Gold Price

Article : Gold is a "Crisis Hedge" not an Inflation hedge

In times of uncertainty investors turn to Gold as a hedge against unforeseen disasters since gold is one of the few investments that is not simultaneously an asset and someone else's liability.

With prices reaching levels we haven't seen since the 1980's, there is talk of Gold as an "Inflation Hedge". But how well does it really work?

Historically, gold and money have been pretty much synonymous so pure Gold was immune from inflation. But that didn't stop currency inflation. In the early days kings discovered that they could "extend" their money supply by adding just a bit of lead to the melting pot. Unfortunately, as the percentage of lead increased the value of the coins decreased causing the first cases of inflation. (And also creating the habit of biting coins to see how soft they were and thus how much lead they contained).

Egyptian Pharaohs issued the earliest gold coins, around 2700 B.C. But they were primarily as gifts for friends and not for commerce.

It wasn't until (560-546 B.C.), that King Croesus of ancient Lydia began issuing Gold coins for general circulation. (Incidentally after 2500 years, the saying "rich as King Croesus" is still floating around.

Incidentally, every country that has employed fair Gold coinage has prospered while those that inflated their coinage with "base" metals failed.

One example is Spain. During the time that Spain was issuing their famous "pieces of eight" it was a world "superpower" but lost that status as it debased its currency.

Gold in the U.S.

Gold circulated as currency unofficially in the U.S. since the beginning using coins minted in other countries like the Spanish "Pieces of Eight". But the U.S. did not have its own gold coinage.

It wasn't until the Coinage Act of 1792 established official U. S. monetary units based on a world Gold price of $19.39 per Troy ounce. Congress changed the gold specification of money in 1834 and again in 1837 when it was set at $20.67 per ounce.

From 1805- 1837 no $10 Gold coins were minted.

The U.S. had periods of high inflation during both the Revolutionary and Civil wars because they were not on a "gold standard" and issued "Greenbacks" instead.

In an effort to curtail inflation at the end of the civil war in 1879, the U.S. government made the "greenbacks" that they had issued during the Civil War convertible into gold putting us on a de facto gold standard.

Finally, in 1900 the government officially adopted the gold standard once again.

By 1914 most countries in the world were on a Gold standard.

From 1880-1914 the U.S. dollar official gold price was $20.67 per ounce and the U.K. official gold price was £ 4.24 per ounce. This resulted in an exchange rate of US $4.87 per Pound Sterling.

This Gold exchange rate was maintained by a complex system of transferring Gold from New York to London. Creating a system of checks and balances that should have prevented the onset of inflation.

This worked fairly well until other countries began abandoning their Gold standard to finance the First World War. The U. S. entered the war late and was able to maintain its gold standard.

However because other countries currencies "floated" against the dollar the true value of the dollar also floated and inflation still occurred (basically other countries were able to export their inflation to the U.S.).

Remember at that time people spent gold and silver coins. Even though the price of Gold was fixed other prices weren't fixed and so the amount of goods people could buy with their Gold could still fluctuate.

Note: Now we are exporting some of our inflation to China as they send us goods and buy our debt.

Over the next 10 years deflation set in as the roaring 20's unfolded as the US economy boomed and Europe suffered the after-effects of WWI.

Finally, in 1929 the system could not stand the internal stresses and the stock market crashed ushering in the Great depression.

In 1933, President Franklin Roosevelt realized that the U.S. could not maintain the pretense that Gold was still worth only $20.67 per ounce (because at that price Foreign governments would have bought all our gold). So he perpetrated one of the greatest frauds ever on the American public.

He forced U.S. citizens to sell their Gold at the official price of $20.67 and once he had collected all the Gold into government coffers, he adjusted the price to its real price of $35 per Troy ounce. Thus the government made a handsome 69.33% profit in a few months (equivalent to a 69% tax on Gold owners). Imagine paying a 69% tax sometime!

This effectively, increased the money supply and "legitimized" the inflation that had silently been occurring behind the scenes as prices increased but gold values did not. In hindsight, this increase in the money supply may have been the key factor in the emergence from the Depression.

Notice that in 1930 inflation since 1913 was up about 64% ... is it any coincidence that FDR raised the Gold price 69%?

NO! That one time adjustment just brought it in line with inflation. But that didn't solve the problem permanently. It just postponed it. By 1970 inflation was up 306% and gold was still officially $35 an ounce. Once again the price of gold needed adjusting.

But this time there was no gold in the hands of private citizens for the government to steal. This put the government in a bind because although US citizens could not own gold, foreign governments could continue to present their foreign exchange tickets at the "gold window" and the US was obligated to pay up in Gold!

So in 1971 President Nixon ended the US gold standard. At that point the price of gold bullion was allowed to float freely and find its own level.

This time rather than take all the Gold from the people (since they had none) the Government raised money by allowing the people to buy Gold back at the new higher free market prices. Thus the government was able to profit once again from the gold FDR stole from its citizens.

Government gold sales had a tempering effect on gold prices for a while as the government liquidated it's "excess" gold bullion. But by the late 1970's the government had stopped its gold sales and the price took off.

Many felt that this rise was in response to inflation fears (and partly it was) as we will see in a moment inflation doesn't necessarily translate into higher gold prices. But fear of any sort usually does translate into higher gold prices.

From the peak in1980 the inflation rate declined but cumulative inflation climbed steadily upward. But rather than keeping up with inflation the price of Gold fell from the peak of $850 per ounce down to under $300 in 2001.

But in inflation adjusted dollars the scene is even worse. The 1980 peak in 2007 inflation adjusted dollars was over $2100 and it fell to under $346 losing a whopping 84% of its value!

So even though inflation rose... gold fell... because the fear level was low (and possibly because governments worldwide manipulated the price).

Inflation was slow and steady but not enough to cause fear. So Gold was not a very good inflation hedge! So why is Gold rising now? Partially because it is a commodity like all other commodities and demand has picked up from China (perhaps they got tired of the gold manipulation game).

More likely the Chinese government is tired of owning US dollars that consistently lose their value, so they are putting a portion of their trade surplus into gold! This is increasing the world-wide demand for gold and putting pressure on the price of gold. They have also allowed their citizens to begin owning gold (as the US did in the 1970s) so increased demand is coming from that sector.

The other reason Gold is rising now is that it is acting its role as a "crisis hedge". Back in 1980 the real reason gold prices were rising was the international crisis arising from the Soviet invasion of Afghanistan and the Islamic Revolution in Iran. The world was in turmoil and inflation was out of control so everyone was scared. When people are scared a paper IOU is not enough.

Three thousand year old traditions of hoarding stores of wealth that are physical, portable and easily devisable are hard to break.

The key is that during times of crisis and fear Gold rises and individual governments can't stop it. During more peaceful times governments are able to maintain control and keep a lid on the price of Gold. This causes Gold to move up in a sort of "stair step" fashion.

When I say "Crisis Hedge" I mean wars, and longer term fear of governments etc. In 2008, we had a "Liquidity Crisis" and Gold did not fare as well. The main reason is that everyone was trying to increase their liquidity at the same time and so were forced to sell their quality assets in order to cover the losses in their junk. Unfortunately, this dragged down the price of quality assets along with the junk.

Conclusion:

As a long term crisis hedge Gold is excellent.

But as a short term inflation hedge it has a spotty record although it has had its moments.

Does this mean Gold is a bad investment now? Certainly not! But it does explain why Gold has not done well over the last 20 years.

An article from Inflationdata.com

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