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by David Friedman

Gold bugs like gold because, unlike fiat money, gold has an inherent value to it. Its relative scarcity makes it more valuable than other things. It’s interesting, then, to list gold bugs’ arguments in favor of gold. Their main claim is that when governments devalue their currency, by letting inflation run rampant and taking on more debt than seems prudent, gold becomes an attractive investment vehicle. Never mind the problems with storing, moving, and securing gold, the gold bugs say: gold has inherent value that fiat currency does not.

That argument is fine as far as it goes: it is true that gold has an inherent value that paper-based money does not. And, indeed, since Nixon moved the US off the gold standard in 1971, our currency has not been tied to anything other than the the promise of the US government to make good on its debts. (Consider that every note you have in your wallet says on it “This note is legal tender for all debts public and private.”)

So, given all of this, yes, the gold bulls have a valid point that where paper currency derives its value from the potentially suspect promises of a profligate government, gold derives its value from its inherent scarcity.

But does it follow that gold will be a good investment in the future? Just because something is scarce doesn’t mean it’s a good investment.

Ken Rogoff, the Harvard economist, wrote recently about gold:

One successful gold investor recently explained to me that stock prices languished for a more than a decade before the Dow Jones index crossed the 1,000 mark in the early 1980’s. Since then, the index has climbed above 10,000. Now that gold has crossed the magic $1,000 barrier, why can’t it increase ten-fold, too?

Admittedly, getting to a much higher price for gold is not quite the leap of imagination that it seems. After adjusting for inflation, today’s price is nowhere near the all-time high of January 1980. Back then, gold hit $850, or well over $2,000 in today’s dollars. But January 1980 was arguably a “freak peak” during a period of heightened geo-political instability. At $1,300, today’s price is probably more than double very long-term, inflation-adjusted, average gold prices. So what could justify another huge increase in gold prices from here?

One answer, of course, is a complete collapse of the US dollar. With soaring deficits, and a rudderless fiscal policy, one does wonder whether a populist administration might recklessly turn to the printing press. And if you are really worried about that, gold might indeed be the most reliable hedge.

But he sounds a sensible note of caution: gold prices are inversely related to interest rates, and interest rates are at historic lows around the world.

Indeed, another critical fundamental factor that has been sustaining high gold prices might prove far more ephemeral than globalization. Gold prices are extremely sensitive to global interest-rate movements. After all, gold pays no interest and even costs something to store. Today, with interest rates near or at record lows in many countries, it is relatively cheap to speculate in gold instead of investing in bonds. But if real interest rates rise significantly, as well they might someday, gold prices could plummet.

The gold bugs make some interesting arguments about the difference between gold and fiat currency. And those arguments are valid. But they ignore the connection between interest rates and gold prices. Their case is not as convincing as they think it is.

Source: When Will Gold Reach $10,000 an Ounce?