John Dizard reports on the NY gold show and Jim Rogers'' plug for commodities

Look beneath the golden gleam

By Tim Lee
Financial Times
September 14, 2003

Optimism is stirring in financial markets and the U.S.
economy. Recent indicators have suggested that
enormous fiscal and monetary stimulus is having an
impact.

Stock markets have held on to substantial gains and
bond yields have risen as forecasts for growth have
been revised upwards. Supply-side arguments revolving
round strong productivity trends are back in vogue, as
is a tendency among analysts and market participants
to ignore the implications of persisting global imbalances.

However, there is at least one warning sign that all is not
well and that problems lie ahead for financial markets
and the global economy.

This is the underlying strength of the gold markets, both
bullion itself and gold mining shares. The gold price has
risen from lows of close to $250 an ounce early in 2001
to almost $380 now. The increase has been prolonged
enough to suggest the end of the previous long downward
trend.

The increase in the price of gold has certainly not gone
unnoticed but it has not been satisfactorily analysed.

Some commentators have seen it as a symptom of the
risks posed to the financial system by the supposed
threat of deflation, while others ascribe it purely to dollar
weakness. Very few observers have taken the traditional
view that the upturn in gold is a sign of nascent inflation
pressures.

Most market participants seem to view gold's strength
as having no longer-term significance, being merely the
result of diversification by investors and accompanying
speculative activity by hedge funds.

The conventional wisdom is likely to prove mistaken.
The gold market may be relatively small but gold retains
its significance as a longer-term monetary indicator.
Contrary to a popular view, this importance does not
depend on the whims of a few central bank governors
and finance ministers but, rather, on the characteristics
that have historically made gold a money, and that lie
behind its long history as a monetary asset.

Looking back, the medium- and longer-term movements
in the real gold price have contained information about
the forces shaping the economy and financial markets.
The difficulty, as always in economics, has been in
understanding and correctly analysing those influences
as they are occurring, rather than after the event.

For more than 100 years gold has experienced very
long cycles in its real value (that is, its price relative
to goods and services), but these long cycles have
occurred around a constant level. That is, in a
long-term sense the real gold price has tended to
remain stable. (This was not true longer ago in history,
when large gold discoveries had an impact). Around
this stable real value there have been three extended
periods of depressed real gold prices: the first from
1920 to 1933; the second in 1952-70; and the third
the period that began in the mid-1990s.

The first of these coincides roughly with the monetary
regime of the gold exchange standard and the second
with the era of the Bretton Woods system of fixed
exchange rates. In both these periods, the price of
gold was fixed by central banks and governments.

The difference between the two was that under the
gold exchange, standard price levels in the economy
were forced into alignment with the low fixed price for
gold -- meaning deflation -- while under Bretton Woods,
ultimately they were not. Central banks pursued
expansionary monetary policies in the 1960s and early
1970s that were incompatible with the low price fixed
for gold, until the system inevitably broke down, with
inflationary consequences.

The third period of low real gold prices, which continues
today, can also be attributed to the actions of central
banks and governments; but the forces at work are
more complex. Beginning in the mid-1990s, central
banks and governments not only sold gold heavily
from reserves and lent gold to short-sellers but their
wider activities also encouraged excessive speculation
in financial assets that further discouraged investment
in gold. In the bubble environment of the 1990s, this
helped create many of the quot;feedback loopsquot; that
sustained the financial bubble. For instance, low gold
prices played a role in helping to suppress inflation
expectations, which further encouraged the financial
markets.

Arguably, the downward trend in the price of gold also
helped to cement the dominance of the dollar as the
world's reserve currency and store of value. The
strength of the dollar, in turn, was a further force
keeping U.S. inflation low even as the Federal Reserve
implemented an increasingly loose policy. The weakness
of gold until the end of the 1990s was therefore integral
to the financial bubble environment, both as a cause and
an effect of the inflation of financial asset prices.

This perspective leads to two main conclusions. First,
the new upward trend in the gold price may well point to
the fact that the post-bubble adjustment process still has
some way to go. Second, particularly if it continues, it
will be an indicator that Fed policy has indeed been too
lax and ultimately inflationary. This implies that the Fed's
latitude for policy action is becoming much narrower.

When these conclusions are added together, they
suggest an outlook for the global economy, and both
bond and stock markets, that is much less benign than
the optimists would have us believe. Investors would do
well to look more closely at gold's steady rise.

-----------------------------------

The writer, an economist, is author of quot;Why the Markets
Went Crazy,quot; published next month by Palgrave Macmillan.

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