It was thought to be impossible. It was believed that it could not happen. But it occurred anyway. We don’t mean the sinking of Titanic but the sinking economy of the 1970s. We mean stagflation – something that was excluded in Keynes’s model, but it happened nevertheless, changing the global economy and the economics forever.
Indeed, when stagflation hit in the 1970s, as the chart below illustrates, it shocked the economists. The hydraulic Keynesian macroeconomics has been discredited, the Phillips curve taken down a notch or two, while the theories of both the Friedrich Hayek, who belonged to the Austrian school, and Milton Friedman, who developed the monetarism, gained popularity.
Chart 1: US CPI annual rate (red line, in %) and the unemployment rate (green line, in %) from January 1960 to December 1989.
Stagflation is the simultaneous occurrence of stagnation and high inflation. It’s a great, negative macroeconomic combo: the high unemployment accompanied by rising prices. It’s a real nightmare for people who lose their jobs and face higher costs of living at the same time. And it is also a horror for policymakers. In simple Keynesians models, there can be either high unemployment or high inflation. There’s supposed to be a trade-off, an inverse relationship in this Phillips curve. If the central bank faces the first threat, it eases monetary policy. If rising prices are that urgent problem to solve, it tightens its monetary stance. But what to do when both plagues keep falling from the sky at the same time?
One option is to call Paul Volcker who has successfully fought high inflation and stabilized economy through draconian interest rate hikes. Or you can buy gold which serves as an inflation hedge and the safe haven asset – and just watch the world burn. That is, after you pay the capital gains taxes on your phantom profits.
The point is that inflation makes us all poorer but in such an environment, gold attracts additional interest and can more than keep up with the pace of inflation. It’s a proven inflation hedge that protects purchasing power on a long-term basis. In ancient times, a Roman citizen could buy a toga, belt and sandals for one ounce of gold. How much does a decent men’s suit cost today? You guessed that right.
Stagflation and Gold
Indeed, gold shined during the stagflationary 1970s, as the chart below shows. As one can see, the price of the yellow metal started to rally in late 1976, suring from slightly above $100 to around $650 in 1980, when the CPI annual rate reached its peak of 14 percent.
Chart 2: Gold prices (yellow line, right axis, London P.M. Fix, in $) and inflation rates (red line, left axis, annual % change in CPI rate) from 1971 to 1989.
Unfortunately for gold, Paul Volcker became the Fed Chair in 1979, quickly slowing the rapid growth of the money supply and allowing interest rates to rise. As a consequence of his decisive actions, inflation declined, while gold topped out and entered a bear market. But if stagflation happens again, gold should gain.