Many people still believe that gold is an inflation hedge.  Maybe that was true in the nineteenth century and before, but I don’t think it is one today.  I don’t think the price of gold over the past thirty years supports the inflation hedge view, either.  But others clearly interpret the data differently from me, since the inflation hedge thesis seems to be firmly embedded in conventional wisdom.

Three factors have changed the place of gold in investing over the past few decades.  All argue against the inflation hedge thesis:

1.  Gold is no longer money.  So it no longer plays its former role as the lynchpin of a system to protect against excessive money creation;

2.  Other instruments have become available that are better inflation-protectors than gold, such as inflation-linked bonds or futures contracts for “hard” currencies like the euro or the yen;

3.  Increasing world political stability and increased respect for the role of profit-making enterprises–especially in China–have reduced the need for anonymous, portable, durable forms of wealth like gold.

The price history

I would separate the price action of gold during since the last gold standard attempt was ended in 1971 into four different periods:

1971-74.  For the twenty-five years prior to 1971, the world price of gold had been fixed at $35 an ounce by the US pledge to convert dollars held by foreigners into physical gold at that rate.  When President Nixon was forced to end this commitment (we were running out of gold), the price quadrupled over the following four years.

1975-1981.  The US worries about the possibility that inflation will spiral upward out of control (the Fed was trying to set money policy be controlling interest rates, but chronically setting rates too low).  Inflation builds throughout the period, with the price level, measured by the GDP deflator, rising in total by 75% over the seven years.

The prices of most tangible assets rise very sharply.  Some companies even substantially restructure themselves by taking on large amounts of fixed-rate debt and using the money to buy even low-quality hard assets–real estate, mining companies and the like (subsequently ruining themselves during the Volcker era when asset prices collapse and their debt has to be rolled over at much higher rates).  Gold quadruples to $850, before quickly dropping back below $400.

1982-2004.  The price level in the US rises by 82%.  The gold price moves up from $398 to $435, or about 9%.

2005-present.  The price level in the US rises by 11%.  The gold price spikes to $1011, but then recedes to around $870.

Price History Chart

period        price level  Δ      gold price Δ     mine production(ton/yr)

1971-1974              +30%              +366%                            1,360

1975-1981            +76%                +113%                            1,220

1982-2004          +86%                    +9.4%                           2,030

(production rises steadily, peaks at 2,600 tons in 2001)

2005-2008          +7%                    +100%                          2,425

How do I interpret these four periods?

1971-74.  The gold price had been held flat at $35 an ounce for 25 years, before being decontrolled in 1971.  Although the open market price had been drifting up a bit before that, during this period pent-up demand is being satisfied and a market-based equilibrium is being reached.

1975-81.  This was a time of sharp inflationary spiral.  The prices of all tangible assets rose sharply, in an environment where many of today’s inflation-protection instruments were not available.  Remember, too, that although the Bretton Woods agreements had fallen apart, currencies were still subject to considerable government interference and didn’t really float yet.

Still, if you’re a gold bug, you’re right that gold protected you against inflation for this period (unlike any time since).

One other factor present during this time–the famous, unsuccessful attempt by the Bass brothers to corner the silver market in 1980, with the aid of a Middle Eastern partner.

The idea was straightforward, although right out of the nineteenth century.  Silver futures contracts at that time gave the holder the ability to ask for physical delivery of the appropriate amount of silver on the expiration of the contract.  The Hunt consortium bought more silver contracts than there was metal available for delivery to settle the contracts.  They helped their own cause by buying physical silver as well.  Then they announced that they would not accept settlement in cash but intended to take delivery of the silver.  During this time silver shot up from about $5 an ounce to $50+.  Gold rose in sympathy, cresting at about $850 an ounce.

In January 1980, the COMEX, the commodity exchange on which the silver contracts were traded, began to change the rules about how many contracts any one person could hold and increased margin requirements.  The Hunts complained, to no avail, that the COMEX officers were the people on the losing side of their contracts.  Silver–and gold–collapsed.  The Hunts lost over $1 billion.

(Aside:  there was a subsequent attempt to corner the heating oil market.  The same idea–own more futures contracts than there was oil and then demand physical delivery.  In this case, the counterparties were more elegant.  The contracts required the holders to provide barges to put the oil in, and allowed the sellers to designate the delivery port.  The counterparties designated the port only after they had leased all the available barges for the period of contract expiration.  The two sides settled.)

1982-2004.  This is the really telling period.  Prices went up by about 3% a year and gold barely budged.  There’s a supply/demand story here, too.  In the Sixties and Seventies, experts on the economy–industrialists, financiers, economists, government officials–agreed that GDP growth would be manufacturing growth and would require equivalent growth in raw material usage.  Sounds crazy now, but until the early Eighties, that’s what people thought.  ( National Lead was even one of the “Nifty Fifty” stocks of the early Seventies.  These were the “one decision” stocks that you needed only to buy and watch the profits roll in.)

Confident of almost boundless growth in demand for their output, mining companies borrowed heavily and launched huge development programs for all sorts of base metals–copper, aluminum, lead, zinc…  These projects started coming on stream in amounts far in excess of the world’s needs just as global GDP was beginning to stagnate.  Output also began to become available from low-cost state-owned mines in developing countries.  These were run more to provide employment and generate foreign exchange than make money.  So mining company losses began to mount.

What to do?  En masse, the firms turned to gold exploration in the late Seventies.  Why gold?  Relatively high value/weight means smaller, less expensive projects, shorter lead times, the possibility of transporting ore to already-existing processing plants.

The net result–world gold production climbed in a steady progression for 20 years, from 1982 to 2001, keeping a lid on prices.   This is the same thing that would happen with iron ore, or chemicals or any other commodity.

2005-2008.  Two decades of stagnant prices teaches miners not to develop new gold mines, unless they’re low cost.  Consolidation of the mining industry into large conglomerates with financial discipline and a diversified mineral base helps, as well.  No new production in prospect, and a growing world population almost 50% larger than in 1982, equals sharply rising gold prices, even with little inflation.

In summary, we have about 35 years of gold trading freely.  For the first seven of them, gold arguably acted as a safeguard against inflation.  For the remaining 28 it hasn’t.  Instead, it has exhibited the boom/ bust behavior typical in any commodity industry as it swings between overcapacity and shortage.