My Response to Tim Wood

March 28, 2005 – Tim Wood is the founding editor of Resource Investor, (www.resourceinvestor.com) an online newsletter focusing on junior mining stocks. It is a newsletter that I find informative and filled with generally good research, so I read it regularly.

Every once in a while Tim strays from the resource stocks in order to shoot arrows at the Gold Anti-Trust Action Committee (www.GATA.org), and he has done so again. His first article appeared on March 20^th, and can be found at the following link: www.resourceinvestor.com.  Then his second article followed on March 24^th and can be found by clicking here.

It is the first article that I will focus upon because in it, Tim challenges GATA’s claim that gold’s lagging price performance relative to other commodities was “more powerful evidence of surreptitious intervention by central banks in the gold market“. GATA’s claim is one to which I wholeheartedly agree. I even helped to support it with an article written for my last newsletter (Is the Gold Price Being Managed?).

At the heart of the matter is the CRB Index of seventeen commodities (this index is owned by Reuters and often referred to as the Reuters/CRB Index). By presenting the relationship between gold and the CRB Index since 1980, I set out to explain two things. First, gold in recent years was diverging from its historical record and underperforming the CRB Index, which provides more evidence of government intervention to keep the gold price artificially low. Second, governments were doing us a favor because by their intervention. They are making gold cheap for us to buy because gold is well below the natural market price that would prevail absent government intervention.

Tim dismissed the possibility of government intervention out of hand, blaming gold’s underperformance instead on the CRB Index itself. As a consequence, I feel compelled to respond to Tim, lest anyone reading my article and his believe that I accept his point of view, and ‘point of view’ it is. His article is an opinion piece that rests upon one premise. As he explains it: “There is no iron law requiring the Reuters/CRB Index to sustain fixed price relationships for time immemorial.”

Tim doesn’t provide any references to support this premise. It’s an indefensible oversight because absent any support, his premise degenerates into just his opinion, rather than sound research. This point is particularly important for there is indeed an ‘iron law’, which I will explain in a moment, but first I need to address Tim’s comments about the CRB Index.

Clearly, this index is not perfect. As Tim rightly points out, the “CRB Index has not kept pace with changes in the world economy” and “That is why so many trade-weighted commodity indices have started to emerge to compete with Reuters/CRB.” It’s true, but then again, the same thing could be said for the venerable Dow Jones Industrial Average. So while I follow other commodity indices – just as I also follow the S&P 500 and other market cap weighted stock indices – there is nothing inherently wrong or inappropriate in comparing gold’s relationship to the CRB Index anymore than there is in comparing gold’s relationship to the Dow Jones Industrials. But this is not Tim’s only ad hominem attack.

Tim goes on to say: “History shows that relationships between components of the CRB Index are always in flux.” But this statement is self-evident and adds nothing to support his argument. Again, think about what happens within the Dow Jones Industrial Average. Exxon and Citicorp are always “in flux”, and so are the other twenty-eight stocks, but so what? Does that mean that the message of a rising or declining DJIA should be ignored? Or that gold’s relationship to the DJIA is not meaningful? Of course not, which brings me back to the basic, underlying premise of Tim’s article and his contention that there is no ‘iron law’ about gold and the price of commodities.

I assume that Tim is not aware of “The Golden Constant“, a wonderful book written in 1977 by Roy Jastram, at the time a statistics professor at the University of California, Berkeley. He proves that there is indeed an ‘iron law’, or in other words a ‘constant’, in gold’s purchasing power, notwithstanding the historical fluctuations that do occur.

By analyzing 633 years of commodity prices in England as well as 176 years of commodity prices in the United States and their relation to gold, this statistics professor presents two important conclusions. First, “gold is an ineffective hedge against yearly commodity price increases“, which is a somewhat surprising conclusion that I’ll get back to in a minute. But despite this limitation demonstrated by his statistical analysis, professor Jastram concludes “gold does maintain its purchasing power over long periods of time. The intriguing aspect of this conclusion is that it is not because gold eventually moves toward commodity prices but commodity prices return to gold.”

To explain this last point, the good professor was speaking in a ‘politically correct’ way, which no doubt was required for college professors in state-run schools in the years immediately following President Nixon’s ‘demonetization’ of gold. Jastram does not accept the view that gold is money, and he does not as a result refer to commodities and their price in terms of gold (e.g., the price of wheat or coal in terms of ounces of gold). As he puts it: “The purchasing power of gold is…how much it can be sold for, translated into how much can be bought with the proceeds of its sale.” Using national currencies an as intermediary requires an added step in his calculations, but it doesn’t detract from his basic conclusions. So to translate, here is what he is really saying in his second conclusion: when commodity prices are expressed as a weight of gold, they remain unchanged over long periods of time. Or in other words, over long periods of time, his work demonstrates that commodities cost the same weight of gold. But why does the professor conclude that gold is not effective “against yearly commodity price increases“?

It’s a good question, and the professor does not attempt to answer it. Why? Probably because he taught statistics, and not political science.

Jastram noted that for periods of time – like the during the Napoleonic Wars and more recently, during the period of the London gold pool in the 1960’s – gold did not keep up with inflation. But he remained focused on the statistical anomaly, rather than the reason it occurred. Yet the reason for gold’s underperformance is obvious. These are periods during which there was active government intervention – for example, suspension of redeemability in England during the time of Napoleon and dishoarding from Ft. Knox during the gold pool days. This active government intervention was aimed to keep the ‘gold price’ artificially low because a rising gold price would bring attention to the prevailing monetary turmoil of the day.

So for periods of time, gold is, in the good professor’s words, “an ineffective hedge against yearly commodity price increases“. And it remains an ineffective hedge until, and this is the professor again, “commodity prices return to gold“. In other words, gold measures the true price of commodities. But during periods of government intervention, gold purchases fewer commodities, meaning its ‘price’ does not keep up with inflation. In time, however, government intervention in the gold market becomes unsustainable, and commodity prices return to their historical norms, i.e., commodities eventually again cost the same weight of gold.

Thus, the relationship between gold and commodity prices is well established, except during periods of government intervention in the gold market, which is the basic conclusion of my previous article. And it is this basic conclusion that Tim Wood tried to refute, but he comes up short given the absence of any supporting evidence, which brings me to one more point.

Tim ends his article with the following chart, challenging the reader with these parting words: “It is interesting how gold has reasserted its monetary role since 2001. If the CRB Index is proof of a conspiracy, then this chart must be sufficient proof of the contrary.”

I really pondered his message thoughtfully. His point was not obvious to me, so I looked for and expected some deep hidden message. But it seems to me there is none.

All this chart shows is that gold and the euro have more or less moved in tandem with one another. It doesn’t disprove that central banks are intervening to keep the gold price artificially low, disrupting gold’s long-term relationship to the CRB Index. All it does is to establish that commodity prices are low in terms of the euro. Now why might that be?

Here’s what Bloomberg said in its interview on March 26^th with Ottmar Issing, chief economist of the European Central Bank: “He also noted that Euro strength was paramount to the region’s ability to secure discounted prices for key commodities, such as crude oil, which is trading at record highs in U.S. dollar terms, but remains historically inexpensive in Euro terms.”

This statement makes it clear that cheap commodity prices are to Europe’s advantage. So why should the ECB be concerned if the US is intervening in the gold market? In fact, Issing’s statement would indicate that Europe is happy that gold and the euro are tracking one another, making commodities and gold relatively cheap in euro terms. But this advantage is temporary, just as it was in all other periods where government intervention for a time adversely affected gold’s purchasing power. As the good professor irrefutably demonstrates, “commodity prices return to gold“, thus proving there is indeed an ‘iron law’. But why does gold maintain its purchasing power over time?

Professor Jastram doesn’t have an answer, but I do. The aboveground stock of gold grows at approximately the same rate as world population and world wealth. In a world of uncertainty, one thing is certain – it’s this ‘iron law’ of gold’s purchasing power. But I suppose on reflection there is also one other certainty – that governments will intervene in the gold market in a vain attempt to prove they are more powerful than gold.