One of gold’s allures is its use as a hedge against negative economic outcomes: inflation, deflation, general economic collapse and even war [with] investors and speculators enter[ing] the market based on their guesstimate of how bad things might get. [An analysis of] how gold performs during inflation and deflation [suggests, however, that there has to be some other] market force – some secret force – that has driven gold prices up so much over the last 10 years.
This article is an edited ([ ]) and revised (…) version of the original written by Hans Wagner to ensure a faster & easier read. It may be re-posted as long as it includes a hyperlink back to this revised version to avoid copyright infringement.
A Hedge Against Inflation?
Many investors see gold as a way to protect their assets against inflation. However, time has shown that this is flawed logic. Looking back at history, had gold kept pace with inflation, it would be selling at more than $2,000 an ounce today. Currently, it’s trading just above $1,250…If gold were a good hedge against inflation, it would have traded at or above the inflation-adjusted price, not its nominal price. Moreover, during the last 30 years, gold substantially lagged behind both the S&P 500 and bonds (as measured by the Merrill Lynch Bond Index).
Conclusion: Historically, gold has not held its value during times of inflation. If you owned gold when inflation rose, your net worth did not keep up. Compounding the problem, gold does not generate cash flow and it incurs an ongoing cost for storage and insurance. All these add up to a poor hedge against inflation.
A Hedge Against Deflation?
The last remaining official link between gold and the U.S. dollar ended in 1971. We have not had an occurrence of deflation since [a fall in] the total supply of money and credit [which] often leads to a drop in the general price level so it is difficult to draw any historical conclusion on how gold might react given our current currency. However, we are able to draw some strong conclusions by looking at silver’s performance in the U.S. during the Great Depression and gold’s performance against the Yen after Japan’s credit bubble burst.
In the U.S., the price of silver in 1932 (the peak of the 30s deflationary spiral) was -50% below its price in 1929. If the price of silver fell during the deflation of the 30s, it is reasonable to assume the price of gold, a similar commodity, would fall as well during a period of deflation.
While Japan did not experience actual deflation, the country’s money supply fell from a double-digit rate in late 1989 to the 2% range in late 1990. the price of gold in Yen terms trended down throughout the first half of the 90s. Had there been actual deflation as the money supply contracted, the price of gold would have fallen by at least as much. [That is] not much of a hedge against deflation.
Conclusion: Indeed, if deflation does occur, there is some evidence to say the price of gold will fall rather than rise, as many expect.
The Secret Factor Propelling Gold Prices
Gold is really a hedge against the loss of confidence… [according to] Nobel Prize winning economist Paul Krugman [and] it is a lack of confidence that leads to a currency crisis. When investors lack confidence in a currency, they turn to other forms of investment. Gold is definitely the place to seek safety if you believe there is a growing crisis of confidence.
The Bottom Line
It does not make sense to assume gold can act as both a hedge against inflation and deflation at the same time. Rather, gold is more suited to act as a hedge against a loss of confidence in the economy or a currency.
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