Monthly Archives: August 2011

Allocating Scarce Resources

A Best Buy in Howell, New Jersey was selling 24-packs of bottled water for $40.56. A question for principles students: Should Best Buy be celebrated or derided for charging such a price? What would be the implications for the allocation of bottled water if Best Buy were to significantly lower their price?

Gold and Inflation, Again

Question: When the relative price of gold increases in the short run, is this a sign of inflation or deflation/disinflation?

This is somewhat of a trick question because either answer is possible. (Doesn’t Scott Sumner always say, “don’t reason from a price change”?) The price of gold in and of itself tells us very little. One must look at other economic indicators to make any sort of prediction.

A number of individuals have claimed that the recent rise in the price of gold is a sign of a coming inflation. However, this doesn’t square with the numbers or the gold market. Over the longer term, gold prices have been rising due to the factors of supply and demand. Over the shorter term, the current increase in the price of gold is consistent with deflationary/disinflationary headwinds — as economic theory predicts.

In the last five years, the price of gold has risen by nearly 200%. Yet, if we look at the price level (as measured by the PCE price index), we see that it has risen only 12% over the past five years.

So what can explain the run-up in gold prices? I talked about this back in December 2009 and the analysis holds true today:

Let’s examine the characteristics of the gold market. Gold has three uses on the demand side: (1) an investment hedge against inflation, (2) jewelry, and (3) industrial uses. On the supply side, there is an existing (stock) supply and a flow supply generated by mining. Changes in the stock supply of gold are most often the result of central bank behavior.

To argue that the increase in the price of gold is the result of monetary policy, one would have to be able to show that policy is loose and that the increase in the price of gold is being driven by investment demand. Readers know that I don’t think that monetary policy is too loose. I will not rehash that argument. However, let’s examine the gold market.

Over the last 5 years or so, we have seen the following changes:

  • Central banks have reduced the amount of gold that they are selling.
  • Gold ETFs have increased the demand by purchasing gold for storage.
  • Gold mining output peaked somewhere around 2001.

Supply declines. Demand increases. Price increases.

When you factor in the substantial increase in demand from India and China, this provides further evidence of a secular increase.

Of course, critics might argue that inflation expectations are accelerating the increase in the price of gold above that secular trend. For example, gold prices have risen 14% this month and 30% in the last six months. Such short term fluctuations could not be caused by the secular factors listed above. So doesn’t this mean that the recent run-up in gold prices is due to higher inflation/inflation expectations? No.

Under a gold standard, a relative increase in the price of gold is deflationary (by definition, since the gold price is fixed). An increase in the stock demand for gold causes a corresponding decrease in the demand for consumption goods and the relative price of gold increases (the relative price of consumption goods falls). Although the world is clearly no longer on a gold standard, a number of individuals as well as central banks are purchasing gold as a safe haven and therefore reducing spending or productive saving (i.e. saving that can be used toward investment).

Moreover, other liquid assets provide similar signals. The yield on the 5-year Treasury has fallen 38 basis points since August 1. The yield on the 10-year Treasury has fallen 67 basis points in the same time frame. This is contrary to what one would predict to coincide with higher inflation expectations, but consistent with the view that rising prices on Treasuries and the rise in the price of gold reflect a flight to liquidity and not increasing inflation expectations.

Quote of the Day

“Interest rates are the price of credit, not an indicator of easy and tight money. Unless and until we understand that money is tight, we will never be able to develop a sound monetary policy.”

Scott Sumner

In Defense of Mitt Romney

I try to stay away from politics on the blog and focus on economics. However, presidential candidate Mitt Romney is being castigated in the media for making a simple, factual statement.

In response to a question from an audience member, Mitt Romney stated, “corporations are people, my friend.” According to NPR, this was “an early Christmas gift” to Democrats because it “made their goal of pushing the narrative that he is a tool of corporate America much easier by providing them with that handy piece of video.”

Color me confused. What did Romney say that (a) suggests he is a tool of corporate America, or (b) is factually inaccurate? Corporations are people. The revenue generated by a firm ultimately goes to individuals whether in the form of wages or profits that go to the owners of the firm (which, in the case of public companies, are the stockholders). Costs beyond wages for a particular firm are paid to other individuals and firms for supplies, services rendered, etc. This is a basic fact and the reason that one will, at times, hear an economist claim that “corporations don’t pay taxes, people do.”

This simple fact, however, has either been misunderstood or misconstrued by the commentariat. In fact, the NPR post explicitly misses this point as the reporter writes:

Anybody these days fortunate to have a 401(k) retirement plan, or even a job with a corporation, understands that when a company makes a profit, there’s a benefit to that firm’s “stakeholders,” as executive-types like to say.

This, however, is only part of the story. It goes beyond profit. Anybody who works for a corporation or who owns or works for a firm that sells goods and services to a corporation benefits from that corporation’s existence. This is what it means to say that corporations are people. Romney was correct.

Site Update

Apologies to my loyal readers. I was without internet access for the last two weeks as I completed my move to Mississippi. I didn’t anticipate being away from the computer so long otherwise I would have posted advanced notice. The last two weeks were perhaps the worst time to be away from the computer in terms of monetary and fiscal policy. Regular blogging should resume soon.