Chuck Ponzi June 28th, 2006

Allright, this is going to go way off topic on this one, but please bear with me for a short while while I explain what is bouncing around in this empty head…

With the 17th FED funds rate hike imminent, we are reflecting on a number of issues…

1. Is there inflation, and how much?
2. What about price deflation and asset deflation?
3. Where are precious metals heading, and is that an indicator or inflation or have they become decoupled much like SoCal Housing?

First off, I have no definite, easy answers for any of them.

Urban Legends

There is a common urban legend about the value of gold. It goes something like this: An ounce of gold is worth about what you can buy a nice tailored suit for. This was the case 100, 200, and 300 years ago, and it is true today.

If you believe this theory, you are picking and choosing your facts. Gold is right now in the $580/ounce range. While you can buy a suit for that price, it is hardly anything I would call a “nicely tailored suit”. This is a bone-stock off-the-rack mid-quality suit. Professionally tailored suits will cost you a lot more in the US. Try $3-$4K on for size and see how it fits.

On the flipside, you can buy a nicely tailored suit in Malaysia for about $580 if you would like to. Of course, the $1500 ticket there might set you back a bit, but otherwise, the urban legend would be true.

Unfortunately, (or fortunately as you might see it) we do not live in Malaysia. Dollar and US financial hegemony has inflated the prices of everything you buy here. Transport costs, risk, etc, all contribute to raise prices here and not there. Gold, on the other hand is easily transportable, has low risk, and its purity is easy enough to test that you would find only a small difference in price between the 2 places.

Imagine for a moment, a machine, that could render a perfect 3-dimensional model of your body and transmit that information to a sweatshop in Malaysia for a few pennies. A tailor could construct a finely craften tailored suit to your specifications from the other side of the world, and final fitting could be done interactively. What would this do to the prices of tailored suits in the US? (that’s a rhetorical question, you don’t need to comment to reply)

In the long run, it would both lower the price in the US and raise the price in Malaysia. It would then be as transportable in both locations as gold is.

Would gold need to change to match this new price? Would it go up, or would it go down? (this, again, is a rhetorical question, there is no link between the price of gold and the price of a nicely tailored suit)

Hedonics

Another urban legend is that when your computer has twice the memory for the same price, the CPI portion for computers is halved.

OK, everybody knows this one isn’t right, but should there be an adjustment to inflation figures if higher quality products replace earlier models? One side of the debate says no, it performs basically the same functions, but does not reduce the cost. The otherside says yes, the enhanced performance will increase the longevity of the product and therefore reduces use costs over the long-term.

What about the car that now gives a user 300K miles of worry-free service compared with the 100K mile version of 30 years ago? Is there some hedonic value that our official figures should show even though it still essentially gets us from point A to point B? What about the same car that uses 50% less fuel? Should that be deflationary, or not?

The answers are not simple. The age-old question of how is inflation defined is critical to our understanding. Generally, it is the loss of purchasing power of money, but that can be measured by price sampling or money supply. A number of factors can serve to temporarily toss one or the other out of whack, and it is important to remember that a holistic approach to inflation is probably the most prudent.

Is there inflation? If you look at houses, yes, but not if you look at computers. Will there be deflation in the future? I would recommend reading the last statement again. Hedonics are someone’s “best guess” into understanding what is driving prices. Hence, it won’t be the same.

I think the appropriate question is not “will there be inflation or deflation”, but rather “Where will we see inflation or deflation? Housing is an almost certainty over the next 5 years in SoCal. (if you have to ask, please read the title of the blog)

Gold, gold gold!

Where is gold headed? I think we already answered that question… nobody knows. It appears to be decoupled from prior fundamentals; it no longer serves as a formal currency, and its value is largely determined by someone’s opinion of its value. Sounds a lot like typical investments… except that it provides no residual cash flow or earnings to base its value on. It is, therefore, a pure speculative asset, and in true Keynsian economics, really contains speculative demand, much like demand for US dollars, Euros, or Yuan.

Just ask the Chinese if they think gold is an “investment”

Is this the end?

Perhaps the appropriate question is not whether this is the end (of anything, you just insert what you think this is the end of), but rather What is this the end of? Perhaps you might reflect on some of the following:

1. Affordable housing in the US.
2. US financial hegemony
3. Sino-US trade defecits and currency imbalances
4. Low interest rates
5. High interest rates
6. The world as we know it
7. The largest financial bubble the world has ever seen.

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