Historically, one of the primary reasons for owning gold, silver or platinum bullion has been their ability to preserve purchasing power during inflationary periods. Over the long term, inflation robs us of purchasing power. If not addressed, inflation also destroys the long-term value of personal wealth.
This chart, prepared by Michael Hodges of the Grandfather Economic Report, http://mwhodges.home.att.net/, shows the US dollar's loss of purchasing power based on the Consumer Price Index (CPI). This 87 percent decline means the 1950 US dollar could buy only 13 cents' worth of goods today.
The picture is similar in Canada. The inflation calculator on the Bank of Canada's website shows that a basket of goods costing CDN$100 in 1950 now costs CDN$863. This represents an 89 percent decline in the purchasing power of the Canadian dollar.
Today, most investors are not concerned about inflation because politicians and central bankers have done an excellent job of persuading us that inflation is under control and represents no threat. The core inflation rate in the US is reported to be 1.1 percent - a 38-year low. It certainly sounds good, but is it true?
What is inflation?
There is much confusion and disinformation about what inflation really is. The 1983 edition of Webster's New Universal Unabridged Dictionary defines inflation as:
" An increase in the amount of currency in circulation, resulting in a relative sharp and sudden fall in its value and a rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet demand. "
But The Encyclopedia Britannica defines inflation as: "An inordinate rise in the general level of prices."
Today, that's what most of us think inflation is: a rise in the price of goods and services as measured by the CPI. This definition, however, confuses the cause and effect. The cause of inflation is an increase in the money supply - the effect is an increase in prices.
Since 1971, when Richard Nixon eliminated gold convertibility for the US dollar, there has been no practical limit on the amount of money that could be created. As a result politicians are able to increase the money supply through credit expansion by ever increasing amounts. Today, the annual increases in the money supply are equal to the total money in 1971.
Over the last year the money supply in Canada, as measured by M3, has increased by 9.8 percent. With all the media interest surrounding the increasing US money supply (4.3%), it is surprising that the Canadian increase, at more than twice the US level, receives little attention. What we do hear from the media is that core inflation rates for both countries, over the same time period, is increasing by less than 2 percent annually.
What is the explanation for this disparity?
First, a large proportion of the increased money supply has gone into the equity markets and real estate. In those cases it is called "capital appreciation", but in reality it is just inflation of those asset classes.
Second, the reported CPI rate is carefully designed to understate to true rate by minimizing key expenses, such as energy costs, food and housing, which affect everyone's lives. In fact, energy and food costs are completely excluded from the CPI, because they are deemed too volatile.
A number of questionable tactics are used to distort other real price increases. Quality changes, euphemistically referred to as hedonic adjustments, are one method. Because a 2005 model computer has twice the speed and memory of a 1998 model, its purchase price is reduced by half for CPI calculations. The Wall Street Journal reports that hedonically adjusted computer prices have dropped 25 percent a year. Today, 46 percent of the CPI's weight comes from hedonic adjustments.
Over 30 percent of the CPI is devoted to rental prices. However, thanks to reduced mortgage rates and low downpayment requirements, many former renters are purchasing homes, suppressing rental demand and keeping rents artificially low.
Similarly, 30 percent of the CPI is devoted to used-car prices. Because of zero interest-rate financing and cash-back incentives, however, buyers are flocking to purchase new cars, thus increasing used-car inventories and suppressing resale prices.
Together, these tactics result in a CPI rate that is purposely distorted to reflect a modest inflation rate. A recent article by Jim Puplava entitled The Core Rate provides an excellent analysis of how the Boskin Commission recommended adjusting the method of calculating the CPI in 1996.
Bill Gross, managing director of the giant Pimco bond fund, recently stated: "My sense is that the CPI is really 1 percent higher than the official numbers and the GDP is 1 percent less. You're witnessing a haute con job."
Since every household must deal with double-digit increases for gasoline, utilities, food, professional services and housing costs, not to mention taxes and government fees, it seems obvious that the real inflation rate cannot possibly be 2 percent, but is more likely in the 6-8 percent range. This is confirmed by the fact that the Commodity Research Bureau Index (CRB), representing a basket of commodities has risen 77% in the last three years, US Agricultural products have risen 21% and oil has risen 223%. Since the price of oil affects nearly all products and services, increases the oil price will ultimately have a profound affect on all prices.
If the true inflation rate is 8 percent, then even those risk-averse investors who believe they have secured their capital by investing in Guaranteed Investment Certificates, at the current yield of 3 percent have, in fact, a guaranteed method of losing money on a daily basis.
Investors must not only minimize the risk of capital loss, but also seek returns that exceed the (real) rate of inflation, thereby maintaining the future purchasing power of their capital. Without accounting for both, investments can become a recipe for losing money. If inflation is in fact running at 5 percent above an investment yield, the capital will have eroded by 55 percent over ten years. After 20 years, it will have lost 93 percent of its original purchasing power.
No wonder Lord John Maynard Keynes said:
"There is no subtler, no surer means of overturning the basis of society than to debauch the currency. The process engages all of the hidden forces of economic law on the side of destruction and does it in a manner which not one man in a million is able to diagnose."
Erosion of financial wealth
Loss of purchasing power isn't the only consequence of high inflation. Over the long haul, inflation can erode the value of accumulated wealth as well. There are two reasons for this.
First, as the money supply is increased through credit expansion, the compounding effects of interest payments can ultimately lead to hyperinflation, and eventually a complete economic breakdown. Goods and services become so costly that no one can afford them. A country's currency becomes worthless, international trade ceases and economic chaos ensues. A classic example of this occurred during the reign of the German Weimar Republic from 1919-1923. In 1919, one ounce of gold was 75 marks. By 1923, it was 23 trillion marks.
The second reason concerns side effects of the strong medicine used by governments and central banks to control high inflation rates.
In the past, inflation has been curtailed through domestic interest-rate manipulation. When inflation rises, the central bank imposes higher interest rates on the economy. In the 1970's, then Fed Chairman Paul Volker, raised the Fed Funds rate to 19% in 1981 in order to tame inflation. This action slows consumption, lowers price pressures on goods and services and brings inflation to heel.
Unfortunately, a high interest-rate monetary policy can play havoc with a country's capital markets particularly when the overall debt levels are as high as they are today.
Bonds and debentures are interest-rate sensitive. As interest rates climb, the market price of bonds, debentures and other debt instruments, such as income trusts, declines.
Mortgages can lose value just as bonds do. Rising interest rates choke off mortgage markets as borrowers look for alternative means of raising capital. Mortgage-based securities, such as mortgage mutual funds, see the value of their net assets drop along with their market valuations.
Although real estate is a tangible asset, it is very interest-rate sensitive. As rates ratchet upwards, the costs of buying, financing, maintaining and renting real property increase. Eventually, as interest rates rise, the market value of real estate begins to fall.
Increasing interest rates negatively impact the value of stocks, too. Rising rates crimp consumer spending. This slows corporate sales of goods and services and causes inventories to increase, profits to evaporate, stock dividends to shrink and stock prices to weaken.
Considering the total US debt, at over 305% of GDP, is more than twice the debt level of the 1970s raising interest rates today could have a devastating impact on today's over leveraged economy.
This puts Alan Greenspan squarely between the proverbial rock and a hard place. If he raises interest rates to subdue inflation and support the US dollar, he risks triggering an economic collapse. If he maintains current interest rates the US dollar may collapse, causing inflation to spiral out of control. If oil prices continue to rise, as a result of hitting Peak Oil, then monetary policy may not be enough to counteract the inflationary affects of rising oil prices.
Considering that the bulk of Canadians' wealth is typically distributed across bonds, real estate and stocks, there is a real risk that rising interest rates could depress all of these asset classes and destroy investor wealth.
Precious metals as a wealth preserver
"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value."
- Alan Greenspan
The above quote is from an article written by Allan Greenspan in 1966 entitled "Gold and Economic Freedom" in which he discusses the role of gold as money. Wealth preservation has long been an attribute of gold and silver bullion, and the reason they have functioned as money for over 3,000 years. Although prices of gold and silver, in local currencies, may have fluctuated during both inflationary and deflationary periods, precious metals have maintained or even increased their purchasing power in both instances.
During the 1970s the average annual increase in the CPI was 7.8 percent, while the average annual compounded increases in the prices of gold, silver and platinum were 42 percent, 43 percent and 29 percent respectively.
We are all familiar with the premise that you can always buy a man's suit with an ounce of gold. Well, I can remember that in 1971 the price of an average car was about CDN$2,300, or 66 ounces of gold, which at that time was CDN$35 per ounce. Since then, the dollar price of the car has increased 6-fold to CDN$14,000, but for the same 66 ounces of gold, priced at CDN$530 per ounce, I can now buy two cars. In 1971 the average price of a house in Canada was CDN$24,600, or 694 ounces of gold. Today the average house price is CDN$219,700 and with the same 694 ounces of gold I can almost purchase two houses. This relationship holds true for most other assets and commodities, including the Dow Jones Industrial Average, where the cost in gold ounces has either remained the same or decreased over the last 30 years. People purchase precious metals when the risk of owning other assets outweighs the opportunity for gain, profit or reward. When used this way, gold is like cash. But unlike cash and other asset classes, precious metals tend to hold their value during periods of high inflation.
This is because precious metals are negatively correlated to most other asset classes, and to cash and cash equivalents, bonds, mortgages, real estate and stocks in particular. This means that the value of precious metals tends to increase as the value of these other assets declines. This has recently been confirmed in a study by Ibbotson & Associates. An executive summary of the report is available at http://www.bmsinc.ca/component/option,com_akoforms/func,showform/formid,3/Itemid,65/.
In an inflationary environment, an allocation of at least 10 percent to precious metals in a diversified investment portfolio helps to preserve the value of the portfolio by offsetting losses in other asset classes.
In periods of very high inflation, where interest rates have skyrocketed, precious metals have at least maintained and usually increased their purchasing power, because their value can never go to zero. Conversely, other asset classes have been completely destroyed by periods of hyperinflation.
This underscores the important distinction between precious metals, in actual bullion form as stand-alone assets. Cash, cash equivalents and currencies, bonds, mortgages, stocks and even real estate are all secured by a promise to pay the bearer. Bullion is not.
Maintaining purchasing power with gold
In his report entitled Gold as a Store of Value, Research Study No. 22 (London: World Gold Council, 1998) British economist Stephen Harmston proves a number of important points about gold's ability to maintain its purchasing power.
First, Harmston's analysis shows that, despite short-term fluctuations in price, gold has maintained its purchasing power over the very long term in Britain, France, Germany, Japan and the US.
Second, while gold has not held its purchasing power during every period of economic and social upheaval, it has held its purchasing power every time financial assets have declined in value.
Third, the inflation-adjusted price of gold has increased since 1971 and, as of 1997, gold's purchasing power remained in parity with the long-term rise in the cost of a typical basket of goods as represented by the CPI.
Harmston's fourth conclusion about gold is particularly noteworthy. Gold's surge in purchasing power during the 1970s occurred partly because of the removal of fixed pricing by the US government. As well, there was a general inflation-driven rise in the prices of other commodities during the 1970s and 1980s, and an increased worldwide demand for gold. As gold supplies expanded to accommodate this demand, gold's purchasing power reverted back to its historic mean which, according to Harmston's studies, was always equivalent to the long-term average rate of inflation.
Inflation rising
Today, there are signs that inflation is on the rise again, and that an inflationary spiral may be about to begin. Both the Bank of Canada and the US Federal Reserve Bank have indicated they will raise interest rates in response to increasing inflationary pressures.
If the money supply continues to grow as it has been, and the price of oil continues to increase inflation is sure to follow. It may now be a good time to allocate at least 10% to the ultimate form of inflation hedge - gold, silver and platinum bullion.
