I have been asking myself the question, what gives gold (NYSEARCA:GLD) value? There are plenty of different opinions, and I'm sure that regardless of what mine is, many will disagree. Nonetheless, as I consider whether to get involved in precious metals, it is worthwhile to look at the argument. It also brings about an interesting discussion about inflation, QE, and the economy as a whole.
The Gold Argument
A typical gold argument is that it performs well when there is panic in the economy and provides an excellent store of value. The other is as a hedge, or form of wealth protection, against paper currency. Since gold is not consumed, the new production is merely "added" to the existing gold supplies. The chart below via Bloomberg shows that relationship that existed between inflation and gold; up until the dot com boom.
The Worst Case For The Economy Is The Best Case For Gold
If gold is to skyrocket in value, then we would hope for inflation, or fear. Let's lay out the worst inflationary scenario for the current state of the economy.
Despite monstrous amounts of QE, there has been no resulting inflation. As the money was primarily used to shore up the balance sheets, the rapid rise of money supply resulted in an equally leveraged drop in money velocity. I wouldn't argue that anything changed, and relatively the same number of dollars in the real economy that existed going into QE existed throughout it and to today. Without an increase in real money supply (that consumers had access to), or the velocity of the money supply, you would not expect inflation.
Won't Growing Wages Stoke Inflation? Not yet. As an effect of stagnant money supply and velocity, the economy should also stagnate. Increased consumption of goods is unlikely, and therefore, wages do not grow as the market tightens and there is slackening demand for labor. We may be seeing signs of a recovery now. However, if the recovery were so robust, rising interest rates wouldn't be such a difficult decision. In reality, the labor market participation has declined over the past 15 years.
Contrast the figure above to the two below. Labor force participation is down, which provided a similar drop in median household wages. So many more households have one working person, or more people are retiring as demographics change, likely both. The result is that the average household has less free cash available for non-discretionary purchases that would typically increase the money supply and stoke inflation.
Most households also started paying down debt through this period, reducing non-discretionary spending further.
Low-interest rates, low labor force participation rates, declining money velocity; these are all compounded by the gravitational pull of earnings to the technology sector. I've stated my views before, so I'll just recite what I've said in the past.
Technological Earnings Drain
Increasingly, technology companies are drawing profits from the economy toward technology services. While this area is good for the economy to an extent, an abundance of profits attracted to very large companies with very few employees results in a vast disparity of wealth in the market and the economy.
This variation means fewer jobs per dollar of earnings for the economy. Replicate that across hundreds of tech companies in the future, and you have a monumental shift in the way the market works. Each person can only have so many haircuts, go to so many restaurants, and buy so many cars.
As a result, GDP growth does not correlate with median wage growth, money accumulates within a smaller group as their salaries rise, and the impoverished portion of the economy grows. It follows that we will see (and have seen) a drastic reduction in the velocity of money through the economy. After all, if wages don't rise, consumer confidence starts to dwindle, productivity drops, and the economy can run on a self-reinforcing pattern of deflation that can be near impossible to stop without extreme measures (see Japan).
Because the root of the economy is deflationary, we do not see inflation as a result of inflationary central bank policies. I see the U.S. having a higher likelihood of importing inflation from the world economy rather than as a result of its actions. Eventually, commodity prices will rise as supplies tighten and global inflation will resume. We aren't looking at the same economy from 10 or 20 years ago, and we aren't likely to see hyperinflation as a result of either QE or low-interest rates. However, there is still a possibility that inflation could be a problem if labor force participation does not pick up and employment rises. For now, there just isn't much of a reason for the real money supply or velocity to increase without a surge in labor force participation, productivity, wages, or a combination of all three - and we haven't even discussed the flaws in inflation statistics.
Back To Gold
Who knows. At what price is gold cheap? I don't know; I don't think anyone knows. Gold is worth what people value are willing to pay for it. The economy doesn't consume gold, and there aren't shortages. Perhaps gold is just considered valuable because it's considered valuable.
Now, to tackle the idea that gold is going to replace fiat currency.
Why Gold Can't Replace Fiat Currency
This answer is relatively clear to me, although I do feel some various opinions have merit as well. However, the simple reason is taxes. Taxes guarantee a demand for currency, in first world economies where regulation is "successful" in stamping out corruption and graft, the local currency is the only method to pay your taxes. Have you ever tried paying the government in gold? Here is an excerpt from an interesting story on someone who attempted to pay his personnel in gold and silver coins.
"The IRS doesn't want this going on; they want you to use their fiat money and be forced into higher tax brackets through progressive taxation coupled with inflation. That way there's no limit on the money they can issue and inflate."
Sure, that statement sounds a bit like a conspiracy theory, but the point remains. The IRS, and the federal government are going to make sure that fiat currency remains the status quo. For fiat currency to end you would need a complete and total collapse of the world economy and government. Until then, you can count on the IRS demanding payment in U.S. dollars, and the fiat currency system remaining in place - despite any inflation that comes or goes.
Gold As A Protection Against Inflation
So if I believe our fiat currency system isn't going anywhere, and I believe the world is logical enough not to destroy the entire system we are all living pretty well on (compared to say, someone in the 1800's), then I don't see much value in gold for wealth protection. In fact, there is always a possibility that gold destroys my wealth in a bear run on the speculative commodity.
The only situation I see value in storing physical gold is if my wealth substantially exceeded my spending needs. If you have so much wealth that you can not possibly spend it in a lifetime, then go ahead and buy a couple of gold bars. It protects you in the extraordinarily unlikely event that the world collapses. It is like buying insurance that protects your home from a nuclear bomb.
It is unlikely you are even going to be around to benefit from the insurance.
At the end of the day, I have zero confidence in my ability to predict gold movements (or anyone to do so for that matter). I trade it occasionally when I see an opportunity or rising fear in the market, but other than that I don't see much value. If the world economy collapses, governments fail, and were all reverted 200 years; I'd much rather know how to grow food and survive rather than have a gold brick to walk around with. At that point, it is probably better to have a gun so you can take someone else's gold brick?
In the much more likely event that governments print currency to rid themselves of debt, or inflation spikes, I am safe in the knowledge that a barrel of oil is still going to be worth a unit of value to someone. The same exists for other goods.
A much better hedge against inflation is stocks (NYSEARCA:SPY). The U.S. government could create money until inflation rises to 100% per year, stocks are just going to go through the roof.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.