September 6th, 2012
The False Promise of Gold as an Inflation Hedge
by Michael Edesess, Advisor Perspectives
If you were a time traveler, hopping from one point in history 2,000 years forward or back, you’d best carry with you – if your time machine will allow it – a small stash of gold. Gold has been an effective hedge against inflation over the very, very long term. But that’s about all it’s good for. The other common reasons for owning gold – in particular, to use as a short-term or even a long-term hedge against inflation – are baseless.
Those are among the findings in an interesting and informative article, The Golden Dilemma, by Claude B. Erb, a former investment management company executive, and Campbell R. Harvey, a professor of finance at Duke University. The two examined six arguments that have been advanced by advocates, such as the World Gold Council, for investing in gold.
One of them is that gold is an inflation hedge. On that score, Erb and Harvey uncovered intriguing anecdotal evidence that gold is a long-term inflation hedge. The evidence, however, applies solely to the very long term: 2000 years. For shorter periods – from a year to a lifetime – no support whatsoever exists for the argument that gold is an effective hedge against inflation. On the contrary, gold ownership poses a much greater financial risk than inflation itself.
In addition to the argument that gold is an inflation hedge, Erb and Harvey explored the validity of five other arguments for holding gold: it serves as a currency hedge; it is an attractive alternative to assets with low real returns; it is a safe haven in times of stress; one should hold gold because we are returning to a de facto world gold standard; and finally, gold is “under-owned.” In every case, the evidence advanced by Erb and Harvey strongly refutes the pro-gold argument. In fact, by the time Erb and Harvey are done, there remain only two possible investment reasons for direct ownership of gold: (1) as a risky “momentum” play; and (2) as a hedge against the remote risk of hyperinflation. I will return to these two justifications later.
A brief history of gold
For those fascinated by this particular precious metal, Erb and Harvey provide interesting information about gold supply and demand and gold markets. They report that the total quantity that has ever been mined, and hence the world stock of gold above ground, is an estimated 171,300 metric tons. That would form a cube 67 feet on a side. At today’s prices, all that gold is worth about $9 trillion (compared to about $90 trillion for the total value of global equity and fixed income).
Of the total tonnage, about 80% of it has been mined since 1900; hence, the legendary pillage of the Americas and the resulting gold and gold leaf adorning cathedrals worldwide represents only a small portion of the above-ground gold. Below ground, however, there is not very much left. According to US Geological Survey (USGS) estimates, there are 51,000 tons of recoverable gold remaining; but, like all USGS resource estimates, this represents the quantity estimated to be economically recoverable using existing technology and assuming current gold prices. That outlook could change with improved technology – perhaps the estimated 8 billion tons that reside beneath the world’s oceans, according to Erb and Harvey, could one day be recovered.
Of the 170,000-odd metric tons above ground, about half of it is in the form of jewelry, 12% is used for industrial purposes, and the remainder is owned, in roughly equal proportions, by central banks and private investors. Of the gold owned by investors, the largest single chunk is in the exchange-traded fund, the SPDR Gold Trust (GLD), which holds over 1,000 metric tons, more than 3% of the gold owned by private investors.
For the last 15 years or so, mining has added about 2,500 metric tons (or about 1.5%) annually to above-ground gold supplies. As Erb and Harvey note, however, “mining production has not significantly increased, even though the price of gold has substantially appreciated over the past decade.” Surprising indeed, considering that the price of gold has increased at a rate greater than 15% per year over the last 13 years.
The US government’s official gold holdings peaked at 20,000 metric tons after President Franklin Roosevelt outlawed private ownership of gold in 1933. President Nixon took the US off the gold standard in 1971, but US private citizens had few legal opportunities to own gold until 1975, when gold began to be an actively traded commodity. Since then, official US government gold holdings have declined to 8,000 metric tons. The US is still the largest official holder of gold – Germany, in second place, is far behind at a little over 3,000 tons. China’s official holdings have been increasing, but at 1,000 tons they remain less than the holding of the SPDR Gold Trust. Among developed countries, there has been a desire to reduce gold holdings, but they found that even an attempted sale of a relatively small amount of their holdings depressed the price, so they entered into an agreement to limit the amount of annual sales to a specified small percentage.
The demand for gold jewelry has a normal negatively-signed price elasticity of demand – in other words, demand declines as the price goes up. The demand for technology applications, however, is price-inelastic, while the demand for gold by investors, paradoxically, increases with its price. This is, as Erb and Harvey point out, the momentum effect.