3 Facts About Investing in Gold

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Editor’s Note: Reason columnist and Mercatus Center economist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.

Myth 1:Gold is at an all-time high.

Fact 1:It’s not if you adjust for inflation.

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Media pundits and policy makers claim that gold is at an all-time high. At Carpe Diem, University of Michigan economist Mark Perry has a useful chart showing that this is only true because such comparisons fail to take into account the effect of inflation on the dollar’s value over time.  

For example, the average nominal price of gold was $612.56 in 1980 and $610 in 2006. How much did the dollar’s purchasing power decline in those 26 years?

Since the value of a dollar changes over time, comparing the price of any good over time requires that we adjust the current price for inflation. And it turns out that gold is only at record highs if you fail to adjust for inflation.  

Perry’s chart uses data from Global Financial Data to show the changes in the inflation-adjusted price of gold from 1970 (the year before the United States last left the gold standard) to 2010 in real 2010 dollars. Adjusted for inflation, the price of gold today is 41.5 percent below the January 1980 peak of more than $2,000 per ounce (in 2010 dollars).  

While not at record highs, the price has certainly been rising. It began doing so a decade ago, around the same time oil prices began rising. Both fell sharply in the 1980s and 1990s, but they began to increase around 2000, partly because rapid economic growth in Asia was lifting demand for all sorts of commodities.

Myth 2:Gold is a hedge against inflation.

Fact 2:Gold prices are typically more volatile than the Consumer Price Index.

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This chart compares the changes in the price levels of gold in red with the consumer price index in blue (recall that the consumer price index, or CPI, is a measure of the changes in prices of all goods and services purchased for consumption by urban households). As you can see, the price level of gold fluctuates drastically while the CPI shifts more modestly. Simply put, this chart illustrates that the price of gold has been more volatile than the overall price level in America throughout recent history.

If gold were indeed a hedge against inflation, we should expect to see a smoothly sloping line illustrating the changes in the price of gold coupled with a more jagged line illustrating the changes in the overall price level—but this is not the case.

Over the past 10 years, gold’s average volatility in a given month was 4.9 percent, according to the World Gold Council; compare this to a roughly 0.15 percent average monthly variation in the Consumer Price Index during the same time period.

So why do investors purchase gold in times of economic recession? Some investors may buy gold to shelter their assets from the risk of inflation. However, it appears that investors overall view gold more as a “crisis hedge.” According to the Gold World Council’s study “Gold Hedging Against Tail Risk,” gold is a hedge against infrequent or unlikely risks that could nonetheless dramatically affect one’s portfolio, such as government default, systemic risk, and revolution. To many people, gold is a safe commodity in uncertain times.

Another potential factor driving the price increase is that these prices are set in a global marketplace which faces increasing demand and decreasing supply. As emerging markets acquire wealth, they demand more gold jewelry and more investments in gold. The study “Gold: A Commodity Like No Other,” for example, says that jewelry is responsible for roughly 50 percent of the market for gold. Gold imports into China have soared this year, making the country a major overseas buyer of gold for the first time in recent history. Indeed, China is on track to overtake India as the world’s largest consumer of gold.  

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The chart above uses data from the United States geological survey to chart the annual world gold production every year since 1900. As you can see, increasing world demand has been accompanied by a slowing level of world gold production, which could explain some of the increase in the price of gold.

Myth 3:We are sitting on a gold mine.

Fact 3:While gold is worth more than we think, it is not nearly enough to make a dent in the national debt.

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At roughly 74 percent, gold makes up the vast majority of the cash, bond, and commodity reserves of the United States. These gold holdings are systematically undervalued since by statute one ounce of gold is priced at $42.22; this number differs starkly from the market price of gold.

According to the Department of the Treasury, the U.S. Treasury holds roughly 264.3 million troy ounces of gold, marked at a value of $42 per ounce, giving a reported value of $11.1 billion at the end of fiscal year 2010. However, if the total U.S. gold holdings were valued at the recent spot price of $1,500 per ounce, they would be valued at near $400 billion.

That is certainly a significant amount of money, but $400 billion still would not cover the debt (not that we shouldn’t sell the reserves if we need to). More importantly, any attempt to sell our reserves would drive down the price of gold by flooding the market.

show http://www.youtube.com/watch?v=7gDXPuup3tY&feature=player_embedded

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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