Monday, April 5, 2010

Gold: Be sure you know what you’ve hedged

Gold and inflation

Of all the things to discuss, gold seems the strangest. So, much has been written from just about every perspective. However, so many people have asked my opinion that a posting seems in order. Rather than take sides in well-hashed debates, two references will point the reader to two lengthy discussions as well as a source for more if needed. The references are followed by some views that might be novel even to one familiar with the issues surrounding gold.

First, one can probably find a variety of opinions at . For example, on March 17th Nick Barisheff started a two part “Primer.” It can be retrieved at . Be aware that his primer is actually an advocacy piece for his position on gold. So, it is worth checking other writer at In the April issue of The Atlantic Magazine , Michael Kingley provides another discussion of the topic. It can be found at . A word of caution to anyone who checks out the articles, read the comments. Some of the comments are as insightful, or even more insightful than the articles.

Before proceeding, there is one comment (made in connection with both articles) that it would be remiss not to repeat. Like everything else, gold and fiat money are subject to supply and demand. Take that a step further by realizing that each potential use for either (e.g., store of wealth, medium of exchange, source of liquidity, method of enumeration or accounting, form of speculation, hedge against various risks, functional value in use, etc.) is also subject to supply and demand. That simple step will put one three steps ahead of most people writing about gold.

The “primer” takes the position that gold is money. The Kingley article discusses gold as a hedge against inflation. The two arguments are often made as if interchangeable. However, they are contradictory both theoretically and historically. They can’t both be valid, and they never have been.

The gold standard, when gold was coined, was associated with some very dramatic periods of inflation for both individual countries and globally. Two well-known examples that have been thoroughly documented are the European inflation after Spain started extracting gold from Latin America and the aftermath of the California gold rush of 1849. There are numerous other less well-known examples. So, historically, gold as money has produced inflation at various times.

People have argued that these historical periods are irrelevant because gold is scarce and new finds are unlikely. Well, quite frankly, if someone wants to increase supply, look to Fort Knox, the NY Fed, and other central banks. Now the individual looking for supply can also look to the stockpiles of the gold ETFs as well. If one wants to depend on governments and commodity speculators for price stability, have at it.

Regarding the theoretical contradiction between the two arguments, anyone who studies how the gold standard was supposed to work knows that inflation in gold surplus areas is essential to the supposedly self-equilibrating characteristic of the theory. Supposedly self-equilibrating, rather than actually, because governments have long since figured out how to “sterilize” (i.e., negate the supposed impact) of gold flows.

That brings up another misconception. People argue that gold, unlike fiat money, is not something governments can tamper with. True, unless they decide to release gold from their stockpiles or to increase their stockpiles. Within recent memory, prices of gold have been held down when European governments reduced their holding and then propped up when China and India recently increased their stockpiles. Further, much of history shows governments pegging gold values in one way or another. Governments clearly are not passive regarding gold, and they never have been.

So, gold is neither a natural form of money nor a natural hedge against inflation. It can play either roll, but only under very specific conditions. So, what does gold actually hedge?

One of the most amusing and telling misconceptions about gold is the lead line on at least one of the current ads for gold. It goes something like this: “Gold is the only asset that isn’t someone else’s liability.” That is supposed to be strength. An asset where there is no counterparty (i.e., no one has promised a return) is better than one where someone promised a return. Go figure! Clearly, gold hedges distrust. The distrust can target government, central banks, bankers in general, or any and every counterparty. It doesn’t matter; it is the distrust that is the issue, not who isn’t trusted.

Further, the statement is just plain wrong. Very broadly-held asset classes, for example, equities, aren’t anyone’s liability. They’re equity. Equity is what is left after liabilities are subtracted from assets. Equities, however, become illiquid, or at least fall in price, during periods of financial or social chaos. Gold can hedge financial and socio-political chaos, but only if the gold isn’t a part of the financial system.

In THE BLACK SWAN: THE IMPACT OF THE HIGHLY IMPROBABLE, Nassim Nicholas Taleb makes the case that extremes are hard (he’d say impossible) to predict. Following his line of argument, the likelihood that they will occur is hard to quantify and consistently underestimated. One doesn’t need to believe he is always right, only that he may be right as it relates to one’s personal ability to always see the future. Concede that error is possible, and it makes sense to have some exposure to gold. Under the circumstances where gold shines, it is too late to start looking for alternatives.

Viewed through this lens, gold is a good hedge against inflation if the inflation is associated with distrust or chaos. It is actually the real or feared chaos and counterparty distrust that gold is hedging. Better yet, that hedge would be valid with or without inflation. However, for inflation that doesn’t result from or spawn extremes, there are alternative hedges against inflation that entail less risk or lower cost. For example, absent the distrust, indexed bonds, TIPS, have a positive return and no storage costs, and absent the financial chaos risk, the stocks of gold miners can effectively hedge inflation risk.

The chaos and distrust argument for gold says nothing about timing unless one adopts the assumption of a perfect ability to forecast chaos and distrust. So, it is a permanent hedge, with the cost usually incurred up front. Gold exposure then becomes like insurance: a pesky necessity for laying-off a specific risk.

So, a not too surprising discloser, for many years I have maintained an exposure to gold. Over the long run, the direct overall expected return is what one would expect from insurance. But, by carefully identifying what risk is being hedged, the actual average return has been better.


  1. You can tell when gold is overpriced by the number of ads by gold buyers/sellers on cable TV. This index is currently at a record high.

  2. I'd agree. I'd add the number of people asking about it and the number of articles about it in the popular press. But, it isn't short term gold prices that motivate the hedge that I think gold really provides. I would write the same thing with gold at $400 and no adds or gold at $3,000 and even more adds.