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Krugman article on Gold

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LeftistSpew

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http://krugman.blogs.nytimes.com/2011/09/06/treasuries-tips-and-gold-wonkish/#more-24069

Like Krugman, I am a "deflationista". I simply don't buy the future-hyper-inflation stuff at all and I think the ultra-low 10-year bond yields are correct in their assumption of a future with zero inflation or deflation. (If you think gold prices are merely a reflection of inflation, then none of this will make sense to you and you can skip this post).

With that context, Krugman writes a rather bizarre article about how the price of Gold can be driven up in a deflationary scenario. The argument, in short, is that when all other investments have very low yields, you lose far less opportunity to hold gold (which just goes sideways by definition). When the effective holding cost goes lower, the price should go up because the former price had the holding cost baked in. (Then there's other weird stuff about tooth fillings and gold mining, which I think is totally irrelevant).

Nevertheless, so far, this is reasonable argument as to why a deflationary scenario should make the price go "up". The $trillion question for investors is this: how much?

I submit that it cannot possibly be the 580% in 10 years as it has risen. Ten years ago, about 74 ounces of gold could be traded for a brand new Toyota Camry. Today, it requires only about 14 ounces to buy the same (higher quality and updated) car.

So for this analysis to hold true, you'd have to assume that "before" the depression one could expect yields of about 19% and now you can expect exactly 0% (or any delta of 19%). This gets even more extreme when you look at only the last 12 months: a nearly 50% run-up in price. I would submit that the short-term number, given a liquid market (which it most decidedly is) should be the operative one. As such, we would have to imagine that investors were getting 50% annual returns in 2010, then the depression came (suddenly in 2010?), and now they get zero. Totally crazy. (Obviously run-away DEflation would explain it, but I think that's crazy too).

A more reasonable assumption, then, would be an approximately 5% delta. Whereas you could once yield 6% in the financial markets, now you can only get 1%. The other correction is that you need to start from where normal investment yields started to crash, which is to say 2008 or so.

As such, you'd expect the price of Gold to be up about 16% (5% APR for 3 years) from it's 2008 price, which is to say about $930 or so (and this is assuming it went from $300 to $800 between 2000 and 2008 by some other force of magic). But even with that assumption, this prices gold at less than half what it is today.

So I think Krugman is dead-wrong about the reasons for the run-up in gold prices, which I think can only be explained by Bubble dynamics and speculation--even when he's very correct in saying that the price certainly does not reflect inflation.

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I think this type of analysis (e.g. today's price is only justified if people were expecting alternative returns of 50% in 2010 and zero now) tells us that something different is happening in gold, but I don't think that one can extrapolate to the conclusion that gold is over-valued, nor that it will be lower (say) a year from now. I'm not making this point about gold alone, but this type of analysis in general. It is extremely useful analysis, but consider the form it takes:

1. Prices we saw at time T1 can be rationally explained if we assume A1

2. Prices we saw at time T2 can be rationally explained if we assume A2

3. A1 and A2 are incompatible by any rational analysis

4. Therefore... the market is mis-priced at time T2

As you see, #4 does not follow, because the market might just as well have been mis-priced at time T1. In fact, the market may have been partly mis-priced (in opposite directions) at both T1 and T2.

It is pretty clear that the people's demand for gold has increased. The fact that people hold gold is not inconsistent with their expecting deflation. Expectations are something of an average viewpoint, of where people think things are going. However, human beings actually think of the future more like it is a set of possible outcomes, rather than some average outcome. There are a fair number of people who think the medium-term (5 year) outlook is credit-deflation, yet, they simultaneously think that the 'tail risk" of crazy political action have increased as well. So, they are buying gold even though they do not think it is going to be their killer investment. The possibility of alternative returns does play into it too: an Krugman is right in the broad sense that the lower the possibility of returns from elsewhere, the more comfortable people are to put some of their money into gold.

It is not clear to me that the demand from gold is coming mostly from people who have inflation expectations, rather than from people who see an increased probability of inflation while continuing to hold a fairly neutral or deflationary expectation.

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