return. To the extent that the "savings glut" hypothesis is correct, the glut is driving down real returns and hence keeping interest rates lower than they would otherwise be for a particular inflation level.
2)If world gold output is indeed growing more slowly tha the world economy, then gold prices will overstate inflation. How about some numbers--what's the Y/Y increase in gold vs the Y/Y increase in world output, and how does it compare with history?
3)The argument that deflationary pressure from offshoring will reduce total inflation sounds questionable. If inflation is basically a monetary phenomenon..and if people spend less on (say) electronics and automobiles because of offshoring, then they will have more to spend on other stuff (including services) thus exerting inflationary pressures on those items.

Gold is right and inflation measures are wrong
The high prices of gold and commodities are accurately forecasting resurgent inflation. The "paradox" of low CPI price inflation is due to the fact that it excludes the prices of food and energy--which are commodities.

Back in the 1970's, the Government decided to exclude food and energy prices from the "core rate" of inflation. The rationale was to insulate the "core rate" from being thrown off by wildly fluctuating energy prices, as happened with the OPEC oil embargo and other arbitrary OPEC price hikes and price cuts.

Instead, over time we have fallen into the trap of just disregarding food and energy prices altogether, as if they don't matter. If the rationale was to smooth out volatility, then the Government should have come up with some multi-year moving average of food and energy prices or some other statistical means to average out fluctuations--not exclude them altogether. To tell Americans that inflation is low when we are now paying well over $3.00 a gallon for gasoline, something nearly every American consumer uses, is just silly.

Indeed, as oil reserves outside the Middle East dwindle and the war on terror in the Middle East drags on, we may have a long term trend of fuel prices rising faster than the "core rate" of inflation. Maybe a decade from now we'll be paying $6.00 a gallon or more for gasoline. If so, then to just exclude this from the inflation numbers is going to chronically underestimate true inflation from now on. We're just kidding ourselves about how bad inflation will be getting.

It isn't all about intrinsic value…
Commody's like gold have an impact on the overall inflation rate and on the monetary markets as well.

Good thoughts
You will get no arguement from me.

Why does gold have value today?
Because people want it?

Also because of it's many applications
Gold is used in more than just electronics, it has other applications in military hardware and other areas besides jewelry. Like any other base product, demand in any area will play a part in dictating price.

Because gold IS money
Any mismatch in the amount of gold and the amount of goods can be accomodated by naturally changing prices of those goods. Its a bogus notion to try to control the amount of paper money to get "stable" prices when your target metric is an agrigate number made up of hundreds of goods, and which the metric itself is under political control. Creation of new paper money is the equivalent of a net wealth transfer from the group of people that hold that same money to the goverment. Gold never does this; required goverment revenue must be gotten by explicit taxes rather than by implicit inflationary means as in the case of paper money. So the reason the chart shows the comodity index higher than CPI is because CPI is a wrong, manipulated for political benefit. Article makes no mention of the amount of liquidity gathering in pools of residential housing. As people buy and move into houses, pressure on rents is relieved. Rents are included in CPI, house prices are not. Thus one big source of error in CPI is explained.

Gold's intrinsic value
"What intrinsic value does gold have?"

As far as I can tell it's intrinsic value comes from the fact that women prefer guys with gold to guys without. I don't expect iPods replacing gold rings in wedding ceremonies any time soon.

Only if accepted
Gold is only money if it is accepted as such.

To answer my previous question, gold was/is used as money because it is rare, fairly easy to process into bars or coins.

But it is only a count of wealth. Gold itself is not wealth.

Real wealth is mined or grown and/or represents energy applied to add value. Since the sun is our primary source of wealth there is a limited, but constant source of wealth that we only need to figure out how to use most efficiently.



Gold and inflation
Maybe gold prices indicate past inflation. The price of gold remained unusually low throughout the 90's, even though the Fed inflated our money supply something awful. It probably remained low because central banks sold or loaned a lot, while productivity in mining increased. With both of those factors flattening out, gold has merely caught up to long term inflation.

If you visit the World Gold Council site, you'll see that their research shows that gold is a poor indicator of short term inflation, but a good one of long term, that is over two decades.

Price increases brought on by excessive money supplies should be worse under our service economy because manufacturing and mining can increase productivity enough to mask the effects of too much money. But productivity growth in services is very low, so inflated money supplies expose their full effect there. For example, look at the rapid rise in the costs of health care. Also, assets, such as real estate, will show the effects more than will manufacturing and mining.

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