Inflation Insurance

John Lim

ON AUG. 15, 1971, President Richard Nixon made the weighty decision to end the convertibility of the U.S. dollar into gold. By doing so, he drove a stake through the heart of the gold standard, a monetary system which fixed the worth of a unit of money to a specific amount of physical gold. Before that day, foreign central banks were able to exchange $35 for one ounce of gold from the vaults of the U.S. Federal Reserve.

By closing the so-called gold window half a century ago, Nixon ushered in the current era of fiat money. Fiat currencies—which include all currencies in existence today—aren’t backed by anything tangible. Rather, their value depends entirely upon the collective trust of people making transactions in those currencies. If that confidence evaporates, so does the value of that money.

What can lead to a loss of confidence in money? In a word, oversupply. Too much of anything can be a bad thing, and so it is with money. Print too much money and you devalue it. When a currency is devalued, inflation results.

Gold is called a precious metal precisely because it’s rare and difficult to mine. Though many have tried, gold cannot be fabricated. Because of this and other unique qualities, the yellow metal has been a store of value for over two millennia.

Gold’s value as an investment is far more controversial. Gold isn’t an investment in the traditional sense because it generates no cash flow. Result? There’s no way to assign an intrinsic value to an ounce of gold. In this regard, gold resembles other commodities. In all likelihood, however, gold will remain a store of value. Those who own gold, as I do, know that currencies have an uncomfortable history of being devalued. In my mind, gold is a form of insurance against this risk.

How has gold performed as an investment over the past five decades? Surprisingly well, it turns out. In U.S. dollar terms, gold has appreciated 8.2% annually, on average, since Aug. 15, 1971. But what has really happened is that the dollar—and other currencies—have depreciated against gold. If you hold the value of gold constant, the U.S. dollar has lost 7.65% in purchasing power per year, on average, since the nation left the gold standard 50 years ago.

Incidentally, advocates of cryptocurrencies claim they’re a store of value, too. Some go so far as to call them “digital gold.” I’m not smart enough to weigh in on cryptocurrencies. But it seems noteworthy to me that the number of cryptocurrencies has exploded from 66 to more than 5,000 since 2013. I prefer to own gold, which has a far longer history as a store of value.

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Roboticus Aquarius
Roboticus Aquarius
1 year ago

I see gold as a diversifier more than an inflation hedge or core investment. Bonds already do a good job as a diversifier, but in their absence, gold has been a nearly equivalent choice.

Jim Wasserman
Jim Wasserman
1 year ago

I admit to a perverse pleasure every time one of my econ students would get big-eyed and incredulously ask, “So there’s nothing holding up the dollar but our belief in its value?” Just like Tinkerbell is saved because the audience claps and pronounces their belief in fairies, so, too, does the dollar stay alive because we believe and accept we can use it to settle debt as legal tender (brilliance of Lincoln for that). You know the Monopoly money is worthless, but you still object to someone digging their hand in the till because all players have agreed to abide by the rules and respect the monetary value of the paper. In fact, creating something or investing it with value happens beyond money, even economics, in many parts of our lives, and is called, not surprisingly, the Tinkerbell Effect!

Brent Wilson
Brent Wilson
1 year ago

There is a pretty good and recent article from WSJ around the topic of Gold as an inflation hedge. The article does note that Gold can be an important part of a portfolio, due to the low correlation to other asset classes. But as a hedge against inflation, data shows “over shorter periods its real, or inflation-adjusted, price fluctuates no less than that of any other asset.”

“Furthermore, the only reason gold came even this close to matching stocks over the past 50 years was its huge return during the first decade following Nixon’s announcement. Take away that decade, and gold has lagged behind even intermediate-term Treasury notes. Over the past 40 years, gold has risen at a 3.6% annualized rate, compared with 12.2% for the S&P 500 and 8.2% for the Treasurys.”

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