The Kondratiev Cycle Revisited: Part Three, Implications for Gold
This is a continuation of a three-part article in which I examine the Kondratiev cycle in its modern form to form an idea of future long term economic trends, including the prospects for gold. In an article last year, I presented my views of the Kondratiev cycle. In that article I introduced the concept of the reduced price. The reduced price is a regular price index normalized for the effect of monetary stimulation. I use it to reveal the K-cycle after 1932 when government monetary policy has produced an effectively permanent inflation that obscures the K-cycle. Another tool that can be used to track the progress of the K-cycle is the ex-ante real interest rate, which can be thought of as a measure of inflationary expectations in the bond market. In part one of this article I use these two measures to show that our current position in the K-cycle is at the beginning of the fall from plateau. The last fall from plateau was in 1929-32.
In part two of this article I show that in the modern era, the fall from plateau will not play out like the last one. Rather than a deflationary depression and an 85% drop in the Dow, we will see a much milder recessionary period, and an ordinary bear market, in fact the September 2001 low could have been the end of the bear market, although we could easily go somewhat lower (i.e. the "double dip" recession scenario). The reason for the milder fall from plateau is massive countercyclical stimulation by the Fed. The reader is encouraged to read parts one and two if they are not already convinced of our position in the K-cycle, or if they do not buy the idea that the Fed can prevent a deflationary depression and severe bear market. The extreme valuation on the stock market makes this difficult to swallow.
After getting through the preliminaries in part one and part two, we can then use the concepts presented to chart a course for the long-term (10-20 years) path for gold prices. As with all my work, my approach is to use historical analogies, but to interpret them using special tools like reduced prices, ex-ante real rates and price to resources (P/R). For example, in my first book, Stock Cycles, I employ historical analogy interpreted through the lens of P/R to project that money markets will outperform stocks for the twenty years after 2000. In that book I proposed a different position in the K-cycle from what I am proposing now. At that time I believed that the 2000 stock peak would be the DG peak, equivalent to 1937 in the last K-cycle. Based on this interpretation of our position in the K-cycle, I believed that inflation would rise to around 5% before heading down and that long bond rate would move well above 7% before heading down.
Although I was right about the stock market I was wrong about bonds and inflation. In my second book The Kondratiev Cycle, I delved deeply into the K-cycle and concluded that I had gotten the position wrong in Stock Cycles. Rather than the DG peak (i.e. 1937 analogous) the 2000 stock peak was the end of plateau (i.e. 1929 analogous). The new tools of reduced prices and ex-ante real rates were part of the evidence which changed my mind. In addition, a generational interpretation of the K-cycle figured prominently. In Stock Cycles I had not recommended gold based on the deflationary nature of the K-winter period. The new evidence in my second book has prompted me to re-evaluate this projection. In the following section I outline my current views on gold.
The long-term projection for the price of gold (POG)
Gold is a unique asset in that is both a commodity and a monetary instrument. As a metal, it is subject to the same sorts of supply and demand pressures that apply to other metallic commodities. Gold has commercial uses and has a production cost, just like other commodities. Unlike other commodities, however, gold has often served as money in the past and thus has a use as a store of value (i.e. savings). That is, gold may be accumulated (hoarded) for the purposes of saving in a way that other commodities are not. For example, central banks and private investors hold large stocks of the metal, relative to annual production and consumption. These large stocks and the willingness of gold owners to keep large stocks of the metal out of economic use means that gold can trade (for years) way out of line with the supply and demand strictures that apply to other commodities. The reason gold is accumulated is that it has served as money in the past and still retains an association with money for a considerable fraction of the world's population.
What this means is the concept of monetary stimulation and reduced prices should have special relevance for gold, even today. Back in the late 19th and early 20th centuries, the American dollar was on the gold standard. What this means is the U.S. dollar was set as equal in value to a fixed quantity (about 1/21 of a troy ounce) of pure gold. This peg to gold produced financial manipulations which resulted in the money supply of the U.S. growing no faster than economic activity. It also discouraged government deficit spending, except during times of war, when the government would go off the gold standard. Expressed in terms of my reduced price concept, the gold standard kept monetary stimulation (S) at a roughly constant value. Except during times of war, S remained in a range, and so reduced prices closely tracked regular prices. As a result the Kondratiev cycle, which is manifested as a cycle in reduced prices, also showed up in regular prices as well. During Kondratiev downwaves, prices would fall, causing considerable economic hardship. This hardship produced calls for "free silver" in the late 19th century downwave and brought in modern Keynesian economic management in the downwave after that. Today this same concern has produced "Greenspanism".
Figure 6 outlines the history of gold prices and how the various efforts to deal with pernicious downwaves have changed the course of gold prices. The "money" role of gold means that we should be able to apply the stimulation concept used to produce reduced prices to the price of gold. Figure 6 shows a stimulation-based model (bold black line) for the price of gold. This model simply assumes that gold price is proportional to the stimulation model for ordinary prices that is used to calculate the reduced price. For the period 1860-1915 the POG and the stimulation model closely agree. The only discrepancy is in the 1862-1879 period during which the U.S. dollar was "off the gold standard". In order to finance the Civil War, the U.S. government had to "print money" (i.e. resort to a fiat currency) in the form of Greenbacks. Doing so took the U.S. financial system "off gold" in 1862 . It was only in 1879 that the dollar came back to "parity" with gold and the U.S. went back on the gold standard . What this means is the price for gold given by the stimulation model (the true value of gold as "money") rose above the market price in 1862 and didn't fall back until 1879.
From 1879 to just before World War I, the U.S. dollar was on the gold standard. This is shown in Figure 6 by the close correspondence between the price of gold predicted by the stimulation model and the actual POG. Of course this is necessary since the whole purpose of a gold standard is to regulate stimulation in such a way that this correspondence occurs. During WW I the U.S. (and the rest of the WW I belligerents) went off the gold standard just as the U.S. had done for the Civil War. After the war, the U.S. (and eventually the rest of the Western world) went back onto gold. But this return to gold was not at parity. That is, the actual price of gold was well below what the stimulation model calls for. For parity to be reached would require politically unacceptable levels of deflation after World War I and so the gold standard was re-established under what was called the gold-exchange system. Throughout the 1920's the economic authorities were able to maintain stable currencies well above the value consistent with gold. When the world economy "fell off the plateau" after the 1929 stock crash, the gold exchange system was no longer tenable and one country after another went off gold. The U.S. left gold in 1933 and a new POG was established at $35 an ounce by a devaluation of the dollar.
World War II introduced another round of stimulation. As a result, the price of gold given by the stimulation model once again rose above the POG. This time the world did not return to the gold standard. Instead, the world currencies were pegged to the U.S. dollar, which was then pegged to gold at $35 per ounce. The strong trade position of the U.S. coupled with the vast gold reserves of the U.S. treasury meant that the U.S. could keep this new "dollar system" going for decades despite the lack of parity between the dollar and gold. Eventually the system collapsed in 1971 and gold began to trade as a commodity. After more than two decades of under-valuation, the POG exploded upward after 1971. Now freed of its monetary characteristics, gold began to behave as a commodity. As the world economy progressed through the inflationary Kondratiev summer period, gold rose in price along with oil and other commodities reaching a peak around the time of the K-peak in 1980-81. That is, gold rose partly as a response to its previous under-valuation, and partly as a commodity following the K-cycle as defined in reduced prices (the red line in Figure 6).
By 1980, gold had become extremely overvalued relative to its value as money. The very fact that gold has been used historically as money suggests that it has a higher value as money than any other use. Thus, once the Kondratiev downwave got underway after 1981 we should expect gold to fall in price along with other commodities, but at a faster rate, because of its overvaluation. Note how gold has fallen in price along with the reduced price (red line in Figure 6) As Figure 6 shows, in recent years, gold has reached parity with the dollar again. That is, gold is no longer either over or undervalued compared to the dollar. Now this does not mean that gold cannot move lower from here. Recall the lengthy periods in the 1920's and the 1940's through 1960's during which the POG was well below it's monetarily-derived value. The economic authorities have in the past held the POG well below its money value for decades. Also the deflationary drag of the fall from plateau should exert a negative pull on the POG in is role as a commodity. On the other hand, gold's role as a store of value could benefit from the uncertainty that accompanies the fall from plateau.
What will likely happen during the fall from plateau is a substantial rise in stimulation. During the 1981-87 fall to plateau the stimulation-based price of gold (bold black line in Figure 6) rose from about $135 to $210. The actual price of gold (bold gold line in Figure 6) was much higher than this, however, and so it fell during this time. If we assume that the fall from plateau will be accompanied by a similar degree of stimulation, we could project that the stimulation-based price of gold (bold black line in Figure 6) would rise from $285 to $440. This suggests that gold purchased at recent lows (260's-280's) should eventually be a good long-term investment (it has already proven to be a good short-term investment). Note that just because the stimulation model for gold is rising does not mean that the POG must rise at the same time. Figure 6 contains abundant evidence that this is not true. What it does mean is if the current rally in gold is yet another bull trap, and prices will fall back again, gold purchased at those lower levels will be undervalued for the first time since 1973.
Right now, with gold prices around $300, gold is neither over or undervalued. There is no monetary driver for gold to move higher or lower and so gold should respond to the same sorts of price pressures facing commodities. The fall off plateau exerts a deflationary effect on the economy, which although countered by massive stimulation, has kept inflation low. Short term rates are low, while long-term rates are high. This situation is normal for the fall off plateau. During this time, reduced price is falling while ex-ante real rates  remain high. What this means is fear of inflation still drives the bond market. But this fear of inflation is tempered by the real possibility of a double-dip recession, drops in reduced prices are associated with recessions and the one we had last year was almost too mild to have been all there is. So the bond market is unsettled between higher rates due to fear of incipient inflation or lower rates due to fear of renewed recession. Similarly, the outlook for gold is unsettled. The utility of long-term analysis is mostly to provide an idea of which levels are likely to be considered "low" and "high" from a perspective of 10-20 years down the road. Based on the stimulation model for gold, it would seem that recent lows in the $260's to $280's range will fall into the lower region of gold's trading range over the next 10-20 years. The unsettled nature of markets at this time suggests that opportunities to accumulate at these levels or even lower could well appear in the next few years. The long-term trend in the stimulation model suggests that such accumulations will outperform money markets in the longer run.
Roper, Don. And Lori Warner, (1991), "Late Nineteenth Century U.S. Monetary Controversy: Reinterpreting the Easy Money Forces",. csf.colorado.edu/authors/Roper.Don/bimetallism.pdf.
Roper, Don. And Lance Girton (1993), "Gold Debt and the Great Depression", csf.colorado.edu/authors/Roper.Don/gold-deb.pdf.
Kolari, James W and Ariel M. Viale, "Gibson or Fisher Paradox? Back to the Future Expectations and Escape Dynamics of a Very Plausible Robust Agent", 2001, unpublished manuscript.