Gold as a means of accounting

If you’ve paid any attention to the inflation vs. deflation debate you’ve noticed that it is fairly convoluted. I’ve read the arguments in great detail and have come to the conclusion that it’s mostly a problem of semantics. Strictly speaking, deflation is a decrease in the supply of money and credit. As bad loans are written off, the supply of credit, which represents the lion’s share of the money supply, decreases.

Colloquially, most people define inflation as rising prices. This introduces a lot of confusion as rising prices are a symptom of inflation rather than its cause. Most of the debates arise as a failure to define inflation (money supply vs. prices) and money (dollars vs. gold). Once those details are pinned down most everyone seems to arrive at similar conclusions. The key to understanding the underlying economic effects is to be able to separate them from the effects introduced by the unit of accounting. Paper money is particularly problematic in this regard, as its value is constantly being debased.

I love repricing things in gold because it brings the long term economic trends into sharp relief.  PricedInGold.com has published some excellent graphs using gold as the numeraire. Look at the Dow Jones Industrial Average (DIA) priced in gold and you will see a clear bear market since 2001. Look at the DIA priced in dollars and the trend is not so clear.

One of the problems with inflation (increasing the money supply) is that it distorts the basic unit of accounting. How can resources be allocated properly when the purchasing power of a dollar is constantly changing? What may nominally appear as profit, or a bull market, may just be a loss of value in the unit of measurement.

Imagine the disaster that would occur in the building of a bridge if the physical length represented by an inch changed every day during its construction. Nothing would ever match up. Nothing would ever work. This is one of the great problems our economy has suffered from for the last decade. A profit in terms of dollars does not necessarily represent a gain in purchasing power. When this essential signal becomes distorted, resources will be constantly misallocated. This leads to a continual state of recession as capital is never invested in line with the needs of the market. A foundation for strong economic growth is never formed.

Bill Haynes recently asked whether another Great Depression was already here. Take a look at the United States’ GDP, when priced in gold rather than dollars, for the answer. A much clearer picture is formed when the effects of unsustainable credit are removed. While the economy may have felt good during the middle part of the last decade, it was largely an effect of living on credit. Much like an individual who lives beyond his means via credit cards, things feel good while future earnings are being pulled in and spent in the present. But when the lines of credit finally run out, the financial reality sets in. It becomes clear that there was no underlying economic growth to support the additional spending.