Olympian gold

Larry Kudlow
Posted: May 31, 2002 12:00 AM
While stock markets have struggled to regain their stride this year, glittering gold has become a runaway investment story. So far, gold funds are up nearly 60 percent in 2002, with the gold price climbing to $320. That's its highest mark since mid-1999. Gold is on fire. Conventional mainstream economists always argue that rising gold prices reflect "special factors" in the world, such as war or other international tensions. So the consensus crowd attributes the current gold rally to the global war on terrorism, ongoing Middle East tensions and even recent bomb scares in New York. But there's much more to the gold spike than that. "Gold and only gold is real money," said banker J.P. Morgan early in the last century. He was right then, and he is still right today. Over the last 5,000 years or so, gold has held its value far better than various substitutes, such as paper currency. And through its long history, gold has always communicated a monetary message of inflation (when money value declines) or deflation (when money value rises). So right now, the clear message of this year's gold rally is that there's been a shift in Federal Reserve policy from deflation to a certain amount of reflation. Essentially, the gold spike points to a big Fed policy change: The basic money supply, or monetary base, controlled by the central bank has stopped shrinking and has resumed a more normal rate of increase. This is welcome news. As the Fed deflated the cash base of the economy from a more than 15 percent growth rate at the end of 1999 to a 5 percent decline rate at the end of 2000, the gold price slumped from $310 to $255. But over the past 16 months, the Fed has expanded the monetary base to a 10 percent growth rate. Hence, gold has turned up. This means a good deal for the economy and the stock market. It means that businesses will gradually recover from a nasty deflationary credit crunch, and it signals an end to the business contraction. Already, industrial production and capital goods orders are turning up. And with lower tax-rates on small and large businesses in place, this recovery process will receive the nurturing it needs. However, looking at the long history of gold, some would say the upturn is a signal that inflation is on the way. But this is doubtful. The gold value of the U.S. dollar has dropped about 25 percent over the past year -- and yes, that's normally an inflationary signal. But the domestic value of the dollar was vastly overvalued prior to this year, largely because the Fed disastrously drained far too much high-powered cash from the financial system. This money crunch created a massive worldwide commodity sell-off that ultimately led to protectionist trade agreements over so-called anti-dumping charges. But the true problem was not commodity dumping, it was bad central banking. Dollars were way too scarce. Fortunately, the Fed has changed its tune. A mild whiff of reflation is a good thing. Not only is the Fed supplying more dollars to the U.S. economy, it is also replenishing liquidity to the world economy. Without exaggerating, somewhere between one-half and two-thirds of the global economy relies on U.S. dollars to grease the wheels of international commerce and trade. So the dollar is back in action where it should be. In purely statistical terms, the government-reported inflation rate could rise by roughly 1 percentage point over the next year or so, but in market-price-rule terms, it's really just a shift from deflation to price stability. Long-term Treasury rates have already discounted most of this, and short-term rates will gradually reflect this over the next 12 to 18 months. This really looks like nothing more than interest-rate normalcy in a rising economy. In the Olympics, athletes go for the gold. In our recovering economy, the gold story is simply too good for investors not to get back in the games.