February 21, 2006, 8:46 a.m.
Supply vs. Supply
All that is gold doesn’t glitter.

By Jerry Bowyer

Some supply-side economists, including some of the disciples of the late Jude Wanniski, think that the Federal Reserve has not tightened enough and that high inflation is on the way. Many of them bolster their case by pointing to high gold prices.

On the other hand, well-known supply-siders like Arthur Laffer and Larry Kudlow, while still looking at gold as an inflation signal, also take into account interest rates and currency markets — both of which are signaling low inflation. They conclude that inflation risks are minimal.

Who’s right? BuzzCharts is leaning toward the minimal-inflation view, and here’s why:

The case for using gold as an inflation indicator is based on the premise that the market knows more than central bankers do. This idea comes from economists Ludwig von Mises and Frederick Hayek, the latter of whom taught that no central planner is smart enough to exceed the combined knowledge of all as expressed in market prices. Markets are not omniscient, they are just more “scient” than any other human institution.

This is good as far as it goes, but it doesn’t go far enough. Why stop at gold? If gold traders know more than a few hundred economists at the Fed, then don’t bond traders and currency traders and gold traders together know more than gold traders do on their own?

In other words the principle of distributed knowledge (the wisdom of crowds) should lead supply-siders away from relying only on gold traders. If applied consistently, the principle should be to look at all the inflation sensitive markets in making determinations about the future of inflation. In fact, the bond market is huge compared to the gold market. Currency markets are also quite large. This means that taking these markets into account, in addition to the gold market, massively increases the size of the “crowd” that we’re tapping in to.

If gold production is allowed to slip — e.g., as a result of a recent deflationary cycle (which, in fact, was what recently occurred) — it can lead to price spikes, in particular if rising incomes lead to a rising demand for gold. We’ve seen this in India and China, where rising incomes have in fact led to rising jewelry demand.

Has gold been rising for these reasons, or has it been rising as an inflation hedge? We need a second, and third, opinion, in particular the opinions of interest rates and foreign exchange rates, both of which are not worried about inflation.

Supply-siders may have come to their recent disagreement in part because of the lengthened shadow of Jude Wanniski — the man who took the empirically driven theories of Art Laffer and Robert Mundell and turned them into a kind of religion (as he did for many ideas through his professional life). Unable to deal with a lack of certainty, he consecrated gold — setting it apart from all other markets and declaring it “the north star” of the world economy. He wrote papers about gold as “the polaris” of financial markets, asserting once to this author that he adopted this theory for reasons other than just economic data: Wanniski believed that there needs to be an absolute standard of value.

This debate has been going on for more than a year between supply-siders — the gold-first crowd on one side, the bond-market/interest-rate/gold-also crowd on the other. Meanwhile, each month the consumer price index comes out with a relatively low reading. If the accuracy of a theory is demonstrated by its predictive ability, then how many months of low consumer price growth do we need before we can question the Wanniski approach to inflation forecasting?

Gold-mania is a theoretical flaw in the supply-side movement that has lead to confusion and inaccurate predictions.

— Jerry Bowyer is the author of The Bush Boom and an economic advisor to Independence Portfolio Partners. He can be reached through www.BowyerMedia.com.

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