The loss of confidence in American financial markets can be measured less by the drop in stock indices than by the rise in the price of gold.  Since the first of the year, gold prices have increased more than 10 percent, while the price of virtually all other commodities and many financial assets have been falling. 

Nearly a quarter century ago, I was asked to do a study on the relationship of the price of gold to prices of all other commodities.  I had assumed that gold would react like any other commodity.  When production improvements and new gold discoveries occurred, its price would fall.  When jewelry and industrial demand increased, its price would rise. 

Much to my surprise, my study showed that gold prices were more closely related to the price changes of commodities than each commodity was to other closely related goods. 

For example, a natural price relationship exists between hogs and corn.  The saying is that the farmer will sell his corn either as-is or as pork depending on the price relationship between the hogs and corn.

However, I discovered that hog prices had a closer relationship to gold prices than it did to corn prices.  Moreover, corn prices were more closely related to gold prices than to hog prices. 

This suggested that gold prices were dictated by more than natural demand and supply conditions.  No other commodity was more closely related to the general prices of commodities than gold. 

The argument for this relationship is that when investors fear higher commodity prices, they run to gold.  If they run to any other single commodity, shifting demand and supply conditions offset general price changes.  However, everyone sensed that gold had some relationship to the entire group of commodity price changes.  Therefore, the safest bet about commodity inflation was in gold prices. 

Now I do not believe that the surge in gold prices means that inflation is just over the horizon.  Higher energy prices in January following price weakness during the fourth quarter might suggest that inflation is approaching.  My own surveys suggest that consumer prices may rise half a percent in January.  They fell 0.2 percent in December. 

However, these price changes should be temporary.  Consumer prices should not rise more than about 2.5 percent in 2002 and 3 percent in 2003.  These expectations are not causing the double digit gains in gold prices. 

Instead, gold prices are rising because investors are losing confidence in holding purchasing power in any other form.  It is rising by default.  No alternatives in holding value appear to be safe for some investors.  (My study also showed that gold was not a safe haven, only a preferred one, as the Hunt brothers discovered). 

Of course, investors had lost confidence in the assets of most countries about two years ago.  Who wanted to hold European stocks or Japanese bonds when their currency values were falling faster than the price of any of those assets could rise?

During that period, dollar based assets received much of the world's savings.  Even with the dot.com bust, world savings still believed the best place was in the U.S.  

Now investors are not so sure.  The dollar's value appears to be far out of line with the ability of American industry to compete with producers elsewhere in the world.  This is not new, but investors did not perceive that an alternative to the dollar existed.  They still do not. 

What they do perceive is less certainty about whether earnings are real in American companies.    

It is unlikely that many companies financed partnerships off their books with company stock and then recorded profits on their books when the rising stock prices allowed debts to be paid down in those partnerships.  No wonder Enron's value zoomed and plunged.  They were using changes in their stock values to generate income.

Nothing like that has occurred since the great utility holding company pyramids that collapsed at the time of the Great Depression.  Enron's stock price pyramiding may not have gone much beyond Enron. 

Nevertheless, investor confidence is shaken.  There still is no alternative to the dollar, but what can you do with the dollars you hold.  Until investor confidence returns or some alternatives to the dollar emerge, it appears that some of those dollars are buying gold.