I have stumbled upon an interesting article by Paul Krugman, a Nobel laureate in economics; the article offers an explanation for the hike in gold of recent years. Krugman, who considers himself a deflationista, i.e. a person who believes the U.S. is currently in a liquidity trap, thinks the gains in gold is another confirmation for a liquidity trap: basically in a liquidity trap people and businesses "sit on their money" and even if interest rates plunge to zero (and U.S. interest rate has been at zero for the past couple of years), investors are still reluctant to invest their funds.
It's hard to prove that we are in a liquidity trap because even if rates are low and the economy is slowing down, there is still no evidence of deflation, especially after the recent CPI report showed the U.S. inflation rate stands at 2.2% in annual terms. But let's not nitpick and accept this analysis. So how does this economic situation explain recent gains in gold prices?
According to Krugman, people are holding on to exhaustible resources such as gold and postponing the usage of said resources for the future, in times when the interest rates are low. In other words, since people don't receive good returns on their investments due to low interest rates, and the liquidity trap means people are sitting on funds, investors have an incentive to hoard gold and postpone the consumption of gold.
It means expectations of inflation weren't the cause of the gold price hike. The problem is the spike in gold came mostly after the Quantitative Easing plans (QE1 and QE2) which the Federal Reserve implemented in 2008 and 2010. Furthermore, the recent pledge of the Fed to keep rates low until late 2014 has reignited the speculation around another QE program in the near future; this pledge helped push up the price of gold during January 2012.
The chart below shows the development of gold price and U.S. Monetary base between 2000 and 2011. It shows two spikes in Monetary Base in 2008 and 2010 after the Fed issued QE1 and QE2, respectively.
Click to enlarge
Sharp gains in gold prices came during that time when people may have anticipated a jump in the inflation rate. Perhaps they felt the USD will sharply depreciate against other currencies.
This chart alone puts a small hole in Krugman's theory, even if it is compelling. The chart could mean that many people hoarded gold in expectation of inflation pressures that up to now don't seem to be occurring.
But Krugman's theory also means that if we are in a liquidity trap, then gold shouldn't rise as much in the near future as it did in the past couple of years. If you are persuaded by this theory, then the rally in gold is over and we should see only moderate increases in the near future. If the opposite is true, it could result in signs of inflation or an additional expansion of the U.S. Monetary base.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
