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Section: Daily Dispatches

In Gold We Trust

By David Ranson and Penny Russell
The Wall Street Journal
Thursday, May 18, 2006

Widespread fear of another global energy crisis is rife, especially
in light of the confrontation with Iran. But the second of Murphy's
Laws cautions that what actually goes wrong is seldom what we
anticipate. While the markets are clearly indicating something
ominous, the current situation is mischaracterized as an energy
crisis -- even if the price of a gallon of gas goes past $3 and
stays there. Energy prices are simply keeping pace with the rising
prices of gold and other commodities. What we are facing is a MONEY
CRISIS: an alarming outbreak of inflation and all its consequences.

It's silly to blame the rise in commodity prices on foreigners; no
country, not even China or Saudi Arabia, has the market power to set
off the kind of across-the-board acceleration in prices that we have
been witnessing. Nor can prices rising this consistently and at this
speed be attributed to an excess of global demand over supply, or
fears about the political situation in Iraq or Iran. Speculators,
another convenient scapegoat, also lack the power to drive world
commodity markets, in spite of their rapacious reputation. The real
culprit is the precipitous decline in the world's mightiest
currency, the dollar, which has lost more than 60% of its gold value
in just four years.

The run on the dollar is largely being ignored by Washington and
Wall Street, and most of the financial press is only beginning to
take note. When analysts do comment on the strength or weakness in
the dollar, they are most often referring to its value in terms of
foreign exchange; little attention is given to the value of the
dollar in terms of gold. When headlines do herald that the price of
gold is rising, there is little recognition that, since gold is
quoted in dollars, it is just as true that the dollar is falling. It
is gold that is a benchmark for the value of the dollar -- not the
other way around. When the dollar price of gold is on the rise, the
dollar prices of oil and other commodities have historically kept

It is only the nominal price of oil that has reached record levels;
in real terms, we are still on the road to recovery from the genuine
energy crisis that culminated with Hurricane Katrina. Although it is
the accepted convention to calculate the real price of an asset from
official government measures of inflation such as the CPI, this
would be a mistake in the case of energy. Since oil is traded in
fast-moving markets worldwide, its real price can only be assessed
by comparison with other internationally traded commodities; for
this purpose the U.S. cost of living index is irrelevant. We suggest
instead using an index of precious-metals prices.

The adjacent chart shows the divergent picture of the oil market
that emerges when representative oil prices (West Texas Crude) are
expressed in real terms. The solid line charts changes in the ratio
of the price of oil to a price index for precious metals over the
past half century. While the chart shows abundant variations in the
real price of oil over time, it also shows the real price
gravitating around a slowly rising trend. The dotted line represents
the equilibrium real price of oil. We believe that its gradual
upward slope reflects the fact that oil is gradually becoming
scarcer with the passage of time.

The chart confirms that the real price of oil peaked out late last
year and has been on the decline since. In other words, the dollar
has been falling relative to its precious-metals benchmark faster
than oil has been rising relative to the dollar. That's why we
believe that the current rise in the dollar price of oil is merely
the process by which this price converges toward equilibrium. Far
from entering into a new crisis phase, the oil market is still
cooling off from the last one.

We estimate from nearly a half century of history that the
equilibrium price of oil, converted back to current dollars, was
about $61 a barrel in April. In other words, the long-term history
of the ratio between oil and precious-metals prices, given the
prices that these metals have now reached, implies that the oil
market would be in balance at $61. The actual price in April was
$70. Reading from the graph, we see that the real price of oil has
moved two-thirds of the way back to equilibrium since Hurricane

It's not the time, however, to breathe a collective sigh of relief.
It is just as foolish to fail to recognize a true crisis in the
making as to conjure one up. As of this writing, gold is fluctuating
around the $700 mark, with silver and platinum up at least as much.
The gold value of the dollar appears to be going into free fall, and
the further it declines the more dire the consequences, including
still higher nominal prices for energy, even without any further
change in the real price. Absent some miraculous reversal, $3-a-
gallon gasoline may be here to stay.

If none of the usual suspects is responsible for gold's sharp rise,
what is? We believe it represents an equally sharp decline in the
confidence of investors -- large and small -- in the likelihood that
Washington will pay back its mounting obligations in undepreciated
money. Throughout history, and especially in wartime, governments
have escaped from fiscal over-commitments by letting their
currencies depreciate. Ambitious spending initiatives, threats of
international conflict and even Washington's political unpopularity
all contribute to the fear that this is happening again now.

Gold is the barometer of public confidence in fiat money, and it is
difficult to rebuild confidence in a currency once it has been
allowed to slide. Gold has been a reliable harbinger of many
economic troubles -- not just of escalating prices at the gas pumps,
but of inflation, rising interest rates, stagnation and poor
investment performance on the part of bonds and equities alike.
Changes in the price of gold are an excellent predictor of all of
these. The dollar's collapse is nothing less than a body blow to
capitalism. When we downplay the significance of energy prices, we
are not denying that a crisis is looming. It's just a lot more
threatening than an increase in the cost of a tank of gas.


Mr. Ranson and Ms. Russell are principals of H. C. Wainwright & Co.,
Economics, an investment-strategy research firm.


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