One of the few reasons why facebook is awesome: I can randomly discuss economics with a complete stranger for over a week. The discussion is still on going but because of its wide content I wanted to include it here. Alex and I started discussing money after one of our mutual friends/acquaintance Brian posted a comment reflecting on the gold price and USD inflation. From that, Alex (if I may label, he seems like a broad Keynesian) and myself (hobbyist of the Austrian school) started going back and forth.
For the funny part, I will go ahead and skip to the end of Part 1. After going back and forth for a few days I realized that Alex must have had some education in the matter so I looked at his profile for the first time and saw that he is a PhD in Finance. Oh Facebook, nothing like randomly have a hobbyist economics guy debating a PhD. Ah well, it’s all enjoyable.
This isn’t the end of the discussion. It may have died down after the “PhD in Finance” scandal, but Brian commented again right after that which got Alex and I started up again. Part 2 can be read here.
Original Poster, Brian:
Not sure what’s happening to the dollar, but have a sense that maybe it isn’t safe to keep money in dollars?
Here are two charts: one is for silver and the other for gold, mapping value from 1985 to the present.
When I was a kid, gold was about $300 and silver was about $7.
Now gold is about $1700 and silver is about $30.
How do you feel about how much value the dollar has lost during our lifetimes?
Gold and silver are commodities. Their prices going up doesn’t devalue the dollar in any broader sense. What do you think is a safer monetary unit, presently?
From the graph you could also draw a similarly erroneous conclusion that the dollar tripled in value between 1987 and 2000. It’s just markets reflecting changes in demand relative to supply – precious metals tend to do better during recessions, though their overall returns are very low as is expected with what’s basically a form of insurance. You can calculate better estimates of the change in dollar value (i.e.inflation) a number of different ways, usually involving a basket of staple goods rather than any single commodity. Over that time period the value of $1 has actually halved, which corresponds to an average rate of inflation of about 3%. That, in global and historic terms is considered relatively low and stable so doesn’t substantially affect rational economic decisions.
Gold’s price going up doesn’t devalue the dollar, but the dollar’s devaluation – all things being equal – cause gold’s price (and everything else) to go up.
Alex, monetary inflation is measured by the increase in the quantity of money, which can cause a change in the value of the money. You can’t measure monetary inflation through a basket of goods. All that gives you is an average price inflation of those goods. There is a relation between the two but they are distinct entities. Because of world market actions, gold’s price reflects the future expectations of monetary & price inflation. So, if it’s future expectations of inflation that cause gold’s price to be so high, then I’d be worried about future price inflation as it will eventually match monetary inflation (which has been astronomical).
Would you care to explain why looking at the change in price of a single commodity (gold) gives a better estimate of inflation than the average a basket of many commodities? What that shows is a huge bias in any inflation estimate due to the countercyclical nature of gold returns. Looking at monetary inflation at the moment also isn’t a good proxy for future price inflation since most of it is held at banks rather than in circulation. There’s a risk that they might begin lending like crazy, but that hasn’t really been supported by any activity on their part. That kind of money is also very easy for the Fed to pull back in. Functionally speaking it’s just been a way that the Fed has been throwing money at the banks through the back door to get them recapitalized
Maybe the price of gold is going up because there’s a gold bubble, partially due to unfounded paranoia about the soundness of the USD. One also has to consider the incentives of goldbugs publicizing these kind of theories. The term “pump and dump” comes to mind.
Gold is used internationally as a monetary inflation hedge; it’s why people buy it. You need to differentiate between monetary inflation and price inflation. See this graph from bloomberg. Any fear about the soundness of the USD isn’t “unfounded”. Monetary inflation is factual and huge. Price inflation has been minimal as Alex mentioned. So Alex, what do you think more likely: the Fed pulls money back in and destroys it and deflates the money supply, or the Fed raising their fund rate so the banks have to lend it out and increase the monetary velocity?
Alex, you are right that price inflation has been held down because the inflated money supply is being held in banks. The velocity of money (a measure of how often t changes hands in an economy) has also gone significantly down reducing price inflationary effects.
Also, there isn’t a gold bubble Philip. I can’t think of anyone who has purchased gold related products in the last 2 years that hasn’t already been pro-gold for 5 years+. Oh, except for central banks of the world; but I wouldn’t bet against them, that’d be foolish of me. When my mom buys some shares of a gold etf, then we are in a bubble.
If there is a gold bubble, it’s certainly not 2-5 years old. Gold still holds residual value from when it was used as currency above and beyond its value for industrial applications.
You can assume that when I’ve used the term “inflation” I’ve been talking about price inflation, as opposed to money supply.
We agree that while the money supply has increased dramatically through Fed intervention, it has not, at least as yet, led to price inflation – due primarily to a lack of bank lending.
The velocity of money has always been tough to measure directly, so it’s usually just calculated as the residual of the PY=MV quantity theory identity. I’m not sure what that adds to the discussion.
To answer your question though, the Fed’s policy depends on the yield on Treasury bonds at the time. So long as the Fed funds rate remains below the return on treasuries, banks have no incentive to lend since they can make a low but certain profit off of putting the borrowed funds in Treasuries and keeping the difference. So the Fed will pull that money back in without a second thought. They’ve committed to keeping the funds rate low for the next year at least, so, no, the banks aren’t going to get any additional incentive to lend. As the economy improves, the velocity of money will increase naturally, and in addition partly due to the Fed pulling back some of those funds. The lower money supply will increase bank lending rates leading to a lower rate of economic growth than would otherwise occur, but keeping inflation (and hence the value of the dollar) within tolerable bounds. Why would the Fed suddenly feel the urge to jack up the funds rate if it hasn’t done it up to this point?
Right, so the price of gold is based off of monetary inflation; not price inflation like most other commodities. That’s why I differentiate between inflation types and why I went on the side track. The dollar is devalued through monetary inflation not price inflation. Hence Brian’s original post.
Hahaha, I just realized I’m arguing with a PHD in finance. Dang you facebook!
To simplify everything, I’ve studied and agree with the Austrian Business Cycle and Monetary Theories. If you disagree with those then I can assure that this student of economics isn’t going to persuade you otherwise, nor would I even try.
lolz. I need to make my profile sneakier!
No worries, it was a rare, real internet “lol”.
See Part Two of this discussion here