Gold As Insurance

Is Gold a Currency Hedge?

Dr. Harvey’s work seems to suggest that gold is not a currency hedge per se. Quoting:

“Exhibit 12 shows how the local currency real price of gold has fluctuated in a number of countries: Australia, Canada, Germany, Japan, New Zealand, Switzerland, the U.K. and the U.S. In each case the local currency price of gold is divided by a local inflation index and the resulting ratio is normalized to an initial value of 1.0. The message of Exhibit 12 is that since 1975 the real price of gold in these eight countries seems to have moved largely in tandem. The real price of gold reached a high level in 1980 amongst all eight countries. The real price of gold fell to a low level in each of the eight countries in the 1990s, and more recently the real price of gold has risen to very high levels in all eight countries. The historical evidence of a seemingly common local currency movement in the real price of gold does not lend itself to a convenient ‘gold as a currency hedge’ explanation. In fact, the change in the real price of gold seems to be lar gely independent of the change in currency values. Furthermore, since the real price of gold seems to move in unison across currency perspectives, it is unlikely that currency movements help in explaining why the real price of gold fluctuates.”

Then Why Buy Gold?

If gold is not a long-term inflation hedge or a currency hedge, and if it produces no income, then why buy it? I can think of three main reasons. First is that the price of gold might go up. It is a very scarce commodity relative to the demand. All the gold ever mined is estimated to be only about 171,000 tons, and less than a third of that amount is estimated to still be recoverable. Overall, gold demand does not seem to vary with price. As Campbell explains:

“The USGS keeps track of estimated annual global gold mine production. Exhibit 18 presents the USGS gold mine production time series, which starts with the year 1900. Annual global mine production has averaged about 2,500 tons per year for the last few years. In 1900, about 30,000 metric tons of gold had already been mined. This means that over 80% of the current aboveground supply of gold has been mined since 1900 and that the aboveground stock of gold has increased by about 1.5% per annum. If global production of gold continues at a rate of 2,500 metric tons a year, and if the USGS is correct in its estimate that there are only 51,000 metric tons of exploitable gold reserves, then gold production will be exhausted in about 20 years.”

There is simply not enough gold in the world that has been mined or will be mined in the next few decades to meet the demand for gold by central banks if they all decide to diversify their portfolios. If the BRIC countries decide to bring their gold-to-currency ratios up to the standard of the US (a standard admittedly declining of late), they would need to find 78,000 tons, not quite half the gold ever mined. If they decided that Switzerland was the “gold standard” for central banks, they would need to buy more than twice the amount of gold ever mined. Neither is possible – and that is just the BRIC countries.

Central Bank Insurance

Which brings us to the second reason to buy gold: “central bank insurance.”

In a perfect world, gold would be a collector’s item, shiny jewelry, or an industrial metal. But this is not a perfect world. Central banks can print money and debase currencies. They don’t have to; it’s a choice, but it’s one that is made all too often.

It seems to me that gold rises and falls in relation to any given currency in concert with general concerns about the long-term viability of the obligations of the government issuing the currency. In the US, the price of gold fell after Volcker slew inflation and then Clinton/Gingrich balanced the budget and the US continued to do so until Greenspan began to openly implement a policy of financial repression at about the same time the Bush administration began to run large deficits and lose control of spending. Then gold rose again, and it has gone up even more as the current administration has showed no sign of wanting to rein in spending.

If I were in Japan right now, I would be buying gold or dollars or anything not denominated in yen. I would not worry so much in Norway, where I will be in a few weeks.

I think there are better investments than gold in terms of future buying power. But I am not certain. At the end of the day, I simply don’t trust the b*st*rds who run this place. (That is supposed to be a laugh line.) I buy gold as insurance against a government and voting population that cannot get its deficit under control and refuses to control entitlement spending. The numbers are clear: the current system is not sustainable.

While I think (hope?) that wisdom will prevail in the face of certain disaster, the history of governments suggests that it will not happen without a crisis. Governments can do foolish things. It is all too possible that governments worldwide will try various forms of protectionism and a currency war in order to try to boost their own exports. That is not a prescription for stable currency valuations. Just in case things don’t go smoothly, I buy a little gold every month.

If the US were to behave responsibly and bring its deficit and entitlement spending under control, then I rather imagine that the dollar would become quite strong over time and that gold would fall in dollar terms. I hope I can decide to pare back my gold purchases next year, as we make good political choices. Right now, that seems unlikely. Taxes are going up, because Republican Senator John McCain and his friends decided not to make the Bush tax cuts permanent back when they were passed. But I see no compromise that will solve the deficit problem. At best, we’ll get maybe 30% of the way there, at least with what I see and hear being discussed.

To get the rest of the way there we will need to see even more tax increases in one form or another. The next phase of deficit control will not be done just with spending cuts and reforms. If you believe it will, I have some swamp land to sell you. The current “compromise” that is being attempted is just the beginning of tax increases, not the end of them. The alternative to tax hikes is that we risk a real fiscal cliff in a few years. If that plays out, I might want to own even more gold.

Finally, let’s assume that we do get a reasonable political solution. Would I sell my gold? No, as it is not an investment, at least not for me. It is insurance against a difficult situation. Can I think of reasons I might sell gold? Yes, but not because things were just so wonderful that I could peer into the future and see a world in which gold would not be needed as a form of insurance against unforeseen events.

I have health insurance, fire insurance, life insurance, and so on. I dearly hope I never use any of them. But I keep buying insurance anyway, because I don’t know the future. And the same rationale is what keeps me accruing gold as a portion of my assets.

What portion should that be? It varies with individuals and their circumstances. When I was younger and made less and had seven kids to feed, educate, and clothe, I had less money available to buy gold. Now I am catching up a little. I tend to buy the same amount every month. I take delivery and put the coins in a vault.

Related articles

• Peter Schiff Update On Fiscal Cliff (ampgoldportfolio.com)
• Is Gold Ready To Explode? (seekingalpha.com)