John Dizard: Every cloud for the stock market has a silver lining

Section:
10:47a ET Tuesday, June 27, 2006

Dear Friend of GATA and Gold:

Financial Times columnist John Dizard today took
note of former U.S. Treasury Secretary Lawrence
Summers' academic study, "Gibson's Paradox and
the Gold Standard," a study that implies
government's interest in suppressing the gold
price. Dizard's column is dismissive of complaints
that government is acting on its interest to keep
gold down, and the column is more disappointing
insofar as GATA sent to him a few weeks ago some
documentation in which government officials ADMIT
a policy of suppressing gold. But maybe Dizard
will follow up, even if no one should hold his
breath.

CHRIS POWELL, Secretary/Treasurer
Gold Anti-Trust Action Committee Inc.

* * *

Every Cloud for the Stock Market Has a Golden Lining

By John Dizard
Financial Times, London
Tuesday, June 27, 2006

http://www.ft.com/cms/s/580522de-0579-11db-bb76-0000779e2340.html

He's your guy when stocks are high
But beware when they start to descend.
It's then that those louses
Go back to their spouses.
Diamonds are a girl's best friend.

Anita Loos, whose character Lorelei Lee sings those lyrics
in "Gentlemen Prefer Blondes," didn't have a PhD in economics but her
observation on the inverse relationship between investment returns
and the value of precious metals (or diamonds) was ahead of its time.

In 1985, about 60 years after the creation of Lorelei Lee, Lawrence
Summers, then a Harvard economics professor, and Robert Barsky,
another Harvard economist, published a study of gold prices and real
returns that is well worth revisiting.

Mr. Summers had a difficult time as president of Harvard, a post he
is giving up at the end of this week. He will go back to being a
professor there, where he has done great work in the past.

An example of that is "Gibson's Paradox and the Gold Standard," the
study referred to above, the first version of which was published in
1985. It seeks to explain why the price level and nominal interest
rates move together when monetary theory says interest rates should
move with the rate of change of those levels. Mr. Summers and Mr.
Barsky used data from the period of the gold standard along with real
returns, interest rates, prices, and gold prices during the post-gold
standard period.

What Mr. Summers and Mr. Barsky found was that the price of gold
moved inversely with the real returns people can earn on
capital. "The willingness to hold the stock of gold depends on the
rate of return available on alternative assets. We assume that the
alternative assets are physical capital and bonds."

This makes intuitive sense; gold is, over time, a way to preserve
capital, not increase it. If you can earn high rates or profits you
will be induced to sell gold and invest in productive capital.

While Mr. Summers and Mr. Barsky went on to other topics, others
updated their study over the years. Peter Palmedo, who runs Sun
Valley Gold, a gold asset portfolio management company, did a
regression analysis of gold against the S&P 500 monthly returns from
1994 to the end of 2002 and found a negative correlation of 94
percent.
So between 1994 and 2000 large capitalisation stocks earned annual
returns of 15.6 percent, while gold earned an annual return of -7.6
percent. During the last gold boom, between 1970 and 1980, gold
earned an annualised return of 19.9 percent, while large cap stocks
brought in 0.2 percent, not enough to keep the Lorelei Lees in
diamonds.

I called Mr. Summers to discuss his old paper, and the 1990s real
returns results.

"These movements you cite were a vindication of the paper Barsky and
I wrote," he said. "It stands to reason that high real returns were
associated with a period when gold prices fell, or the subsequent
decline [post-1999] was associated with an increase in the price of
gold."

Indeed, the gold price bottomed in September 1999 and US stock prices
peaked in March of 2000.

According to Mr. Palmedo's analyses, if real returns on capital drop
only to their long-term average of 5 percent, instead of overshooting
to the low side, gold's real returns will be more than 6 percent. If
returns drop to2 percent (still above those of the 1970s), gold's
real returns rise to12 percent or better.

There is one anomaly that show sup in the application of the
Summers/Barsky model over the 1990s. While the real returns on risk
capital fit the model very well, real interest rates in the late
1990s were below the predicted trend.

The equity return numbers do make sense. Mr. Summers and Mr. Barsky
wrote that the real rate of return is "subject to shocks. These
shocks reflect changes in the actual or perceived productivity of
capital."

In the mid- to late 1990s that productivity rose due to the
application of computing and communications technology, as well as
the rapid increase in developing world productivity.

Real interest rates in the late 1990s, however, were held down below
where they should have been.

Alan Greenspan's Fed, along with its counterpart central banks, kept
real rates lower than they should have been to offset the effects of
financial crises, the Asian flu in 1997, the LTCM/Russia crisis of
1998, and the Y2K non-crisis of 1999/2000. So real interest rates
during this period did not track real returns as they should have.

This has been turned into a conspiracy theory by gold bugs. Ignoring
the tight negative correlation between equity returns and gold, they
have focused on the low interest rates, concluding that they
illustrate a suppression of the gold price. Reg Howe, a leading gold
bug and a partner in Golden Sextant Advisors, wrote in 2001 that "the
historical evidence adduced by Barsky and Summers leaves but one
explanation for this breakdown of Gibson's Paradox: what they
call 'government pegging operations' working on the price of gold,"
adding that "Barsky and Summers underscore the futility of trying to
control [long-term rates] without also controlling [gold prices]."

I went to see Mr. Barsky to discuss this interpretation. He has not
been close to Mr. Summers in the intervening decades but dismissed
the notion that the former Treasury secretary was carrying out some
conspiracy to suppress gold.

"The 'government pegging operation' we referred to was the gold
standard itself. By definition, there wasn't a 'free market in gold'
during the period of the gold standard. This wasn't a policy-
prescriptive paper at all. In any event, the causality we identified
in our paper was: Real rates of return drive real interest rates and
the gold price. The gold price doesn't drive real interest rates."

There was, many would argue, a policy failure from the late 1990s to
the end of the Greenspan era: monetary policy was too loose, and that
is leading to serious trouble. But it didn't have anything to do with
gold price suppression.

While the work of Mr. Summers, Mr. Barsky, and Mr. Palmedo does not
cover what the professors refer to as "high frequency" fluctuations
in the gold price, the thesis does steer investors in a useful
direction: Years of low return on risk capital go with years of high
returns on gold.

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