Putting the Gold Price in Perspective

July 22, 2008 – I wrote the following article for “Information Line”, published by Michael Checkan and Glen Kirsch, the proprietors of Asset Strategies International, Inc. in Rockville, Maryland, www.assetstrategies.com.

The first thing people usually consider when buying gold is its price, but unfortunately, they are grabbing the wrong end of the stick. Price is of secondary importance. To explain why, one has to examine the reasons for buying and holding gold.

The motivation to buy gold is usually driven by the pursuit of some defensive financial strategy. For example, gold is a proven and time-tested inflation hedge, so people acquire gold if they believe inflation is likely to worsen. This defensive strategy aims to protect your purchasing power because with gold you hold sound money instead of some inflating national currency.

Another defensive motivation to acquire gold is its unique attribute of being money with no counterparty risk. This significance of this risk was highlighted by the bank-run at Northern Rock in the UK last year and more recently, Bear Stearns in the US. People withdrew their money from those banks because they recognized that their ‘money’ was only as good as the financial capability of those banks to make good on their promise. In contrast, gold is not dependent upon a promise because it is the only money that is a tangible asset, and not an I.O.U. of some financial institution.

Another reason people focus on the price of gold is because they consider it to be an investment, but it’s not. Investments generate rates of return because you put money at risk, for example, by lending it or buying equity in a company. If the investment is successful, you will generate a return, increasing your wealth. But gold doesn’t do this. Gold preserves wealth; it doesn’t increase it.

For example, one ounce of gold purchases approximately the same amount of crude oil today as it has at anytime over the past 60 years. Who would want an investment like that? Gold hasn’t generated any rate of return. It hasn’t given its holders the opportunity to buy more crude oil. But because you can still buy essentially the same amount of crude oil, an ounce of gold has done exceptionally well at protecting wealth by preserving purchasing power, which is what money is supposed to do.

Money is a temporary store of value where we place a portion of our wealth while we decide whether to spend, invest or save (hoard) it. So when we hoard gold, we are in fact saving money until that moment in time when we decide to spend or invest it, which brings me back to my basic point.

Does one question the price (i.e., purchasing power) of dollars before choosing to open a savings account? No, of course not. Savings represent the portion of one’s accumulated wealth held as liquidity (i.e., money) either for a rainy day, to accumulate before spending or investing it, or just to safeguard this portion of your wealth safely and securely. But an inflating dollar doesn’t achieve these aims. The dollar – and indeed every other national currency – has severe problems that undermine their usefulness. In contrast, protecting wealth is what gold does exceptionally well by preserving the purchasing power of one’s liquidity, not necessarily from day-to-day or week-to-week, but consistently and reliably over longer periods of time.

So instead of focusing on gold’s price when buying it, focus on what gold is, what it offers, and what it accomplishes for you. Gold is a form of savings that securely preserves that portion of your wealth that you choose to hold as sound money.

I recognize that it is difficult to view gold in this way and to give little regard to its price, particularly because we are so used to looking at prices of goods and services in terms of dollars and not gold. Also, we have been trained to think of gold as an investment instead of what it really is – money. But we can overcome these biases and incorrect conventional wisdoms.

One way to do that is to consider accumulating gold on a regularly monthly basis. In other words, save some money every month, but don’t save dollars, the purchasing power of which is being inflated away. Save sound money instead. Save gold.

When gold is viewed in this way, it is clear that even with the four-fold increase in the gold price since 2001, no one has ‘missed the boat’. Building savings by accumulating gold is always a good thing.

Putting the Gold Price in Perspective – follow-up

The above article generated some interesting questions from readers of “Information Line”. Here is one of those questions and my response.

Q. – “I read this with interest, but if I buy gold in 2008 at $1000 per ounce and now it’s 2010 and gold is $500 per ounce, why do I not feel good??? Of course, if you buy gold in 2000 at $280 per ounce and sell in 2008 at $1000 I know you feel good, but life does not always work that way!”

A. – You are looking at gold from the perspective of a trader. In other words, you assume that the only advantage to owning gold is to profit from its price swings. Gold is money, and there are also other important benefits that come from owning physical gold. These include:

1. No counterparty risk – When you own physical bullion, you own a tangible asset. Physical gold is money not dependent upon anyone’s promise, which is an attribute becoming increasingly important as the present financial crisis deepens. Ask anyone who had money in Northern Rock in the UK or Bear Stearns about their experience when those banks failed. Better yet, ask anyone who lived through the Great Depression to learn about the fear that arises when your wealth is reliant upon counterparty risk in a financial crisis.
2. Consistency in commodity purchasing power – If gold were to drop to $500 in 2010, the price of crude oil, wheat and other commodities will have also dropped. You would be able to buy gasoline at $2 per gallon again, and a loaf of bread at much less than today’s price. There is a close correlation between the price of basic commodities and gold. So the loss of purchasing power from a drop in gold’s price may be less than it seems at first glance.
3. Not reliant upon government decisions – The value of the dollar is dependent upon government politicians and bureaucrats. Therefore, the dollar has become a political tool, rather than what money is supposed to be, namely, a neutral tool useful in commerce available to one and all and unfettered by government interference. Government actions can undermine the usefulness of currency. Moreover, when you own dollars you are speculating that the government will not take any actions harmful to the currency. That’s not a good bet because experience has shown that governments eventually and inevitably totally destroy the currency under their management.
4. Assets outside the banking system – Gold provides diversification by enabling you to place a portion of your money outside of banks, and indeed, the entire monetary system of fiat currencies. Therefore, this portion of your wealth is removed from the threat of capital controls and other government imposed restrictions. This safety you receive from gold can be enhanced further when you store gold in countries outside of where you live and where there is no history of asset confiscation by government.

The above points explain why gold has value. Namely, it is useful in many different ways. But there is one last point worth mentioning.

While the future is unknowable and unpredictable, the probability of gold falling to $500 in 2010 is “slim to none”. The only way for gold to fall to that level would be for the purchasing power of the dollar to be significantly enhanced. In other words, instead of inflating the dollar, the US government would need to embark on a new monetary policy aimed at deflating the dollar, the result of which would be to enhance the dollar’s purchasing power, repeating the experience of the Great Depression. Monetary policy is aimed specifically at avoiding another deflationary Great Depression, so it is reasonable to expect that the dollar will continue to be inflated, meaning the price of gold will continue to rise.