February 13, 2007

Oil, Inflation, and Gold

You see headlines like this all the time in the mainstream financial media - "Rising Oil Prices Drive Demand for Gold as Inflation Hedge". But what does that really mean?

Higher oil prices cause concern over "inflation" which drives demand for gold?

Does that make sense?

Another frequently seen headline is similar to the one for this report from Bloomberg earlier today, "Gold Climbs as Dollar's Decline May Spur Demand From Investors".

This one seems to make sense the first time you read it - if you're holding U.S. dollars and they're declining in value against other paper money, then these U.S. dollars are probably declining even faster against the world's oldest money in the form of precious metals.

The first paragraph of the report says as much.

"Gold prices advanced in London as declines in the U.S. dollar spurred demand for the precious metal as an alternative asset."

That all seems to make sense, but what about the relationship between oil and gold and the slightly nebulous concept of an "inflation hedge" that connects them?

Defining "Inflation"

It seems that in order to solve this puzzle you first have to define "inflation" to know what it is that you are "hedging" against. The idea of a "hedge" is pretty simple - Merriam-Webster says it is "a means of protection or defense".

So there's action being taken to "protect" or "defend" against "inflation". Merriam-Webster defines "inflation" as "a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services".

They seem to be infected with the same sort of thinking that dominates most of contemporary economics - where the definition of inflation is actually the symptom of something else.

At least they're honest about it.

As usual, Wikipedia has a much more thorough discussion of the subject (after all, it is an encyclopedia and not a dictionary). But, encyclopedia subjects normally start with a definition, and here is where you first see a few wheels turning - a few qualifiers right at the outset.

At Wikipedia, "inflation" is defined as follows: "In mainstream economics, inflation is a rise in the general level of prices, as measured against some baseline of purchasing power."

A distinction is made between "mainstream" economics and other economic theory and other qualifiers exist in the "general" level of prices measured against a "baseline of purchasing power".

As evidenced by the rest of the material on this page, the topic is much more complex than Merriam-Webster lets on. The discussion includes eight different commonly used measures of inflation, a discussion of hedonic adjustments, and what appear to be thousands more words including "other theories".

The first topic in the Other Theories section is Austrian Economics where it is found that, "Austrian economics views inflation as an increase in the money supply itself, and views moves in the general price level as being subsidiary to changes in money supply."

That must be why the oil-gold question is being asked here today.

For any observer concerned about causes rather than symptoms, inflation is much better defined as the increase in money and credit, and it is there that the oil price/inflation hedge/gold price logic breaks down.

Oil Prices and Gold Prices

The mainstream thinking on the subject of oil, inflation, and gold is evident in this Bloomberg story from a week or two ago:

"Gold prices rose in New York on speculation higher energy costs will boost the appeal of the precious metal as an inflation hedge.

Gold sometimes moves in the same direction as the price of oil, which has almost tripled in the past five years. Gold reached a 26-year high of $732 an ounce in May, and oil climbed to a record in July."

Yes, rising oil prices will drive up the consumer price index (the mainstream view of inflation) and people will feel that perhaps they should trade in some of their dollars for gold because gold will also rise in price.

But that still doesn't really make sense.

What if 50 percent of oil production were knocked offline and oil prices shoot through $100 and the consumer price index in the U.S. rises to 10 percent?

Would people then feel a need for "protection" as the price of oil rises?

Similarly, what if some low cost manufacturer from the other side of the world drives down the cost of imported goods and keeps consumer prices far below where they would otherwise be?

Would people then feel that they need less "protection" or no "protection"?

A much more sensible approach to the question of what causes the gold price to move is to simply look at money and credit and assess whether there is just too much of the stuff being created.

The price of oil and its impact on consumer prices just confuses the issue.

Here's a chart of reconstructed M3 from the Now and Futures website to help out on the money creation part (the Federal Reserve stopped publishing this data a year ago - they said it costs too much to maintain and provided too little helpful information. The black line, M3b, is the reconstructed portion).

No one really knows how much credit has been created since the stock market bubble burst almost seven years ago.

Gold is probably going to go higher.