What About Gold?

Gold’s historic role amid currency crises and the underpinnings affording refuge from wealth destruction wrought by inflation

Views regarding the value of gold as a financial asset cover a wide spectrum from gold is the only “true money” to gold is worthless “because you can’t eat it”.  In this post I will offer a discussion of gold’s historic role and consideration of the precious metal’s utility as it pertains to providing refuge from financial wealth destruction resulting from price inflation in order that you can decide for yourself.  I hope the insights offered help you decide how valuable a gold holding, or gold related holdings (e.g. precious metal mining stocks/funds), may prove to be as insurance guarding your financial wellbeing along with that of those who depend on you.

Every national currency in the world today is fiat, meaning no national currency is anyone’s liability.  Contemporary national currencies are all literally IOU nothings.  If you were to take a $100 bill to the US Treasury or US Federal Reserve bank (a.k.a. The Fed) and demand that they back it with something, anything, they would look at you like you are crazy.  Although the Federal Reserve accounts for the dollars it creates as liabilities on its balance sheet those dollars don’t qualify as liabilities in any practical sense since they carry no promise or obligation of any kind from anyone; we accept them in payment only to the extent we are confident they will serve to secure the goods and services which ultimately support our wellbeing in this world.  In short fiat currency is supported by confidence alone, and as history attests that confidence can be shattered suddenly and unexpectedly when expansion of the money supply continually accelerates.  Debasement of currency is the fundamental motive force propelling price inflation but collapse in confidence (i.e. demand) is the trigger which unleashes episodes of severe price inflation and consequent financial paper wealth destruction.

Debasement of fiat currency, including the US dollar, knows no technical limits.  Most US dollars today aren’t even printed rather they are conjured through nothing more than accounting entries at the Fed as it credits banks with new reserves.  With a few key strokes massive quantities of notional money appear out of thin air.  Imagine being able to log onto your bank account and legally add zeros.  You could just take a moment to sit down and add a bunch of zeros to your balance then sweep the sweat off your brow and enjoy being a multibillionaire…sweet deal!  Of course in so doing you would be seizing part of the wealth of every other dollar denominated asset holder in the world without offering anything to them in return.  So, not so sweet, at least for those of us who believe in treating our fellow human beings fairly.  Though the process employed by the Fed is more involved since the Fed “buys” assets, typically US Treasuries, the end result is the same.  Damage wrought comes in the form of price inflation of goods and services along with declines in the value of fixed rate financial assets (e.g. bonds), an asset class held widely in pension funds for example.  Stocks rise nominally in the face of price inflation but ultimately fall dramatically in inflation adjusted terms (perhaps the topic of the next post).  As evidenced by the history of fiat currencies resultant financial damage can strike suddenly and prove debilitating.  Even very well developed countries which fancied themselves immune to damaging price inflation have been proven utterly vulnerable as they debased their fiat at accelerating rates (see Weimar Germany, early 1920’s). 

So, what class of assets aren’t damaged by price inflation, hence offering refuge from wealth destruction?  Tangible assets, meaning those we can reach out and touch physically, generally aren’t diminished in value.  How do we know?  Self evidently it is the prices of tangible assets, or goods, which are inflating.  Goods generally hold their value as the value of fiat currency falls, hence more fiat is required to purchase the same goods which is what we call price inflation.  Note, service prices inflate as well hence some intangible assets, such as a technical skill, can be expected to increase in value with general inflation.  However as history demonstrates wage increases broadly fall short of inflation rates during serious periods of inflation and bouts of high unemployment punctuate inflationary crises.  For the purposes of this post I am going to assume the reader has already invested in their skill development so we are focusing on what assets you can hold to protect your wealth from inflation.    

Real estate composes the largest body of tangible assets and we all need a place to live so owning real estate makes sense for many.  Real property owners can fair particularly well during periods of serious inflation since those who have fixed rate mortgages enjoy price gains on a financially leveraged real asset!  Who loses?  Those funding fixed rate mortgages and renters who face rising rents (and those who live on old boats).  So owning real estate can provide security amid currency debasement but real property also presents some problems such as increasing carrying costs (e.g. insurance, maintenance, taxes) and high transaction costs when sold.

Another problem posed by real estate is perhaps less obvious.  Real estate is illiquid.  You generally can’t sell real estate in part or whole quickly with low transaction costs.  The potential sale value of real estate can serve well to preserve, or build, your wealth but that value doesn’t serve for needed liquidity.  We all understand the necessity of keeping part of our wealth in highly liquid form to facilitate routine transactions, so we hold money.  Fiat currency can in fact serve this function very effectively provided it isn’t being debased, or at least not debased in a way which results in high and unanticipated price inflation.  However history demonstrates that, ultimately, governments which control fiat currency can’t resist adding zeros.  Over time promises are made, debt is issued and markets are manipulated until governments and their central banks face one of two options; slow or reverse currency debasement triggering deflationary collapse or continually accelerate via money conjured out of thin air until confidence breaks resulting in inflationary collapse.  At that point the hard earned wealth you keep liquid in fiat currency, or financial assets denominated in the currency, will suffer serious destruction.

So how can you keep part of your wealth both liquid and safe from serious inflationary losses?  What you need are highly liquid tangible assets and there aren’t many options.  In fact, precious metals are pretty much it.  Precious metals are ultra liquid and enjoy the key qualities of sound money.  They are scarce, uniform in quality, durable, easily divisible, portable AND they can’t be conjured out of thin air through accounting entries in anyone’s account (sorry politicians).  Note, we are talking about physical bullion not unallocated gold at a leveraged financial institution. Beware fractional reserves and depending on a financial institution’s promise to repay the assets they borrowed and used without telling you (read you client agreement and understand rehypothecation).  This isn’t to suggest people should carry gold coins in their pockets to pay their bills.  Gold is always liquid and in demand, especially when everyone needs protection from inflation, so it can be sold quickly and efficiently for fiat which is then held relatively briefly to facilitate purchases in the usual manner.

Financial history is clear.  When a currency collapses gold priced in the currency skyrockets to a much greater extent than the inflation rate.  Such is the case because gold is both highly liquid and tangible, a rare combination of asset qualities. Gold can be expected to protect your wealth from inflation while providing liquidity.

Are there downsides to holding gold bullion?  Of course.  The price of gold can be volatile making planning a challenge, although easy enough to live with when the price is rising fast due to inflation.  Also history informs us that governments, which gain great power through control of fiat currency, react badly when their currency grows ever more akin to trash and people choose to use alternatives.  Historically governments, including the US government, have outlawed ownership of gold bullion at times.  They may pay something for gold seized, or not, but guess who sets the price.  They may also outlaw gold’s employment in facilitating transactions or forming contracts.  And of course gold you hold can be stolen by anyone.  For security it may be stored in a secure private vault (e.g. safe deposit box) but that entails a carrying cost, usually relatively small, and governments may seize gold from vaults too. 

Despite some drawbacks we know from history that people around the world desire gold holdings, intensely, as wealth held in financial paper and cash is seriously damaged by inflation. 

Final note, you actually can eat gold which is nontoxic but it is chemically inert hence won’t provide any calories and probably doesn’t taste like much (my speculation, never tried it).  You may want to think twice before taking financial or economic advice from someone who says gold is worthless because you can’t eat it.  If nothing else the high gold price renders such guidance suspect.  Although to be thorough, and in fairness, if everyone were literally starving and they had nothing to trade food would indeed be more valuable than gold.  Insights offered here are not meant to aid in preparation for such an extreme outcome.

I hope the insights offered prove helpful as you navigate your financial future amid hazardous conditions in the years ahead.

Wishing every innocent soul peace and wellbeing.

Cruising Economist

Here’s a beautiful creation to calm the soul from Raumata, in Pa’umotu (you won’t understand a word but it won’t matter…promise)