Look Beneath the Golden Gleam

Financial Times, 15 September 2003

Optimism is stirring in financial markets and the US economy. Recent indicators have suggested that enormous fiscal and monetary stimulus is having an impact. Stock markets have held on to substantial gains and bond yields have risen as forecasts for growth have been revised upwards. Supply-side arguments revolving around strong productivity trends are back in vogue, as is a tendency amongst analysts and market participants to ignore the implications of persisting global imbalances.

However, there is at least one warning sign that all is not well, and that problems lie ahead for financial markets and the global economy. This is the underlying strength of the gold markets, both bullion itself and gold mining shares. The gold price has risen from lows of close to $250 per ounce early in 2001 to almost $380 now. The increase has been prolonged enough to suggest the end of the previous long downward trend.

The increase in the price of gold has certainly not gone unnoticed but it has not been satisfactorily analysed. Some commentators have seen it as a symptom of the risks posed to the financial system by the supposed threat of deflation, while others ascribe it purely to dollar weakness. Very few observers have taken the traditional view that the upturn in gold is a sign of nascent inflation pressures. Most market participants seem to view gold's strength as having no longer-term significance, being merely the result of diversification by investors and accompanying speculative activity by hedge funds.

The conventional wisdom is likely to prove mistaken. The gold market may be relatively small but gold retains its significance as a longer-term monetary indicator. Contrary to a popular view, this importance does not depend upon the whims of a few central bank governors and finance ministers but rather on the characteristics that have historically made gold a money and lie behind its long history as a monetary asset.

Looking back, the medium- and longer-term movements in the real gold price have contained information about the forces shaping the economy and financial markets. The difficulty, as always in economics, has been in understanding and correctly analysing those influences as they are occurring, rather than after the event.

For more than a hundred years gold has experienced very long cycles in its real value (that is, its price relative to goods and services), but these very long cycles have occurred around a constant level. That is, in a very long-term sense the real gold price has tended to remain stable. (This was not true longer ago in history when large gold discoveries had an impact). Around this stable real value there have been three very extended periods of depressed real gold prices, the first from 1920 to 1933, the second in 1952-70 and the third the period that began in the mid-1990s.

The first of these coincides roughly with the monetary regime of the gold exchange standard and the second with the era of the Bretton Woods system of fixed exchange rates. In both of these periods the price of gold was fixed by central banks and governments. The difference between the two was that under the gold exchange standard, price levels in the economy were forced into alignment with the low fixed price for gold meaning deflation while under Bretton Woods, ultimately they were not. Central banks pursued expansionary monetary policies in the 1960s and early 1970s that were incompatible with the low price fixed for gold, until the system inevitably broke down, with inflationary consequences.

The third period of low real gold prices, which continues today, can also be attributed to the actions of central banks and governments, but the forces at work are more complex. Beginning in the mid-1990s, central banks and governments not only sold gold heavily from reserves and lent gold to short-sellers, but their wider activities also encouraged excessive speculation in financial assets that further discouraged investment in gold. In the bubble environment of the 1990s, this helped create many of the “feedback loops” that sustained the financial bubble. For instance, low gold prices played a role in helping to suppress inflation expectations, which further encouraged the financial markets.

Arguably, the downward trend in the price of gold also helped to cement the dominance of the dollar as the world's reserve currency and store of value. The strength of the dollar, in turn, was a further force keeping US inflation low even as the Federal Reserve implemented an increasingly loose policy. The weakness of gold up until the end of the 1990s was therefore integral to the financial bubble environment, both as a cause and effect of the inflation of financial asset prices.
This perspective leads to two main conclusions. First, the new upward trend in the gold price may well point to the fact that the post-bubble adjustment process still has some way to go. Second, particularly if it continues, it will be an indicator that Fed policy has indeed been too lax and ultimately inflationary. This implies that the Fed's latitude for policy action is becoming much narrower.

When these conclusions are added together, they suggest an outlook for the global economy, and both bond and stock markets, that is much less benign than the optimists would have us believe. Investors would do well to look more closely at gold’s steady rise.