Stay constant

Larry Kudlow
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Posted: Dec 13, 2003 12:00 AM

Some supply-siders believe the pronounced rise in the price of gold is a warning of future inflation. They have a point, but at the present it's a weak point.

It is always useful to recall that the collapsing dollar of the late 1960s and '70s, measured as an enormous rise in the dollar-price of gold, heralded the era of hyper-inflation and stagnation -- otherwise known as stagflation. Back then, the gold cover on bank-reserve supplies from the Federal Reserve was broken, and the country was also moved off the Bretton Woods dollar-gold exchange-rate rule. Both of these events combined to totally unlock the monetary spigots. Prices subsequently soared -- including the price of oil, which of course is priced in dollars. (Faint echoes of this have recently reappeared, as OPEC ministers complain of the cheap dollar.)

Even in the late 1980s, in a much smaller way, an unwanted depreciation of the dollar in terms of gold and foreign currencies triggered a mild re-inflation, which temporarily moved back up to 5 percent.

However, when analysts wander through history in search of gold-price reference points that might be consistent with this or that inflation rate, they should resort to constant-dollar gold prices rather than current-dollar prices. Production costs change over time because of shifts in technology, productivity and the world supply of gold. Moreover, economic environments change as tax-rates and regulatory reforms occur. Economies are also influenced by world political events. Constant dollars -- adjusted for the effects of inflation -- give a clearer picture of what's going on.

Today, greater monetary discipline, lower tax-rates, deregulation and rapid technology investments, advances and applications have all led to fantastic gains in output-per-hour productivity efficiencies -- markedly changing the economic backdrop for the better. Over the last two decades, dollar value has improved enormously, while gold prices have plunged.

Inflation, meanwhile, has become virtually nonexistent.

So, when measured in constant 2000 dollars, gold has slumped from $1,207 in 1980 to $260 in early 2001, and has rebounded to $364 today. From this perspective, it seems that all we've experienced is a long secular period of disinflation, which occasionally lapsed into outright deflation -- in part from Schumpeterian technological advances with their associated pressures on lower across-the-board prices, and in part from Fed money-destroying stupidity, such as occurred in 2000-2001.

Rather than a harbinger of inflationary doom, the $100 rise in the real gold price over the past three years is a welcome sign that monetary deflation has been curbed by the Fed. The central bank finally woke up to the need to start creating plenty of new dollars to finance a return to prosperity and accommodate the most powerful tax cut of the past 20 years.

In ballpark terms, if the constant-dollar gold price rises by another $100 in the next year or two, only then will the inflation outlook shift upward by a couple of percentage points. Economy-slowing interest-rate rises would follow suit by the mid to late years of the decade.

That said, the fact remains that tax-rates on investment, capital formation and work effort have been slashed. This is an inherently pro-growth and counter-inflationary development. Add surprisingly strong productivity gains to this scenario, and we find ourselves in the constructive economic position of producing more goods to absorb any potential monetary excess. As the economy's potential to grow moves up, its potential to inflate moves down.

In short, another long prosperity boom is very likely.

Going forward, the mission for U.S. economic policy should be to stabilize the value of the dollar in terms of gold and the major foreign currencies. This will protect the interests of both the investor and the consumer -- key elements of a winning political coalition for President Bush next year, and essential components of the new prosperity boom.