Tuesday, September 6, 2011

Finite Commodities in a Deflationary Era

Paul Krugman has a very interesting post trying to explain the recent increase in the price of gold via a Hoteling type theory.  The basic idea is that if the price is going to appreciate at the rate of interest to some final price (at which no-one wants to consume any gold) then if expected interest rates drop, the price of gold ought to immediately rise to account for the fact that the future price appreciation will be slower - his figure above summarizes the idea.

I don't know enough about the supply of gold to know if I buy the applicability of the Hoteling theory (which critically depends on the assumption that the finite extent of the resource is known).

But one point I wanted to make - if you buy this basic scheme as a possibility, then there are an awful lot more commodities in sufficiently short supply that you might try to argue that this kind of effect could be going on there too: copper and oil particularly come to mind.  One could try to construct a more general story here about why we have a combination of deflationary pressures in much of the world combined with very high commodity prices.

On the whole I find the "rise of BRIC/decline of the West" type explanations more plausible - but it's worth thinking about other explanations - and of course the situation could be overdetermined with more than one mechanism contributing.  Food for thought anyway.


Rob said...

Truly astonishing how little most "experts" like Krugman understand.

We have insufficient growth to support existing debt, hence deflation (cash + credit contraction). At same time central banks are trying to offset with money printing. Because majority of people are hurting, any new money is spent on non-discretionary items like food and energy (aka commodities).

So inflation in the things we need to survive and deflation in everything else is exactly what one would predict.

Gold is a different story. Anyone who understands the big picture knows that the majority of paper wealth will vaporize via deflation or hyperinflation soon. These people buy gold in the hope it will preserve some of their wealth.

yvesT said...

Yeah, seems to me that whatever the price of Gold, when it is truly bought as raw material to build products, and where it isn't an essential part of the product (electronics and not jewelry), it never makes a big part of the final product cost (and for jewelry can be considered as coins or ounce).
So the key word here is "perceived security" and bubble in front of market krash, seems to me that Krugman is trying to avoid this basic fact.

Timaeus said...

I think the concept of "finite resources" is sometimes overwrought... Most resource extraction is about economics. For example copper and gold and oil reserves actually grow as the forward price they fetch increases. Lower grade sources become economically feasible with higher prices.

In an ultimate sense some resources must be finite, but for practical purposes I think this hard finite limit is often overused especially in the shorter time frames we think of with current economic theories.

Stuki said...

What Timaeus said.

As for Hotelling Theory, the price of oil and, to a lesser extent, copper and other industrials, will be tempered by storage costs to a much greater extent than gold.

In addition, the unprecedented reserves the Fed has equipped banks with, despite banks having virtually no credit worthy projects to lend to in a recession-soon-to-be-depression, are still available as collateral to the usual heads-I-win-tails-you-lose crowd. Hence are likely used to engage in riskier bets than people would place with their own money. This is bound to have an effect on the demand for all assets, gold included.

Kobayashi said...

Gold is essentially the embodiment of the concept of being finite. It is an abstract idea, appearing in a tangible, nice-looking form.

Therefore it has no choke value, because it is not used for anything necessary (true, it is used in highly discretionary items such as jewellery and that demand affects price significantly at present) but it is a kind of investment instrument which cannot be printed away.

In addition, it is important to note that in many countries individuals do not buy gold because they are investing in the traditional sense of expecting price appreciation or other yields but rather they are afraid that - as it happened numerous times in the European history during just the 20th century the century - their assets will be exproprited, confiscated, nationalised, taken away (wether in the form of one-off wealth taxes or through other legal techniques) (analysts tend to focus on inflation only when thinking about gold's safe haven nature).

EconomistDuNord said...

Rob said...

"Truly astonishing how little most "experts" like Krugman understand."

and then goes on to make the patently ridiculous (and impossible) comment that:

"Anyone who understands the big picture knows that the majority of paper wealth will vaporize via deflation or hyperinflation soon."

Truly astonishing how such complete idiots think Krugman knows "little". You'd think they'd learn a little humility after noting the fact that Krugman's been righter than nearly everyone about just about everything.