In Gold We Trust (WSJ) OP-ED
By DAVID RANSON and PENNY RUSSELL
May 18, 2006; Page A14
Widespread fear of another global energy crisis is rife, especially in light of the confrontation with Iran. But the second of Murphy's Laws cautions that what actually goes wrong is seldom what we anticipate. While the markets are clearly indicating something ominous, the current situation is mischaracterized as an energy crisis -- even if the price of a gallon of gas goes past $3 and stays there. Energy prices are simply keeping pace with the rising prices of gold and other commodities. What we are facing is a money crisis: an alarming outbreak of inflation and all its consequences.
It's silly to blame the rise in commodity prices on foreigners; no country, not even China or Saudi Arabia, has the market power to set off the kind of across-the-board acceleration in prices that we have been witnessing. Nor can prices rising this consistently and at this speed be attributed to an excess of global demand over supply, or fears about the political situation in Iraq or Iran. Speculators, another convenient scapegoat, also lack the power to drive world commodity markets, in spite of their rapacious reputation. The real culprit is the precipitous decline in the world's mightiest currency, the dollar, which has lost more than 60% of its gold value in just four years.
The run on the dollar is largely being ignored by Washington and Wall Street, and most of the financial press is only beginning to take note. When analysts do comment on the strength or weakness in the dollar, they are most often referring to its value in terms of foreign exchange; little attention is given to the value of the dollar in terms of gold. When headlines do herald that the price of gold is rising, there is little recognition that, since gold is quoted in dollars, it is just as true that the dollar is falling. It is gold that is a benchmark for the value of the dollar -- not the other way around. When the dollar price of gold is on the rise, the dollar prices of oil and other commodities have historically kept pace.
It is only the nominal price of oil that has reached record levels; in real terms, we are still on the road to recovery from the genuine energy crisis that culminated with Hurricane Katrina. Although it is the accepted convention to calculate the real price of an asset from official government measures of inflation such as the CPI, this would be a mistake in the case of energy. Since oil is traded in fast-moving markets worldwide, its real price can only be assessed by comparison with other internationally traded commodities; for this purpose the U.S. cost of living index is irrelevant. We suggest instead using an index of precious-metals prices.
The adjacent chart shows the divergent picture of the oil market that emerges when representative oil prices (West Texas Crude) are expressed in real terms. The solid line charts changes in the ratio of the price of oil to a price index for precious metals over the past half century. While the chart shows abundant variations in the real price of oil over time, it also shows the real price gravitating around a slowly rising trend. The dotted line represents the equilibrium real price of oil. We believe that its gradual upward slope reflects the fact that oil is gradually becoming scarcer with the passage of time.
The chart confirms that the real price of oil peaked out late last year and has been on the decline since. In other words, the dollar has been falling relative to its precious-metals benchmark faster than oil has been rising relative to the dollar. That's why we believe that the current rise in the dollar price of oil is merely the process by which this price converges toward equilibrium. Far from entering into a new crisis phase, the oil market is still cooling off from the last one.
We estimate from nearly a half century of history that the equilibrium price of oil, converted back to current dollars, was about $61 a barrel in April. In other words, the long-term history of the ratio between oil and precious-metals prices, given the prices that these metals have now reached, implies that the oil market would be in balance at $61. The actual price in April was $70. Reading from the graph, we see that the real price of oil has moved two-thirds of the way back to equilibrium since Hurricane Katrina.
It's not the time, however, to breathe a collective sigh of relief. It is just as foolish to fail to recognize a true crisis in the making as to conjure one up. As of this writing, gold is fluctuating around the $700 mark, with silver and platinum up at least as much. The gold value of the dollar appears to be going into free fall, and the further it declines the more dire the consequences, including still higher nominal prices for energy, even without any further change in the real price. Absent some miraculous reversal, $3-a-gallon gasoline may be here to stay.
If none of the usual suspects is responsible for gold's sharp rise, what is? We believe it represents an equally sharp decline in the confidence of investors -- large and small -- in the likelihood that Washington will pay back its mounting obligations in undepreciated money. Throughout history, and especially in wartime, governments have escaped from fiscal over-commitments by letting their currencies depreciate. Ambitious spending initiatives, threats of international conflict and even Washington's political unpopularity all contribute to the fear that this is happening again now.
Gold is the barometer of public confidence in fiat money, and it is difficult to rebuild confidence in a currency once it has been allowed to slide. Gold has been a reliable harbinger of many economic troubles -- not just of escalating prices at the gas pumps, but of inflation, rising interest rates, stagnation and poor investment performance on the part of bonds and equities alike. Changes in the price of gold are an excellent predictor of all of these. The dollar's collapse is nothing less than a body blow to capitalism. When we downplay the significance of energy prices, we are not denying that a crisis is looming. It's just a lot more threatening than an increase in the cost of a tank of gas.
Mr. Ranson and Ms. Russell are principals of H. C. Wainwright & Co., Economics, an investment-strategy research firm.
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