Is Gold Still A Store Of Value ?

(July - 1997)

"Once the cornerstone of the international financial system, the precious metal has in recent years become increasingly irrelevant to central bankers and investors as a hedge against inflation"

The question in my mind is how it could possibly be considered shrewd to sell something at historically low prices.

The above is extracted from an article which appeared in the July 4 1997 edition of The Australian Financial Review, Australia's most respected financial newspaper. The subject of the article was the recently announced sale by the Reserve Bank of Australia of two thirds of the country's official gold reserves. The conclusion of the article is that, with gold prices at their lowest point in many years, the Reserve Bank has acted shrewdly by getting out before their stockpile of gold becomes worth even less. The question in my mind is how it could possibly be considered shrewd to sell something at historically low prices. The answer to this question is publicised throughout the Western World on a daily basis. Firstly, gold is no longer a store of value to be held in defense of inflation. Secondly, we have entered a new era in which inflation has permanently been brought under control. Let us consider the merits of these answers, and therefore the future of gold, by firstly looking backwards.

The Past

Until very recently gold has widely been thought of as a hedge against inflation. However, this was not always the case.

Two major changes have occurred this century in the relationship between gold and US dollars. The first of these occurred in 1934 when President Roosevelt confiscated the private gold holdings of US citizens and de-valued the dollar relative to gold. Prior to 1934, the dollar had been defined in terms of gold at the fixed rate of $20.67 per ounce. From 1934 until 1971 gold was officially linked to the US dollar at the rate of $35 per ounce, that is, the US Government guaranteed to provide one ounce of gold in exchange for 35 dollars and vice versa. During this period gold was therefore a hedge against deflation - its purchasing power increased or decreased with that of the dollar. For example, during the 1930's Depression the purchasing power of gold increased due to the contraction in the supply of dollars (deflation), whereas the period from 1945 until 1971 saw a reduction in gold's purchasing power due to an increasing supply of dollars (inflation).

The second major change occurred in 1971 when the US Government stopped defining its currency in terms of gold, thereby reneging on its promise to redeem gold for dollars at the rate of $35 per ounce. From this point onwards the value of the US dollar in terms of gold was set by the market and gold became a hedge against inflation (as the purchasing power of the dollar reduced, correspondingly more dollars were needed to purchase the same quantity of gold ).

Before looking at gold's current status and future outlook, at this time it is also worth considering the reasons why the US was forced to abolish its quasi gold standard in 1971. We can do this by reviewing the changes which occurred in the flow of gold in to and out of the US during the period between 1934 and 1971.

During the 1930's and early 1940's there was a net flow of gold in to the US. This means that one ounce of gold was generally considered by investors to be worth less than the official rate of $35. However, from 1947 until 1971 there was a net flow of gold out of the US, meaning that investors were very willing to swap their dollars for gold at the $35 rate. The flow of gold out of the US accelerated during the 1960's as the expanding federal debt, and the monetisation of that debt, caused an erosion in the intrinsic value of the dollar. By 1971 the choice facing the US Government was clear. In order to avoid the total depletion of their gold reserves and consequently a complete collapse in the value of their currency, they would have to either pursue responsible fiscal policies (curtail spending and reduce debt) or cease redeeming dollars for gold.

The Present

The bear market in gold has led many people in the West to conclude that gold no longer has a monetary role and is no longer a useful store of value. The argument which is often made is that even if inflation was a problem there are numerous means available in today's financial world for investors to protect themselves. For example, an enormous derivatives market now exists which enables investors to hedge against almost any eventuality. There is certainly no need to allocate any portion of one's net worth to a costly lump of metal which provides no income and seems to constantly drop in price.

The current situation is such that even goldbugs are losing heart. Puzzled by the seemingly endless price depreciation they concoct conspiracy theories involving central banks and the media. In reality gold's bad publicity is not a conspiracy, in the same way that the negative press accorded to the stockmarket at the 1974 cyclical low was not a conspiracy. It is simply typical of the emotional extremes seen at, or near, the bottom of any market.

As I have mentioned in previous articles, the price of gold is low because the monetary demand for gold remains low. The impact of the low monetary demand has been compounded by a shift in the above ground gold stock as sales by central banks are absorbed by private investors and commercial/industrial users. In order to determine if gold is currently a worthwhile investment we need to define the conditions under which the monetary demand for gold will increase and then to ascertain whether such conditions are likely to prevail during our investment time frame.

What Is Needed For Gold To Thrive ?

Firstly, what is not needed is deflation. The 1930's deflation saw an initial upward re-valuation of gold by the government in order to provide increased liquidity, but the net flow of gold into the US throughout the remainder of the 1930's indicates that gold would have traded below $35 per ounce had a free market existed. Gold, as well as being money, is a tangible asset. During a period of deflation the price of all tangible assets in the economy will decrease in terms of the national currency. The exception would be a financial collapse of such magnitude that the quantity of dollars ceased to matter. If this situation were to eventuate then we would all be losers, including the holders of gold, as the result would probably be anarchy.

Gold, as well as being money, is a tangible asset.

Despite the proliferation of derivatives, gold will still be sought after in times of inflation. Value is a subjective thing and for thousands of years people throughout the world have attributed value to gold and have accumulated gold as means of storing their wealth and of protecting themselves from the de-basement of non gold based currencies. It is difficult to believe that such a fundamental change has occurred in recent years that a value system which has existed since the beginning of civilisation would suddenly become defunct.

The Future

In my opinion, the only reason to buy gold is to protect oneself from the effects of inflation. Inflation results when the money supply increases at a greater rate than the supply of "real things". The diluting effect of the increased quantity of currency not only causes the prices of tangible assets to rise, but also results in a loss of confidence in most financial instruments. The reason to buy gold now is if the signs of inflation are going to become evident during the next 12 months.

The plethora of economic statistics which are released each month are currently giving contradictory signals. We are seeing the highest GDP growth rate and lowest unemployment in a decade, and at the same time we are witnessing stagnant prices, poor retail sales, and high rates of personal bankruptcies. We have a US stock market which continues to surge to new highs, seemingly in defiance of all traditional measures of valuation, the highest rates of money supply growth since 1987, and yet relatively stable interest rates. At the moment the available evidence can be used to argue with equal credibility and conviction for an inflationary or a deflationary future. However, I am convinced we are heading for high levels of inflation simply because this outcome is consistent with the short term agenda of the monetary authorities and the politicians. The monetary authorities (the US Treasury and Federal Reserve) desire to maintain the perception that the US financial system is stable and hence avoid what Alan Greenspan has termed "systemic risk". The perception of stability revolves around the ability of the US to service its debt and to attract buyers for new debt issues. The only way of coping with the current debt levels is to surreptitiously default by repaying the debt with dollars whose value has been significantly reduced through inflation. A method of selling new debt in an inflationary environment, without the need to pay exorbitant interest rates, has already been introduced (inflation indexed bonds). The politicians, on the other hand, simply want to get re-elected, a feat which is infinitely easier in an over-heated inflationary environment than it is in a recession.

Conclusion

The credit expansion of the 1920's culminated in the deflationary 1930's because the government could not introduce enough new money to fill the gap in the money supply caused by debt defaults. This occurred because the amount of currency which could be created was limited by the amount of gold held in official reserves. The same limitation does not exist today and I am willing to bet that the money supply will be increased to whatever level it needs to be to avoid any meaningful short term economic slow down.

Milhouse