The Inflexibility of Alex Dumortier
This is my rebuttal to Alex Dumortier's article “Warning! Gold is now 3 times overpriced!” Let's skip the introductions, since you can get the background by reading Alex's original article, my response, and aforementioned “3 times overpriced” article.
Quoting directly from Alex's article:
“It's all about inflation
Gold enthusiasts -- including my challenger -- are always going on about the runaway growth in the money supply and they extrapolate wild price targets for gold on that basis”
This is not a good start. Besides vectoring his opponent with the term “wild price targets” (particularly amusing in an article that prices gold at $475!), I have made no price targets for gold. Never have. Never will. Prices are subjective and arise from the interaction of market actors. It is a fatal conceit to think you can determine the proper price of any economic good.
It's also a petty criticism.
On the other hand, it is correct to say that I am always going on about the money supply. It is also correct to say that Alex completely ignores it. I notice that Alex didn’t post any charts of money supply growth. Here are charts of Base Money, M1, and M2 growth. I allow the reader to decide if this is something worth “going on” about.
And my personal favorite, Excess Reserves
Here's the trillion dollar question: What does Bernanke do with the excess reserves? If he made a bonfire, I can assure you the price of gold would plummet, perhaps all the way to $475. But why pay interest on them - something no other Fed chairman has ever done - if they aren't going to end up in the economy? In fact, why pay interest on them at all? It's the banking equivalent of sticking money in your mattress. Does your mattress pay interest? Mine doesn't.
"However, it makes more sense to focus on inflation, since that is what investors should be concerned with when they evaluate an asset as a store of value. In plain terms, nobody cares about the size of the money supply when they are spending accumulated savings. What they care about is whether their savings buys the same, fewer, or more goods and services than they used to. Why focus on a proximate cause (the money supply), when you have a measurable variable (inflation), which is exactly what you're after?"
In the long run, excess money supply growth is the only cause of (price) inflation. If I were a lawyer, I could insist that it be ruled a proximate cause, i.e. that there is sufficient evidence to rule it the cause of the injury despite being unable to deliver a scientific proof. But we’re not preparing a legal brief. In economics, the only long run cause of price increases is excess money supply growth.
In that light, here is a proper analogy to describe Alex’s advice:
You arrive at the doctor with a gun shot wound. Dr. Dumortier orders a transfusion, but does not address the wound itself. You protest and he replies, “Look! You are losing blood. That is the important issue to a person that wants to stay alive. Why bother yourself with the proximate (i.e. the real) cause of your problem? Stop going on about that gaping exit wound in your lower back and stay focused on your blood level.”
Any investor that cares about protecting wealth needs to be cognizant of both proximate causes and metrics used to measure the damage. Inflation metrics attempt to measure the damage caused by runaway money supply growth. To focus on the metrics while ignoring the cause is a denial of the cause. Is Alex in “cause denial?” The proof is in the pudding. In two consecutive posts about gold prices, Alex has failed to do any monetary analysis. I think he’s afraid of what he might learn.
"My updated $475 fair price estimate for gold is based on the long-term average of inflation-adjusted gold prices going back to 1833 (I use the same methodology here to show that silver is also a massive bubble.) My challenger wants to exclude any data prior to 1971, arguing that fixed-price regimes are irrelevant to this analysis, even declaring that "there is no historical mean price of gold." I entirely agree with that last statement -- if we are referring to nominal prices. However, the data suggests that inflation-adjusted prices do have an average that looks pretty stable (see graph below). This is consistent with a notion that is very dear to gold investors -- that of the yellow metal as a stable store of value.
Real vs. nominal
Under classical and managed gold standards, the nominal price of gold was fixed, but that didn't prevent real gold prices from adjusting. Real gold prices varied with the supply of gold, the allocation between monetary and nonmonetary gold and the returns on real assets, including stocks and bonds. The fact that real gold prices were less volatile prior to 1971 is not reason enough to throw that period out. Changes in volatility regimes aren't incompatible with the existence of a stable average."
Lack of volatility was NOT my reason for suggesting that Alex exclude pre-1971 inflation-adjusted prices. I pointed out the lack of volatility in an attempt (fail) to knock some sense into Alex. I understand CFA’s don’t need to know anything about the gold standard and how it worked. We are not on a gold standard anymore and I suspect none of his clients care about it. But if you are going to build a mean price table using gold prices from 1833-1971, perhaps you would want to know just a little bit about the period you are studying. Just a little bit.
I pointed out the lack of volatility and explained price behavior (in real, inflation-adjusted terms) as a teaching tool so that Alex and my readers would understand the chart and how the gold standard worked.
The gold standard (and I am going to put this in all caps with bold letters so maybe, just maybe, he’ll see it this time) REGULATED THE SUPPLY OF DOLLARS!
There, I feel better. This must be what it’s like to have a student that is so set in their ways; they won’t even consider other methods.
What regulates the supply of dollars today? Take a look at those money supply graphs again. Appearantly, nothing does.
Maybe some of my readers have followed me long enough to remember the debates I had with pro-Fed supporters regarding the pros and cons of the gold standard (more properly known as the Gold Coin Standard.) They usually went something like this:
Fed supporter: “David, you ignorant sl*t. The problem with the gold standard was its inflexibility.”
David in Qatar: “Listen you baboon’s arse. That inflexibility was only a problem for the government and bankers. It was a wonderful feature for the common American.”
No matter which side of that debate you call yours, one thing should be clear to you. Alex Dumortier has no idea what any of us are talking about.
The inflexibility of the gold standard is the reason that his inflation adjusted chart shows few volatile price movements prior to 1971 and no price movements anywhere close to the volatility of post 1971. The slight pre-1971 movements were a result of the varying reserve requirements regulated by the government. Anything under 100% reserves will cause gold’s real, inflation-adjusted price to rise and fall relative to the fixed price. America never had 100% reserves, hence, the small amount of volatility.
That red line Alex has drawn across his chart? It is meaningless. There was no mean price of gold from 1833-1971. There is no existence of a stable average. There was a fixed price, which varied from the inflation-adjusted price due to the limited, but real ability of the banks and government to extend the supply of dollars without a corresponding increase in the supply of gold. This is what my opponent calls a proximate cause of (price) inflation. It is the cause of (price) inflation. That ability to extend the dollar supply was checked inherently by the system (e.g. price specie flow mechanism, balance of payments, bank runs.) The inflation-adjusted price of gold went up because of excess dollar supply growth and then the inflation-adjusted price of gold went back down as the systemic forces regulated the supply of dollars.
What about the factors that Alex listed (supply of gold, allocation between monetary and nonmonetary, and the return on real assets) for inflation-adjusted price movements from 1833-1971?
1. The supply of gold under a gold standard only causes the inflation-adjusted price of gold to move if the supply of dollars does not move in step. Historically speaking, rising gold supplies in relation to dollars was rarely an issue (there was a large influx of gold to America from 1914-1917… for what should be obvious reasons.) The problem usually was the other way around (dollars being increased without a corresponding gold increase.) Obviously this is not a primary factor in gold’s real price movements from 1833-1971. Strike one.
2. The allocation between monetary and nonmonetary gold changes as a result of the changes in the inflation-adjusted price of gold, not the other way around. If the value of monetary gold increases, i.e. it can buy more goods, grandma has an incentive to smelt her necklace. If you are on a gold standard and grandma smelts her necklace to make a gold coin, it can only have a lasting impact on the inflation-adjusted price if a new corresponding dollar amount is not eventually created. The reason granny smelts her necklace in the first place is because of changes in the gold’s value relative to the dollar (or changes in the inflation-adjusted price.) Strike two.
3. Under a gold standard, changes in the return on real assets is primarily a result of the relationship between the supply of gold and supply of dollars, not a cause. Strike three.
I have no idea why Alex felt the need to point out his chart was inflation adjusted. I addressed that thoroughly in my first post. He needs to stop staring at his chart and study monetary history. I fear that his inability to comprehend my first rebuttal is my fault, but I am not a professor by trade. I work on computers and computers don’t ask questions unless you tell them to.
Let's move on. Alex's next target is his standard attack on low-hanging fruit: the conspiracy theorists....
"Inflation is understated?
Another objection that gold enthusiasts raise constantly is the notion that the consumer price index published by the Bureau of Labor Statistics no longer provides an accurate picture of inflation because of some technical changes in the calculation methodology. I don't think that gold enthusiasts' criticisms of the CPI withstand scrutiny; in fact, some of them are based on outright falsehoods."
We can devote a series of articles to the inflation metrics currently in vogue with mainstream economists. From the Austrian School point of view, inflation is subjective and dependent upon the “shopping basket” and subjective value scales of each market actor. Econometric inflation analysis assumes objective utility - the concept that your satisfaction can be measured to a statistical certainty - and a few hand specific “shopping baskets” that purport to represent the average consumer. Obviously, this is ridiculous (and makes me 34% more annoyed.) There is no such thing as objective utility and there is no average consumer.
Alex ran a CPI conspiracy “debunking” article a while back and I probed him on objective vs. subjective utility. Like the gold standard debate, I suspect that he had no idea what I was talking about. So if it makes him feel better to assign the conspiracy theory label to my rebuttal, have at it. My rebuttal has nothing to do with inflation being understated.
If I could be charitable, I would. Gold might be in a bubble. But you could never determine it using Alex's methods. His way is fancy guesswork that confirms his bias. He wants to believe gold is in a bubble, and in order to confirm that belief he ignored the crucial points in my rebuttal. Here, I'll prove it to you:
Alex Dumortier, please answer the following question: “Looking at your inflation-adjusted chart, why is there not a single price movement from 1833-1971 that is equal to or greater than the 4 price movements I pointed out (early 70s, 1980, late 80s, and present) in both volatility and peak?”
Luck? Just a hell of a bunch of smart guys back in the 1840s? Didn't give in to all that bubble mania?
The correct answer is because the gold standard (say it with me) REGULATED THE SUPPLY OF DOLLARS!
Coming Up Next
In my next post, I'll look at some more interesting issues. Is there a mean price for any economic good? What are some of the primary factors that cause gold to rise in price? How many gold bubbles have there been since 1971, world wide? Can we use an inflation metric from 1971 to present to prove gold is in a bubble?
I will leave you with this to chew on. The following is a chart of the value of the USD versus other trading partners since 1973. Even with the destruction of currencies around the world, America's dollar value has lost 50% since its high in the early 1980's against other major currencies. This is the primary reason that gold is at $1,500 today.
I apologize for making this a two-part installment, but that is a lot to cover and it's been a tiring week.
David in Qatar