Gold prices are way up, but the inflation statistics are quite tame. Why is this happening? Is somebody lying to us, or is gold not all it’s cracked up to be?
This used to be a very obscure debate. Some free market economists (like the great Steve Forbes and the late Jude Wanniski) have held that gold prices can be used to predict future inflation, but some (such as Art Laffer and Larry Kudlow) do not. I started writing about this topic in 2004, but I got a very negative reaction from many people with whom I usually agree on the big issues. I decided to tread lightly and focus most of my attention on the questions on which my friends and I agree. The problem is that this obscure question about economic growth, inflation and gold prices has now moved to center stage. In the annals of economic history, it’s what 2007 will have been about.
Here’s how we got here: Over long periods of time human production of gold had increased at roughly the same pace as human production of everything else. At times when the worldwide economy was growing at about 1%, the worldwide growth of gold reserves was also running at about 1%. This meant that a currency backed by gold would grow and shrink at roughly the same rate as the economy in general. This fact is the basis of what economists call the “Gold Standard”. If the money supply grew at the same pace as the supply of goods and services, then the prices would remain stable. Early in the 20th century, liberal economists rejected the idea of a currency backed by gold, not because they failed to see that unbacked money would cause inflation, but precisely because they saw that it did. They wanted inflation—because they believed that inflation would make people feel wealthier than they really were, and thereby trick them into spending more than they otherwise would. This argument was advanced most effectively by a British economist named John Maynard Keynes. Free market economists quickly saw the flaw in Keynes’ argument—that eventually people figure out that they’ve been tricked and respond by cutting back on spending. Economists such as Ludwig Von Mises accurately predicted that this would set up a cycle of boom and bust. They were proved right by the Great Depression, and ever since then conservative economists have defended gold against its liberal detractors. It has been a useful tool for them, particularly when it was used by Arthur Laffer and Robert Mundel in predicting the wave of inflation that struck America in the 1970s after Nixon removed the dollar from the gold standard. Because of its success as an inflation predictor, gold went from being a useful tool to being a central dogma in the conservative creed.
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