Gold prices are way up, but the inflation statistics are quite tame. Why is this happening? Is somebody lying to us, or is gold not all it’s cracked up to be?

This used to be a very obscure debate. Some free market economists (like the great Steve Forbes and the late Jude Wanniski) have held that gold prices can be used to predict future inflation, but some (such as Art Laffer and Larry Kudlow) do not. I started writing about this topic in 2004, but I got a very negative reaction from many people with whom I usually agree on the big issues. I decided to tread lightly and focus most of my attention on the questions on which my friends and I agree. The problem is that this obscure question about economic growth, inflation and gold prices has now moved to center stage. In the annals of economic history, it’s what 2007 will have been about.

Here’s how we got here: Over long periods of time human production of gold had increased at roughly the same pace as human production of everything else. At times when the worldwide economy was growing at about 1%, the worldwide growth of gold reserves was also running at about 1%. This meant that a currency backed by gold would grow and shrink at roughly the same rate as the economy in general. This fact is the basis of what economists call the “Gold Standard”. If the money supply grew at the same pace as the supply of goods and services, then the prices would remain stable. Early in the 20th century, liberal economists rejected the idea of a currency backed by gold, not because they failed to see that unbacked money would cause inflation, but precisely because they saw that it did. They wanted inflation—because they believed that inflation would make people feel wealthier than they really were, and thereby trick them into spending more than they otherwise would. This argument was advanced most effectively by a British economist named John Maynard Keynes. Free market economists quickly saw the flaw in Keynes’ argument—that eventually people figure out that they’ve been tricked and respond by cutting back on spending. Economists such as Ludwig Von Mises accurately predicted that this would set up a cycle of boom and bust. They were proved right by the Great Depression, and ever since then conservative economists have defended gold against its liberal detractors. It has been a useful tool for them, particularly when it was used by Arthur Laffer and Robert Mundel in predicting the wave of inflation that struck America in the 1970s after Nixon removed the dollar from the gold standard. Because of its success as an inflation predictor, gold went from being a useful tool to being a central dogma in the conservative creed.

The chief evangelist for this dogma was a Wall-Street Journal reporter named Jude Wanniski. Jude saw Laffer’s success in understanding and predicting the economy and concluded that gold was the North Star, the Polaris, of the financial universe. Jude’s enormous skill as a communicator and personal tendency toward monomaniacal focus helped to form a tight movement of economists and politicians who came to be known as Supply-Siders.

The problem is that Jude forgot why gold had been useful in the 1970s, which left him and his followers vulnerable to confusion in times when gold isn’t useful. Gold is useful when the gold supply expands at roughly the same rate as the economy, and it is not useful when the economy doesn’t.

For example, after Christopher Columbus discovered the New World, European conquerors swept through Central America and plundered its gold. The yellow metal flowed back across the Atlantic by the boatload for the entire 16th Century. The explorers had found an extremely efficient way of producing gold—by stealing it. However, the economy of Europe had not been as successful at finding highly efficient ways of producing any other goods and services. Not surprisingly, prices exploded upward, destabilizing both Europe’s prices, and its political systems.

The opposite occurred in the 19th Century. For example, the 1830s were characterized by enormous explosions in wealth generation in the English-speaking world due to the commercial application of railroads. But gold supplies did not expand at the same pace. Goods increased, gold didn’t, and price deflation was the result. In fact, it wasn’t until 1849 and the discovery of gold in California by the now-famous 49ers that this long drought of deflation ended. I could multiply examples, and so could you if you simply went to Google and typed in the words ‘panic of’. You will learn about the panic of 1837, the panic of 1893, and 1907. And of course we all know about the panic of 1929.

So you see, gold is only a reliable inflation predictor in generally normal times. The problem is that we are not living in generally normal times: we are living in the first genuinely global boom of capitalism in human history. Microchips the size of postage stamps do, in a moment, what entire communities of scholars used to do in a year. And this at a price approaching zero. My friend Rich Karlgaard calls this ‘the cheap revolution’. We have never seen any thing exactly like this before, but we have seen some events remotely like it. For instance, the industrial revolution of the early 19th Century and the electrical and automobile revolutions of the 1920s were similar. In all these cases, the result was perplexing waves of deflation.

Of course, things are the same now, only more so. We’ve got at least 2 billion new capitalists in the world, and they’re all in direct competition with us and with each other. The fastest-growing sector of the economy is on the internet where the physical infrastructure is made of melted sand and electrons. How in the world could anyone believe that one particular yellow metal, which is dug out of the ground in certain provinces of Africa, Russia and Canada, could contain in itself all the knowledge which we need to forecast with perfect precision the growth of global wealth?

I had a conversation once with Jude not long before he died about this question. I asked him why gold had to be the North Star. He said it just was. And I asked him again to tell me why. After a few rounds Jude became irritated and declared that there has to be something you can count on. There has to be something fixed which doesn’t change. I agree. But the fixed thing isn’t gold—it’s human nature. Human knowledge is limited. No one man knows all, nor does any one class of men. Gold investors are smart, but not infallible, and in those amazing moments in time when human creativity meets economic freedom, our growth cannot be bounded in the same way as some inert metal.