A Flawed Week – Gold & Econ

It has been quite a week for two distinct sets of groupies – gold and austerity bugs.

Gold has dropped like a rock (or should I say, like a commodity) in the past week, continuing a general trend and is now down 27% from its high.  Of course it was up nearly five fold at its high from 2005…so for those buy and hold people, this isn’t especially devastating.

I’m not a fan of gold and never have been.  I don’t believe it has fundamentals in which to judge value and it reminded me of the mortgage bubble whenever I turned on the radio (I have other reasons, just not the topic today).  This doesn’t mean that I’m gloating right now, I know from experience that next move in gold could be up or down in a big way (and that is the problem).

I think the main pleasure I receive from this gold volatility is that it further demonstrates that it’s not a good store of value or a hedge against inflation for a person who is living right now (perhaps it can be over long periods of time).

Someone buying gold at the top in 1980 has seen a return of about 1.5%, even if gold had risen to $2,000 an ounce the total return would have been only around 2.7%, below the 3.2% rate of inflation for the period.

If you had been fortunate enough to buy at its low in 1985, the annualized return is nearly 6%, even after this current downturn in price.  Not bad, until you consider you could have done much better in bonds and with less risk.

But this misses the point.  When I was visiting my mother for Easter she was telling me about a gentleman who thought gold was the place to put all your savings.  The only place your money will be safe is in gold, he said.  This is ridiculous.  Anything that fluctuates as much as gold does (up or down) is a poor place for savings or money that you might need to live on in the short and even intermediate term.

I have no problem if someone wants to speculate in gold with a small portion of their funds as long as they have an overall strategy that makes sense, but this idea that gold is a safe investment (obviously I define the term differently) is a load of bull.  Gold can certainly be a diversifier, but whether it will add to return or not is tough to tell, especially at today’s price (which is admittedly better than a few weeks ago!).

Another flaw in the ointment was uncovered this week in a now famous study (turned into a book “This Time It’s Different: Eight Centuries of Financial Folly”) by Carmen Reinhart and Kenneth Rogoff,  “Growth in a Time of Debt.”  According to blogger Mike Konczal:

Their “main result is that…median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower.” Countries with debt-to-GDP ratios above 90 percent have a slightly negative average growth rate, in fact.

This has been one of the most cited stats in the public debate during the Great Recession. Paul Ryan’s Path to Prosperity budget states their study “found conclusive empirical evidence that [debt] exceeding 90 percent of the economy has a significant negative effect on economic growth.” The Washington Post editorial board takes it as an economic consensus view, stating that “debt-to-GDP could keep rising — and stick dangerously near the 90 percent mark that economists regard as a threat to sustainable economic growth.”

Three main flaws were uncovered, including an incorrect formula in a spreadsheet, Konczal continues:

They find that three main issues stand out. First, Reinhart and Rogoff selectively exclude years of high debt and average growth. Second, they use a debatable method to weight the countries. Third, there also appears to be a coding error that excludes high-debt and average-growth countries. All three bias in favor of their result, and without them you don’t get their controversial result.

I’ve never really given this study much merit and found the book almost impossible to get through, the reason is different though than the above flaws.

The real flaw of the study has been pointed out by Modern Monetary Theorists and Monetary Realism proponents since the original release – there is not a proper distinction made between the monetary regimes.

I think Cullen Roche over at the PragCap blog does the best job in pointing out the true folly of the study in his post “Still Missing The Point on Reinhart/Rogoff,” he says:

“…, but anyone who understands the modern monetary system would have disregarded the paper from its very start.

The paper lists currency using nations like those in Europe alongside currency issuing nations (like the USA) and makes no distinction between the monetary systems.  This is a colossal error.  It renders the paper largely useless.  It’s like comparing the state of California or my household to the federal government in the USA.  Of course, one has a central bank that can create currency while the other does not.  The nations in Europe are users of a currency with a foreign central bank.  This creates a very real solvency constraint that has proven to create substantial economic instability.  Comparing these two types of monetary systems is an apples and oranges comparison.”

For some reason the goldanista’s and the austerianista’s tend toward the same camp (though not always) and this week can’t be over quick enough for them.

Scott Dauenhauer, CFP, MSFP, AIF


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