Gold's Current 'Message'

February 13, 2009 | By: Calafia Beach Pundit

Judy Shelton has a good article about the virtues of a gold standard in yesterday's WSJ, so I thought I would add my chart (click to enlarge) 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 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.

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