Guest Post: Gold As a Hedge: A Back-of-the-Envelope Calculation

Tyler Durden's picture

Submitted by Charles Hugh Smith from Of Two Minds

Gold As a Hedge: A Back-of-the-Envelope Calculation

How much gold would an individual investor need as a hedge against the total depreciation of fiat currencies? Here is a back-of-the-envelope calculation.

My view that gold is a prudent hedge is well-established in my archives. For example, from 2006: Gifts and Gold (December 9, 2006) (promoting the idea of giving gold as a gift):

Recently, another friend asked if I was a "gold bug." I said, no, I wasn't. But I did say I thought it prudent to own some actual physical gold and some mining stocks or a gold ETF, and maybe some silver if you follow that metal or consider gold and silver roughly equivalent. As shown here this week, all currencies are declining against gold. Nuff said.

Beneath the Surface, Part III: The Dow and Gold (November 29, 2006)

From approximately 1980 through 2002, the ratio of the Dow and gold moved in sync (i.e. was in correlation) with the Dow Jones Industrials. But since the market low in 2002, the two have radically diverged.

Now it is always possible that a historic correlation has been broken. But it behooves those of us trying not to lose whatever capital we might have in this world to consider an alternative: that the divergence will return to convergence.

(Discussion of how this could be achieved: either the dollar strengthens or gold rises.) The likelier possibility is a collapse in the dollar and a doubling of the price of gold.

At the time that was written, the gold/Dow ratio was 20--now it is 8.3 (Dow 12,500, gold $1,500). In other words, the divergence has only widened.

This raises an interesting question: how much gold would be needed as a prudent hedge against the total depreciation of fiat currencies? I recently conducted a back-of-the-envelope thought experiment on this topic in the Weekly Musings (for subscribers/major contributors).

Here is an outline of the thought experiment and calculations. Please note this is NOT A RECOMMENDATION TO BUY OR SELL ANYTHING, it is a thought experiment presented as "food for thought." Please read the HUGE GIANT BIG FAT DISCLAIMER below.

Starting point assumption: There is some probability (low or high is a matter of judgment) that as a result of the fundamental imbalances in the current global financial system, all fiat currencies will depreciate to near-zero. This is also referred to as hyperinflation or loss of faith in paper money.

A persuasive case can be made that this is not a probability but the inevitable end-game of the Status Quo: Deflation or Hyperinflation (FOFOA).

A 27-page analysis Apropos of Everything, Parts II & III reaches the same conclusion, while also making a strong case that the only functional, practical choice as a replacement for debased paper currencies is a gold-backed currency.

I have been persuaded of this since reading Gold: The Once and Future Money by Nathan Lewis, who has kindly corresponded with me on a variety of topics.

This book is an extremely readable history of money, gold and the politics of monetary policy as well as a carefully reasoned explanation of why gold-backed currencies provide stability. (Some argue that the 19th century booms and busts prove this wrong, but those booms and busts were credit-based. But I digress.)

I have also speculated here on the possibility that the private sector would lead the way to gold-backed currencies by establishing a non-State gold-backed "note."

Some readers have said that gold itself is money, but this isn't the point: the point is that trade over great distances requires a trusted medium of exchange, be it "commercial paper" or some other promissory note that can be exchanged to buy and sell real goods. This has been true since the rise of modern capitalism in the 1500s. (For more on this topic, please read this wonderful three-volume history of early Capitalism: The Structures of Everyday Life (Volume 1)
The Wheels of Commerce (Volume 2)
The Perspective of the World (Volume 3)

The point here is that there is a possibility that all fiat currencies will experience a loss of faith/rapid depreciation as the Status Quo devolves. Please read the above article links for more.

You don't have to judge this as likely to consider a hedge, you simply have to assess it as possible.

So how much gold would a household need to hedge their paper wealth against depreciation? In Apropos of Everything, Parts II & III Paul Brodsky reckoned that gold at $10,000 an ounce would enable the U.S. to back its current money supply with the 256 million ounces of gold it holds in reserve.

That is one rough approximation of how much gold one would need to hold to hedge paper financial assets. If gold were to rise 6.6-fold from $1,500 to $10,000, then $10,000 of gold at today's price (6.6 ounces in US dollars) would hedge $66,000 in paper financial capital.

In other words, after the dollar (and other paper currencies) fell into the black hole and disappeared over the event horizon, then the 6.6 ounces would be equal in purchasing power to the $66,000 in paper assets that just vanished.

I know there are many other complicating factors, but this is a rough calculation.

I reached a different conclusion by following the idea presented by Brodsky that gold-backed money would have to equal all the current paper money.

First, let's take all current financial net worth (assets minus liabilities) in the U.S. which according to the Fed Flow of Funds is about $35 trillion. (Net fixed assets such as real estate are about $10 trillion.)

Total financial assets are $47 trillion, but these include corporate equities and non-corporate business assets which include factories, production facilities, etc. owned by the corporate and non-corporate enterprises. These tangible assets would still retain their utility value after the "event horizon" depreciation, so I don't think they should be included in purely paper financial assets such as stocks based on "blue sky," bonds based on future promises of payment, etc.

If you disagree, then take the $47 trillion number as a starting point. Or if you reckon corporate profits are an income stream that will retain value after a fiat currency depreciation, then feel free to adjust the financial assets down to whatever number you think approximates the financial wealth that would be lost in a stick/slip "black hole" currency depreciation.

The U.S. has about 25% of the world's wealth, so let's multiply the $35 trillion in purely financial capital by four: thus the global economy has about $140 trillion in purely financial wealth (pension funds' holdings of blue-sky stocks, bonds, etc.)

Once again, this is all back-of-the-envelope.

There are about 5.3 billion ounces of gold "above ground," roughly 160,000 tons. At the current price of $1,500 an ounce, all the available gold is worth about $8 trillion. About half is in jewelry, 10% in industrial uses and 40% as central bank reserves and investment.

If gold took the place of fiat currencies as "money," the available gold would have rise to about $140 trillion in value. In today's dollars, that's about 18 times its current price. So $1,500 X 18 = $27,000 an ounce.

Let's round that off to $25,000 an ounce. (Feel free to round it up to $30,000 if you prefer.) If you prefer to subtract industrial gold or other uses from the calculation, then the number will be much higher. I am presenting the idea as simply as possible.

To hedge $250,000 in paper financial wealth (recall that productive real estate, windmills, factories, etc. would still retain their productive utility value after currency depreciation), you would need 10 ounces of gold, or $15,000 worth at today's prices.

Though we cannot be sure of much in the world, we can be fairly certain that gold will not go to zero value. Thus owning gold is not like owning a futures contract which expires.

Let's say total fiat currency depreciation never occurs, and instead gold falls 50% in dollar-denominated value to $750/ounce. Many consider this very unlikely, just as others think a loss of faith in the dollar is a near-impossibility. Both are possibilities, regardless of the odds anyone places on them at any one moment in time.

Then the hedge against complete destruction of paper money would have cost $7,500, in "opportunity cost" if nothing else. That's a relatively modest price for $250,000 of "portfolio insurance" via a hedge that doesn't expire.

To complete the thought experiment: it doesn't really matter if the "new dollar" or quatloo are whatever is backed by gold or not; it might be a "hard currency" based on limited circulation, or some other scheme. The point is that if the present currencies suffer significant depreciation, then gold will reflect that.

In other words, if one "new dollar" replaces 20 devalued dollars, then gold will be worth 20 X $1,500 or $30,000 an ounce when the "new dollar" is imposed. Gold needn't be the "official money" at all to act as money.

Is now a good time to establish a gold hedge? I have no idea. I have no idea what will happen, tomorrow or next year or five years from now-- to the price of gold in dollars, to the value of dollars in other currencies, or anything else for that matter. Me only pawn in game of life. The thought experiment is an exploration of hedging, it is not a speculation on the future price of anything.

Please note this is NOT A RECOMMENDATION TO BUY OR SELL ANYTHING, it is a thought experiment presented as "food for thought." Please read the HUGE GIANT BIG FAT DISCLAIMER below.

HUGE GIANT BIG FAT DISCLAIMER: Nothing on this site should be construed as investment advice or guidance. It is not intended as investment advice or guidance, nor is it offered as such. It is solely the opinion of the writer, who is NOT an investment counselor/professional. All the content of this website is solely an expression of his personal interests and is posted as free-of-charge opinion and commentary. If you seek investment advice, consult a registered, qualified investment counselor (As with any other professional service, confirm their track record and referrals).

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Magnix's picture

Well, Ill keep buying gold nuggets (and silver) to reach a ounce and because they're affordable!

Dr. Richard Head's picture

GOLD IS IN A BUBBLE!!!!! /sarc

DoChenRollingBearing's picture

C H Smith and Rick Ackerman have moved closer to FOFOA's view.  Smith referenced FOFOA's latest article above.  The article is long and dense, but stuffed with mind-blowing observations...

In the comments section of FOFOA's article, you will note both Smith and Ackerman commenting positively on FOFOA.  They have become converts...

IMO FOFOA is right.  If you do not have any, get some physical gold.  If you plan your affairs right, it will carry your wealth through the coming hyperiflation or whatever.

Shell Game's picture

Smith referenced FOFOA's latest article above.  The article is long and dense, but stuffed with mind-blowing observations...

Couldn't agree more, Sr. Bearing.  FOFOA's latest essay held many epiphanies.  Sad that most humans on this earth have had little to no schooling in money, and far too few have searched out these lessons on their own.  FOFOA is one of the finest sites for understanding money that I've found.


Ignatius's picture

"The road will seem so straight and fair to travel, you will kick yourself for stumbling through the brambles for so long, and wonder at your neighbors who still can't see the path, though it is truly a freeway." (Aristotle, courtesy of FOFOA)


FOFOA has few peers on the subject of money and gold.

malek's picture

Yep, and even Mish and Karl Denninger have stopped declaring gold buyers/owners to be completely nuts. While they're not yet promoting gold ownership, it is a big step, and in the right direction in my opinion.

Whizbang's picture

If there is a full devaluation of fiat currencies down to 0, your gold will be less valuable than lead, which actually has uses in the real world. Get real you clowns

SheepDog-One's picture

I agree, this theory that the present valuation of world fiat currencies $140 trillion will be made whole by a rise in gold to $30,000 an ounce is totaly ridiculous.

Upon fiat USD world reserve currency replacement, gold will be valuable only to melt down and cast bullets.

chumbawamba's picture

Yours and Whizbang's are rather narrow, shallow, uninformed and unedcuated views of gold.  You know not of what you speak.

I am Chumbawamba.

FeralSerf's picture

Gold is a better material for bullets than lead due to its greater density.  Tungsten is good too.

He who has the best bullets (and delivery mechanisms thereof) wins.

Stuck on Zero's picture

Deplete Uranium is the best.

bonin006's picture

Tungsten is hard, much better for armor penetration than lead or gold, but will wear out your barrel. A thin lead (or gold) plating on the tungsten will fix this. 

dbach's picture

Are you suggesting that without a fiat currency we will revert to bartering? That there will be no medium of exchange?

SheepDog-One's picture

Its amusing to me how people have no placated themselves into believing a USD world reserve currency default is nothing, and we'll just get some equally valued 'gold backed' paper exchange at 1:1 face value some morning and we all just go on like nothing at all happened. Truely a sick, braindead, stupid nation.

Re-Discovery's picture

We get it.  'Gold is useless'.  'Silver is a joke'.  We are just idiots who never learn.  It's to the point where you guys should stick to your theses, and we will with ours.  I NNNEEEEDDD people like you.

SheepDog-One's picture

I never said gold wouldnt rise, it probably will quite a lot. But $30,000 an oz? Thats to match up with the present or perceived 'value' of all this paper floating around...theres never going to be $30,000 oz coins upon a USD default. And well before a dollar default PM's will be declared illegal and confiscated anyway and to all those who say that wont be 'complied' with ust look how panicky everyone got over a few % drop in PM's.

chumbawamba's picture

Again, your views are ignorant and uneducated.  Perhaps you should read some history (there's 5000 years of it for your perusal) before you make such comments.  I'd explain where you're wrong but you wouldn't understand anyway.

I am Chumbawamba.

FEDbuster's picture

Right now an oz of gold will buy 1 AK47 ($400), 1000 rounds of 7.62x39 ($225), a good Katadyn water filter ($175), years worth of inexpensive storage food staples ($600.) and you can put together an ok first aid kit for $100.  If the S really HTF, those items won't be available for any price, let alone an oz of gold.  Gold requires some level of rule of law, a supply chain of goods and an easy way to determine it's value.  Investing in gold is a "systems up" investment.  I am not an anti gold guy (I own some), but in a complete economic crash I would rather have the five items listed above than an oz of gold.

Another way to think about it is if I unable to procure food and water any more, would I trade my limited food and water for your gold?  Hell no.  With no means of finding out what "spot" is for gold, would I trade anything of practical value for gold?  No.  If you haven't read the book "The Road", you really should.  It takes you to the place where gold has no value, but a good pair of boots are priceless.

chumbawamba's picture

Right, because the world is always either black or white.  When it's not white, it's black.  And when it's not black, it's white.

I know these things, okay?  That's why along with my gold and silver I also have an armory, ample ammunition to supply the various weapons within, stores of seeds and a greenhouse to grow food year round, etc.

Unless you plan on living in Bartertown forever, things do eventually reorganize, and there will ALWAYS be a place where your gold has monetary value.

If you want to sit here and argue pedantics then count me out.  I have more prepping to do.  I need to go stockpile history books to hand out to all the doe-eyed Mad Max's that will be passing by my farm on their way to Morrow Morrow Land with a flock of mostly prepubescent children, bookmarked to the chapter after the great cataclysm where things get rebuilt.

I am Chumbawamba.

tmosley's picture

Yup, it's called "utility".  Having one AK47 is as good as having a hundred, if it's just you doing the shooting.  However, there is no loss in utility from having more gold or silver.  

Other things SHOULD be bought first, but they only need to be bought once.  Gold and silver can always be accumulated.

And yes, anyone calling for an end to trade (the only situation where gold would have no value) is a moron.  As long as there are more than two people in the world, there will be trade.  As long as there are more than a few thousand people in the world, they will use gold as currency (if they aren't fools).

goldenrod's picture

Why does it have to be one extreme or the other? Either we all drive SUVs to Starbucks for a latte or it is Mad Max.  I think it is going to be something in between.  Excessive debt, peak oil and a declining currency will reduce the standard of living of more and more people.  Gold protects your assets from currency debasement.  That is all.


writingsonthewall's picture

Try trading your lead for a boat trip out of the country fool. I'll get passage with my gold while you're still trying to sell your ass for a space in the hold.


Captialists know the price of everything and the value of nothing....the problem is the 'price' is in 'toilet paper' - which their linear brains cannot handle!

tmosley's picture

Again, here is your problem--you can't tell the difference between capitalism, which is what you are practicing (since gold is capital), and socialism, which you accuse the other of practicing (ie extracting a boat ride at gunpoint).

Your little head is all twisted up.  But at least your actions are correct.

trav7777's picture

If there is a full devaluation of fiat currencies down to 0, your gold will be less valuable than lead, which actually has uses in the real world.

This is just idiotic nonsense...the largest economy south of the border and 5th most populous country on the planet, has seen COMPLETE devaluation of more than one currency just in the past couple of decades.  There has been no time at which fucking bullets and the use thereof are a substitute for anything.

Al Gorerhythm's picture

There has been no time at which fucking bullets and the use thereof are a substitute for anything.

How about civility, honesty, integrity, responsibility. 

Nate Taggart's picture

OK, then buy silver, unless you think the entire electronics industry (and most other industries) is going to find a replacement.  

Al Gorerhythm's picture

@ Whizbang,

I don't think that there will be a cataclysmic full devaluation either (A-la Zimbabwe) but you can't deny a possibility.

The game play is to rely on the delivery success of the adage (a belief that a statement must be true because of the duration of its use): Paper currencies carry enduring intrinsic value. 

A cursory investigation of the performance of ANY paper currency, proves the adage to be thoroughly unsubstantiated. A telling and enduring negative performance indicator is the demand interest rate that is tied to paper currencies. It is a risk demand variable, calculated in the pursuit of returns that eliminate purchasing power loss over time, when saving or extending credit. Par value risk, Option Theory 101.

The current volatile erosion of purchasing power (see USDX) is a measure of over-supply, instilling a valid a loss by credit holders, in the "Good Faith and Credit" of the issuers.

Central currency issuers realize that through their oversupply, if there is a complete loss of trust, creditors will demand tangibles as settlement for their credit notes.In other words, they demand immediate and full settlement, not payment.

In order for the issuers to maintain the illusion of value (as delivered to the masses) and to satisfy creditors, the issuers won't default completely. They will promise to pay more via higher interest payments or cash payments, (creditors taken care of) and revalue their reserves (numeraire) which just happens to be the gold.

Gold is the foundation that supports the bridge, interest rates are the keystone that completes it. Gold has to and is being revalued, so that reserve ratios allow credit to be extended (a balanced system). That's what is happening, steadily, inexorably, drip by drip until it is worth the risk to carry credit on the books, against income. Smart creditors purchase gold in anticipation of its revaluation. When risk ratios are thought to be fairly balanced, gold will be exchanged for paper.

You seem to be convinced that these issuers are delivering reasonable returns on their notes. I see over-issuance, ergo a loss of my faith in their good credit. Honesty is a hallmark and measure of good faith. After the GFC, I don't see anyone in chains, other than a couple of bit players. I'm asking for a return to honesty in dealings with these issuers and am abandoning them until I see the evidence to the contrary.

Your opinionated statements, supported by ad hominem attacks, make for shallow or thin deliberations. Show some substance.

mule65's picture

Avoid Stocks.

- Tyler Durden

Tyler Durden's picture

the circularity of CDS shorting... this one should make your head
explode... This has long been perceived as the FED's very last
recourse. Maybe one should really start buying stocks ahead of the
uber-hyperinflation that will imminently ensue. We recommend wheelbarrow
stocks.This is textbook back against the wall. But at least the stock
market takes another crutch up." March 18, 2009 - Tyler Durden, on the start of QE1, and since which precious metals have outperformed stocks by about 2.5 to 1
Ignatius's picture



In light of Ackerman's and Smith's recent bow to FOFOA on the issue of hyperinflation, do you think you might consider adding FOFOA's blog to your links? His most recent post (4/23) on the Hyperinflation/Deflation debate is a gem.

SheepDog-One's picture

OH snap, mule ass-rammed.

writingsonthewall's picture

"HUGE GIANT BIG FAT DISCLAIMER: Nothing on this site should be construed as investment advice or guidance. It is not intended as investment advice or guidance"


Too late - I just bought all the gold in Fort Knox...


....which is nothing, just an empty warehouse.


Here is some investment advice you should all heed.

"FIAT currencies always fail"

Here's the historical evidence.


Past perfromance DOES lead to future failure.

SheepDog-One's picture

You bought the WHOLE 5 oz of gold plating in Ft Knox?

Hephasteus's picture

Well you can sell it 20,000 times and get the money each time and then charge people storage fees. It's a fraud that has been going on since the 1600's. It just changed from run out of town to kill everybody.

Long-John-Silver's picture

Why would anyone buy Gold plated Tungsten?

Sudden Debt's picture

As a paperweight it does look cool :)

I have one on my desk.

FeralSerf's picture

I have a tungsten plated gold paperweight on my desk to discourage thieves and other gov't agents.

SheepDog-One's picture

Assumes that the PRESENT 'value' of fiat currencies will be matched by a rise in gold to match it? Nonsense, gold may become a backing of a world currency, but the value of currency in the world will be far smaller than it is today. This article jumps off on the wrong foot. Gold will rise to match $140 trillion in value to replace present fiat currency, or $30,000 an ounce? Gold will rise, but thats just retarded.

Long-John-Silver's picture

Please Google "Zimbabwe Inflation" and tell us again how $30,000 an ounce Gold is retarded.

DiverCity's picture

Folk like SheepDog, even though I well agree with him that we face a looming financial collapse (or indeed have already functionally collapsed), have a mental block because their reference point is USD.  Hence, $30K/oz. of gold to them looks like an outlandish figure.  But that's what's really retarded -- the notion that $30K will buy a whole hell of a lot after revaluation.  Free your minds, grasshoppers.

SheepDog-One's picture

Well thats what Im saying, in effect. Its not ME who doesnt see the currency issue for what it is, its after the USD is replaced by whatever, we have nothing. Not $140 trillion in newly valued gold, just a banana republic without even bananas to sell.

Guys, youre never going to be trading coins at the store for $30,000, upon a USD default, people will be using coins as slingshot ammo or melting them down to cast bullets. This 'pain free world reserve currency default' scenario is for the birds.

DoChenRollingBearing's picture

SheepDog, I normally agree with almost everything you write.

But, not on this.  If/when gold has its big move (when paper gold dies), I may buy the two gas stations in the town I live in with my $55,000 gold...  Or the maybe nearby toll bridge...

If I do not BUY anything big, then my gold will go to my child (or grandchildren in the future?).

I certainly will not be taking my gold coins to the coin shop for fiat.

FeralSerf's picture

It's too bad that the gas stations will be out of gas by then.

dussasr's picture

I'm long term bullish on PMs and bearish on the dollar, but I am with Sheepdog on this one.  The PMs will only go up for so long until they are confiscated by the govt or some firebrand politician starts WWIII or maybe both.  The desirability of holding gold reaches its zenith at precisely the same moment that holding it becomes illegal.

You can't just change from one economic paradigm to a completely different one without the high likelyhood of violence.  There will be too many unemployed/hungry people looking for vengance and someone to blame for their condition.  Who will they target?  Well the "evil" people with the gold of course!

trav7777's picture

can you point me to where the fuck else gold has ever been illegal?

I mean I look through a ton of hyperinflations and I don't see it...

dussasr's picture

As soon as people begin to loose confidence in fiat they try to dump it for gold.  In a futile attempt to prevent that the government outlaws gold.  They follow the same play book every time.  Argentina, Mexico, and the US have all done it.  I don't have the exact number but gold ownership is still illegal in some 40 or 50 countries today.

trav7777's picture

huh???  When the fuck did this ever happen in Argentina or Mexico?

Name the 40 or 50 countries.

Long-John-Silver's picture

Here is how every post currency collapse economy operates.


Merchants pop up and setup general stores.

They set up a TAB system where you bring in goods where-by your TAB is credited.

As you buy goods your TAB is taken down.

Merchants like Gold and Silver because they can pay to have large amounts of goods shipped in.

Services will be included in this system. Say you are a mechanic and repair all sorts of stuff that can't be replaced now. The Merchant backs up your labor charging the customers TAB while adding to the mechanics TAB. In effect the merchant is a bank as well but is using goods and services instead of the failed currency.

LRC Fan's picture

Sorry but this sort of logic doesn't work on idiots.  How many Germans do you think would have agreed if you warned of $1 trillion marks for an oz of gold?  They would have laughed you out of the room.  It's the same thing now.  I try telling friends/family silver and gold will go absolutely to the moon in terms of dollars, and eventually won't be available for dollars and they laugh right in my face.  They actually think higher prices are good, because it's all proportional and our wages/stock market "winnings" go up too, so inflation doesn't matter.  We'll see, when gas hits $5 then $6 and then $50 in short order, who is right.

Also everyone laughs if you mention Zimbabwe, saying "that's a 3rd world country" or something stupid.  When I bring up the fact that it makes our situation of trillion dollar debts and deficits that much worse, since it will bring down everyone else, their eyes glaze over.  Just keep buying silver and gold while you still can score them with dollars.  Eventually everyone will be forced to wake up, and then gold and silver will go "offerless" as Tyler mentioned yesterday, at least in terms of US dollars.