How Much Safer is Gold Over the U.S. Dollar?

Gold

In today’s tumultuous times, we are hearing the cry to have more assets in gold to protect us even more loudly than usual. We need to always think first before we leap.

On the face of it, it does seem to make sense to consider hedging against losing buying power with hard currencies such as the U.S. dollar or any currency by holding wealth in precious metals such as gold to protect ourselves against this risk.

There is a lot more to this idea than meets the eye though. We need to start with comparing holding gold with what else we may have our money in, such as the stock market. There are several calculations that need to be made here to get an idea of how investments stack up, starting with the requirement that any investment needs to be also measured against not investing at all, as well as other alternatives that may exist apart from holding cash or investing in either stocks or gold.

It never makes sense to choose investments with lesser probable outcomes, like our wanting to hold either gold or stocks or anything else if they currently have a negative expected value. Investors are faced with deciding between different investment options, with the main ones being stocks, bonds, precious metals, and cash. Cash gets depreciated by the rate of inflation, and inflation is actually just a measure of how much something loses value in terms of purchasing power over time, but all assets are subject to inflation, including gold, and this is the biggest reason why favoring gold for its inflation protection is such a bankrupt idea.

Gold is not a currency, and it’s not as if you can benefit from gold’s not losing as much purchasing power as the U.S. dollar, because we aren’t living in ancient times where people actually used gold to barter with. The invention of money put an end to that forever, and we cannot even understand gold without using its value in money as a reference point, like how much gold is worth per ounce in hard currency.

Understanding this one thing also puts an end to thinking that gold is in itself some sort of natural inflation hedge, as its being valued in currency subjects it to the same inflationary risk as any other asset. Just like money is not valuable in itself and its value is determined by what we can get from spending it, gold’s value is also fundamentally determined by what you can get back by spending it, which requires that it be converted into money first and then get what this particular amount of money can bring.

This renders inflation ubiquitous and universal and actually serves as a constant when comparing assets. If this were a mathematical equation, we would negate inflation on both sides of the equation just as if both sides added an identical number and they cancel each other out.

If neither the price of gold or the value of stocks does not change over a period, and we have 5% inflation over this time, you have lost exactly 5% with both gold and stocks. They both can be cashed out for what you paid for them, and this buying power of these two identical sums of money get reduced by this 5% inflation.

The gold peddlers want you to think that owning gold has somehow reduced your exposure to inflation risk but that is only because their understanding is at the kindergarten level, and given that so few people get beyond the kindergarten level in their understanding of gold versus other assets, their confusion is actually pretty genuine, which they then spread to others like a virus.

We might think that the problem is that we cannot pay for things directly with gold and it has to be converted to currency first, but even this is an illusion. In the above example, let’s say we start out with $10,000 in gold, the price we just paid for it, versus just holding the $10,000 in a shoebox.

A year goes by, and the price of gold is still $10,000, so the nominal value of each as not changed. There is a third option, which is to buy something that costs $10,000 at the time, but the price has risen a year later to $10,500 due to this 5% inflation.

Inflation Punishes All Assets the Same Way

If we sell our gold, we only get $10,000, so we’re $500 short, the same amount that we are short if we just hold the cash. If, somehow, there were able to pay for this with either gold or currency, where we barter the gold for the item, but this gold is still only worth $10,000 and the item now costs $10,500, so this is still going to require that we kick in the extra $500 ourselves.

Even if the seller prefers gold to currency, he or she would be foolish to take $10,000 worth of gold over $10,500 worth of cash, as they could sell it for cash and use it to buy $10,500 or gold, not just $10,000. The idea that gold is a hedge at all against inflation is therefore a pure illusion based upon misunderstanding.

This does not mean that inflation is taken completely out of the equation though, even though it is universally applicable across asset classes. We ignore inflation at our peril, especially during times of high inflation where the net change of different types of assets can differ drastically.

Looking at net changes of the value of assets requires us to look at both losing value to inflation as well as changes in nominal value. Let’s say that the inflation rate doubles over a period of time, where our $10,000 now only buys $5,000 worth of stuff. Our cash in a shoebox strategy yields a net loss of $5,000, as we bear the entire loss due to inflation because keeping money in a box does not have a return attached to it.

Our gold has gone up to $20,000, and with all things being equal, people’s income have doubled as well and they can now afford to pay more for gold, and this in itself doubles its price. We broke even on inflation with this, and it hasn’t been because we bought gold, it is due to buying an asset that is subject to inflationary pressures as well, with the price of everything doubling including gold.

The real reason why we have not suffered the impact of inflation is that we have hitched our money to something that is subject to inflation, which is any asset other than cash in fact. Gold can indeed protect against inflation this way, as alleged by the peddlers, but so can anything else whose value changes over time independently of inflation. With money, all you have is the inflation and that is where the risk lies.

The reason why this strategy can work is because you own something else other than currency that is indexed to it. What the gold pushers should be telling people is that when the risk of inflation goes up, we need to make sure we are in something else other than cash or instruments that are not subject to inflation, or not subject to them enough, like treasuries.

In the end, this calculation can be made very simply by just looking at rates of return, where inflation is the constant and is negated to get to relative valuations across assets. Gold in our example has lost half its value to inflation but has doubled in price such that its buying power is made constant. Cash has no return attached and bears the full 50% loss in buying power.

Stocks over this time have not just doubled in value but have tripled, where this $10,000 now becomes $30,000 nominally, and $15,000 net of inflation. Since gold only doubled, stocks have provided a 50% better return than gold, and whatever inflation happens to be is not even material to the calculation, as it will reduce the value of all returns accordingly. The difference then becomes reduced to just comparing returns to see how well off or less well-off we end up with a particular investment.

Deciding Between Assets Is All About Performance

If we are trying to decide between cash, gold, or stocks, this all comes down to how each asset is performing return-wise. If an asset is losing value, this loss will be added on top of the losses from inflation, where if inflation is 5% and we’ve lost 10% nominally, this yields a total real loss of 15%. The 5% gets deducted from all results, where we are left with comparing X-0.5 with Y-0.5, where X and Y are comparative returns and the inflation rate is the constant, leading us to directly compare X and Y without even needing to consider the inflation rate.

The rate of return of cash is 0 so we’ll always have a loss equal to whatever the inflation rate is. Depending on how our gold or stocks do, the real return may be more or less than this accordingly. This does clarify things enough to just look at the expected performance of an asset comparatively and decide on which may be expected to yield the best real return.

To the extent that the expected return of an asset is greater than zero, this will represent its advantage over cash, and if expected return goes negative, this puts it behind cash by that amount. We not only cannot avoid looking at potential returns when deciding between investments if we seek to understand the matter, there isn’t anything else valid to look at.

The last thing we ever want to be doing is to take a false idea that gold has some special property that protects against inflation and then just use that as our reason to buy or hold it. This puts our money on an idea that is completely false and ignores all of the truth involved, the prospects of return that decide how assets perform against one another.

It turns out that there is only one valid way to decide whether to invest in gold or not at any particular time, and it has absolutely nothing to do with inflation. It does have everything to do with how gold is performing versus other assets like stocks, but the blind man’s bluff that gold dealers want us to play won’t ever get us in a position to ever decide.

There is a warning here about inflation that we need to hear, and it is the risk of cash that is fully prone to inflationary risk versus other assets which have different outlooks. It is the fact that cash does not have the potential to go up in value that makes it so prone to this risk, where something else like gold will manage to keep up with inflation in the long run and stocks will manage to outpace it over time.

Given that gold keeps up with inflation and cash loses the entire amount of it, if you’re worried about inflation, preferring gold over cash is a valid general principle, but we cannot make the mistake of assuming that these are the only choices. That’s where the idea of gold as a hedge against inflation crashes, just because it is a hedge against cash, and you could instead buy just about anything that retains its value over time, a pile of manure even, and get the same inflation hedge.

The prospects of a given investment therefore matter purely, without the need for any consideration of inflation apart from how such a thing may affect its value. Stocks famously do well in inflationary periods, provided that the economy is expanding and it isn’t just stagflation, inflation without the normal accompanying economic growth, and gold also tends to do well due to more people flocking to it during higher inflation which drives up its price.

Cash isn’t the worst investment to be in during higher inflation, as increasing inflation deals a knockout blow to bonds, where you lose not only the full value of inflation but inflation rising also significantly puts down the value of bonds due to the need for the yield to rise to keep up with inflation. When the yield on bonds rises, this causes a corresponding drop in their price and their value, with bondholders left holding the bag.

We always need to be worried about cash losing to inflation, and that is transparent enough for most to at least understand this a little, although few people fully grasp how significant this is. The majority of people who own bonds really do not understand how evil inflation is to these assets though and pay a big price for it when inflation heats up.

The absolute biggest need to pay attention to inflation is therefore with the substantial risk it has to bonds, where we are going to be subject to inflationary losses on all our assets but should never want to pile capital losses on top of this.

People need to trade both bonds and gold the way that we trade stocks, by paying attention to price trends as well as anything else helpful in predicting future price movements, seeing gold do well lately but be at a point where we’re in a consolidation phase with the profit takers piling up in the waiting room and looking like they may be ready to pile on even more.

The same people are lined up in the bond waiting room, as we saw a huge bull market for bonds peter out lately with a predominantly bearish outlook going forward. With inflation this low, things can only go up, things can only get worse if you are in an asset like bonds that gets punished proportionately as inflation rises, where our record high bond prices are forced to significantly retreat in their dance with inflation as it goes up from here.

Gold has done so well as inflation dropped, and has put in nice gains again this year during a recession. With inflation so low and expected to be so low for quite a while, this is the last time people would be needing to hedge against it, given it is not even here.

This part doesn’t matter, as the desirability of an asset is always about where it is trending, in the highest periods of inflation as well as in the lowest ones like this year. Whether or not we should hold gold always depends on what it is doing, and as long as we realize just this, we’ll at least be looking at the right thing.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: monica@marketreview.com

Topics of interest: News & updates from the Office of the Comptroller of the Currency, Forex, Bullion, Taxation & more.