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Gibson's paradox


This is the observation by the economist, J.M. Keynes, that during the period of the Gold Standard, there was a direct correlation between the long-term interest rate (Keynes used the yield on British "Consols") and the general price level. The paradox stemmed from the way it differed from the consensus view that the long-term interest was correlated with the rate of change in prices, i.e. inflation. Under Gibson's Paradox, with a gold standard, a falling price level corresponded with falling real interest rates.
With the gold price fixed, the purchasing power of gold is obviously increasing.

The thinking behind Gibson's Paradox can be transferred into today's world of floating gold prices and fiat money. A rising gold price equates to a falling price level (in terms of gold purchasing power) and lower real interest rates. This makes sense as falling real yields make holding financial assets less attractive, while rising real interest rates increase the opportunity cost of holding gold (which has zero or a minimal yield). In simple terms and outside of a Gold Standard, Gibson's Paradox suggests that the gold price rises as the attraction and confidence in financial/paper assets declines. This was neatly outlined by former Fed Governor, Wayne Angell, in the minutes of an
FOMC meeting in July 1993.

"The price of gold is pretty well determined by us… But the major impact on the price of gold is the opportunity cost of holding the US dollar… We can hold the price of gold very easily; all we have to do is to cause the opportunity cost in terms of interest rates and US Treasury bills to make it unprofitable to own gold".

-Gibson's Paradox is a free market phenomenon. Studies have shown that it was disrupted by government intervention in the gold market after World War 1 and the London Gold Pool in the run-up to the collapse of Bretton Woods. In both of these instances, when government intervention was relaxed, the gold price rose strongly and found its correct market level. Given renewed intervention by governments in the gold market from around 1995, it seems reasonable to expect the same to occur this time.

Our conclusion on what drives the gold market is that the gold price "comes out of hiding" as real yields on financial assets decline and especially as the risk of a financial crisis in terms inflation or deflation rises. As the risk rises, the role of gold as "true" money and a store of value reasserts itself. In essence, gold acts as a barometer of the financial attraction and confidence level of paper money.



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