Economics on Trial THE FREEMAN NOVEMBER 1998

A Golden Comeback, Part III
by Mark Skousen

"A free gold market ... reflects and measures the extent of the lack of confidence in the domestic currency."
-- LUDWIG VON MISES

In the past two columns, I've highlighted the uses and misuses of gold. Despite occasional calls for a return to a gold standard, the Midas metal has largely lost out to hard currencies as a preferred monetary unit and monetary reserve. Most central banks are selling gold.

Gold has also done poorly as a crisis hedge lately. It has not rallied much during recent wars and international incidents. U.S. Treasury securities and hard currencies such as the German mark and Swiss franc have become the investments of choice in a flight to safety.

Nor has gold functioned well as an inflation hedge over the past two decades. The cost of living continues to increase around the world, yet the price of gold has fallen from $800 an ounce in 1980 to under $300 today.

What's left for the yellow metal? I see two essential functions for gold: first, a profitable investment when general prices accelerate and, second, an important barometer of future price inflation and interest rates.

Gold as a Profitable Investment

Since the United States went off the gold standard in 1971, gold bullion and gold mining shares have become well-known cyclical investments. The first graph demonstrates the volatile nature of gold and mining stocks, with mining shares tending to fluctuate more than gold itself. The gold industry can provide superior profits during an uptrend, and heavy losses during a downtrend.

One of the reasons for the high volatility of mining shares is their distance from final consumption. Mining represents the earliest stage of production and is extremely capital intensive and responsive to changes in interest rates.1

Gold as a Forecaster

Gold also has the amazingly accurate ability to forecast the direction of the general price level and interest rates. In an earlier Freeman column (February 1997), I referred to an econometric model I ran with the assistance of John List, economist at the University of Central Florida. We tested three commodity indexes (Dow Jones Commodity Spot Index, crude oil, and gold) to determine which one best anticipated changes in the Consumer Price Index (CPI) since 1970. It turned out that gold proved to be the best indicator of future inflation as measured by the CPI. The lag period is about one year. That is, gold does a good job of predicting the direction of the CPI a year in advance. (All three indexes did a poor job of predicting changes in the CPI on a monthly basis.)

Richard M. Salsman, economist at H. C. Wainwright & Co. in Boston, has also done some important work linking the price of gold with interest rates. As the second graph demonstrates, the price of gold often anticipates changes in interest rates in the United States. As Salsman states, "A rising gold price presages higher bond yields; a falling price signals lower yields. ... Gold predicts yields well precisely because I~ it's a top-down measure. It is bought and sold based purely on inflationdeflation expectations; thus it's the purest barometer of changes in the value of the dollar generally."2

In sum, if you want to know the future of inflation and interest rates, watch the gold traders at the New York Mere. If gold enters a sustained rise, watch out: higher inflation and interest rates may be on the way.

1. For further discussion regarding the inherent volatility of the mining industry, see my work The Structure of Production (New York: New York University Press, 1990), pp. 290-94.

2. Richard M. Salsman, "Looking for Inflation in All the Wrong Places," The Capitalist Perspective (Boston: H. C. Wainwright & Co. Economics),October 15, 1997. For information on his services,call (800)655-4020.