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Ever since Ben Bernanke began
flooding the banking system with trillions of new dollars in the fall of
2008, economists and other pundits have disagreed on whether the US is in
store for a grinding deflation or an accelerating inflation. Part of the disagreement
stems from some people using the terms to refer to prices, whereas others
refer to changes in the total quantity of money and credit.
However, even if we restrict
ourselves to movements in the prices that average households face in the
marketplace, there is still widespread disagreement. Although the
overlap isn't perfect, typically the Keynesians warn that with high
unemployment, the US runs the risk of a Japanese "lost decade" of
flat consumer prices and stagnant economic growth. Many Austrians, in
contrast, warn of a different decade: namely the United States during the
1970s, when Americans suffered high unemployment and price inflation.
To bolster their position, the
Keynesians confidently point at the low yields on various government bonds,
signaling that "the market" expects modest price increases over the
coming years. In contrast, soaring gold and silver prices have been the trump
cards for those Austrians predicting skyrocketing prices in general.
For a while the Keynesians had no
adequate response to this. They suggested that commodity prices were
volatile, and that emerging market demand — coupled with production
shortages — could explain the meteoric rise in gold and silver over the
past few years. In a particular act of desperation, Paul Krugman recently suggested that gold was
simply in a bubble pumped up by Glenn Beck.
Yet now the Keynesians (and others
who think the world is in a deflationary liquidity trap) seem to have settled
on a secure new theory: gold prices allegedly jump in response to a low real
rate of interest. If this theory is correct, the Keynesians can explain the
high gold prices of both the 1970s and today, and can confidently maintain
that Bernanke needs to open the monetary spigots to help the economic
recovery.
A Theory of Gold Prices
The theory linking gold prices to
(real) interest rates isn't new, but lately it has become chic because of its
relevance to the policy debate over Fed policy. Last October Eddy Elfenbein spelled out
the basics and did some quick calibrations to derive a rule of
thumb: "Whenever the dollar's real short-term interest rate is below 2%,
gold rallies. Whenever the real short-term rate is above 2%, the price of
gold falls."
Much more recently, Paul Krugman literally couldn't get to sleep worrying about
the issue, so at 4:30 in the morning he wrote up a
blog post using formal economic modeling to explain why gold
prices should adjust upward whenever real interest rates fall. After reaching
his result, Krugman declared,
[S]uppose
this is the right story, or at least a good part of the story, of gold
prices. If so, just about everything you read about what gold prices mean is
wrong.
For this is essentially a
"real" story about gold, in which the price has risen because
expected returns on other investments have fallen; it is not, repeat not, a
story about inflation expectations. Not only are surging gold prices not a
sign of severe inflation just around the corner, they're actually the result
of a persistently depressed economy stuck in a liquidity trap — an
economy that basically faces the threat of Japanese-style deflation, not
Weimar-style inflation. So people who bought gold because they believed that
inflation was around the corner were right for the wrong reasons.
For completeness, we can also link
to Brad DeLong,
who elaborates on Krugman's stance. DeLong graphs
the price of gold against (a proxy for) real interest rates, and generally
speaking they move in opposite directions. In particular, when real interest
rates were arguably negative in the late 1970s and early 1980s —
because annual price hikes were greater than nominal interest rates —
the price of gold was high. But in our current crisis, we also have
low real rates of interest, because nominal interest rates are so low. DeLong
gives the intuition for this outcome:
On this interpretation gold is and
always has been a super Treasury bond: a very long duration asset that is or
at least is perceived to be "safe" in the sense that its price does
not trade at a discount (due to risk and default premia)
from a Treasury bond of the same duration but instead trades at a premium.
What is the Austrian economist to
make of these claims? Is it really true that the meteoric rise in gold can be
chalked up primarily to a collapse in the real interest rate? Is the fear of
dollar debasement truly just a figment of Glenn Beck's imagination?
Looking More Critically At Those Charts
Although many in the deflationist
camp think they've plugged the last chink in their armor, let's not rush to
judgment. Far from providing a theoretically sound and empirically confirmed
explanation, Krugman and DeLong have really
just explained the two huge gold price spikes of the late 1970s and in the
last few years. But there are other falsifiable implications of Krugman's model; let's see if it passes those tests too.
First, let's reproduce the chart of
daily yields on 20-year Treasury Inflation-Protected Securities (TIPS) that Krugman used in his own post:
 
If we study the dynamics of Krugman's model, we see that it implies that sudden and
large changes in the real interest rate should lead to one-shot adjustments
in the price of gold in the opposite direction. This is the mechanism, after
all, by which Krugman thinks he has adequately
explained the sharp rise in gold prices over the last few years.
Yet there are large stretches in
the above chart that do not fit this story. For example, the real
interest rate (as measured by 20-year TIPS
yields) rose quite sharply from 2.06 percent on January 3, 2006,
to 2.58 percent by July 3 of that year. That's a very strong move for such a
short time period.
It's unclear how much this shift
should have moved the price of gold, since Krugman's
model is qualitative. To actually calculate the new equilibrium spot price,
we'd need to plug in a number for what he calls the "choke price"
of gold, at which nobody would buy gold for industrial or commercial applications.
Yet regardless of the size
of the move, the direction is perfectly clear: if Krugman's
basic story is right, then this large increase in the "real rate of
interest" over a six-month period should clearly have reduced the
real price of gold.
So how well does Krugman's theory hold up?
Eyeballing the charts at Kitco,
the spot price of gold in early January 2006 was $530. By early July the spot
price had risen to $623. After adjusting for the change in official CPI,
that's still a 15 percent increase in the "real" price of gold,
during a short stretch when Krugman's theory says
gold prices should have gone down, and probably sharply. Oops.
Krugman's model has
other implications, too. For example, if the real interest rate holds steady
for an extended stretch, then the real price of gold should rise (on an
annualized basis) by the same rate during that period. Unfortunately, the
yield on the 20-year TIPS bounces all over the place, so it's hard to test
this implication. Even so, as the chart above indicates, the yield is
relatively calm during the year 2005, and hovers around 2 percent. Sometimes
it's lower, sometimes it's higher, but it doesn't stray too far from 2
percent during the year, at least compared to how volatile it is on the rest
of the graph.
So if Krugman's
model were the whole story, then the real price of gold should have increased
only about 2 percent during the year 2005. In fact, the spot price increased
from $428 to $512; after adjusting for the change in CPI, the real price
increased about 16 percent.
To sum up, whether we're looking at
large moves in the real interest rate over shorter periods, or fairly steady
real interest rates over longer periods, there are patches using Krugman's own data set that are at complete odds with his
model. Krugman and DeLong think they solved their
pesky problem of rising gold prices, but they really haven't. They came up
with a qualitative model in which sudden drops in the real interest rate lead
to instantaneous upward shifts in the price of gold. Seeing this result, they
declared, "Mission accomplished!" and cracked open some beers. But
there are several other implications of their model that fail to match the
data.
Now it's true, Eddy Elfenbein's model for gold prices seems pretty good:
But the problem is, Elfenbein is just curve fitting.
The elegant theoretical apparatus that Krugman et
al., deploy requires gold to respond to long-term interest rates, yet Elfenbein admits that he instead used short-term rates to
generate the above graph. What's more revealing, Elfenbein
says of his above chart,
The relationship isn't perfect but
it's held up fairly well over the past 15 years or so. The same dynamic seems
at work in the 15 years before that, but I think the ratios are different.
That's fine as far as it goes, and
perhaps short-term traders in the markets will find Elfenbein's
model useful. However, he clearly hasn't given us "the" model of
gold, since he himself admits that (a) it doesn't dovetail with any
theoretical explanation and (b) it really only "works" when he
restricts the data to a certain period and then plays with parameters to get
the best fit. With such a procedure, one might "explain" gold
prices by reference to all sorts of things.
In fairness to Elfenbein,
he is quite transparent about the limits of his accomplishment. (Alas, no one
ever accused Paul Krugman of comparable modesty.) Elfenbein writes,
Let me make this clear that this is
just a model and I'm not trying to explain 100% of gold's movement. Gold is
subject to a high degree of volatility and speculation. Geopolitical events,
for example, can impact the price of gold.
This is an excellent point, and
should give pause to those who think Krugman et
al., have solved the alleged mystery of soaring gold prices. It is well known
that geopolitical events can cause sharp movements in the price of gold. It
is interesting to note that these do not necessarily coincide with the
required movements in the TIPS yields. For example, after President Obama
told the world that US forces had killed Osama bin Laden on May 2, gold prices
tumbled about $55 per ounce over the next few days. But the 20-year TIPS
yield slightly fell too. (For Krugman's
story to work, TIPS yields should have risen on the
"expansionary" news, in order to knock down gold prices.)
Ignoring the Elephant in the Room: Gold
Is the Market's Money
In the section above I showed the
shortcomings of the real-interest-rate theory in terms that even mainstream
economists can appreciate. But now I want to point out the fundamental
problem with the approach of Krugman et al.: they
are trying to explain the price of gold while ignoring its historical function
as the market's money.
For example, let's look under the
hood of Krugman's model. If you can wade through
the jargon, this is what he's doing: Krugman first
assumes that there is a fixed stock of gold (already mined) in the possession
of various owners. Then, that fixed stockpile slowly disappears as it flows
into commercial and industrial applications. But the crucial thing is, in Krugman's model the only reason to hold gold is
that you expect the price paid by dentists (for gold fillings) to go up in
the future. Here's Krugman in his own words:
Here's how it works. Imagine that
there's a fixed stock of gold available right now, and that over time this
stock gradually disappears into real-world uses like dentistry. (Yes, gold
gets mined, and there's a more or less perpetual demand for gold that just
sits there; never mind for now). The rate at which gold disappears into
teeth — the flow demand for gold, in tons per year — depends on
its real price … (emphasis added)
Notice the part I emphasized: Krugman is quite consciously ignoring the fact that there
are some people out there who hold gold "that just sits there." He
says, "never mind for now," but he never comes back to this crucial
point.
As we should expect by now, Eddy Elfenbein's introduction to his own analysis is
refreshingly candid:
But the question is, "How can
anyone reasonably calculate what the price of gold is?" For stocks, we
have all sorts of ratios. Sure, those ratios can be off … but at least
they're something. With gold, we have nothing. After all, gold is just a rock
(ok ok, an element).
How the heck can we even begin to
analyze gold's value? There's an old joke that the price of gold is
understood by exactly two people in the entire world. They both work for the
Bank of England and they disagree.
It is clear that neither Krugman nor Elfenbein has any
appreciation for the historical role of gold (and silver) as a medium of
exchange. Ludwig von Mises, in his classic work
The Theory of
Money and Credit, explained systematically how gold can begin
as a normal commodity, with its relative price determined by its use as a
factor of production.
Yet because of the process I
summarize in this article,
traders begin holding gold (or other media of exchange) not because
they want to use it to make necklaces or tooth fillings but because it is a
very liquid asset. When this process snowballs, gold (or other media of
exchange) becomes commonly accepted, and at that point the market has
spontaneously given birth to a money. (See a recent
challenge to this view.)
Once we understand gold's
historical role as the world's market-based commodity money, we can see why
it is the inflation hedge par excellence, and also why people rush
into gold when they are fearful. The equilibrium relationships described by Krugman et al., need to be true, other things equal,
but they have by no means demonstrated that Bernanke needs to inflate more.
Conclusion
I submit that Krugman,
DeLong, et al., will have a hard time really understanding the market's
embrace of gold (and silver), if they try to explain its price with a model
that ignores gold's historical role as a medium of exchange. (To his credit,
the deflationist
Mish has always emphasized gold's special place as the market's
money.)
When bad news from Greece causes
Treasury prices to rise, everybody accepts the commonsense explanation that,
"Investors are fleeing the euro into the dollar." So why should it
be such a mystery that Bernanke's incredible dollar pumping would send
worried investors into safe-haven currencies (gold and silver) that cannot
be debased?
There are plenty of investors
— including small potatoes as well as big guns such as Jim Rogers
and Marc Faber
— who are quite clear about why Bernanke's policies have pushed up
commodities in general, and the precious metals in particular. We don't need
to draw up fancy models to get inside their heads; these people are screaming
their motivations at us every day.
Now perhaps these high-profile
investors are wrong, and we really are in store for stable consumer prices as
far as the eye can see. But I don't think
so, and neither do the millions of other people rushing into gold.
Robert P. Murphy
Article originally published at Mises.org
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