In the distant past, former Fed Chairman Alan Greenspan was a rabid “gold bug.” His article “Gold and Economic Freedom,” written in 1967, is still a classic defense of the role of gold in the monetary world. The full text can be accessed from my Blogroll using the link entitled “Greenspan on Gold.” I strongly suggest that you read it right now. It was a masterpiece when it was written and it is a masterpiece today.

Now fast forward to 2007. Alan Greenspan’s memoir, “The Age of Turbulence,” is a New York Times best seller and talks about gold in several different chapters. Greenspan, to his credit, is openly nostalgic about the glorious era of the gold standard when inflation was virtually nonexistent.

But he explains to us that modern society has made a bargain with the Devil which has made inflation virtually inevitable. He lays it on the line. We are unwilling to pay for entitlement programs such as Social Security and Medicare by taxing ourselves. Instead, we run persistent deficits. Monetary inflation is the unavoidable result of printing the money necessary to pay for more things than we are willing to tax ourselves for.

He predicts, therefore, that we are facing a major inflation problem going into the future and that the Fed will have no choice but to fight inflation with its major weapon — higher interest rates. And not just higher nominal interest rates, but higher REAL interest rates. That is, interest rates that exceed the rate of inflation. (Given the B.S. built into the governments CPI numbers, the interest rate right now would have to be over 10% to meet that objective).

So is gold out of the picture? Here is what the Maestro says on page 481: “For the most part, the American people have tolerated the inflation bias as an acceptable cost of the modern welfare state. There is no support for the gold standard today, and I see no likelihood of its return.”

A few pages later (page 491) he reflects on the question of whether stable prices will ever be possible. He says: “Monetary policy can simulate the gold standard’s stable prices. Episodes of higher interest rates will be required. But the Volcker Fed demonstrated that it can be done.”

Ah! The Volcker Fed. For those of you who are too young to remember, Fed Chairman Paul Volcker, during the Jimmy Carter Presidency, was appointed in the midst of the last great gold bull market and at a time when inflation (as honestly reported) had clearly gotten out of hand. Volcker boosted interest rates into the stratosphere and had Federal T-Bonds yielding double digit interest rates. This boost in real interest rates brought inflation under control by pushing the economy into a major recession.

Greenspan has laid out the challenge very accurately. If you want the essential characteristic of gold, that is, an absence of inflation, the Fed has to be prepared to substantially raise interest rates and create a real return on cash as opposed to the inflationary death by inches that we are experiencing today.

So it all boils down to whether Bennie and Ink Jets have the onions to raise interest rates to much higher levels. It is important to note, however they have to deal with issues that Volcker did not. We now have a nine trillion dollar national debt and massive deficit spending. Also, at the moment, we have a financial system that is in a shambles thanks to the consequences of the ongoing real estate bubble.

The fundamental question for the gold investor, therefore, is whether Bernanke is likely to pull a Volcker. In my opinion, that is not likely to happen (if at all) until gold has gone much higher than it is right now. In the meantime, I appreciate the Maestro’s kind words about gold.

As for the gold standard, he may be right that it will never come back. There may be some other solution out there to the current worldwide economic mess. In the meantime, however, gold is going to appreciate in value while everything sorts itself out.

This entry was posted on Monday, November 5th, 2007 at 4:49 pm. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.