I side with Joe Terranova contra Dennis Gartman and Tim Seymour for the next $50 in gold (12:20), but it’s not like I’m net short across all personal accounts or anything.

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Editor’s Addendum: A related video….

I haven’t had time to put something rigorous together on this, but if you look at the diffusion of major innovations in the US, it’s hard to avoid seeing a curve that basically leveled off by the 1970s, about which time the rate of productivity growth also fell off. Adoption of PCs and the internet boosted productivity in the ’90s, but the hottest new companies today are not, for the most part, oriented towards increased productivity. Much salient innovation since the 1970s has been of the consumer product variety, and serves to fill time rather than compress it. Technologies that effectively compress time (e.g. the train, the telegraph, the assembly line, the computer) and make processes more efficient (cold fusion) are more favorable to asset returns.

All of this has happened while globalization is also beginning to level off, developed world population has leveled off, and the ratio of non-workers to workers worsens in the developed world. None of these developments would reasonably seem to be favorable for returns, though nominal rates may rise of course.

These questions have great political import in their relevance to prospective cash flows for public entities with balance sheets at varying levels of long-term impairment. Various public pension trustees are arguably caught in a naive empiricism that does not sufficiently recognize these factors. On the other hand, these causes are difficult to show historically and significantly. Someone on the left might claim that Thiel and other libertarians are overrating these factors out of convenience to their overall political and economic narrative.

A perverse tragedy here is the lack of investment enthusiasm for biotech and healthcare. What could be more important? Where do we need more supply and lower prices? Apart from the question of longer lifespans on public debt, why can’t this technology translate into higher asset returns?

Now, Dr. Krugman could argue at least two points:

First, even if you assume Japanese-style growth, Social Security would still account for less than 10% of GDP. This however leaves aside the state and municipal versions of the pension problem, that might eventually take the form of demands at the federal level, and in any case are relevant to state taxpayers. It looks like he is telling half the story, and then with only half the numbers. Not to mention Medicare, which perhaps is only a different issue in a pedantic sense, if not in terms of urgency.

Second, if further stimulus were applied as Krugman recommends, we might have a chance of achieving those GDP targets. If however income is now structurally impaired by demographics or other factors, as some argue, those numbers are out of reach pending some new technology. Maybe you can double down on a bad balance sheet if your cash flow assumptions are good, but in this case they seem to be a product of naive empiricism. This is the same sort of empiricism that got pension funds that had assumed 8% annual returns in trouble. Those numbers seem to be picked from the same fictional future world as the GDP projections that Krugman endorsed, and as usual there is a willful blind spot to reasons why the past might not reflect the future.

To be clear, although it would be largely in my self interest, I am not some right-winger bent on ending social security. In my view, the minimum age must be raised. Dr. Krugman rightly points out that this would put a disproportionate burden on low-income workers, which is why I counter that any age hike must be coupled with means testing, which I prefer to higher taxes. Those on the left that argue that means testing would undermine the popularity of the program are absurd partisans. What is the metaphor? That would be like wearing the wrong color shirt to the wrong neighborhood, getting shot and then freaking out that your shirt is ruined, but not going to the hospital. Neither the right nor left would be thrilled with with an age hike / means testing deal, but that’s what makes a good compromise.

Deferral, abetted by private and public conflicts of interest, is the essence of the problem and is at the root of both the corporate and sovereign credit crises. Now, it’s one thing when you have an impaired balance sheet propped up by good cash flow, but there are reasons to believe that prospective growth and public income will also be lacking relative to the 20th century. These reasons of course are swept under the rug by at least one liberal economist. Paul Krugman chides someone for rambling on about demographics one day, and tells us we are turning Japanese the next. Why are we turning Japanese? Krugman sees this, but thinks we must defer that issue to deal with unemployment and deflation. To what extent, however, are unemployment, deflation, and the series of booms and busts over the last 30 years symptoms of demographics? If that’s the case, if pension rate of return assumptions are off for this or other reasons, things could get late early.

Anyway, to paraphrase Jon Stewart, this isn’t a game. Try to keep “garbage words” out of your titles if you aren’t going to have any real discussion. If everything is quoted, the quotes lose their meaning and everything is implicitly endorsed.

The basic points:

Gold does well when real rates of return are low. Real rates describe the price of gold much better than inflation alone. This is because real rates reflect the opportunity cost of holding a relatively useless asset. Part of the reason gold seems irrational is that this extrinsic pricing is unintuitive and largely unappreciated.

Gold does well when liquidity, measured for example by LIBOR, is not especially tight.

Sentiment can be predictive with gold.

The “extrinsic” way of thinking is natural in the fx world where all trades are two‐sided, and the idealized one‐sided currency , e.g. Dollar Index, is a weighted average of two‐sided rates. Other examples: the Fed Model and Dividend Discount models explicitly tie together the pricing of equities and interest rates. The housing bubble was to some extent already a mispricing of money in the form of interest rates. What was the “right” price for housing given the price of money?

Do people who claim that assets exhibit “irrational” moves have a clear idea of what level of volatility would be “rational”, especially given such cross‐influences? I do not endorse the Dividend Discount Model, but no-one can deny that it is a fundamental model, and it predicts higher volatility when rates are low. Given current levels, a 10% one day drop of the market is by no means absurd. The stock market should also have more idiosyncratic volatility when it is driven by “top-down” policy, rather than averaging many “bottom-ups.”

There is perhaps a “long-termism” fallacy. Even if prices change glacially, if you want to maintain a portfolio limited to 30 stocks out of a universe of 6000, it is easy to see how a sensible person might change the “best ideas” list with some frequency. The more prices change, the more frequent portfolio changes would be in order from a valuation standpoint. Again, asset prices are not hermetically sealed, one‐sided meanings and values. There is always some discount factor or relative valuation at play.

The easiest way to achieve a shock “20 standard deviation” move is to just not mark (or mis‐mark) for a while. Deferral of pricing is much more likely than active trading to originate an explosion large enough to affect the underlying economy. Deferral of pricing, not active trading, played a large role in the corporate credit crisis. Social Security and entitlement programs are also “off balance sheet” debt. At least banks failed to predict the future. Governments failed to predict the past. The basic demographic and longevity trend has been apparent since at least the 1960s.

Demographic trends suggest lower real returns than those seen in the 20th century. Do economists have a demographic blind spot?

In its approval of Trend Exchange and preceding statements, the CFTC has confirmed a very broad definition of “commodity” that includes “event” contracts. The old debate about whether or not the CFTC has jurisdiction over “prediction markets” has been decided for now. Yet, there is considerable dissent within the Commission. Commissioners Chilton and Sommers have expressed disapproval that the Commission did not first address the general questions raised in the 2008 Concept Release. To this point, given the very broad definition of “commodity,” it now seems that Intrade and online sports exchanges could be in violation of the Commodity Exchange Act. The Commission does not consider an “economic purpose test” in the contract review process, and there is no statutory basis for such a test being used in jurisdictional determinations. Perhaps as a matter of practice, in accordance with the spirit of the Act, the Commission is considering such a test for jurisdicitional questions as I suggested in my Concept Release comments (surprisingly cited by the MPAA group). Otherwise, it seems inconsistent that exchange-traded sports bets, for example, would not also be considered commodities and be subject to the Act.

As a whole, the Commission has apparently decided to defer such questions and focus on specific techniques for ensuring that the new contracts fulfill the Act from the standpoints of manipulation and fair trading. To these ends, the CFTC will require, “entities and individuals who control a film’s marketing budget, release date or opening screen number to provide the Exchange with information regarding such decisions whenever that entity or individual holds a position of 1,000 or more contracts.” Additionally, the Commission will require a “firewall” within studios and distributors, and has restricted certain employees from trading altogether. These are procedures that I had recommended for event contracts, but they are relatively novel mechanisms in the commodities world. Whether or not the CFTC would agree to support special trading restrictions was the pivotal question in whether the contracts would be approved. I applaud the principled, politically independent thinking of the Commission and the can-do attitude of the Market Oversight Division — though some headline risk has been assumed here if something should eventually fall through the cracks.

Much more time is spent promoting institutional arrangements of “constructive ambiguity” (e.g. Bretton Woods) than pointing out short-falls with transparency. The problem is that what’s being argued for under the aegis of “ambiguity” is just flexibility, mostly in the form of deferring decisions. (Not to mention that institutional arrangements can also become inflexible.) Clearly ambiguity is desirable when it manifests itself as flexibility, but this does not mean that ambiguity is desirable in and of itself. Best makes some pertinent observations (that are, for instance, relevant to CDS dynamics) but tries to wrap them up in a pleasingly ironic theory that alone threatens to undermine her conclusions. Early on, she tells us that she is “drawing inspiration from both postmodernist and critical theoretical traditions.” The thematic emphasis on ambiguity is no doubt influenced by such strains of thought, which stress “the irreducibility of difference.”

The early Bretton Woods regime is lauded for its ambiguity and “continuous deferral” of adjustments, and this points the the fundamental problem in the analysis. While active trading may increase short-term volatility, the author espouses a philosophy of deferral that is actually more dangerous and more at the cause of the financial crisis than active trading. Deferral of pricing creates the illusion of constancy where there is actually change, and enables longer-term booms and busts that are more pernicious and cause longer-lasting pain and dislocation than the “intersubjective” spirals the author warns against.

Take an example: traders push CDS prices up, causing the underlying entity’s borrowing costs to rise, thus ensuring default. This “intersubjective” dynamic would not be possible were there not already a fundamental basis for concern over the entity’s debt — if the entity had not already irresponsibly deferred its obligations. Which problem is more fundamental? This of course is exactly what happened in the credit crisis, as banks refused to transparently price their holdings. “Continuous deferral” is a recipe for less frequent, perhaps, but almost certainly more intense explosions. Is this kind of deferral not at the heart of the impending entitlement crisis, another kind of “off balance sheet” debt? It doesn’t matter if pricing will never have a perfect technical solution, you still try to price up to the point of ambiguity, which, as Best repeats, is always there anyway.

Lastly, the author holds out the Bretton Woods period as one of unsurpassed prosperity while ignoring the corresponding population boom and other factors contemporaneous with the currency regime. For their sake, Keynesians need to heed the demographic winds more closely.

[Originally posted to Amazon, 2/15/10.]

The price of money in turn was influenced by the demographic savings glut that previously fueled the tech bubble. At this point, governments failing to predict the past — the trend of increased longevity — seems like the biggest problem. The escalated contentiousness in the Senate is, in part, a symptom of this slow motion failure and the “lower stakes” for all of us.

But in shorter time-frames gold critics do have half a point. Since 2003, on a daily basis, gold returns have only been 12.5% correlated to changes in the inflation rate implied by 10-year TIPs. On a monthly basis, gold returns are 9% correlated to those of the TIPs spread.

We can look back further if we examine the the monthly performance of gold versus year-over-year changes in the CPI index. The CPI index for a given month is released in the subsequent month, so CPI monthly values are shifted forward in this study to correspond to the month of their release. The YoY change in CPI is further assumed to be the market’s expectation of future inflation. All gold prices here are daily averages based on the London PM fix through December 1974, and Comex/CME spot thereafter.

Ignoring the fact that gold generally rose in this period, it doesn’t do particularly well when inflation is elevated by this definition. A cut-off of 4% was used because it was the round number that most nearly bisected the 501 months in question, but the pattern holds-up when this parameter and other assumptions are varied:

So what does gold hedge against? Gold does well when real returns are low. You can’t consider inflation without looking at prevailing rates and growth. The rates used below are the average of daily 10yr constant maturity rates (GS10) within a given month. As Larry David would say, “pretty … pretty good”:

3% was used because it is again the round number that most nearly bisects the observations, but it can be varied without changing the essential result. There are also simple ways to define low real returns without a fixed parameter that show similar performance breakdowns with very different distributions of months. Now, these are retrospective studies, not trading systems, but obviously there is little chance that those returns were drawn from populations with the same mean.

It’s surprising that thoughtful types like Nouriel Roubini and Martin Feldstein have questioned gold’s inflation hedging, but didn’t mention this point — it seems glaring: people hold the relatively useless metal when real rates and opportunity cost are low. This simple point somehow never comes through in the noise surrounding gold: the glib Spam-sagacity vs. the Fall of The Republic, all the go-to arguments.

Clearly there are other factors that may throw the model off for long stretches of time. These may be false positives (e.g. non-dollar weakness) or false negatives (e.g. if gold is monetized to the point that it rises in deflation).

Putting aside the current weakness related to the Euro and elevating risk aversion, since I’m expecting real rates to be on the low end compared to the late 20th century, my bias is still long gold. If yields should rise, especially if they are driven by vigilance, gold might make less sense.

[Cross-posted with minor changes from Seeking Alpha]

More generally, even if short term trading increases short term volatility, Paul Krugman must realize that the public doesn’t care about daily volatility. The public cares about longer term booms and busts in asset prices, which short term trading naturally has less to do with. Short term traders buy and sell. If you make exiting positions more expensive, serial correlation rises, which is exactly what you would expect when liquidity declines. Paul Krugman must realize that this makes extended booms, imbalances and busts all the more likely.

At some point the argument of transaction tax proponents comes down to the following: Hey, short term traders are “socially useless,” so screw them. People will agree with Krugman’s article because of that sentiment, not because of the economic quality of the arguments presented there.

Krugman has to dig in and elaborate on an anti-transparency theory of “constructive ambiguity” here. The short-term financing trick was a cute stopgap but doesn’t get him where he seems to want to be.

Oh, and so much for that “London as financial capital of world again” idea, unless finance continues to decline in influence.