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Gold, Deflation and Krugman's Flawed Economic Analysis

Commodities / Gold and Silver 2011 Sep 07, 2011 - 09:53 AM GMT

By: Adrian_Ash

Commodities

Best Financial Markets Analysis ArticlePaul Krugman's changed his stance on gold. He's still wrong though…

LOOK AT THIS! It seems some people have been waiting to buy gold until Paul Krugman advised it!


Take this comment, responding to his NY Times blog post on Tuesday:
 
"I really wish that you'd posted this a few years ago; it would have given me a rationale for buying into gold... for I have spent the past few years scoffing at the goldbugs while watching gold prices continue to rise!"

The world's second-most famous beard in economics today – arch-Keynesian, stimulator extraordinaire, Nobel-winner Paul Krugman of Princeton – says he's squared the fact of rising gold prices with his view that we're in economic deflation.

Indeed, Professor Krugman's apparently been awake all night worrying about gold prices. You might hope all economists and columnists who insist on writing gold off would do the same. Otherwise, their model of how things work might be revealed as a sham, a fraud at best, and you're left wondering how they get any sleep at night at all.

Credit to Krugman then. Sure, he's four years into gold's credit-deflation-defying rise. Yes, he could have widened his study of deflation-hit Japan to see gold prices rise too...or have read his friend Larry Summers' famous paper of 1988 to see why...or even come at it through Google. Still, better later than never!

"I am, of course, a big deflationista," says the big deflationista, a true believer that the Western Credit Bust points to falling demand, falling output and thus falling prices. "I see it record low interest rates strongly vindicate my position. As I like to point out, if you'd believed the inflationistas at theWall Street Journal and elsewhere, you would have lost a lot of money.

"But what about gold?

"Well, I’ve been thinking about it – and the answer surprised me: soaring gold prices may be quite consistent with a deflationista story about the economy."

Krugman used to think – like most other academics and commentators who've got nothing to lose – that gold should only ever rise amidst inflation. The plain fact of relatively low inflation during the six-fold rise in gold prices since 2001 mean he has changed his mind, and changed it thanks to re-reading an old economics paper on pricing theory.

Cue a handful of abstract graphs mapping demand for an "exhaustible resource" (e.g. gold) against its real (i.e. inflation-adjusted) price. As with any resource, lower interest rates on money affect that price today – pushing it higher – because the urgency of using it is pushed back. Or so says the Nobel-winning economist.

"The logic, if you think about it, is pretty intuitive: with lower interest rates, it makes more sense to hoard gold now and push its actual use further into the future, which means higher prices in the short run and the near future."

So far, so good. But trouble is, gold's use – for 89% of global demand over the last five years for instance – comes solely in its ownership. Jewelry, bar and coin demand swamps industrial use nearly nine times over. So owning gold would seem to be its own reward when the gold price rises but all other major asset classes fall.

Contra Krugman again (as he acknowledges in a quick aside), the above-ground stock of gold does NOT "gradually disappear into real-world uses like dentistry." Gold's real-world use, throughout history and most especially in the ravenous consumer markets of India and China, is precisely in holding it, not in seeing it vanish.

Yes, the damn stuff is indestructible anyway. You need cyanide to dissolve it. But the high and persistent value which humanity has long put on gold is what explains the fact that, out of the 170,000-odd tonnes ever mined in history, pretty much every last gram is still with us – known and accounted for – whether in sock drawers, around necks and wrists, in bank safe-deposit boxes or safe and sound inside concrete, steel-doored vaults three storeys below ground.

"Just about everything you read about what gold prices mean is wrong," says Krugman, adding (if only a little) to the wealth of inaccuracy and ignoring all that good stuff on gold on the internet. His new thinking, he claims, "is essentially a 'real' story about gold, in which the price has risen because expected returns on other investments have fallen.

"[Gold] is not, repeat not, a story about inflation expectations."

Only half-wrong. Because inflation expectations DO drive the gold price, as the research papers which Krugman himself points to make clear. But it's only ever a story about inflation RELATIVE TO interest rates. Because low to negative real rates of interest – when cash-in-the-bank lags inflation, losing real value year-after-year – are very much behind the deep, long-term trend in gold prices today. Just as they were in the 1970s. Just as they were when the world decided it didn't need QUITE so much investment gold in the 1980s and '90s, and the gold price fell over 80% in real terms.

You got 4% real returns on average from cash in the bank between 1980 and 2000. Who needed an inflation hedge?

Most urgently today, and given that we here at BullionVault have long said real interest rates drive gold, today's sub-zero real rates look highly likely to keep driving gold prices higher until 2013 (and beyond) thanks to central bankers being obsessed with avoiding deflation. What's more, and most pertinently to Professor Krugman's new thinking, inflation expectations also drove people to hoard gold during the 1930s' depression, even as consumer prices actually fell (unlike in this modern-day depression so far).

Yes, despite positive real rates – courtesy of commodity prices and the cost of living in nominal Dollars sinking fast – people chose to swap cash for rare metal, helping drive gold's real value sharply higher. Why? For fear of policy-makers – spurred on by their academic advisors – turning to the printing press as a "solution" to deflation and risking a monetary train wreck as a result.

Couldn't happen today though – right Professor?

By Adrian Ash
BullionVault.com

Gold price chart, no delay   |   Buy gold online at live prices

Formerly City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine, Adrian Ash is the editor of Gold News and head of research at www.BullionVault.com , giving you direct access to investment gold, vaulted in Zurich , on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2011

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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