06 Sep 2011

Krugman on Gold: I Am Clairvoyant

Gold, Krugman 32 Comments

This almost freaks me out. The handful of people who regularly tune into my Saturday “office hours” for Mises Academy classes can verify this: It was literally just last weekend when I said something like, “I mean, if it weren’t for gold prices, I might be really concerned about my worldview here. It does trouble me that bond prices are so high; am I really saying all these smart guys in the market are idiots? But on the other hand, the soaring price of gold and silver during this slump should be keeping Sumner and Krugman up at night, too.”

Obviously that’s not an exact quote, but I kid you not, I said something along those lines. And then today I read at Krugman’s blog:

“(Yes, it’s 4:30 AM where I am. I found myself wide awake, thinking about gold prices. You got a problem with that?)

In assessing economic prospects since the financial crisis of 2008, there have been two kinds of people: …inflationistas and deflationistas….

I am, of course, a big deflationista, and as I see it record low interest rates strongly vindicate my position. As I like to point out, if you’d believed the inflationistas at the Wall Street Journal and elsewhere, you would have lost a lot of money.

But what about gold? As some readers and correspondents love to point out, you would have made a lot of money if you’d bought gold early in this mess. So doesn’t that vindicate the inflationistas, to some extent?

My usual response has been that I have no idea what drives the price of gold, to say that it’s a market driven by hoarding in Asia, Glenn Beck followers, whatever. But maybe I’ve been too flip here. Why not think about what actually should be driving gold prices? And I mean think about it, rather than going for slogans about inflation, debased currencies, and all that.

Well, I’ve been thinking about it — and the answer surprised me: soaring gold prices may be quite consistent with a deflationista story about the economy.

32 Responses to “Krugman on Gold: I Am Clairvoyant”

  1. AP Lerner says:

    Historically, gold has been just as correlated with deflation as inflation. It’s true. Look it up. He kind of has a point on this one.

    • bobmurphy says:

      I can’t look it up. I’m still shaking from discovering my magical powers.

      • Joseph Fetz says:

        It’s ‘Magic Bob Murphy’…. Behold!

    • Jonathan M. F. Catalán says:

      I don’t get your point in the first sentence. What are you talking about? The price of gold, or the price of other goods in terms of gold?

    • Aaron says:

      We (in the US) haven’t really had deflation in the US since the gold standard. And of course, deflation in terms of gold during the gold standard is completely different than deflation in terms of dollars.

      Japanese gold price (through the supposed Japanese inflation of the 90s)…

  2. Zack A says:

    I wonder if Krugman thinks that the Feds huge balance sheet and highly accommodative measures taken since the crisis has anything to do with low bond yields. And, let’s say if by acknowledging that if the Fed had not taken such accommodative measures rates would be higher right now, would that undermine his worldview? In other worlds, how do we know what the yield curve and the bond market overall would have looked like if the Fed had never intervened in the first place? Taking the Fed into consideration, I don’t see how people can point to the bond to somehow vindicate the notion that inflation is not a potential threat.

    In my opinion, the accommodative measures taken by the Fed coupled with loose monetary policy on behalf of other central banks are the driving forces behind this gold bull market. Basically, people are slowly but surely losing faith in fiat currency and flocking toward gold to store their purchasing power because it’s out of the reach of reckless central bankers.

    How can a deflationary scenario be bullish for gold? If real rates are rising as paper money is gaining purchasing power, why would you buy gold? Of course, Krugman could say “its just irrational fear! No currency debasing going on!” But surely the dollar has lost value against the Swiss franc, the Canadian dollar, and a myriad of other foreign currencies not to mention gold has not gone up as sharply against the Swiss franc as it has against our dollar.

    All in all, Krugman’s story doesn’t make sense with regards to the bond market, or the fact that the price of gold rising is somehow indicative of a deflationary scenario. With the CPI running at 3.6 percent, the PPI going higher how is that consistent with a deflationary environment?

    As Peter Schiff always points out, it’s not gold that is going up, it’s the dollar that is going down. It’s taking us more and more dollars to buy an ounce of gold than it used to. That wouldn’t be the case in a deflationary environment or in an environment where the dollar was gaining purchasing power.

  3. Seth says:

    “As I like to point out, if you’d believed the inflationistas at the Wall Street Journal and elsewhere, you would have lost a lot of money.”

    TIPS haven’t done so bad, have they?

    • bobmurphy says:

      And then he goes on in the next breath to talk about how gold buyers did well, and how that’s the line Glenn Beck has pushed. So he should have said, “As I incorrectly liked to point out…”

  4. MamMoTh says:

    I wonder why no one is interested in how coconuts have performed.


    • MamMoTh says:

      Coffee has performed better than gold over the last year. Who made that call, inflationists, deflationists, or coffee partyers?

      • skylien says:

        You are showing a chart for the purpose of showing how bad gold is, which at the same time shows as the best performing asset to be Silver?

        Not a striking case 😉

        BTW: Ever heard of “Nash equilibrium” ? With coconuts and coffee (and IMO with fiat) you cannot reach that.

        -> Very long article…

      • bobmurphy says:

        Krugman is up at 4am. What do you think?

        • MamMoTh says:

          Good point. And what about corn? Do you go to the movies that often?

          • bobmurphy says:

            MamMoTh, no, I don’t. It’s almost like the explanation must come from the monetary side. Hmm…

  5. Yancey Ward says:

    This sort of reminds me of the story of the Titanic. When the ship began to go down by the bow, the passengers, not believing the ship could sink, could not be easily enticed into the lifeboats, and many went to the safest remaining parts of the ship. I wonder, in conjunction with Zack A’s comment above, whether or not you can explain the bond market and the gold market the same way- most still believe the ship unsinkable, and thus rush to the safety of the sovereign bond market, while a few decide to buy a lifeboat in gold. Right now, the bond market is winning on sheer numbers, and maybe those people are correct and the gold buyers are wrong, but this play has acts to go before we sleep.

    • Joseph Fetz says:

      “Right now, the bond market is winning on sheer numbers”

      Less than 2% on a 10-year, I don’t think so. You must be talking volume….

      • bobmurphy says:

        Right, but if the deflation people are right, then we’d see low bond yields. In other words, it is a sign that “the market” doesn’t expect price inflation, if bond yields are low. They’re not talking about people earning a high rate of return by investing in bonds, in fact they’re saying the opposite (except for people who rushed into bonds right away before yields collapsed).

        • Robert Fellner says:


          My understanding of the bond market is that historically it has never served as an accurate measure of significant changes in future price inflation either up or down, is this not correct?

      • Yancey Ward says:

        Money and volume of buyers.

  6. Jack says:

    I’m a little confused.

    “Well, I’ve been thinking about it — and the answer surprised me: soaring gold prices may be quite consistent with a deflationista story about the economy.”

    Is he saying he “deflationistas” running their mouths have created the runs to gold? Or is he for once conceding that maybe his side has it wrong? Or am I missing something?

    • Jack says:

      Oh haha nevermind. I had to read that one over again. But how exactly could the soaring gold prices possibly be consistent with that story? Whatever helped him get back to sleep, I guess.

    • Yancey Ward says:

      He is saying the opportunity cost of holding gold has gone down (returns on other assets are falling), thus people are willing to pay more for it. I don’t disagree completely, but the impression I am increasingly getting from Krugman is that he is a man baffled by what has happened since 2008, and what is happening today. This blog entry of his seems of a kind with many of the recent ones.

      • joshua says:

        I think what has happened since 2008 has baffled everyone to some degree, unless you’re either really smart or really good at fitting narratives to your previously existing worldview.

        • Yancey Ward says:

          But think about this- what if you had given the Krugman of 2007 an outline of the recession of 2008-2009, and also told him that the US, and a lot of the developed world would run 10% budget deficits, the US government would increase real expenditure by the amount we have in the last 4 years, that the Fed would keep short term rates pegged to almost zero, and start to enforce that rate out to 2 years maturity. What would he have predicted about unemployment? I can’t imagine any scenario that he would have guessed 9% unemployment and job growth stalled in 2011. I can think of one economic school that would have had no problem predicting the outcome in 2007 given those policies.

  7. Strat2131 says:

    Exeters inverse pyramid of liquidity


    I think short term shocks (0-12months) will continue to push people into more liquid investments, but in the long run 30 year paper investments aren’t sustainable. Smart money is beginning to realise this and get out while the fed has been purchasing. This is pushing foreign governments out, so the feds balance sheet will have to expand going foreward.

  8. Tel says:

    Looking at Krugman’s first two graphs, the second graph shows the gold price accelerating towards the “choke price” but I would expect that the first graph defines a first order Ordinary Differential Equation which inevitably gives an exponential decay, so the second graph should show gold price becoming asymptotic to the horizontal “choke price” horizon, but never actually reach that point (presuming Krugman’s scale is not drawn such that infinity exists halfway down the axis, in which case you have to ask what comes after infinity).

    So taking this down to the fourth graph (“New path” / “Old path”) they both bend the wrong way, and they should both become asymptotic to the “choke price” horizon, not sure if they can sensibly cross , but I think not.

    Mind you, this is all presuming that Krugman’s demand curve (the very first graph) remains constant over time, and if the money supply expands then probably the whole demand curve would move up as time goes past, because they guy wanting a gold filling now has more of the easy-credit money in his pocket to buy that gold filling.

    • bobmurphy says:

      Tel, I’m not saying Krugman did the whole thing right, but I think he’s right that the Hotelling model would show a price path like the one he depicted. In that model, the price of the exhaustible resource in equilibrium has to rise with the nominal rate of interest. At a constant interest rate, that implies exponential growth of the spot price, not asymptotic growth.

      • Martin says:

        As I understood it, is that when the real rate changes you get jumps to the new price path and when the (expected) real rate changes often, you will see a lot of jumps.

  9. Martin says:

    Bob, if you’re interested, there is model of gold prices that fits the data rather well and its author is arguing that gold prices are not linked to inflation, but to real rates.


  10. david stinson says:

    If Krugman’s big point is that demand to hold gold is inversely related to short term real interest rates, then it’s not news. Gold investors have known for awhile that that was the case since the interest rate is part of the opportunity cost of holding gold. Listen to anyone like Marc Faber or many others and they will invariably say that very low or negative real interest rates have spurred the gold rally over the last ten years.

    The story that gold has historically done better during deflationary periods than during inflationary periods, absent the real interest rate effect, is, I believe, an artefact of the gold standard. In other words, under a gold standard, a drop in the price level or deflation is defined as an increase in the value of gold just as now deflation is defined as an increase in the value of the dollar in terms of other goods. The excellent Summers/Barsky paper linked by Krugman is helpful in that regard. It also implies, as I recall, that the Fisher effect is really just an artefact of paper money regimes, in the same way that Gibson’s Paradox was an artefact of the gold standard. Under a gold standard, there was generally no ex ante expectation of monetary disequilibrium.

    Regarding inflation, this is what I said here about two months ago:

    ” inflationary expectations are not, I would suggest, fully captured these days by a point estimate or a single expected value. In calmer times, not only would inflationary expectations across individuals exhibit more similarity but each individual’s estimated probability distribution of future inflation outcomes would likely be much more concentrated around the mean. Nowadays, an investor might think that, on balance, inflation will remain lowish, but also believe that there is a non-negligible probability that inflation will be substantially higher due to, for example, debt monetization or more rapid erosion of the US dollar’s position as world reserve currency.

    In such circumstances, gold may also trade in part like an option. The greater the range of potential likely outcomes, the greater the potential future volatility and the greater the value. The network effect that helps to sustain the choice of a reserve currency in stable times could in unstable times help to speed a decline in value. This increases the potential future volatility in an environment in which confidence in the currency or policymakers has been undermined.

    Thus, the bond market and gold may not be sending inconsistent signals, they may just be conveying information about different elements of inflationary expectations (point estimate vs. dispersion). Put another way, you may not expect your house to burn down (the point estimate) but you will probably still buy fire insurance (the option).”

    Regarding the Hotelling model, the thing to remember about gold is that the market is dominated by stock supply not flow supply because gold is for the most part not consumed. The supply available for trading is much higher than current output. Also, gold is not exhaustible in the sense that oil is since gold is not consumed. I am not sure whether that is relevant to the Hotelling model. I think that the remonetization of gold is proceeding (although, at this point, limited to its role as a store of value) so that the gold price as a nascent currency exchange rate is presumably also be an element in price determination.

  11. Rocky White says:

    Here’s a great article in the Financial Times that alludes to why bond prices are so high and I believe it should make sense to Austrian economists.


    Basically, the amount of cash held by companies, banks, security lenders, etc. has grown so large that they are running out of liquid safe investments. Banks only insure up to $250,000 but these companies have much more than that that. They aren’t trusting the banks with the rest of their money. All this extra cash is ending up in money markets and the repo world which are backed by gov’t bonds. Also, some of the cash is invested directly into treasuries. This has caused a shortage in treasuries and caused prices to skyrocket. Below is a quote that basically sums it up:

    “Or, put another way, faced with a choice between betting on the safety of the US government, or its banks, cash-rich large companies and asset managers are choosing the former. It is an entirely rational choice. But it is also a powerful reminder of how profoundly distorted the US financial system remains.”

    Hope this helps explain the high bond prices.

  12. stickman says:

    The problem with the Hotelling Rule, is that it hasn’t been very successful empirically.., Not for gold and not for other metals either. (And remember that I’m in the deflationist camp!)

    That being said, the reasoning behind the H-R is perfectly valid in of itself… It is simply hard to abstract to a pure interest rate effect in the real world. (The standard H-R ignores technology shocks, which obviously play a huge part in the output and price path of non-renewable resources.) In that light, I certainly think that there’s merit in Krugman’s argument. It doesn’t fully account for the price of gold — which is IMHO largely a result of people’s fear of insolvent Govts and a lack of comparatively attractive investments going around (insert beauty contest joke here) — but it does a decent job of reconciling things with the rock-bottom bond rates.

    In a related point, people tend to forget that the supply elasticity of gold is negative. Well… it certainly is for South Africa, which has only just been overtaken as the world’s largest gold producer.