Don’t hold your breath

The late-May spike in the gold price proved to be short-lived, but that didn’t prevent gold bugs from speculating that the bears, the banks and the bookkeepers were at last going to be put to rout. For they saw the future, and it was inflationary.

Inflation, in gold-bug theory, is the time that the metal takes over its role as an inflation-proof “store of value” and gold’s price, denominated in weakening currencies, rises at more or less the rate of inflation. If inflation is back, then gold is on the way up.

(It is an inescapable premise of the store-of-value model that gold’s value with respect to goods and services remains the same; production costs consequently rise at the same rate and operating margins do not change. But for the ideological purist, it’s the gold price that matters, not whether mines make money.)

Rumours that the Bank of England may short-turn its gold auction plans or reduce the amount of gold on offer have been said to reflect the Bank’s worries about inflation. There may be a simpler explanation still: bidders for the auction gold pay in U.S. dollars into the Bank’s clearing account at the New York office of the Federal Reserve, and U.S. dollars have been dangerously overvalued for more than a year. This is not the time to be making a discretionary sale denominated in U.S. money: so the Bank might just not do it.

Another phenomenon supposed to be linked to forthcoming inflation is a stickiness in long-term interest rates, which have not fallen as far as short-term rates. But with Republicans surrounding the new U.S. president preaching tax cuts — and Fed chairman Alan Greenspan repeating the litany — a steeper yield curve was exactly what could be expected as the debt markets recognized that, with tax cuts coming, less U.S. government debt was going to be repaid, and the government would have to visit the debt well more often over the next decade.

There are more signs that the inflation argument just won’t stand up, even though the money supply might grow: demand for goods and services might actually fall, both in the United States and in Europe.

The economic situation in Europe looks like a repeat of the late 1970s: a sudden increase in oil prices has radically increased the inflation rate, even as economic growth has slowed. The twenty-five-year-old spectre of “stagflation” has returned to haunt the Euro area, but the European Central Bank is still busy defending the currency. Tight money will slow growth; tight money whose spending power is being eroded by higher prices for energy and imports will choke it.

As for Japan, its current economic malaise might be thought to be pathological were it not for the Bank of Japan’s insistence on maintaining the value of the yen, which has damaged investor and consumer confidence for four straight years. That has at last been reversed: the Bank now has real interest rates at zero and has a stated policy of keeping rates low until deflation ends, whatever the yen may do. This may mark the beginning of a long-overdue period of growth; but reversing a deep trough in the business cycle takes time, especially in a relatively structured economy like Japan’s. We are unlikely to see heavy new demand from the developed East for a while.

In the U.S., economist Dean Maki, late of the U.S. Fed and now at Putnam Investments, demonstrated in two recent papers that spending by upper-income U.S. households (the top 20% by income, which owns about four-fifths of directly held stock and about three-quarters of mutual funds) was directly correlated to gains those households had made on the equity markets. In one paper, Maki and Fed economist Michael Palumbo showed that savings rates in that top income bracket had declined from 8.5% to minus 2.1% of income between 1992 and 2000, at the same time that equity markets were tripling in value. Savings by households in the middle and upper-middle brackets changed little; and the profligate poor in the lowest 40% increased their savings rate from 4% of income to 7.3%. Keynes’s dictum about recessions being caused by the desire to save being greater than the desire to invest may not have been borne out, but it’s plain that, from the point of view of the lowest-income households, there was a recession on even as the market boomed and the rentier class bought its new Lincoln Navigators. (Thorstein Veblen’s “conspicuous consumption” was on display on the expressways of every large U.S. city.)

In a second paper, Maki and co-author Karen Dynan found strong evidence for spending growth in households that received large capital gains. In lower-income households, where capital gains are smaller and generally sit in pension funds or retirement accounts (if they arrive at all), the labour and housing markets are what influence consumption. Steady employment, not a soaring Nasdaq 100, is what buys a new car or fridge.

If this means (as it almost inevitably must) that consumer spending is likely to fall, then there is little likelihood of inflation. And growth in the U.S. economy will not be maintained by Bush’s tax cuts ten years out, but by dull old monetary expansion now.

Next week: The barbaric relic of a market failure.