On his Global Economic Trends Analysis Blog, Michael Shedlock poses the question Is Gold an Inflation Hedge? The answer: "Gold in many timeframes is not much of an inflation hedge." This conclusion is derived entirely from looking at the US$ price of gold over several periods of time. In this article, I will argue that the cited analysis is US-centric, and that when the US$ exchange rate is taken into account, Shedlock’s conclusions are questioned.
A US-Centric View
Gold is an international market. Its price is quoted on a continuous 5×24 basis; it is always for sale somewhere in the world. The demand for gold consists not only of the demand by elderly US investors who once held a gold coin, but by people in many different countries, some of which have never had a local currency that has gained anywhere near the mindshare as has the US$.
The problem with concluding anything based on the US$ price alone is that an analysis of US$ price of gold is as much an analysis of the US$ exchange rate against other fiat currencies as of the value of gold itself. The US$ exchange rate is affected by many political variables, including currency intervention by foreign central banks and the sometimes non-linear effects of the Fed’s inflation. Dollar inflation, working through what James Grant calls the "international monetary non-system" has in some periods had the paradoxical effect driving up the value of the dollar against other currencies. During those periods, the dollar price of gold performs poorly, but the price in other currencies outperforms.
In order to get a real answer to the question, the performance of gold against fiat money in general must be examined. In this article I will extensively cite the research of Paul van Eeden, who has analyzed the behavior of the gold price in a series of articles published on his web site. In Gold — A Commodity?, van Eeden writes:
Given that net investment demand [for gold] represents the aggregate of global economic trends, it makes no sense to try and understand its correlation to the gold price in US dollars alone, without considering the price of gold in the rest of the world, which by definition must incorporate all exchange rates. An analyst in Lusaka, for example, may find value in analyzing the gold price strictly in terms of Zambian kwacha, but in reality his analysis will reflect mainly the kwacha exchange rate, with a minor contribution from the actual gold market. The same applies to an analyst in New York, working strictly from a US dollar perspective.
In order to measure the performance of gold against fiat money in a way that is independent of the exchange rate of any particular fiat currency against other fiat currencies, van Eeden has "created a global gold price using a GDP-weighted index of 35 currencies, representing in excess of 75% of the world’s economy." A graph of the gold price from 1990-2001 (a period of time in which the US$ price of gold was in a deep decline) shows gold in a slowly rising trend against the index.
Under a section subhead "Proof," Shedlock shows several charts of the US$ gold price against the US$ index and money supply measures. The US$ price of gold does not show any particular correlation to these other measures as might be expected if it were an inflation hedge, including the unstated assumption that the US$ were the only currency in the world.
According to van Eeden, when the gold price is examined against a global weighted index of fiat currencies, it is rising approximately at the same rate as the purchasing power of fiat paper money is declining. Van Eeden’s data show that gold has done a good job maintaining purchasing power over time against fiat money inflation. In other words, gold functions as an inflation hedge. The market has priced it like other currencies on the international money markets.
In Understanding the Gold Price, van Eeden explains that from an international perspective, the gold price did not decline during the 90′s, when it did fall substantially in US$ terms:
Even though the gold price in U.S. dollars has declined by over 30% since January 1990, the average gold price in the world has increased by over 20% during the same time. This not only reinforces the concept that talking about the gold price is currency specific but more importantly, it shows that the average gold price in the world is stable and in fact steadily increasing.
This in turn is a strong indication that gold is still a safe haven for capital. Gold has not lost its value as a store of wealth.
The Overvalued Dollar
As van Eeden explains, the poor performance of the US$ gold price during the 90s was primarily a reflection not of declining monetary significance of gold, but of the dollar’s overvaluation relative to other fiat currencies. The over-valuation of the dollar resulted from several factors: a massive asset bubble in the US; a series of currency crises fueled by debt implosions in the developing world; and the reluctance of Japanese central planners to allow the Yen to appreciate as they attempted to inflate their way out of the 15 years of doldrums following the collapse of their credit bubble in the 80s. I will say a few words about each of these factors,
The US asset bubble played an important role in creating the over-valuation of the dollar. Since I have expanded on this thesis elsewhere, I will only summarize here. Peter Warburton in his book Debt and Delusion presents a compelling case that the 90s was a period of high inflation, but the as central banks relied increasingly on deficit financing through securities markets rather than bank credit, inflation was increasingly channeled into financial assets rather than those of consumption goods.
The Greenspan Fed aided and abetted the process by creating an understanding among financial players that it would inject sufficient liquidity to prevent any possibility that asset prices would be allowed to fall. This "Greenspan Put" started with the unusual measures that were taken to halt the fall of stocks in the 87 crash, and continuing with a series of bailouts and interventions throughout the latter half of the decade.
The resulting bubble in US financial assets ignited worldwide demand for US$ as foreigners, anxious to get in on the US equity market party, expressed their demand for US equities as demand for the dollars with which to purchase them. A “virtuous cycle” then resulted in which demand for US stocks reinforced demand for dollars, and vice versa, driving them both higher in an ever-accelerating upward spiral. Foreign investors profited on the capital gains and the appreciation of the dollar exchange rate relative to their home currency (until the whole thing went splat).
Van Eeden cites the role of a series of financial meltdowns in emerging markets as a factor driving demand for the US dollar. The developing world was jarred by a series of debt implosions and currency devaluations starting with Brazil (1992), Mexico (1994), the Asian Contagion (1997), Argentina (1999), and Russia (1998). In response to each crisis, there was a “flight to safety,” with capital seeking out the perceived safe haven asset class: US Treasury debt.
A point that van Eeden does not make is the connection between these crises and the dollar reserve system. The post-Bretton Woods floating fiat currency system established the dollar as the reserve asset, but exchange rates are often manipulated based on ill-advised political factors or unwise economic policies. Attempts by economic ministers of small countries to fix their exchange rates above or below market value create a buildup of imbalances between the small nations and the rest of the world, inevitably followed by a swift crisis of one kind or another.
Van Eeden illustrates the response of the US$ gold price and the dollar’s exchange rate to each crisis. He follows up with some charts of the gold price in the currencies that were in crisis (Mexico, Indonesia, Russia). Had you lived in one of those countries, gold would have been a very effective hedge against inflation — or more accurately a hedge against monetary devaluation (which is often several years of repressed inflation all at once). On a worldwide average basis, gold has not been losing purchasing power; on the contrary, it has been in a rising price trend. Van Eeden concludes:
As you can see from the above examples, even though the dollar-gold price did not necessarily respond to crises, the average gold price certainly did. But the world had become fixated on the dollar-gold price and it has become generally accepted that gold had lost its value as a store of wealth. From the above examples however, it should be clear that nothing is further from the truth.
Central Bank Sales
Research by the activist organization Gold Anti-Trust Action (GATA) suggested that gold sales by central banks are part of a pattern of intervention prevent the US$ price of gold from performing its signaling function to financial markets. GATA’s extensive research on central bank gold sales has uncovered considerable evidence of a undisclosed central bank sales in larger quantity than the disclosed sales, unreported gold-for-paper derivatives between central banks, false and misleading accounting on the books of central banks for gold that has already been sold into the market, and the buildup of a large paper short position in the gold market created through derivatives. While some of their research is quite technical, I would encourage anyone who is interested to spend some time on their web site or watch their DVD.
Van Eeden disputes the idea that central bank sales have had any effect on the gold price. Here I part company with him. While van Eeden shows that gold is weak in US$ because the US$ is strong, and concludes that central bank sales have no effect on the gold price. In his model, the direction of causality is from dollar exchange rate to US$ price in gold. However, if the US$ exchange rate is influenced by the gold price, then it could be true that the US$ was strong in part because gold has been weak. Management of the gold price itself, then, could be part of the "strong dollar policy" publicly advocated by several US Treasury secretaries.
GATA’s argument is as follows: there is a bi-directional feedback mechanism between the dollar exchange rate and the US$ price of gold. While a perception of inflation will result in a rising gold price, cause and effect could go in the opposite direction. Many traders in financial markets use a rising US$ gold price as an indicator of the extent of US$ inflation. That is, a rising gold price can drive the perception of inflation as well as the other way around. If the US$ gold price began to rise, the bond and currency markets would react by bidding down the price of bonds and the bidding up the dollar exchange rate against other currencies. GATA has located a research paper by former Treasury Secretary Summers which puts out the idea that the long-term interest rates could be managed indirectly through control of the gold price.
Gold: A Commodity?
While Mr. Shedlock agrees that gold is money and not a commodity, his analysis does not fully take this into account. To understand the purchasing power of gold, it cannot be compared to one other currency. If someone wanted to get an idea of the purchasing power of say, the Russian ruble, would they compare it only to the dollar? A global approach such as van Eeden takes is necessary in order to separate the individual currency-specific factors from gold.
When the dollar’s link to gold was broken in the 70s, some economists — thinking that the gold derived its value from its association with paper money — predicted that the US$ price of gold would drop to a value reflecting its use as a commodity. Instead the US$ plummeted in an inflationary crisis and has depreciated ever since, while the purchasing power of gold on a global basis has remained relatively stable.
While the memory of gold as money is vanishing in the United States, in many countries, the local currency (or one in a sequence of failed local currencies) has never earned anywhere near the prestige as has the US$. Gold has been in continuous use as a store of value more or less forever in parts of the world lacking the enlightened monetary central planning that we have grown confident with here. US investors may not remember gold but they are selling theirs to those who have never forgotten it.
In Making Sense of the Gold Price, van Eeden writes:
If gold is a commodity like rice or aluminum, then it should be priced as such. It would seem that under such circumstances, gold is the most overpriced commodity in the world. The value of gold as a commodity stems from its physical properties: electrical and thermal conductivity, resistance to corrosion, malleability and ductility. The biggest market for gold will be in the electronic industry where it will compete with other metals, notably copper. If gold were to truly compete with copper in mass production of electrical components then the price of gold would have to be competitive with the price of copper. Copper trades for around $0.80 a pound and gold for more than $4,000 a pound. This means that the gold price would have to drop to less than $0.06 (six cents) an ounce to be in the same region as the copper price. Obviously gold is not being priced as a commodity. There is a demand for gold that inspires people to pay substantially more for it than its commodity value. Gold is money.
Elsewhere on LRC, I have presented a more fully worked out analysis of gold supply and demand worldwide. My analysis shows that a large component of the present demand for gold is a demand-to-hold, or monetary demand. The next largest component of gold demand is jewelry demand, which is arguably monetary demand as well, though this would probably not convince someone who thinks that gold has been demonetized. Most of the demand for gold, worldwide, is demand-to-hold rather than demand for use. A large (and stable) demand-to-hold in proportion to total supply is a characteristic of money, not of a commodity.
While I am in agreement with Mises’ view that the purchasing power of money is in constant flux as money prices change, van Eeden’s work shows that gold is doing a reasonably good job of maintaining purchasing power parity on a worldwide basis. More extreme fluctuations in gold’s purchasing power when converted into US$ have a lot to do with changes in the US$ exchange rate.
The dollar price of gold can be flat or falling even when the quantity of dollars is increasing so long as the dollar exchange rate against other currencies rises. The non-buyer of gold, then, is speculating an appreciating dollar exchange rate cancelling out the effect of currency debasement.
Robert Blumen [send him mail] is an independent software developer based in San Francisco.