On Wednesday, Peter Schiff — the President of Euro Pacific Capital — and Nouriel Roubini — NYU Economist — debated the state of the economy, the future of inflation, and the direction of gold prices. Both figures are well-known for correctly predicting the housing crisis well before it happened.
Schiff argued that the economy is weak and it continues to weaken given the Federal Reserve’s policy of easy money, low interest rates, and quantitative easing. He argued that as a result, gold prices would continue to rise, and that we will ultimately see a much higher gold price in the coming years, and the Federal Reserve continues to purchase Treasury bonds in order to subsidize America’s debt. He argued that while this policy may be inflating asset prices and while it may be sending stock prices to all time highs, this is ultimately a deleterious economic policy that will weaken the economy.
Roubini believes that the economy is improving as a result of the Federal Reserve’s policies, and that the economy ultimately benefits from low inflation. He further pointed out that during the Great Depression and the recent financial crisis we saw deflation, and that this is a state of affairs that the Federal Reserve’s inflation rate targeting of 2 percent is meant to avoid. He also predicted lower gold prices.
While Roubini is correct in stating that we have seen week economies coincide with periods of deflation, the point he is missing is that the deflation was a consequence — a corrective phenomenon — that was the result of mispriced assets. In the Great Depression, the U S. Dollar’s value was distorted. During World War 1, the Federal Reserve increased the money supply so that we could fund the war. However, back then the dollar was tied to the gold price at $20.60, and despite the fact that the Federal Reserve increased the amount of money the gold price remained the same. In short, the dollar became overvalued in that it could buy too much gold.
As a result, foreigners were enticed to invest in the U.S. so that they could accumulate dollars and buy gold inexpensively. This led to an economic boom that went to extreme levels. As a result, we had the stock market crash in 1929 and a subsequent banking crisis in the early 1930s. The decline in asset prices was a consequence of a previous unwarranted increase in asset prices. In other words, asset prices deflated, but this was a process of these assets coming down to their correct valuation. While this hurt a lot of people — particularly those who owned stock or who had bank accounts with banks that failed — it was ultimately a necessary correction if the U.S. economy were to get to a point where it could start growing again.
Similarly, in the financial crisis of 2007 – 2009, the deflation we saw was the result of the preceding boom. Inflated house prices and the run-off economic activity from that extra money entering the economy were the problem. The market attempted to rectify this as bad loans defaulted and house prices came down from absurd levels.