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Matt Machaj

Matt Machaj

Matt Machaj, PhD, is an economist whose research is focused on the monetary policy, the gold standard, and alternative monetary regimes. Matt is a university…

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Gold as an Anti-Inflation Hedge?

My first article is based our just-released Market Overview (monthly reports). It focuses on gold as an anti-inflation hedge, and why it is precisely a hedge against something else. In the article below I will focus on John Paulson's recent comments on gold by discussing the link between base money and gold. In short, significant increases in base money can be good reasons to be bullish, but not necessarily as bullish as Paulson argues.

John Paulson is betting in favor of gold based on his inflationary explanation of the current situation. He is consistent is his belief in the inflationary scenario when he states that the housing market is not far away from the bottom. He even goes so far to say that buying a home is one of the best investments one can make. (Let us not forget that Paulson correctly predicted the peak in the housing market and became a billionaire by short selling subprime mortgages in 2007). So where is the consistency? What does being bullish about gold have to do with being bullish about the real estate market? The answer is: if you believe in strong inflationary forces, you have to believe they should prevail macroeconomically, and you cannot separate various markets. If money printing should lead to inflation, you should see inflation everywhere, because it is a universal phenomenon; an upward march of prices. Of course, some markets are more affected than others. One price can increase by 10%, another by 25%, other by merely 4%. Nevertheless, once inflation takes a hold there are no doubts about it, since rising prices are noticeable virtually everywhere. Therefore, it would seem contradictory to argue on the one hand that high inflation is coming, and at the same time state that the housing market should still plummet. In other words, if you believe in hyperinflation, you should believe in a runaway boom, a flight into real assets, any assets useful to the public despite any possible debt shackles (since the real value of debt shrinks in the high inflation storm).

This of course does not imply that gold always has to move in the same direction as real estate. But, if the argument for buying gold is based on hyperinflationary conclusions, then one must accept the consequences and argue that other real markets also have to boom. That is the nature of high universal inflation: everything gets more expensive (except for money and past contracts, which lose their value). Therefore, if one posits that gold will rise because very high inflation is around the corner, one could just as well say that real assets are going to rise due to the upcoming inflation.

Actually the same goes with interest returns, including government bonds. If high inflation is on its way, one should see investors demanding inflationary compensation. In other words, interest returns on current investments should take into consideration the inflationary wave that is supposed to swipe the currency market. If you believe in hyperinflation, observe current interest returns and all commodity markets. If you do not see an upswing in both cases, nobody's really expecting high inflation to happen. Therefore, you should not make the case for gold based on hyperinflation argument.

In the environment of very high levels of inflation (tens of percent) gold will rise as other real values. What is the case with single-digit inflationary scenario? Is gold really the inflation-hedge as it is touted? People believe so, and they are right when it comes to high inflation scenarios, but if we focus on smaller doses of inflation there is little correlation between the inflation rate and the gold price. Actually, as stated above gold is an anti-inflation instrument only when big inflation is on its way. Very big. The last 40 years tell us that gold has its own cycle, in fact unrelated to levels of inflation. Take a look at this graph:

Gold and Consumer Price Index 1973-2013 Chart

For the last 40 years the dollar was constantly losing its value (right scale) sometimes faster, sometimes slower. Yet gold appears to have its own way of reacting to this steady decline in the dollar's purchasing power. Take as an example the case of the period between 1982 to 2002 when the dollar lost half of its value. During the same period gold did not gain 100% to compensate for inflation. It did not increase and did not even stay at the same level. In fact it lost its value. It was one of the worst inflation-hedges one could pick. It did not save your capital from inflationary policies. Worse, because it was inferior to the dollar putting your green paper currency in socks was a better choice than buying gold.

Two decades is not a short run. We do not take the highest gold price from the 1980s to prove the point. During those 20 years gold was losing its value faster than the dollar. Then things changed. For the next ten years the dollar lost its value, but there was a significant shift in the gold market. During that period of time, as we well know, gold gained tremendously. Even though the time period is not very long it can clearly confirm one thing: gold has its own separate market. Its value may be related to the inflation rate, but it is not a primary reason for major shifts in the value of gold. Simply put, there is more--much more. Historically gold is not a good inflation hedge (or precisely it can be in only certain circumstances).

The key to proper understanding of the gold market and more importantly - making a correct investment choice in the gold market - is getting rid of this popular notion about the yellow metals and admitting that gold will not necessarily save you from the inflation monster. Yet it can save you from something else: the endangered dollar system.

As mentioned earlier, the above is a part of the first Market Overview report that we have just published. The full version includes detailed discussion of the anti-inflationary investing vs. anti-system investing (when is gold exactly an inflation hedge?), physical gold production, mining costs, and more. We are generally fans of the try-before-you-buy policy, so we have already provided two parts of this month's Market Overview this and last week. We are also posting this month's Overview later than usually so that if you sign up for the monthly subscription, you'll be able to read 2 monthly Market Overview reports in this period. The price for one month is $14.95, but we decided to lower it for the first month to $9.95. So, instead of one for $14.95 you get two for $9.95 - that's a 67% discount for a premium publication. We're not saying that you have to sign up but we highly recommend that you do and given the discount, it would be a waste not to take advantage of it. You can sign up here.

Thank you.

 

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