1:33 pm
Tue February 17, 2004

Good as Gold?

Recently gold has traded above $400, and many expect it to continue to appreciate. Why?

Wilmington NC – [Click the LISTEN button to hear Dennis' commentary.]

I continue to be surprised when asked, Isn?t the dollar as good as gold? Some believe it is backed by gold. Once, it was.

Six thousand years ago Egyptians cast gold into money. It has been a primary form of money much of the time since. Many classical economists ? John Locke, David Ricardo, J.S. Mill, to mention a few ? wrote about the benefits of gold-backed money and the perils of the alternative, bank money, such as America?s Federal Reserve notes.

One argument for gold-backed money ? that is, a currency fixed to a specific quantity of gold ? is, it prevents the issuing government from increasing the supply of money and thus, depreciating its value. When a currency is fixed to gold, government can create no more money than it has gold. With bank money, the argument goes, a country that runs up large debt has an incentive to increase the money supply. This decreases the value of its currency, and it can pay back its debt with money that is worth less than when borrowed.

When a currency?s value declines, prices for the things it buys increase. This is inflation.

The modern era of gold-backed money, or the gold standard, ended in the 1930s. Great Britain left the standard in 1931 because of a drain on its gold reserves ? too many people demanding gold for British pounds. America followed in 1933, as did other countries. After World War Two, the US returned to the gold standard ? it then held three-fourths of the world?s stock of gold. The US fixed the dollar to gold, and other countries fixed their currencies to the dollar.

As other countries prospered, dollars accumulated elsewhere and America?s stock of gold dwindled. Confidence in America?s ability to sell gold for a fixed dollar price also dwindled ? justifiably ? and in 1971 President Nixon took America off the gold standard, where it remains.

Since then, the dollar has been backed primarily by things it will buy. This is not a bad deal, because most everything we need can be purchased with dollars. Including gold. But we really don?t need much gold ? it?s primary productive use is in electric circuits, although most of us like it for decoration. Thus, a major benefit of owning gold is that, it can be sold for dollars which then can be spent on things we need.

Given this, it is instructive to examine the price of gold. It was $35 an ounce before the gold standard was ended in 1971; by 1980 it had risen to $850. This reflected rampant inflation in the 1970s and loss of confidence in the dollar. Thereafter, as the dollar was shored up by the Federal Reserve with high interest rates in the 1980s and by the balanced Federal budget in the 1990s, the price of gold declined. It fell to about $250 by the late 1990s.

Recently gold has traded above $400, and many expect it to continue to appreciate. Why? This might seem perplexing, given that the value of gold rests largely on the value of the dollar. The explanation may be that speculators are buying gold ? bidding up its price ? in anticipation that the large Federal budget deficits create an irresistible incentive for the government to increase the money supply, thus lowering the value of the dollars it uses to pay back its debt. This would set off a new round of inflation, pushing up prices for just about everything, including gold.

Thus, gold buyers are speculating on re-inflation. They are betting that the Federal government will not stem the growth of its budget deficit any time soon. A cost of such speculation, however, is foregone interest. Other inflation hedges, such as indexed bonds, pay interest. Gold does not.