15 Sep 2011

Taking On Krugman’s Latest Theory About Gold Prices

Gold, Inflation, Shameless Self-Promotion 30 Comments

For those who follow these things, you know that in the past few weeks the “mystery” of soaring gold prices has apparently been solved by Paul Krugman. Far from signaling that some investors are worried about the fate of the USD, Krugman thinks soaring gold prices are the natural reaction to low real interest rates.

In today’s Mises Daily I poke some holes in this chic explanation. After documenting two testable implications of his model that are way off (i.e. fail the tests), I write:

To sum up, whether we’re looking at large moves in the real interest rate over shorter periods, or fairly steady real interest rates over longer periods, there are patches using Krugman’s own data set that are at complete odds with his model. Krugman and DeLong think they solved their pesky problem of rising gold prices, but they really haven’t. They came up with a qualitative model in which sudden drops in the real interest rate lead to instantaneous upward shifts in the price of gold. Seeing this result, they declared, “Mission accomplished!” and cracked open some beers. But there are several other implications of their model that fail to match the data.

Then later I say:

I submit that Krugman, DeLong, et al., will have a hard time really understanding the market’s embrace of gold (and silver), if they try to explain its price with a model that ignores gold’s historical role as a medium of exchange.

30 Responses to “Taking On Krugman’s Latest Theory About Gold Prices”

  1. MamMoTh says:

    What’s more important is to understand the historical role of gnomes in gold digging which only happened because gnomes were too short to reach out for coconuts, even with a stick. That’s how barter started and gold is considered a medium of exchange.

    • bobmurphy says:

      Yeah, so?

      • MamMoTh says:

        So if gnomes were bigger, or coconut trees smaller, coconuts would be the medium of exchange as it should.

        • Secret Agent says:

          Good thing that in the real world, trolls, who are slightly hunched over, are the perfect creatures to harvest linen and cotton so that they are the medium of exchange, as it should.

  2. David S. says:

    This is about as moronic as it gets, and is possibly dishonest too.

    First, Krugman never wrote that expected negative real rates was the sole mover of gold prices. Yet, you take one short segment of a graph in which you say his proposed relationship doesn’t hold, and declare it a problem. Of course, you post nothing about other supply and demand dynamics at the time that have nothing to do with inflation, your preferred explanation.

    And of course I noticed the distinct absence of a graph showing the correlation between gold prices and US inflation, which is negligible and in any event, certainly far, far less impressive than the inverse one between expected real rates and gold prices.

    Then you just claim gold is money at the end, with an anachronistic reference to a book by some idiot who thought he could be a non-mathematical, unscientific economist.

    You’re a joke and no one capable of critical thinking in the slightest degree can possibly take you seriously.

    • David B. says:

      David S.

      “Then you just claim gold is money at the end, with an anachronistic reference to a book by some idiot who thought he could be a non-mathematical, unscientific economist.”

      Ah, the old “you are unscientific” canard. Well, as MamThought had to concede in an earlier discussion, you will soon concede as well.

      You see I contend that not one economist of any stripe has ever performed an actual scientific experiement according to the scientific method. You see… I understsand this because I understand what the scientific method actually is.

      So you could easily prove me wrong by citing one, just one scientific experiment conducted by ANY economist using the scientific method.

      Please provide this evidence so that I can be saved from all of these idiots.

      • MamMoTh says:

        You can’t be saved. You believe the sum of all angles in any triangle equals 180 degrees is a fact of the real world. And you believe you know what the scientific method actually is? Why is it that all Austrians are delusional?

        • David B. says:


          “And you believe you know what the scientific method actually is? ”

          You’re going to challenge me on the definition of the scientific method now? Oh this should be glorious fun. Any person can open up google, type in “scientific method”, and see for themselves that no economic “experiment” meets the criteria.

          But you have an alternate definition that you wish to propose?

          Do tell…

          • MamMoTh says:

            I challenged your understanding of it, not the definition.

            • David B. says:

              Oh that’s funny. You are a slipperly littel weasal aren’t you?

              I remember challenging your understanding of the scientific method and your response that Japan was a “living MMT science experiement” (not exact, but close enough right?)

              Since I am laughing too hard to type a full response, I’ll let the readers decide if that one fits the scientific method.

              Like I said, you have a great sense of humor, but you failed to meet the criteria of my simple challenge.

              David S. will also fail. If you are going to claim that Austrian School Economics is unscientific (and you have), then you must present evidence that your big boy school is all that. You presented no evidence because there is none.

              Ok, well I’m sure you are late to Mosler’s Temple ceremonies, so I’ll let you go.

              • David S. says:

                You’re incapable of understanding science. That’s why no one would have a scientific discussion with you. You’re an intellectual peasant, and probably financial one too.

              • Dan says:

                David S also lets magnum codoms fall out of his wallet when he talks to girls. He’d be such a pimp if he didn’t live in his parents basement.

              • David B. says:

                David S.

                What a phenomenal response to my challenge. You are clearly cut from the same cloth as MMT guy.

                The point I am driving at here is that econometricians are guilty of attempting to take the scientific method of the physical sciences and applying it to economics. However, they know this is impossible. So they can’t actually use it. They therefore invent a new scientific method or “redefine it” as MMT guy would like to do.

                The Austrian School on the other hand is scientific but not by aping the method of the hard scientists (not that they don’t applaud their success, but only because it is impossible due to human action), instead by applying logical deduction from a priori maxims.

                My long winded point is well understood in this community. I just like to highlight the fraud inherent in Keynesian and MMT protestations that Austrians are “un-scientific”. It is a very amusing fraud, to me.

                Thanks for playing David S. Sorry that you will not be invited to the bonus round.

      • Daniil Gorbatenko says:

        =Ah, the old “you are unscientific” canard. Well, as MamThought had to concede in an earlier discussion, you will soon concede as well.=

        David, could you share a link to that discussion? Thanks.

    • bobmurphy says:

      David S. wrote:

      You’re a joke and no one capable of critical thinking in the slightest degree can possibly take you seriously.

      Yeah, I figured you would respond in this way. As I recall matters, David S., you have been challenging me to answer Krugman’s model. What more could I possibly do, than to show that it leads to very wrong “predictions” in several respects? I didn’t look at a tiny stretch where it was off by 1.2%, instead I showed a period of sharply rising real interest rates that were accompanied by a 15% hike in gold (when his model said gold should have fallen strongly), I showed an entire year of fairly steady real rates where his model said gold should have appreciated 2% but instead it appreciated 16%, and then I pointed out that his model can’t deal with geopolitical shocks such as OBL’s alleged killing.

      This is how science works, David S. Someone proposes a model that does a good job explaining two major experiments (high gold prices in the late 1970s and today), and then someone else tests other implications of the model.

      My article doesn’t prove the Austrians are right, of course. I’m just showing that Krugman hasn’t definitely solved the “mystery” of soaring gold prices.

      To me, it’s clear what has happened here: You think the Austrians are nuts. Krugman comes along with a model that gives you what you need for rising gold in the last few years. So, you hold the model up as if it a good model.

      Then I point out the flaws, and you say, “Well nobody ever said it was a perfect model.”

      Suh-weet. Feynman would be proud.

      • Andrew says:

        “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong”

        -Richard Feynman

      • David S. says:

        Your article doesn’t address the whole issue, yet you have the nerve(and ignorance and license by an ignorant audience) to say Krugman’s model doesn’t explain all movements in gold prices. . Why not do one that takes into account rising retail and industrial demand, falling supply, and expected negative real rates?

        And let’s see you curve fit for us inflation and gold prices. lmao Your “model” is a total joke. How many short segments could you even find that showed consistent co-movement in gold prices and inflation?

        • Secret Agent says:

          Why not do one that takes into account rising retail and industrial demand, falling supply, and expected negative real rates?

          It’s stupid to do one that takes into account rising retails and industrial demand, because in the absence of inflation (which is what you are trying to refute as the reason so we must hold it equal), a rise in the demand of retail and industrial goods would accompany an equal and opposite fall in the demand for other goods. But the demand for virtually everything is rising. Gold and pretty much everything else has risen in demand.

          Secondly, falling supply is even more stupid. The supply of gold has been increasing over time. The rate of increased supply production has occasionally decreased, but the total supply has always been increasing.


  3. David S. says:

    I should also point out that the gold market is extremely tiny in the context of the world market and compared to the Treasury market specifically, for example, Hence, if you think the market’s sending mixed signals, it is speaking vastly more loudly against any high inflation outcomes in the US.

    • kavram says:

      You forgot to mention that the Fed is buying a good deal of the Treasuries. To the degree that “the market” is buying Treasuries, I feel the reason most investors are buying U.S. debt is simply to flip it back to the Fed at a jacked-up price. It’s kindof naive to look at interest rates as a gauge of market expectations when you have the Fed targeting the federal funds rate at .25%

      You could say that the Fed is driving up the gold price too, but this is just the market’s natural reaction to the unprecedented “liquidity injections” of the last few years

      • David S. says:

        That’s funny, because the Fed holds very small percentage of Treasuries.

        • kavram says:

          last fiscal year the Fed bought 10% of the Treasuries, foreign Central Banks bought another 50%.

          I was wrong to put the blame solely on the US Fed, but these aren’t insignificant figures. My point stands that the yield curve is a poor indicator of “market expectations”

  4. Brian Shelley says:

    David S.,

    Krugman is basically assuming that the real dollar price of gold is unchanging by asserting that’s it’s simply backwardation from real interest rates that drives the price. By my back of the envelope calcs, he would have to assume a duration of about 20 years to get a 4x change in gold from interest rates alone.

    As a opposed to Bob, I have no problem granting some of Krugman’s model. For all intensive purposes I would say that the worldwide real price of gold is effective unchangeable. So, if we grant Krugman’s implied assertion that the expected duration is 20 years, then the expected sales price would include the gold market’s 20 year expectations of inflation. Therefore, we should not expect to see any strong correlation between current spot gold and current CPI.

    This does not contradict the Austrian viewpoint. If the government were debasing the currency by literally printing money and handing it out randomly that would lead to a direct correlation between CPI and gold. What they are doing, though, is manipulating interest rates through money printing. The backwardation has a much faster effect on gold prices than the increase to the money supply.

    Where Krugman is wrong, is that his theory doesn’t apply to real estate and other commodities. If the value of real estate were purely drive by backwardation of future sales price, then we should see a perfect correlation between real rates and residential real estate prices. That is clearly not the current case. Why? Because expectations of future prices have fallen. Even during the boom, home prices accelerated far faster than changes to the real interest rate would imply because price expectations grew.

    Lastly, what he is also missing is that while the worldwide real price of gold does not change, the value of the dollar will change. Lower real interest rates create an arbitrage situation pushing the dollar down in value. Thus the future expected dollar price of gold will climb relative to the world price, if, as the Fed has promised, rates are to remain low for quite some time.

    Therefore, when the federal reserve lowers real interest rates the price of gold will go up because of backwardation and expectations of a falling dollar. The Austrian view that gold doesn’t change, but everything else does, is still maintained.

    Also, because of the long time duration for gold, implied in his model, it would only require a segment of the market to believe that future inflation is actually higher than the general market believes for expectations of dollar gold prices to rise and current gold prices to rise. Explicity, though, you can’t use EMH to suggest that gold prices predict higher inflation.

    • David S. says:

      Why don’t you make your back of the envelope calculations explicit?

      • Brian Shelley says:

        I ball parked real interest rates starting around 5% and assumed they dropped to -2% today. I think that’s vaguely the numbers in recent history. That 7% change in interest rates over 20 years give me a PV 4x as high.

  5. Brian Shelley says:

    “intensive purposes “…ugh

    “all intents and purposes”

  6. david stinson says:

    I don’t see any inconsistency between the views that a) there is a re-monetization of gold underway, and b) the gold price is inversely related to real exchange rates.

    The opportunity cost of holding money has at least two components – the foregone real return on productive assets (i.e., real interest rate) and the expected future rates of inflation. My inclination is to think that since money itself is of zero maturity, the relevant real interest rate in the case of gold (as money) is the very short term rate, not the long term rate.

    • Brian Shelley says:

      I think the duration is probably longer. Gold doesn’t rot, so the expected time before exchange for dollars could be years.

      • david stinson says:

        Hi Brian.

        The way I think of it is that money is of infinitely short duration and that’s why one doesn’t receive interest. It’s perfectly liquid. It’s not about the physical life. In that regard, since most money these days is digital, so-called “paper money” doesn’t rot either (not from age anyway!).

        • Brian Shelley says:

          OK, bad analogy on my part.

          When people buy gold, they normally plan to hold it for some time. Usually people don’t plan to hold cash for that long. As long as dollars are the currency, I think that will be true. From a dollar price perspective, I would model gold as longer duration than zero.

          If gold became as liquid as dollars, I would grant it a much shorter duration.