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Post on the Gold "Correction"
Created by John Eipper on 04/20/13 3:06 AM

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on the Gold "Correction" (Istvan Simon, USA, 04/20/13 3:06 am)

Gold is a hedge against expected inflation. A correction in the gold market means that the market does not except inflation. This is against some of the things that Tor Guimaraes has said, together with some of the things that Cameron Sawyer has said. I disagree with Tor about the reason for the stock market's rise.

JE comments:  A valid point.  Gold has presently gone back to its price levels of early 2011.  Is this simply the sign of a bubble, or is it a vote of confidence in the world's fiat currencies?

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  • on the Gold "Correction" (Cameron Sawyer, Russia 04/20/13 4:50 AM)
    In response to Istvan Simon (20 April), the price of gold, to some extent, is a leading indicator of anticipated inflation. It's more complicated than that--more about anon--but let's start there.

    A falling gold price does not mean that the market expects no inflation. It means that the market expects less inflation, or inflation occurring later, compared to what it expected x amount of time ago. Less inflation might still be a whole lot of inflation.

    I trust that every WAISer can appreciate this extremely simple truth.

    So gold was at about $845 at the beginning of 2008. In September it jumped up to over $900, then fell down to $720. This was partially the result of the spike up in the dollar after September, 2008 (which was no vote of confidence in the dollar!), but also partially from an expectation of deflation, which WAISers will recall was the real danger at that moment.

    By September, 2009, by which time the global Quantitative Easing movement had gotten underway, gold was going up, up, and up. It passed $1,000 and never looked back. That's a 39% increase at a time when inflation was running about 0%. What does that tell you? It tells you that the market was running away from fiat currency, and since it still didn't want to run back into assets, it chose what is neither assets nor fiat currency, namely gold. Why did the market run away from fiat currency? Because it was being debased--the volume of it being created made it clear that at some point in the future it would be worse less relative to other "stuff."  In other words, the market expected inflation.

    In 2011, gold reached its peak of about $1900. This occurred at a time when it appeared that there could be a widespread collapse of the European banking system. Since then it has fallen back to about $1400. Does that mean that the market does not expect any inflation? Gold today is almost double the price it was in October, 2008. It's up 55% compared to the beginning of 2008. If the gold price were a pure proxy for future inflation, those figures mean that we're in for at least 50% more inflation during a short enough time horizon to be built into prices today. That's a shockingly huge amount of inflation! Just because today it might be 50%, instead of 100% as it looked in 2011, doesn't mean that the market doesn't expect a tsunami of inflation.  It just means that the tsunami is 15 meters high, rather than 30 meters high, according to the collective estimation of the market. What the gold price of $1900 meant, in terms of anticipated inflation, doesn't even bear thinking.

    Of course, gold is not a perfect proxy for future inflation, for the same reasons that gold-backed currency is not a perfect currency. However, it is extremely interesting that the development of the gold price between the beginning of 2008 to today roughly parallels the growth of the US M2 during the same period. That's partially a coincidence, because M2 is historical while the gold price is prospective. Nevertheless, both indicators imply, in one way or another, each in their own way, the very same thing--that we have about 40% to 55% too much money, compared to the stuff there is to buy with it. If the velocity of money returns to a normal level, it means that it would take three or four years of 10% to 15% inflation to bring stuff and money back into balance. Of course we don't know that exactly, because the mechanisms are all much more complicated than that. For example, the gold price is much more speculative, that is, it reflects a relatively greater proportion of "fear and greed," than share prices--because gold does not issue earnings statements; there is nothing to do "intelligent analysis" on, other than the money supply. But still--we do get a rough picture, of a certain amount of inflation, which everyone expects.

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    • Historical Trends in Gold Pricing (Istvan Simon, USA 04/21/13 3:16 AM)
      Cameron Sawyer (20 April) is right that the price of gold falling does not necessarily mean that the market expects no inflation, but it may mean that the market expects less inflation (or I may add, less uncertainty) than it expected some time prior. In my opinion, though, the rest of Cameron's analysis is faulty.

      Cameron reviews what happened to the price of gold since 2008, and attaches his interpretation of the price fluctuations since then. First of all, why since 2008? Why not since August 1971, when Nixon ended the link between the dollar and gold?

      In 1971 gold was $35 per ounce. It had been at that price ever since the Bretton Woods agreement in 1944, which fixed the rate of exchange between gold and the US dollar. This act of President Nixon, its causes and antecedents and what followed, is described as usual quite well and accurately in Wikipedia:


      The price of gold shot up to $400 shortly after 1971. But then it went up to as much as $800 before falling back to $400, where it more or less then remained for decades. One has to mention, of course, other things that were happening during this period which had much to do with these fluctuations in the price of gold, in particular the rapid rise in the price of oil as a result of OPEC and the Egypt-Israel war in 1973.

      I will not even attempt a turn-by-turn explanation of the fluctuations in the price of gold since 1971. It is in my opinion futile to try to do so, because the price of gold at any one time is determined by a complex set of factors and therefore superficial analyses are bound to be simply wrong. My purpose here is simply to bring a much longer perspective to this question and to make a few general observations:

      1) From 1944 to 1971 the price of gold remained constant at $35. But in the same period the stock market rose very significantly, and there was also significant inflation. So the price of gold, when compared not to the dollar, but to the price of other goods, fell by a very significant margin. It is therefore not at all surprising that when the artificial link between the dollar and gold was abolished, the price of gold shot up more than 10-fold.

      2) However, the price of gold then remained after its relatively brief excursion into the $800 level territory, at $400 or less for again several decades. This means again that relative to other goods, it fell constantly! An investor that put his money into gold in 1980 made a terrible mistake. While in dollar terms his investment was relatively safe and did not significantly lose dollar value, over a long period of time the dollar itself lost value, and therefore with it so did gold. To give an example of this, 3% inflation per year is considered quite tolerable and even desirable. But over 20 years, 3% inflation amounts to an 80% drop in value!

      Compared to stocks, 1.38 ounces of gold would buy 1 DJIA (Dow Jones Industrial Average) in September 1980. It would take 38.92 oz. of gold to buy the same in September 2000. Gold then would start to gain value relative to the Dow, but when President Obama took office in January 2009, so at the height of the financial crisis, it still would take 8.7 oz of gold to buy 1 DJIA. Today it takes 10.49 oz of gold to buy 1 DJIA. Our hypothetical gold investor in 1980 is still losing big time today.

      All of this points to the need for a longer view on the relative price of gold against other goods. And if an analysis is made in those terms then the current price of gold is not that much different than what it had been during various times of its history.


      JE comments:  Another factor that has impacted gold pricing is the emergence of China, India and other nations as major gold purchasers.
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      • Historical Trends in Gold Pricing (Cameron Sawyer, Russia 04/21/13 5:31 PM)

        Istvan Simon (21 April) is making my point for me.

        Gold shot up in 1971 because the Nixon left Bretton Woods and, by fiat, rescinded the right of holders of US dollars to redeem them in gold. This at the same time Nixon announced his own "quantitative easing" program, with the famous (or infamous) remark that "we're all Keynesians now." The market anticipated that the dollar would be debased by the unfettered printing of them--in fact, Nixon specifically admitted he was going to do that. The market understood at that juncture that unfettered printing of dollars would cause a lot of inflation, just like the market understands the exact same thing today. The market was right; we all know what happened after that, with inflation in the US hitting nearly 20%. The gold price is telling us the same thing today, and the fact that it went down to 55% above its level just before the crisis, down from nearly 100%, just tells us that the patient's temperature is down to 105 degrees from an almost certainly fatal 110 degrees. He's still in the hospital. The market will be right, just like it was in the 1970s. We have better quality central banking today than we had in Nixon's day, so we can hope that things won't turn out so badly as then, but inflation at 20% in the next few years is not entirely out of the question.

        The price of gold fell again, as Istvan mentions, after Paul Volcker's monetary about-face was announced, and it fell especially after Ronald Reagan forcefully announced that he would keep Volcker and continue the monetary reforms started under Carter. That was another leading indicator of inflation--the market understood that the state had decided that come what may, inflation was going to be reduced, which meant that dollars were going to be worth more in the future than what the market had been assuming theretofore. Hence the fall in the gold price.

        The price of the DJIA in gold is entirely irrelevant to this discussion. Unlike gold, the DJIA is not primarily a monetary phenomenon. The companies represented by shares listed on the Dow are not static things like gold bars, but entities which can increase their sales and profits, or decrease them, go bankrupt, merge, etc. Over the long term, the Dow consistently outperforms any kind of money, from dollars to Euros to Swiss Francs to gold--really as a function of economic growth over the long term, reflected in the performance of large listed companies, exceeding inflation. The point of pricing the Dow in gold is simply to demonstrate to investors that gold is not an investment--it is a dead asset which, over the longer term, rises only when fiat currencies are debased or are expected to be debased. Holding gold is like keeping hundred dollar bills in a coffee can. I'm not ridiculing that; there might be perfectly good reasons to keep 100 dollar bills in a coffee can, under some circumstances--if you are a Ghanian, say, and you know that the latest revolutionary government is going to print a bunch of worthless money in order to rob people of their savings and pensions, or if you are a Cypriot with more than 100,000 euros of savings. Likewise, we might perfectly reasonably hold gold if we know that currencies are going to be debased (today might be such a time). But other than that, holding gold is not an investment, unlike investing in the stock market, which increases in value quite apart from any monetary phenomena. That is why economists draw charts like the ones Istvan has referred to.

        I'm not sure why Istvan persists in this argument. Is he forming his own one-man Flat Earth Society? The relationship between increases in the money supply and inflation is one of the least controversial things in economics. In fact, the word "inflation" itself originally referred to an increase in the money supply without any reference to prices at all. It's an extremely simple principle--if you sharply increase the amount of money, then prices shoot up, because the amount of stuff (assets, goods) is relatively inelastic. Changes in the velocity of money also affect prices, because it is not only the amount of money, but its motion through the economy, which determines the balance between stuff and money. In economic crises, we often have sharp drops in the velocity of money, which causes deflation when the money supply stays the same. Deflation is an extremely dangerous phenomenon--that's what caused the Great Depression. So these days, big increases in the money supply are used to intentionally cause inflation, in order to counteract deflation. Causing inflation is the specific purpose of these measures. It is important to grasp that prices have already shot up, compared to what would have happened to them without Quantitative Easing--and that was the whole point.

        If anyone doubts these simple principles, the tiniest bit of reading will quickly chase away the fog. A good place to start, as is so often the case, is with the excellent, succinct, and clear Wikipedia article on inflation:

        "The term ‘inflation' originally referred to increases in the amount of money in circulation, and some economists still use the word in this way. However, most economists today use the term ‘inflation' to refer to a rise in the price level. An increase in the money supply may be called monetary inflation, to distinguish it from rising prices, which may also for clarity be called 'price inflation.' Economists generally agree that in the long run, inflation is caused by increases in the money supply."


        The Wiki article on inflation is well worth a read for anyone even slightly interested in the subject. Particularly interesting is the History section, which goes through a long list of occurrences of money supply increases and associated rounds of inflation, going back to the Song Dynasty in China in the 11th century.

        JE comments:  Another historical instance of inflation was Peru in the 16th and 17th centuries, when so much silver was available that the prices of actual stuff became astronomical.  Even precious metals, if too abundant, can act more or less like fiat currency.

        I wonder how much gold a bag of potatoes cost in the Warsaw ghetto?

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        • Historical Trends in Gold Pricing (Istvan Simon, USA 04/24/13 2:00 AM)
          Cameron Sawyer wrote on 21 April: "Istvan Simon is making my point for me." I don't see where and how, but if I am making your point for you, Cameron, why you spend so much effort rebutting it?

          Cameron "explains" what happened to gold prices since 1971. It is amazing how he can recall exactly what happened to gold prices in the last four decades with just a few comments. For example, not a word on gold mines or production, or what others have been doing in terms of buying and selling gold, all of which obviously have a lot to do with the price of gold at any one time. For Cameron everything can be "explained" with a few simple comments about what Nixon did, or Carter did, or Reagan did. Anyway, after this "explanation," he says: "The market was right; we all know what happened after that, with inflation in the US hitting nearly 20%."

          Unfortunately, Cameron's recollections are wrong:


          Inflation in the United States never hit nearly 20% since 1971. Its two peaks were in 1974 at 11.80%, after which it eased to 6.72% in the next year, 1975, and 13.91% in 1979, which was in the Carter presidency. In both cases this had more to do with oil prices, not fiscal irresponsibility by either President Nixon or Carter. If any one was fiscally irresponsible, it was Ronald Reagan, who was very much a Keynesian, except that he tried to sell his deficits with the novel theory of supply-side double talk--which in turn was correctly termed voodoo economics by George H. W. Bush. Inflation data, however, disproves Cameron. There were large increases in the money supply under Reagan, but there was no major inflation.


          Cameron then says: "The price of the DJIA in gold is entirely irrelevant to this discussion. Unlike gold, the DJIA is not primarily a monetary phenomenon. The companies represented by shares listed on the Dow are not static things like gold bars, but entities which can increase their sales and profits, or decrease them, go bankrupt, merge, etc."

          I beg to disagree. The of DJIA in gold is not irrelevant. It is a valid comparison of investments. There are gold investors, just like there are stock investors. Cameron is also wrong in saying that gold bars are static. They are not--the price of gold depends on supply and demand very much like the price of everything else. There is absolutely nothing special about gold. It is a commodity needed in the economy for electronics, jewelry, dentistry and so on, and also used by some as a hedge against inflation and uncertainty. Nonetheless, its price is determined no differently than the price of copper or steel or lumber. If a new mine is discovered or starts producing gold, it affects the price of gold the same way as a new copper mine affects the price of copper.

          Cameron asks: "I'm not sure why Istvan persists in this argument. Is he forming his own one-man Flat Earth Society? The relationship between increases in the money supply and inflation is one of the least controversial things in economics."

          I respond: I have explicitly acknowledged the relationship between inflation and the money supply in this discussion (please re-read my posts on the subject), so I am not quite sure why Cameron accuses me of things I have never done or resorts to the Flat Earth Society metaphor. I should say that I am in good company--I read Paul Krugman and Joseph Steiglitz on these matters, and I think that it is safe to assume that both these Nobel Laureates know about monetarist theories at least as well as does Cameron. Yet neither forecasts anywhere 20% inflation (or even 10% inflation) as does Cameron. I'll let WAISers or anyone else reading these lines decide for themselves which is more likely.

          JE comments:  Can gold really be called an investment?  It pays no dividends or interest, but real estate doesn't, either.

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          • Real Estate as Investment (David Duggan, USA 04/24/13 3:26 PM)
            In response to JE's comment of 24 April (see Istvan Simon's post), real estate, meaning anything that is attached to the land, can yield rents, produce, timber, rights of way, easements, and other monetizable assets. Depending on the state, you may also get mining and water rights, "fly-over" rights, and the right to access to the courts to protect your investment as against adjacent owners, even if it is intangible (such as a view or prohibition from noxious odors).

            JE comments: But of course; I realized I was wrong as soon as I hit "send" this morning. My excuse?  The hour was early, and it's been at least ten years in Michigan since anyone made money from real estate...

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          • Historical Trends in Gold Pricing (Robert Whealey, USA 04/26/13 1:52 AM)
            Istvan Simon (24 April) is 100% correct on the inflation figures for 1974 to 1979. I taught my students for twenty years, that Pres. Carter merely passed the oil cartel price rise on to the US industrial sector. Paul Volcker was an honest Keynesian and drove the interest rates up and created unemployment, because he was an honest Federal Reserve Chair and followed the law as it should always be followed since 1913. If he did not raise the interest rates, the free Deutsche Mark and Yen could continue to rise against the free dollar. The price of oil was not the only cause of inflation. Also one must include the ever-rising arms budget promoted by the Pentagon in the name of the sacred god of "defense."

            I disagree that Reagan was a Keynesian. Supply-side economics is contradictory to Keynesian ideas. Keynes said that a short-term inflation for the purposes of creating emergency unemployment payments to the lower classes would create "effective demand." In a few years the free market would rise again.

            Wartime inflation is caused by the government spending year after year until victory on the battlefield achieves a lasting peace based on a territorial border. World Wars I and II left the US with a surplus of gold and paper dollars and left Germany bankrupt two times. The US Civil War gave victory to the North, and new production rolled back the greenbacks in 10 or 20 years after 1865 with production and new dollars backed by gold. We hardly need to mention that George W. Bush had no victories in the Greater Middle East. He could have bought oil cheaper than he could conquer it.

            US World War II debts were rolled back in five years by production. The Korean War was a stalemate. Truman raised taxes to pay for war from 1950-53. Presidents Johnson, Nixon were military deficit spenders. In their minds, the debts could be passed on forever. Neither brought victory on the battlefield. There is little productive potential to squeeze out of a Third World jungle.

            The financial crisis of 2005-2009 proved that debt does indeed matter. The only reason the US has a mild inflation is because EU and Chinese spending is at a higher level at this time. I voted for Obama, but his Federal Reserve Bank can only kick the can down the road for three months at a time.  Obama may muddle through to 2016, if he can keep the Pentagon and the Middle Eastern panic machine at bay. So Istvan may call himself a Keynesian, but John Maynard Keynes in 1944-46 put limits on inflation with the IMF. Keynes still followed Adam Smith's factors of production. Keynes was no finance capitalist, and he knew that World War I had destroyed five or six empires. None of them could perpetuate the 19th-century gold standard. The gold exchange standard worked from 1944 until 1971, when the unsustainable debt of Vietnam forced Nixon off the fixed rate of $35 per ounce.

            Will Germany and France sell dollars sometime in the future? Gold could rise again.

            JE comments: Gold will rise again--it always has. The uncertainty is whether it will rise soon, sink lower before eventually rising, or stay at its present rate for another five to ten years. In any case, I'm quite certain the big players here are no longer Germany and France, but China, Russia and the Middle East.

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            • Was Reagan a Keynesian? (Istvan Simon, USA 04/26/13 6:31 AM)
              In response to Robert Whealey (26 April), Ronald Reagan's economic policy was Keynesian, because he spent a lot of money when the economy was in a recession and there was a general economic malaise in the United States, which was the case in the Carter years. Reagan did this mostly by spending huge amounts on the Pentagon, including some boondoggle projects like Star Wars. Star Wars was completely useless, but it did accomplish one thing: it scared the Russians and that in turn led to the collapse of communism in the Soviet Union and Eastern Europe. Ronald Reagan also restored confidence and optimism about the future of the United States, and that was a great accomplishment in my opinion.

              Is it better to spend on defense or social programs? The truth is that sometimes it is necessary to spend on defense, and Robert Whealey is incorrect that defense has been consuming larger and larger portions of US resources. The opposite is true. But from an economic point of view, it matters only a little bit what the government spends money on. By spending on defense, Reagan created jobs. Jobs in the defense industry, jobs that improved the economy, lowered unemployment and therefore increased consumption, which is what mostly drives the United States economy. So therefore Reagan's economic policies were Keynesian, and quite successful in reviving the United States economy.

              Robert Whealey says that deficits really matter. Well, I'd say they matter in the long run, but in the medium run they matter very little. That was the case of Reaganomics, and that is the case now as well. Deficits do not cause inflation if they are handled properly. And in the United States they have been handled properly by good policies of the Federal Reserve.

              JE comments: Reagan (more precisely, his advisers) would have stridently denied any Keynesian tendencies, but perhaps Nixon said it best. Aren't we all Keynesians?  The only disagreement has to do with where you want your stimulus to go:


              Yesterday in Dallas, all five living US presidents gathered for the inauguration of the George W. Bush Presidential Library.  Was it a meeting of five Keynesians?  I've always enjoyed these photo ops of the world's most exclusive club.  (Well, the ex-Pope Society might be even more exclusive...)

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              • A Meeting of Five Presidents...and At Least Two PMs (John Heelan, UK 04/27/13 4:03 AM)
                JE asked on 26 April: "Yesterday in Dallas, all five living US presidents gathered for the inauguration of the George W. Bush Presidential Library. Was it a meeting of five Keynesians?"

                I suspect it was also a meeting of the "Carlyle Group Pension Fund for Senior Retired (and Incumbent) and Wannabe Presidents." Even Blair and Berlusconi were there!

                JE comments: Suddenly, it's 2006! We've experienced a lot of '90s nostalgia lately, but the Dallas meeting may be the first articulation of "Oughts Fever."

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