Inflation, Deflation, Whatever: People Buy Gold in Money Crises

Gold's previous bull market, ending with the sharp run-up to $850 per ounce in Jan. 1980 and rising more than 24 times over for dollar investors, came in the 1970s.

That decade gave us soaring inflation, too. So gold, or so everyone says, must deliver its strongest returns when the cost of living shoots higher. Right? Not quite.

"In the long run, stocks have thrashed gold as great long-term hedges against inflation," Jeremy Siegel, professor of finance at Wharton University, Pennsylvania, has shown. What's more, the eight-year bull run in gold prices so far this decade has come against the lowest average consumer-price inflation since the early 1960s.

In other words, the common opinion of gold as first and foremost a defense from inflation is wildly awry, if not amiss – a point those investors now ready to buy gold should consider.

Just look at the last 30 years. Consumer prices in the United States, even on Washington's data, have pretty much trebled since 1980. But starting at what was then an all-time high of $850 per ounce, gold simply failed to keep pace. In fact, it dropped half of its purchasing power (monthly data).

At worst, back in 2001, gold's loss of purchasing power for US investors reached beyond 85%. The broad S&P index, on the other hand, stood more than eleven times higher, even as the Tech Crash pushed US equities into a nosedive.

Oh sure, things have reversed a little since then. But not enough to reverse the cold fact of gold's losses during the long, grinding inflation of the late 20th century. It may not have forced an inflationary panic amongst investors; they were happy to buy bonds (corporate and sovereign) even as inflation chipped away at the promised yields. But savers saw the value of their cash shrink by one-half across the developed world, and by far worse across the emerging economies.

How can we square it with gold's miserable losses between 1980 and 2000...?

"Well," you might hazard, "perhaps gold bullion only responds to rapid inflation – the nasty kind we got in the late '70s, rather than the 'mild' case our money has suffered ever since?"

But again, you'd be wrong – or very close to it. Between 1980 and '81, consumer price inflation in the US destroyed 17 cents of the dollar's purchasing power, an ugly depreciation by any reckoning. Yet the dollar price of gold dropped 40% during that same period. Longer term over the 1980s and '90s – a truly horrific period of sustained inflation, then averaging 4.6% per year and vicious by any twenty-year comparison in history – the real value of gold sank by more than four-fifths.

Look further back – even to when physical gold stored in government vaults underpinned the dollar, just as it underpinned all major currencies – and you'll find that gold almost always made a poor hedge against rising prices. In the mid-70s, Professor Roy Jastram at the University of California at Berkeley found that gold failed to keep pace with the cost of living during seven inflations in Britain across more than three centuries. In the United States, Jastram spied six inflationary periods between 1808 and 1976. On average, they saw the purchasing power of gold fall by more than one-fifth!

Only the final period in Jastram's study – beginning in 1951 – saw the metal gain value, and it continued to gain purchasing power for the next 30 years. By the end of 1980, the average annual price of gold had risen more than 17 times over. But right from that top it was downhill for the next twenty years.

How come?

What changed at the start of the '80s? Two things in short order. They were entirely connected.

First, Paul Volcker – the famously tall cigar-puffing chairman of the US Federal Reserve – raised dollar interest rates to nearly 20%. So second, and as a direct result, the rate of inflation sank from that record peace-time spike above 14%.

Volcker's strong medicine took nearly two years to slow the rate of inflation. But it killed the gold price almost instantly. Before Volcker hiked rates – and before he and his successors gained ample room to cut them year after year: "There was a kind of great speculative pressure," as Volcker since said. The Fed noted how "speculative activity" in the gold market was spilling into other commodities. One official at the US Treasury called the gold rush "a symptom of growing concern about world-wide inflation."

So yes, people piled into gold as double-digit inflation and collapsing bond prices destroyed their savings at the end of '70s. And yes, it took a record return paid to cash for the devaluation of money to slow down, allowing a cautious return to risk assets like corporate debt, listed equities and new private ventures – assets whose long-term appeal rests on stable costs and expenses, rather than a speculative guess at how the central bank might set its interest rates from one month to the next.

But now, in contrast, Britain stands on the brink, the United States will likely confirm it on Friday, and Japan's pretty much there – yet again – suffering the horrors of inflation's bleak evil twin, deflation.

How come gold just keeps hitting new record highs?

Before the 20th century, short periods of falling prices were as common as scurvy, and just as harmless for the long-term value of money and assets. Indeed, deflation is a good thing, for savers at least. Provided their savings institutions stay solvent. And provided their cost of living actually goes down faster than the value of the assets they've saved. Which is not what's happening today. And that brings gold's other key feature – the one investors should note if they buy it as a tightly supplied metal that shot higher in price when inflationary panic struck in the late '70s.

Because fact is, gold also offers a deep, liquid market (if held in its internationally tradable form of large wholesale bars) with no risk of counter-party default (if owned outright, rather than through a trust or a fund or a similar financial structure).

In our debt-deprived world today – where the outstanding value of what retirees and savers are owed is deflating much faster than costs – it's this attraction of gold...it's "off risk" advantage...which is fast-gaining appeal amongst large funds and private investors alike.

Inflation and deflation – both a crisis in money – both also force business and growth to give up. What remains, paying zero and promising nothing, is the need to simply store wealth and savings for a better tomorrow, whenever (or if ever) it shows.

Comments

[ROLEXDAYTONA:]

Only few buy physical Gold in times of crisis and those are 70-100 years old today, most pundits buy mining stocks and those since the crisis started are 40% down on average same as SP500.
They have double risk, if markets will move higher but Gold lower, they are going to lose more.

Feb 19 07:30 AM

[SW Richmond:]

"The Fed noted how "speculative activity" in the gold market was spilling into other commodities."

Speculative activity tries to anticipate and discount activity in the real economy. It seems to me, though, that the bulk of the speculators are in fact a herd. The herd has become convinced by deflation-thesis, and are acting accordingly.

The Chinese, on the other hand, are doing the smart thing and thinking long-term; they are buying the resources they will need to build their domestic economy and solidify their international position as a manufacturer/exporter. The Chinese seem to have no interest in upsetting the apple cart by making any shocking moves in the gold or Treasury markets.

This is an interesting move by the Chinese, as it belies a faith in the enforcement of contract law that is a fundamental tenet of capitalism.

Feb 19 07:55 AM

[Roger Knights:]

Here's an ill-chosen phrase that cries out for revision:
"as common as scurvy, and just as harmless"

Feb 19 08:03 AM

[Roger Knights:]

There are two other attractions of gold:

1. The long-shot possibility that governments, under pressure, might co-operatively return to some form of gold standard at a much higher gold price. Even if this doesn't actually occur, if the mere possibility ever becomes seriously mooted about in conventional and official circles, it will boost gold's price considerably.

2. Foreign bond and currency crises, rumblings of which are now beginning to impact the Euro. If severely impacted, European flight capital could goose gold greatly, even if the US dodged the impact of inflation, deflation, and the root evil of flation itself.

In neither case need one own "fizzy-cal" gold to benefit.

Feb 19 08:19 AM

[orca:]

My reason for being long fysical gold is that it is the only portable and liquid fiat currency hedge. Top quality diamonds are fine too, 10 carat and up, however you can't break a 10-carat diamond in 100 pieces when bartering. Silver is too bulky for its worth. Moreover gold (in Europe, I don't know if true in the USA) is VAT exempt since supposedly there aren't many industrial uses (hence the VAT exempt) for it. I hope for a crash in gold so I can add to my position but I don't see it coming in this environment.

Feb 19 08:21 AM

[Mad Hedge F...:]

GOLD! GOLD! GOLD! This is the cry being heard worldwide by investors in the Great Gold rush of 2009, looking for a generic “short America” trade. Where in the past gold seekers used sluices, shovels, and jackhammers to extract the glittery stuff in California’s Sierras, Alaska’s Klondike, and South Africa’s Rand, today the instrument of choice is the mouse. Online traders are unleashing clicks by the millions to buy ETF’s, American Eagles, mining shares, and futures contracts. With stock traders sitting on their haunches, wondering if the Dow will hold 7,000, this is the only thing that is working right now. Traders are buying gold more for what it isn’t, than what it is. It isn’t made of paper, made in the US, or held in custody by Bernie Madoff or Stanford Financial. The yellow metal hit a new high for the year of $887 overnight, and the risk of a “melt up” is increasing. The Street Tracks Gold Trust ETF (GLD) is now the seventh largest holder of the barbaric relic in the world. For the newly aggressive, look at the DB Gold Double Long ETF (DGP), which gives you a 200% long exposure to gold.

Feb 19 09:00 AM

[doubleguns:]

It seams to me that we are leaving the lower level fear of economic crisis and ratcheting up to the extream fear of a possible currency crisis. If one currency begins to fail it will have an impact on others around it and possibly lead to a domino effect. The rumors of a currency crisis in eastern europe have started.

The dollar strengthening at the same time as gold means those who can buy gold are buying gold and those that can buy dollars are buying dollars but I think they would prefer gold if possible.

The real test for the US will be when everyone wants back out of dollars. They will become cheap, cheap, cheap along with the treasuries. That will be the final test to see if the US ends up with a currency crisis.

Feb 19 03:02 PM

[Celcius:]

You should not be using the CPI index to compare gold prices. The CPI data is highly manipulated BS. Especially, since government social programs are indexed to it. A better analysis would have used third party inflation data like Shadowstats.com to accurately display the relationship.

Gold is the only safe alternative to fiat currencies, and this is extremely important when the financial industry and government propaganda consistently under estimate or under report the severity of the crisis for their personal gain.

Feb 19 03:37 PM