Submitted by Tomas Salamanca of the Ludwig von Mises Institute of Canada [9],
The last two years have been disappointing for gold investors and what happened this week to the yellow metal epitomized the frustrating price movement. After the Fed startled the markets by announcing that it was going to continue with its current rate of bond purchases, gold shot up from just under $1300 an ounce to $1370. But late Thursday, it started to back off somewhat from those gains before falling sharply on Friday. It ended the week at $1325, virtually unchanged from the prior week.
How can that possibly be? It has, after all, become more evident that the Fed is politically hindered from turning off the money spigot. If gold can’t stay elevated on that development, what hope is there going forward that it will resume its decade-long uptrend and eventually overtake the 2011 high of $1900 per ounce? And so why bother investing in gold?
Yet the case for investing in gold does not depend on the market’s reaction to the Fed’s latest doings. For a trader in gold — someone looking to profit from taking a position over a period of days or weeks — it certainly would. An investor, by contrast, has a longer time horizon — years, if not decades. For the investor, whether or not to buy gold necessarily entails forming a judgement about the larger and more enduring forces that impinge on its price. Is our politico-economic system, in other words, congenitally disposed to the cheapening of the currency?
Those who invest in gold basically answer yes. And they have very solid grounds for that stance. In the democratic polities that prevail today in the developed world, politicians have very strong incentives to run budget deficits. For the way to maximize votes is to spend money on benefits for the public and then to simultaneously minimize the taxes levied to fund those benefits.
Propelling this dynamic along is that the economies of developed nations have liquid bond markets in which government debt securities, whose safety can be believably affirmed by the state’s power to tax, are eagerly sought by risk-averse investors. In this way, the bond market greatly relaxes budgetary constraints on politicians, being equivalent to a payday loan provider that ensnares a spendthrift individual into amassing a huge debt. When this debt becomes unsustainable, and the bond market finally acknowledges the mess it enabled, politicians must decide between imposing fiscal austerity or printing money to pay off the debt. The latter is the politically more attractive option, especially as the resulting inflation can be blamed on private industry. The recognition of this inflationary tendency built into our politico-economic framework is what constitutes the case for investing in gold.
Nor is this all just idle theorizing. The logic of a democratic inflationary bias is well illustrated by the historical experience since August 1971. This is when the last remnants of an external constraint on money supply creation was done away with by President Nixon’s closing of the gold window. Before then, the U.S. government stood ready (at least vis-a-vis other central banks) to exchange dollars for gold at $35 per ounce. How would someone, aware of the long-term inflationary threat that Nixon’s decision posed, have done had they invested in gold at the time and held it until now? The answer [10] is that they would have generated an 8.7% annualized rate of return.
Compare that to investing in stocks. Let’s say you invested in the S&P 500 index over the same time frame. Now one big difference between investing in gold and stocks is that the latter pay dividends. So to make our comparative test of gold even stronger, let’s assume one reinvested the dividends in the S&P 500. How much would such an investment in the S&P 500 have returned? The answe [11]r is 10.2%. Yes, that’s 1.5% more than gold, but with shares one is actually betting on a group of private companies’ ability to generate profits. With gold, one is simply looking to preserve purchasing power over goods and services. To have only sacrificed 1.5% for this more modest aim has arguably been a good deal.
Or let’s pit gold against government bonds. What we are comparing here is actually closer. Like gold, government bonds do not involve a play on future company profitability. Their yield is supposed to cover the time value of money as well as compensate for expected inflation. So how would an investment in 10 year US treasury securities, with a reinvestment of their coupon interest payments, have performed from 1971 until now? The annualized rate of return was 7% [12]. That’s 1.7% less than holding gold.
[13]
Over the past forty two years, one would have been better off holding what Keynes called the barbarous relic than what are commonly described as the safest securities in the world. Unless there is a tectonic change in our politico-economic structure — such as a return to a hard money standard — it’s hard to see how this will change.