Why Gold Prices Will Keep Going Up

To be sure, on one of those four incredible days — which all occurred in January 1980 — gold closed at $850 an ounce, a substantial 13% higher than yesterday's price of $747.40. So I suppose we could say that gold is still a long way from its all-time high.

But be patient. Gold is already up almost $47 an ounce from when I said in a September column that is was headed for $2,000. And back in 1980, its ascent to its then-historic $850 included a frantic 28% run for the peak in just a single week.

But in 1980 the bull case for gold was coming to an end. A spectacular climax, no question about it, but nevertheless an end. That's because in 1980 the Federal Reserve recognized that we were in an inflation crisis, and it had the courage to crank up interest rates to whatever level was necessary to defeat it.

Now a new bull case for gold is still young, with lots of room to run. Today's Fed is nearly blind to inflation risk, obsessed with bailing the economy out of the consequences of the subprime credit binge.

It's not just the Fed, either. No one seems really focused on inflation. And why should they be? Official measures like the CPI are heading down, after all. But those indicators lag reality. If I'm right about a new wave of inflation, it could take months or even years before it shows up in those statistics. Especially since inflation is being statistically masked by lucky flukes such as the flood of cheap consumer goods from China, artificially suppressing measured average prices.

What gold has done already — trading up to levels only exceeded on four days, ever — tells me that inflation is a real risk. The all-time high oil price tells me the same thing. So does the all-time low exchange rate of the U.S. dollar vs. foreign currencies.

But what's so great about the bull case for gold is that, by some ways of looking at it, you don't need to agree with me about inflation at all.

Some inflation skeptics say that the high gold price is a function of global growth, especially the rise of a new consumer class in China and India. The story goes that millions of people kept for decades in poverty and without property rights, suddenly find themselves — thanks to globalization — with both the money and the rights to buy gold for the first time. Whether it's jewelry to show off their new prosperity and freedom, or a store of value against the chance that they may someday lose that prosperity and that freedom, gold is the go-to consumer good.

Some inflation skeptics say that the high gold price is a function of geopolitical risk. With Iraq in chaos, and North Korea and Iran rising as nuclear threats, gold, they say, is fulfilling its time-honored function as a safe haven in perilous times.

I tend to think of gold strictly in monetary terms, but it's hard to ignore the idea that twin surges of global growth and global uncertainty should drive up demand for gold. Against this demand, not very much gold is actually being mined. Experts say that jewelry demand alone is now outstripping new mine production. It's not easy to bring new production into play quickly. You probably think there are plenty of mines out there, just waiting to swing into production. But don't forget what seasoned gold traders say about all those mines — "the definition of a gold mine is a hole in the ground with a liar standing on top of it."

That means that to meet today's demand, someone who already held gold has to be persuaded to part with it. And, quite obviously, that means that the price has to rise to do the persuading.

Now let's switch gears for a second. Suppose you're one of those permabears who thinks that the U.S. housing crisis and the subprime debt collapse is going to destroy economic growth on a world-wide basis. You don't have to be all that far out on the idiot fringe to believe that. Plenty of prominent Wall Street economists do.

If you believe that, then you must believe that all that gold demand from China and India will collapse when the U.S. economy destroys the world economy. But that just brings you back to my original case for gold — inflation.

Look at what's happening already. At the first whiff of a housing slowdown in the U.S. last year, Ben Bernanke stopped raising interest rates. Last month, after a little bout of market volatility triggered when some subprime mortgages went into default, Bernanke cut rates. Imagine what Bernanke would do if things started to really get bad. Interest rates would be back to 1% before you know it. I think they'd be zero, or even negative, if Bernanke thought he could pull it off.

Whether that would be enough to do anything about a housing collapse I have no idea. But I know that it would ignite a wave of inflation pressures. On top of the inflation pressures already initiated from the last time the Fed held rates that low — and which they never really addressed with correspondingly high interest rates — those new pressures would spike the CPI at least to 5%.

Five percent doesn't scare you? In 1971 inflation lower than that was enough to make President Richard Nixon impose wage and price controls on the entire national economy. Maybe you've forgotten, but 5% is a lot of inflation. And it tends to lead to 6%. And 7%. And so on...

There's no way out but up for gold now. Either the global boom continues and rising demand carries gold higher, or the boom goes bust and the consequent inflation does the job for gold.

The great economist John Maynard Keynes once called gold a "barbaric relic." And that's just about what most economists think today. And most investors in gold are derided as "gold bugs." It's perfect, isn't it? An investment with a nearly bullet-proof bull case behind it, yet one that the conventional wisdom utterly rejects. A contrarian's delight!

How to play it? There are so many ways. Me, I have a big stash of gold coins in a safe deposit box. But you could just as effectively invest in one of the exchange-traded funds that hold physical gold, such as the StreetTracks Gold Trust (GLD). Or you could buy the stock of mining companies — giants like Newmont Mining (NEM), and any of dozens of smaller more speculative companies (but don't forget what I said about the holes and the liars).

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.