Stephen King: Why gold rings hollow as a worthwhile indicator

Those who swear by gold are presumably in a heightened state of excitement
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Imagine a world where a single indicator told you everything you needed to know about the economy. Imagine that this single indicator gave you advanced warning of all the possible twists and turns in the economic cycle. Imagine, too, that you're a central banker. As a result of this single remarkable indicator, you can keep the economy on a virtuous path, able to ignore the siren calls of inflation and recession.

The current crop of central bankers would, surely, love an indicator that had such extraordinary properties. The Bank of England wouldn't have to worry about publishing an Inflation Report full of ifs and buts about the likely path for inflation over coming quarters (the next set of ifs and buts comes out on Wednesday). Ben Bernanke, the chairman of the Federal Reserve, wouldn't have to worry too much about what he said to CNBC anchor Maria Bartiromo at the White House Correspondents Association Dinner because his message to her would merely be a repeat of his statement to US Congress a week earlier.

No longer, therefore, would central banks have to worry about the possible ambiguities in their policy messages: with access to a miraculous indicator, ambiguity would be banished and clarity of message would be the order of the day.

Remarkably enough, some people think that this miraculous indicator already exists. It's yellow, shiny, doesn't tarnish and is typically measured in Troy ounces. I'm referring to gold. As a means of exchange and store of value, it's been around for thousands of years. It is a remarkably resilient currency, supposedly unaffected by the political and economic disturbances that undermine the value of others. For some, therefore, it is an unbiased indicator of likely future economic developments, a divining rod to reveal truths that other currencies simply cannot detect.

Those who swear by gold are presumably in a heightened state of excitement. Last week, the gold price, measured in dollars, hit a 25-year high. So if gold truly is the miraculous indicator that's often claimed, perhaps we should sit up and take note, even for those of us who are not hooked on bling. The problem, though, is working out exactly what this miraculous indicator is telling us. Many gold bugs argue that a higher gold price indicates rising inflationary pressures: it's another way of saying that rapid money supply growth ensures that the value of currencies falls relative to gold, whether those currencies be dollars, euros, sterling or dog's teeth (apparently quite popular as a medium of exchange in Papua New Guinea a few hundred years ago).

The problem with this argument, however, is that it doesn't really fit the facts. The gold price has been rising since 2001 yet, from that year through to 2003, markets were more concerned about deflation than inflation. Admittedly, there has been an association with some periods of high inflation - the gold price was high in both the mid 1970s and in the early 1980s following the first and second oil price shocks - but, other than those episodes, the association has been really rather thin. Other periods of economic overheating - notably the late 1990s equity bubble - don't register on the gold scale at all: through the late 1990s, the gold price was steadily falling.

Further back in history, gold itself was not particularly successful as a store of value. Like any other currency, gold's value can be measured in terms of the basket of goods and services that can be acquired with it. During the 16th century, Spain flooded Europe with gold and silver, thanks to the activities of Cortes in Mexico, and, not surprisingly, the value of both precious metals fell significantly: it was, if you like, an early example of inflation, suggesting that, as a divining rod, gold can be a little too droopy at times.

Gold bugs could reasonably argue, I suppose, that the chances of experiencing another Spanish century, with ever-increasing supplies of gold, are rather low. These days, paper currencies, not gold, are in danger of increasing in supply. Seen from this angle, gold provides an independent yardstick, an internationally traded precious metal acceptable to all that is not subject to the whims of monetary authorities, nor to their occasional errors - an argument in favour of a return to the gold standard, some would say.

If this view is correct, then the latest rise in the gold price might just be telling us something. Over the last few weeks, the price of gold has hit a local peak not just in dollars but also in almost any other currency you could care to think of. Might it be that central banks the world over have, simultaneously, made mistakes that make gold a safer bet than all paper currencies? Are we about to find that pieces of paper - our trusted stores of value and mediums of exchange - are about to become worthless?

It's certainly true that markets are now more worried about inflation than before. The steady rise in bond yields since the beginning of the year suggests that a combination of continued strong global growth and rising commodity prices is leading to unease about continued price stability. Markets may also be more worried than before about the possible mistakes that central bankers are sometimes prone to make. These divide into two categories: mistakes of communication and mistakes of policy selection.

Ben Bernanke's off-the-record comment to Ms Bartiromo at last week's White House bash falls into the first category: Mr Bernanke doubtless wants to offer a more transparent approach than the famously-Delphic Alan Greenspan but, to date, transparency of thought appears to be leading to a muddling of message.

As for mistakes of policy selection, all central banks are struggling at the moment. If growth slows down, should policymakers regard this as a softening of demand, thereby justifying lower interest rates? Or, instead, should they regard weaker growth as an indication of supply disruption associated with higher energy prices, in which case lower interest rates are most certainly not justified?

It's difficult to believe that these worries are best captured in movements in the price of gold. If central banks are in danger of making mistakes, then most financial assets become more risky. Yet the majority of financial assets - with the exception of bonds - seem to be well-supported. The gold price may be high - seen by some as an indication of heightened risk - but so are other asset prices. If gold may once have provided protection against economic and financial excess, it's not doing so any more. Gold is part of today's excess, not a hedge against it.

Statistically, the gold price simply doesn't have the qualities needed in a miraculous indicator. It may be high at the moment, but that, in itself, provides insufficient information for anyone - central bankers included - to judge an economy's next steps. Gold bugs sometimes claim that there are hidden messages in the price of gold that the rest of us are unable to see. Perhaps so, but I'd hate to think that our policymakers could base their decisions on the economic equivalent of the Da Vinci Code.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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