July 18, 2006

Arguments Against Investing in Gold

Today, when asked about investing in gold, most people will just give you a curious look. This, however, is quite different from the response that would have been elicited just a few years ago. The events of the last year or so seem to have planted a seed in the collective consciousness of ordinary folks around the world who would have responded to the same question with a blank stare earlier in the decade.

Today, many people may even get a little twinkle in their eye at the thought of buying precious metals as an investment - some perhaps recalling a recent article in the mainstream financial media about hedge funds, others remembering the words of a much older relative who spoke of purchasing gold coins many years ago.

But, by and large, the arguments against investing in gold are still too compelling for most individuals today.

If you are under fifty years old, you likely have only the vaguest recollection, if any at all, of soaring gold prices years ago. As a college freshman in 1979, there are hazy memories of attending a lecture in Economics where gold's ascent from $220 an ounce to two or three times that price was discussed. And, the early 1980s sale of a high school class ring that surprisingly fetched three times its 1978 purchase price can also be recalled.

But aside from these events, a personal history involving gold is non-existent to me. That is, up until the turn of the century.

This is the strongest argument against investing in gold today - people are generally not familiar with the stuff after two decades of it being mostly irrelevant, and they don't feel comfortable laying their money down on something that their friends, family, or investment advisor have not yet sanctioned.

It's OK to be wrong, but it's not OK to be wrong all by yourself.

In that case, others just think that you are stupid, crazy, or both.

The herd instinct and the preference for safety in numbers will forever make individuals poor investors - this is simply a fact of life that most, unfortunately, will never realize. This very much applies to the purchase of gold by individuals today.

Of course, this is one of the most compelling reasons to make an investment in gold at the moment - before friends, family, and every certified financial planner in the country is convinced of its enduring value when compared to paper money. Gold's value relative to U.S. dollars is sure to rise dramatically in the years ahead as more and more ordinary citizens realize their government is devaluing their currency in order to make good on promises that it can not otherwise keep.

Surely, the strongest argument against investing in gold today is that most people are not familiar with it, they may be wrong, and then they would feel stupid.

But, what are the other arguments?

Gold provides no return

Ask almost any economist today and they'll tell you that while gold is irrelevant in our current monetary system, it is also a poor investment because it provides no return. Stocks pay dividends, savings pays interest, bonds pay a coupon, and real estate generates rental income.

But gold just sits there.

It just sits there like it's been sitting there for thousands of years - never destroyed, rarely consumed, dug out of the ground at great expense, but most importantly (and in stark contrast to paper money or its electronic equivalent) gold is rare.

This particular characteristic of scarcity - not being easily created or reproduced - is what has given gold increasing appeal over the last few years as people around the world have noticed that governments and central banks have opted to solve problems by creating more money - out of thin air.

Naturally, as more money is created in this manner it makes all the existing money worth just a little bit less, and while a slowly increasing supply of money serves everyone's long-run goals, money supplies increasing at 8, 10, or 12 percent for many years tends to create an imbalance between the amount of money and the amount of goods that it can purchase.

Meanwhile, gold just sits there, waiting for the money/goods imbalance to be noticed by the population as a whole, who then assign a higher value to gold - not because gold has changed in any way or done anything at all, but as a reflection of the declining value of money created out of thin air. In the end, gold doesn't need to provide a return to investors - it simply goes up in value to reflect the growing imbalance between money and goods.

As long as money is created out of thin air, not providing a return seems to be a poor argument against investing in gold.

There are better hedges against inflation

Many times the mainstream financial media has been heard to say that gold offers a "hedge against inflation", and that some investors buy gold for this reason. Another argument against investing in gold is that there are other products available today that offer a better hedge against inflation than does gold.

A prime example of such products are Treasury Inflation Protected Securities, better known as TIPS. With TIPS, the government uses the change to their index of consumer prices to determine an interest rate that guarantees holders of the securities a rate of return that is "protected" from inflation.

But this makes little sense for two reasons.

First, the consumer prices used to calculate the guaranteed rate of return may not mesh well with your long-term plans. Say, for example, you wanted to buy a house a few years ago you put some money aside for this purchase. If the inflation protection offered by the government were working properly, you'd be able to buy the same house this year, next year, and the year after that with the money that was set aside.

That has been far from the reality of recent years.

Second, since the government controls how much money is created, why don't they just create less money and then they won't have to offer "inflation protection"? Isn't this similar to buying "protection" from the mob? Why doesn't the government simply limit the increase in the amount of money they create to roughly the same increase in goods and services that it is used to purchase, and then no "protection" would be necessary?

Using the government's protection against inflation also seems to be a poor argument against investing in gold.

Central banks will sell their gold to keep the price down

Though it's not clear why they keep gold in their vaults, the central banks of the world have in the past sold their gold into the markets causing prices to drop. The Bank of England famously sold about half of their stash when gold prices were at multi-decade lows back in 2001. Future Prime Minister, and current Chancellor of the Exchequer, Gordon Browne has been roundly criticized for orchestrating this sale that, had he waited a few years, would have netted his country another 4 billion pounds.

While central bank gold sales have been occurring with much less frequency in recent years, and in fact the process seems to be reversing as central banks in Russia, Argentina, and elsewhere are now buying gold, these banks do still have a lot of gold - at least according to the records that they keep.

Through gold leasing programs over the years, "bullion banks" have borrowed many, many tons of gold from central banks, sold it into the market, then invested the proceeds at a higher rate of return than the typical one percent per year charged by the central banks to borrow their gold. Of course, in theory, all this gold must be returned to the central banks in order for the books to be squared - some say that as much as half of the gold listed on the bank's ledger has left their vaults under these terms.

Much of it now dangles from the necks of Indian women, or is stashed away in safe deposit boxes somewhere, as the bullion banks ponder their options in holding up their end of the bargain with the central banks. Unfortunately, the price at which they would have to repurchase the stuff in order to return it to the central banks is now 50, 100, or 150 percent higher than when they borrowed it in recent years.

Alan Greenspan once commented that the reason why central banks continue to hold gold reserves is in case there is a crisis. One look around the world today and the potential for crisis makes central bank selling of gold less likely and a poor argument against investing in gold.

The government could confiscate gold

With the stroke of a pen in 1933, Franklin D. Roosevelt outlawed the personal ownership of gold coins and bullion in the U.S. in an attempt to address one of the causes of the Great Depression. Citizens were required to sell their gold to the government at $20.67 an ounce, and shortly thereafter, the gold-dollar relationship was adjusted to $35 an ounce for purposes of settling international transactions.

Gold was fixed at $35 an ounce until 1971 when Richard Nixon announced that the United States would no longer exchange gold for dollars at that rate, forever severing the link between paper money and gold. Three years later in 1974, the limitation on private ownership of gold was repealed, and the relationship between gold and U.S. dollars was left for markets to determine.

During the 1970s, gold proceeded to rise over 2000 percent relative to the dollar, peaking at over $800 before Federal Reserve Chairman Paul Volcker raised interest rates to 20 percent, inducing the worst recession since the Great Depression and restoring confidence in the U.S. currency which endures to this day.

Some people believe that the U.S. government could once again confiscate gold should the situation warrant, and in light of government actions in the years since September 11th, this does not appear to be outside the realm of possibility. However, when you think about it, why would the government confiscate gold? It plays no role in any monetary system - paper money can no longer be exchanged for gold and the settling of international transactions no longer requires it.

In the world of contemporary banking and finance, gold is irrelevant - a relic of the past - completely unnecessary.

For the U.S. government and its central bank to confiscate its citizens' gold would be the most colossal admission of failure for any monetary system in history, and conditions precipitating such action would surely be the end of the world as we know it - perhaps shotgun shells would serve as better currency than gold coins in that case.

Fear of the government taking away gold held by its people is also a poor argument against investing in gold.

There's only one good argument

In the end there appears to be only one good argument against investing in gold today, and that is the possibility that you might look stupid in front of your friends and family. But ironically, this is probably the strongest argument for investing in gold, since these same friends and family will likely be buying gold for themselves in a few years.

When every investment advisor in the land is advising that some portion of your investment portfolio be allocated to gold and when the shoeshine boy starts talking about gold mining stocks, that's your cue to start selling, not buying.

My advice?

Buy some gold, just don't tell anyone.