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Global inflation sparks renewed interest in gold

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Global inflation sparks renewed interest in gold

Why popular beliefs about precious metal are dangerous

  • The price for gold has increased 5 percent for the year.
    hto2008/FlickrThe price for gold has increased 5 percent for the year.

BOSTON — Inflation, that nasty beast, the great destroyer of wealth, is making a comeback.

People across the globe are beginning to feel the pain. In Europe, prices increased at a two-and-a-half year high in April, pressuring the European Central Bank to increase interest rates. In China and Brazil concerns over inflation have caused stocks to slump. American prices have risen as well, for now at a rate that many economists are comfortable with, but that is bound to change eventually.

Inflation is the enemy of wealth, because it picks the pockets of society’s most industrious, essentially by degrading savings. If you work hard to put, say, $50,000 in the bank and prices double, it’s as if you only had $25,000.

Buying gold is often touted as a way to protect against inflation. The theory is that gold retains its value regardless of the mistakes and malfeasance of decision makers, making it a good way of storing value.

So is it time to pour your savings into the yellow metal?

Some high-profile investors think so. For the first time in two decades, central banks have been buying more than they sold, according to the Financial Times. India, Saudi Arabia, Russia, the Philippines and Mexico are believed to be stocking up. China has doubled its gold reserves, to more than a thousand metric tons. Iran is reportedly buying bullion, although this is partly out of concern that assets denominated in dollars or euros risk being confiscated.

Both short- and long-term investors have profited from gold. Despite recent headlines about sharp drops, over the past week or so gold has recovered much of its losses. The price is up about 5 percent for the year. If you had bought bullion in 2005, you would have more than tripled your money.

A hedge against inflation?

In uncertain times, there’s something psychologically reassuring about holding high-value assets that you can actually look at and touch. The logic behind buying gold is that you’re not relying on anyone else to pay back a loan or otherwise make good on the investment (assuming you hold the actual metal in your own vault).

As a hedge against inflation, it makes sense to buy assets that people need. A home bought in the 1960s, for example, would have skyrocketed in value during the 1970s, when inflation was high.

But here’s the key question: what will the price do in the future? If inflation rises, will gold rise more quickly? Since gold doesn’t pay interest or dividends, its wild ascent means that investors are betting the price will forge ever higher, or at least that it will fare better than other investments. With gold, you’re essentially buying the hope that at some future date, someone will be willing to buy it from you at a higher price than you paid.

After all, it’s largely useless unless you can trade it. You can’t eat it. You can’t even bring it to Wal-mart to buy supplies; although Utah’s state House passed a bill recognizing it as legal tender, in all practicality it would be about as easy to give a cashier some slivers of the precious metal as it would to trade a cow for a tank of gas.

So in the realm of physical assets, it’s important to keep in mind that there’s a big difference between owning something essential, like a home, and owning gold: people need homes. People may want gold, to adorn themselves for example, but very few people actually need it.

Despite gold’s reputation as a storehouse of value, it is actually a highly discretionary purchase. Investors — aka speculators — currently hold more than half of the world’s gold, according to the World Gold Council, an industry association. Of the rest, jewelry accounts for about 80 percent.

Insurance and fees

The risk of betting your future on something that people like but don’t need gets even higher as inflation casts its nefarious spell on the economy. That’s because when prices go up, the Federal Reserve is almost certain to raise interest rates—the higher the inflation, the higher the rates. The Fed, after all, has a mandate to fight inflation. To do so, it has to put the brakes on the economy, which it does by raising interest rates, making it more costly for people to borrow.

As interest rates rise, holding the yellow metal gets less attractive. Why? Although goldbugs denigrate “fiat currency”—the government-issued money that the global economy runs on—there are several advantages to keeping your wealth in the currency-denominated world. A big one is that people will rent it from you.

When you buy a stock or a bond, you basically let a company or a government borrow your excess savings. In return, they pay you rent, in the form of dividends or interest, or by increasing the value of the stock you’ve purchased (if you had purchased Apple stock in early 2009, for example, your investment would have tripled, even though Apple hasn’t paid dividends in a long time). As the Fed raises interest rates, the rent you get by lending your savings goes up. 

In contrast, when you hold gold, rather than earning interest, you may need to pay insurance and storage fees. So would you rather put your $50,000 in gold, or in a CD or bond which, in a high-interest economy, could yield $5,000 or more each year? If you choose gold you’d better hope that a lot of other people do too, because if the masses get tempted by those interest rates, the value of your gold will collapse. 

This is the scenario that played out during the administrations of presidents Jimmy Carter and Ronald Reagan. In the early 1980s, with inflation well above 10 percent, the Fed unleashed its anti-inflation arsenal. It raised its benchmark interest rate as high as 18 percent. As expected people shifted their money into high-interest fixed investments, such as bonds. Gold crashed, losing more than 50 percent of its value by 1982. If you had bought gold in 1980, when inflation was high you would have lost a lot of money.

Of course, it’s important to point out that people did earn a handsome return buying gold in the mid-1970s, just before inflation got out of control. When inflation was rising, the price of gold soared from about $100 in 1976 to more than $850 in 1980. That’s a very nice gain indeed.

But the situation back then was not entirely analogous to today. Until 1971, the U.S. dollar was officially tied to the price of gold, meaning that the Fed didn’t control interest rates the way it does today. When inflation rose in the late 1970s, Fed officials had much less experience in fighting it. In the decades since then, they have become much better at anticipating inflation and keeping it under control. So the gold bubble of the late 1970s — caused largely by investor anxiety — may not be replicated in the near future. Another key point is that, despite its reputation, gold didn’t perform as a citadel of value. It rose, and then plummeted.

As Warren Buffet said at Berkshire Hathaway’s April 30 annual shareholder meeting, if you owned all of the world’s $7 trillion worth of gold, you could melt it and form a cube measuring 67 feet on each side. “You could get a ladder and climb on top of it and say ‘I’m sitting on top of the world.’ You could fondle it, you could polish it, you could stare at it.” But Buffet explained that, unlike spending that same $7 trillion buying all the farmland in America or several ExxonMobils or other “earning assets,” owning all that gold is a speculative exercise: you buy it not because it produces value, but because you hope someone else will come along and pay more for it.

As with any bubble, gold is a fine investment as long as you sell before the price drops. Inflation—and the high interest rates that come with it— could kick off that avalanche.

This article originally appeared on GlobalPost.

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