The Case for Gold
Ask individuals how much of their assets are allocated to gold and you'll likely get blank stares.
We're talking 'bout the dollar bill
And that old man who's over the hill
Now what are we all to do
When money's got a hold on you
Ask individuals how much of their assets are allocated to gold and you'll likely get blank stares. Few of them have thought about gold as a viable asset class in their portfolios. However, if you'd have posed the same question to typical investors 50+ years ago, they would have known what you were talking about. Has gold become obsolete as an asset class? Or are today's market participants ignoring important lessons from history?
Effective market participants are aware of the arguments for gold as a viable financial asset class.
Gold as a Means for Diversification
The charts below show price behavior of the S&P 500 index (SPX) and the price of gold bullion (in US dollars per ounce) over a 15 year period.
(Charts courtesy of www.StockCharts.com)
What should be apparent is the generally negative relationship between the SPX and gold. In other words, when stock prices go down, gold goes up, and vice versa. Over long periods of time, the inverse relationship between stocks and gold holds up pretty well. Therefore, a rationale for owning gold and other precious metals is diversification and risk management. Since gold and other financial assets such as stocks and bonds are not well correlated, precious metals can help reduce the systematic risk embedded in a portfolio.
Gold as a Unit of Monetary Exchange
Economic history has yet to record a country or civilization that has been able to preserve the purchasing power of its currency over long periods of time (Faber, 2002). The mechanism relates to a tendency of ruling classes to expand money supply beyond its value. There are many reasons why governments might debase currency over time, ranging from deliberate attempts to appropriate wealth and power to well intended public service initiatives meant to smooth market functioning (Mises, 1949). Regardless of intent, the outcome has always been consistent with basic economic principles. More money chasing fewer goods results in higher prices and, consequently, less purchasing power per monetary unit. If governments can print currency by 'fiat,' then the purchasing power of the money you hold in your hand today is very likely to decrease in the future.
Countries have often tried to limit monetary debasement by linking currency supply to some quantity of a 'reference' substance or commodity. Historically, markets have preferred gold (and its close cousin silver) as that reference medium (Rothbard, 1990). Gold is a scarce commodity, which helps fix its relative value as a standard of reference over time. It is also easily divisible, durable, and portable--all useful properties of monetary units. In the past, actual gold and silver metal, in either coin or non-coin form, have been used as direct mediums of exchange. Gold was used in the world's first coinage more than 2500 years (Lewis et al., 2006).
Gold has also been applied as an indirect medium of exchange. For nearly 150 years, the value of each US dollar was linked to a specified weight of gold, and dollar owners could readily exchange their currency for the precious metal. This 'hard currency' system served as a check on government tendencies to print dollars by fiat. If the US Treasury created too many dollars, then citizens might lose confidence in each dollar's value, exchange their paper money for gold, and deplete the nation's gold supply (Rothbard, 1990). Essentially, currencies backed by a gold standard instill monetary discipline.
The primary influence that governments have over the monetary system is capacity to persuade citizenship to abandon one sort of money and adopt another (Mises, 1934). And history suggests that states have been extraordinarily persuasive in migrating citizenry away from gold backed monetary systems to fiat currencies. Today, in fact, there are no gold-backed currencies in existence. Every currency on the planet is linked to a 'print-by-fiat' monetary system. The United States began uncoupling the dollar from gold nearly 100 years ago and US ties to the gold standard were completely severed by the early 1970s. The collapse of a gold backed currency system heralded freely floating exchange rates and gold prices (Lewis et al., 2006).
(Source: Bureau of Labor Statistics)
The results have been predictable. Money supply has been exploding higher. Using Consumer Price Index data from the Bureau of Labor Statistics (which likely underestimates the magnitude of dollar debasement), the purchasing power of the US dollar has been in decline, falling over 95% since 1913 (see chart above). By these estimates, the same basket of goods that costs $100 to purchase in 1913 costs over $2000 in 2006 dollars.
The value of gold has increased in kind, moving from approximately $40 per ounce in the 1970s to over $600 per ounce by the end of 2006 (see chart below).
(Source: US Gold Council)
Although the strength of the relationship varies from time to time, as the value of fiat currencies goes down, the price of gold generally goes up (Mises, 1934; Rothbard, 1990).
In fiat currency environments, gold's relative stability makes it attractive as a standard of reference for monetary exchange.
Gold as a Safe Haven
In times of economic crisis, people can be observed converting assets into gold. As if by instinct, individuals appear to view gold as a way to preserve wealth during periods of stress and uncertainty (Mises, 1949; Rothbard, 1990).
Structural characteristics of our global monetary system suggest that an upcoming period of economic stress is not of the question. Central banks have been creating mammoth quantities of money and credit. History suggests that if people lose confidence in the value of fiat money, they tend to seek gold as a safe haven.
Paradoxically, the very 'boom-bust' economic cycle that bureaucrats may seek to temper may be exacerbated by their efforts to intervene with market mechanisms. For example, monetary intervention is thought by some to have contributed to the height of the hyperinflation that plagued Germany following World War I and the depth of the depression that gripped the United States during the 1930s (Anderson, 1949; Rothbard, 1963). If central banks fail in their ongoing attempts to quell economic cycles, the effect on gold prices may be favorable over time.
As such, gold offers a means for managing risk in times of crisis.
There are a number of arguments against gold. It pays no dividends or interest like a share of stock might. Owning gold ties up capital and requires resources for physical storage.
Domestic markets for precious metals are relatively underdeveloped. Acquiring the physical metal is can be difficult. Moreover, liquidity is low meaning that gold is difficult to sell at the 'spot' price.
Gold may not be immune to a major deflationary event either. Given the levered nature of today's financial markets, a broad-based decline in prices might take the value of gold down along with other asset classes, although some feel the effects on gold might be muted or temporary (Faber, 2002; Rothbard, 1963).
By and large, the general public has indicated little interest in gold. While the bearish arguments have merit, the structure of modern monetary systems and trends in fiat currency creation suggest that prudent investors should carefully consider gold as a viable asset class and hedge against uncertainty.
Anderson, B.M. (1949). Economics and the public welfare. New York: D. Van Nostrand Co.
Faber, M. (2002). Tomorrow's gold. Hong Kong: CLSA Books.
Lewis, M., Lee, A., Pearson, G., Richardson, P., Crane, J. Sieminski, A., Lewis, M. (2006). A user guide to commodities. London: Deutsche Bank AG.
Mises, L. (1934). The theory of money and credit. London: Jonathon Cape Ltd.
Mises, L. (1949). Human action. New Haven: Yale University Press.
Rothbard, M.N. (1963). America's great depression. Princeton, N.J.: D. Van Nostrand Co.
Rothbard, M.N. (1990). What has government done to our money? Auburn, AL: Praxeology Press.
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