The Golden Dilemma

If you’ve read the one article I have written on precious metals, or have taken a look at the Prepper Pyramid, you know I do not put much stock in the owning of physical gold.  This is purely a personal choice and one based on my own prioritization methods.  I also recommend that if you do want to own gold, there are many other pieces of the puzzle that should be in place with respect to a prepping strategy prior to taking the plunge.  That stated I will not criticize those who put huge amounts of faith in gold or choose to own loads of it, it’s your money and your life and you are entitled to do whatever you please with it.  There truly is no singular prep strategy template which we should all cover down on, we all have different sets of values and ambitions.

I wanted to write that introductory paragraph in order to set the stage for some information I am about to share with you.  Regardless of your stance on gold I encourage you to read some of the arguments the authors of the paper make before judging it or simply scoffing at it as nonsense.  I would hope that you are not the type of person who only seeks out information which completely aligns with your own personal beliefs, the equivalent of the king who has a bunch of “yes men.”  Sometimes it is good to take in what the other side has to say (the equivalent of me watching MSNBC) if only to analyze it and further affirm your position.

I came across a paper entitled The Golden Dilemma after reading an article on Marketwatch, which cited it as a reference.  I contacted the author of the paper and asked for permission to post some of it here, with the stipulation that I would give him full credit and link back to the location where it could be downloaded in its entirety for free.  What I would like to do is simply post a few snippets from the paper, parts of which apply to preppers in particular.  The rest can be downloaded by visiting this link.

Common Arguments for owning gold

It is not surprising that there is so much disagreement about gold’s future. This disagreement reflects the fact that at least six somewhat different arguments have been advanced for owning gold:

• gold provides an inflation hedge

• gold serves as a currency hedge

• gold is an attractive alternative to assets with low real returns

• gold a safe haven in times of stress

• gold should be held because we are returning to a de facto world gold standard

• gold is “underowned”

The debate over the prospects for gold resembles in some sense the parable of the six blind men and the elephant (see Saxe 1872). Different perspectives and different models lead to different insights. Depending upon which rationale or combination of rationales one embraces, gold is either very expensive or attractive. The debate over the value of gold is also an example of a Keynesian “beauty contest” which suggests that the price of gold is not determined by what you think gold is worth – what matters is what others think others think gold is worth (see Keynes 1936).

Gold as an inflation hedge

Probably one of the most widely held beliefs about gold is that it is an inflation hedge. Jastram (1978) pointed out that historically gold has been a poor hedge of inflation in the short run though it has been a good hedge of inflation in the long run. For Jastram, the short run was the next few years and the long run was perhaps a century. Jastram used the phrase “the golden constant” to communicate his belief that the real price of gold maintained its purchasing power over long periods of time and that gold’s long-run average real return had been zero.

Military pay as an example

In the era of Emperor Augustus (reigned from 27 B.C. to 14 A.D.), a Roman legionary was paid about 2.31 ounces of gold a year (225 denarii) and a centurion was paid about 38.58 ounces of gold a year (3,750 denarii) (see Speidel 1992). Converted to U.S. dollars, the pay of a Roman legionary was about 20% that of a modern day private in the U.S. Army and the pay of a centurion was about 30% greater than the pay of a captain in the U.S. Army.

Similar to the U.S. aggregate experience since 1791, there is little or no income growth in military pay over 2,000 years. Interestingly, this conclusion is not that sensitive to the final price of gold.

There are two insights here. First, some incomes denominated in gold might be a very long-term hedge – in that the real purchasing power of some wage rates are roughly preserved. Second, it helps us to begin to understand what the expected return on gold is not. Even though 2,000 years is only a fraction of the time that gold has been mined, it provides a lot of annual compounding periods. A claim that gold could have “equity-like” returns in the future needs to be reconciled with the past. Starting 2000 years ago in the year 12 A.D. one dollar compounding at just 1% a year, turns into $439 million over 2,000 years. If the rate of return is increased to 1.62%, the ending value is $100 trillion – more than the today’s combined capitalization of world stock and bond markets.

In “normal” times, gold does not seem to be a good hedge of realized or unexpected short-run inflation. Gold may very well be a long-run inflation hedge. However, the long-run may be longer than an investor’s investment time horizon or life span.

The “gold as a safe haven/tail risk insurance” argument

Consider the famous Hoxne Hoard which is currently on display at the British Museum. The Hoxne Hoard is an example of what can happen when trying to make a safe haven investment. The Hoxne Hoard is the largest collection of Roman gold and silver coins discovered in England. Evidence suggests that the hoard was buried sometime after 400 A.D. by a wealthy family seeking a safe haven for some of its wealth. The 5th century A.D. was a time of great social stress and political turmoil in England as the Western Roman Empire unraveled. The fact that the hoard was discovered in 1992 means that the family failed to reclaim its safe haven wealth. Indeed, the Hoxne Hoard is an example of an “unsafe haven”.

Jeffrey Gundlach astutely pointed out that the weight of gold limits its portability, both during normal times and during times of stress. Thinking in terms of the ratio of market value to weight (somewhat like a “flight capital” Sharpe ratio), he observed that many precious gems are a more efficient store of flight capital than gold (see Or and Phillips 2011). Gold is viewed by many as being durable and largely imperishable, characteristics which make gold its own safe haven against the ravages of the world. It is not necessarily a safe haven for the owner of gold. As Marc Faber once put it, “When Timur sacked Aleppo and Damascus in 1400, it didn’t help to have your savings in gold. You lost your life and your gold” (see Ash 2009).

Hyperinflation

For some proponents of gold investment, the hyperinflation of the Weimar Republic stands as an electrifying example of the risks of a fiat currency regime. The hyperinflation of the Weimar Republic during the years 1922 and 1923 is an example of a possible endgame for a country that spends much more than it earns. The German mark-U.S. (gold) dollar exchange rate rose from 430 in 1922 to about 433,000,000,000 by 1924. If such a hyperinflation unfolded in the U.S. today, if gold moved exactly in line with the inflation rate and if the real price of gold was unchanged, then the price of gold would exceed $1.68 trillion an ounce.

So, does the price of gold provide hyperinflationary tail risk protection? Is gold a hyperinflationary talisman? Not surprisingly, the answer to a large degree depends on how the question is asked and the specific scenario that unfolds. It is perhaps instructive to think about how an absolutely clairvoyant investor might assess the ability of gold to provide a hyperinflation hedge. It is also useful to be aware of the historical frequency and magnitude of hyperinflationary episodes.

Imagine a Brazilian investor in 1980 who possessed perfect foresight of how Brazilian inflation would unfold between 1980 and 2000. Exhibit 15 shows that from 1980 to 2000 Brazil had an average annual inflation rate of about 250%, the currency was renamed and devalued numerous times, and the nominal price of gold rose substantially in Brazilian currency terms. Yet, using the IMF’s measure of Brazilian inflation, the real price of gold fell by about 70% between 1980 and 2000. This means, broadly and illustratively speaking, that by the year 2000, an ounce of gold had 30% of its 1980 inflation adjusted purchasing power. This is similar to the real price decline of gold faced by a U.S. investor during the same time period.

So, if purchasing power declined 70%, was gold a successful Brazilian hyperinflation hedge? It depends on one’s perspective. Compared to an expectation that gold would move one-for-one with the Brazilian price level then gold was not a successful hyperinflation hedge between 1980 and 2000. However, investors keeping cash-in-a-mattress or investing in a portfolio of Brazilian nominal bonds probably lost most of their real value from 1980 to 2000. Compared to a close to 100% decline in real value for cash and nominal bonds the 70% decline in the real value of gold was a great alternative. A key takeaway from Exhibit 15 is that even though countries, such as the U.S. or Brazil, may experience very different inflation experiences their real gold return experiences will probably be similar and there is no reason to expect that the real gold return will be positive when a specific country experiences hyperinflation.

Conclusion

Investing in gold is potentially a way to maintain purchasing power. The purchasing power of gold rises and falls as the real price of gold rises and falls. Investing in gold entails a bet as to the future real price of gold, whether or not an investor even thinks about the bet. It is a fact that the real price of gold is very high compared to historical standards. A number of reasons have been advanced to explain the current real price of gold – some of these stories argue the real price of gold is too high and others suggest the real price could go even higher. The goal of this paper is to analyze these competing narratives.

We find little evidence that gold has been an effective hedge against unexpected inflation whether measured in the short term or the long term. The gold as a currency hedge argument does not seem to be supported by the data. The fluctuations in the real price of gold are much greater than foreign exchange rate changes. We suggest that the argument that gold is attractive when real returns on other assets are low is problematic. Low real yields, say on TIPS, do not mechanically cause the real price of gold to be high. While there is possibly some rational or behavioral economic force, perhaps a fear of inflation, influencing variation in both TIPS yields and the real price of gold, the impact may be more statistically apparent than real. We also parse the safe haven argument and come up empty-handed. We examine data on hyperinflations in both major and minor countries and find it is certainly possible for the purchasing power of gold to decline substantially during a highly inflationary period. When the price of gold is high in one country it is probably high in other countries. Keynes pointed out “that the long run is a misleading guide to current affairs”. Even if gold is a “golden constant” in the long run, it does not have to be a “golden constant” in the short run. Conversely, current affairs are possibly a misleading guide to the long run…

In the end, investors are faced with a golden dilemma. Will history repeat itself and the real price of gold revert to its long-term mean – consistent with a “golden constant”? Alternatively, have we entered a new era, where it is dangerous to extrapolate from history? Those are the uncertain outcomes that gold investors have to grapple with and the passage of time will do little to clarify which path investors should follow.

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