This article is from 1997 and is still worth reading today, as it will help you understand the realtionship between gold, US dollar and inflation.
Introduction
Gold has been a poor investment for many years. This is a statement which is almost universally accepted in today's world, but one which is only partially true. The truth is that gold has been a very poor investment when measured in US dollars, but has generally proven to be a sound investment when measured in terms of almost any other national currency. The Indians and the Chinese, the world's largest buyers of gold, have seen the value of their gold investments increase by approximately 200% over the last decade. Due to a collapse in their national currencies, South East Asians and Koreans have also seen the value of owning gold .
The US dollar reached a cyclical low in April 1995, from which it has risen over 50% against the Yen and 30% against the Deutsche Mark . This means that German and Japanese investors who exchanged their national currency for gold in April 95 would now be showing a profit on their investment, despite a 21% decrease in the US dollar gold price over the same period.
What we have witnessed over the past 2.5 years is a massive shift of investment capital into the US dollar from all other currencies, including gold. Investors around the world have placed enormous faith in the US dollar and, therefore, in the US economic, financial and political system which supports the dollar. Gold has been a victim of this flight to the US dollar, although it has fared better than many of the government controlled forms of money.
With the US dollar continuing to strengthen as capital flees from EMU-generated uncertainty in Europe and debt-based currency crises throughout Asia, why should anyone invest in gold ? Why not just invest in US dollars and US dollar denominated assets ? In my opinion, there are only two reasons to invest in gold.
Reason # 1 To Own Gold
Many supporters of gold continue to put forward the argument that Central Banks are controlling the gold price. The reason for the popularity of this argument appears to be the misconception that the demand for gold exceeds the supply of gold. After all, if the demand for something does exceed its supply by a substantial amount and for a long time, and the price goes down, then it is logical to assume that there must be dark forces at work to manufacture this unreal situation. The problem is, whenever you start from an incorrect premise and then develop your arguments based on flawless logic, you must necessarily arrive at the wrong conclusion.
Perhaps it is hard for goldbugs to accept that gold is a genuinely unpopular investment at the moment when compared to the all-conquering US dollar. However, the fact is that net CB sales of gold over the past few years have been small. Gold loans by CBs have probably had some effect, but the over-riding factor is that private investment demand for gold has reached its lowest point since 1971. Until there is an increase in this demand then the above-ground stock of monetary gold, more than 60% of which is held in private hands, will be an available source of supply.
Just as it is wrong to think that the supposed annual deficit in gold supply (the difference between newly mined supply and commercial demand) will lead to a higher gold price, it is equally wrong to think that the above-ground stock held by the CBs is necessarily sufficient to meet demand for many years to come. Trillions of dollars of investment capital is moving around the world each day searching out stability or protection or investment returns. If confidence in financial assets and government controlled currencies was to significantly reduce, then the total gold reserves of all CBs (worth 320 billion dollars at current gold prices) could be absorbed in an instant by private investors.
Government controlled currencies are liabilities of the monetary agents and are backed by debt. Their value is hence based on the level of confidence in the financial and political systems and their rates of exchange tend to oscillate daily based on changes in this confidence level. For example, if doubt arises regarding the quality of the debt which provides the asset backing for a currency, then capital will shift from that currency into an alternative investment. Gold, a tangible asset which has been valued as a store of wealth for thousands of years, provides an ideal alternative.
Those who are advocating the CB conspiracy theories are failing to appreciate a very important point : The primary reason to own gold as an investment is because it is not controlled by central banks and governments.
Reason # 2 To Own Gold
The second reason to own gold is a corollary of the first. The debt which forms the asset backing of a national currency can be split into two groups - private debt and government debt. The quality of private debt will reduce if the cashflow of the borrowers is insufficient to meet the repayments and /or the value of the underlying security for the loan (real estate, shares, etc) becomes less than the amount of the loan. This is the situation which Japan has faced since 1990 (lending based on collateral rather than cashflow followed by a substantial reduction in asset values has resulted in huge, non-performing private debts). Large scale defaults on private debts will force asset sales, pushing down asset values even further, and stop new investment . Liquidity will thus be removed from the system and interest rates will fall to a point where investment once again becomes feasible. The process is self correcting unless, of course, the government tries to help.
A different set of rules, however, apply to government debt . These rules can begin to be understood by first reading the following explanation of central bank powers taken from a speech given by Alan Greenspan in January of this year :
"Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank. That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency."
As Greenspan points out, a government can never run out of its own currency. Therefore, the cashflow of a government will never be insufficient to service its internal debt. It can simply create as much money as it needs through the issue of new debt. It should also be noted that governments never have to concern themselves with the value of the assets used as security against their loans, because there are none. The asset which backs all government debt is the full faith and credit of the government.
A problem for a country occurs when new money is created at a consistently greater rate than the increase in the supply of tangible assets, resulting in rising prices, reduced demand for financial assets, and increasing interest rates. This situation arises as greater and greater levels of debt are needed to sustain a stock market or real estate bubble, or to pay for government/business expansion, or simply to service the repayments on existing debt (both private and government).
Throughout history people have accumulated precious metals to defend their wealth from destruction as every form of paper currency ever created has been devalued through inflation. This is the second reason to own gold :
Gold is the only form of money which has maintained its purchasing power over a long period of time
Continue reading: Gold Versus The Dollar (Part Two)
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