Gold as an Inflation Hedge – By Robert Murphy

By Robert

When he’s not bashing Austrian economics, economist Noah Smith likes to mock the allegedly paranoid contributors to ZeroHedge. For example, in a recent post at Bloomberg, Smith argued that the goldbugs were full of it and that the yellow metal offered poor protection against an irresponsible Federal Reserve. In this post I’ll explain the actual case for gold, because plenty of people (not just Noah Smith) seem to think its virtues have been exaggerated.

To set the stage for my own views, here’s a taste of Smith’s complaints about the standard hard-money case for gold as a hedge:

The standard story for why you should buy gold is that it’s a hedge against the inherent weakness of the fiat money system. Unfortunately, it isn’t. For example, gold is a poor hedge against inflation. The correlation is very weak. Remember that gold had its huge bull run in the 2000s and a long slide in the ’80s…but inflation was higher in the ’80s than in the 2000s!

A more speculative and extreme version of the story is that the whole fiat money system is destined for collapse, and that after this happens we’ll go back to using gold as money. If that did happen, you’d want to own a lot of gold at that moment. Unfortunately, there are some big problems with this story, too. Technology has advanced to the point where we can use things like bitcoin instead of heavy, easy-to-steal physical commodities like gold. And if civilization collapsed to the point where we couldn’t even use computers anymore, I’d advise you to invest in guns, ammunition, seeds and antibiotics instead of gold.

If you actually take Zero Hedge’s constant gold-flogging to heart, you could lose a lot of money. Since gold hit a peak in 2011, it has lost about 33 percent of its value in real terms.…

Now, if the gold crash is only temporary, and someday gold heads toward infinity, then losing money on paper is no problem…unless, of course, you have to sell to cover retirement expenses or pay some medical bills.

As I said initially, I’m using Noah Smith’s post as a springboard, because I have seen plenty of gold critics offer similar arguments.

First of all, gold behaved great as an inflation hedge during the problems of the late 1970s: Consumer prices were rising at an alarming rate (after Nixon fatefully removed the last fetters from the Fed and turned the dollar into a true fiat currency in the beginning of the decade), hitting almost 15% year-over-year increases by March 1980. In reaction, the price of gold zoomed from $116 per ounce in September 1976 to $668 by January 1980. Yes, it’s true, the price of gold had collapsed by 1982, but so had the rate of inflation in consumer prices. Gold zoomed upward as the Fed wreaked havoc on the dollar, and then when Volcker contained the threat, gold fell back down.

We see a similar pattern in our recent crisis. As the Fed made announcements of further rounds of QE, gold continued its steady climb, from $734 an ounce in November 2008 to almost $1,900 in September 2011. Then it collapsed in the spring of 2013, but isn’t that exactly what should have happened, if you thought gold was a hedge against reckless Fed policy? After all, Bernanke told Congress in May 2013 that the “stepdown” in QE could come soon. All throughout 2013, the Fed gave more and hints about the eventual “taper,” and actually began implementing it in December. Indeed, had gold continued to rise through 2013, I can easily imagine guys like Noah Smith saying, “Wait a second! I thought the goldbugs said gold was going up in response to expectations of future debasement. So as the Fed offers more guidance and reduces its plans of future bond buying, shouldn’t that push down the equilibrium spot price of gold?”

In any event, those of us who have recommended gold as a true hedge (not as a short- or medium-term investment) have nothing for which to apologize. For example, I was giving readers of my blog advice in December 2009 to develop multiple streams of income, pay down variable rate debt (such as credit card debt), and to acquire some gold and silver. Noah Smith and others like to tell their readers how following the advice of guys like me (when I was worried about massive price inflation) would lead to disaster, but I don’t see any of my actual recommendations being bad, even though I was definitely wrong about imminent increases in consumer prices.

So for one thing, people who got into gold and silver coins when “alarmists” like me first recommended doing so are still fine, but the real point was that if things really do get awful, then the market price of the precious metals will go through the roof. Sure, Smith is right that holding bitcoins at that point will be good too; I agree. Yet that doesn’t rule out the case for holding some physical coins—even “junk silver” like US coins from the early 1900s which other Americans will easily recognize—as a great form of emergency wealth.

There were definite reasons that gold and silver emerged as the market’s choice of money, before governments actively overrode this voluntary outcome. For example, gold and silver are very durable and easy to transport, unlike cattle or houses. Further, gold and silver are homogeneous and easily divisible, unlike diamonds and emeralds. Finally, gold and silver have convenient market exchange values relative to their weights, making them more convenient forms of money than platinum (too scarce) or copper (too abundant).

In conclusion, Noah Smith is certainly correct that in order to justify holding large stockpiles of gold, someone needs to believe that the financial markets are underestimating the damage that the Federal Reserve has unleashed on the dollar and the broader economy. Well, I do think that, and so do most of the people who enjoy reading ZeroHedge. We might be wrong, but there’s nothing dubious about our analysis, and historically gold has done just what guys like me have expected from it.

3 thoughts on “Gold as an Inflation Hedge – By Robert Murphy

  • July 26, 2014 at 11:59 am

    You say gold went down because of the announced “stepdown” in QE (the so-called “taper”). But then why did the announced stepdown not bring stocks down as well?

    Second question: I am trying to understand how it is possible that QE increased stock prices without increasing the CPI. Does this mean that all the new money created with QE was used to buy stocks? But is this even possible? Technically how can this occur?

    Thank you

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