Streetwise

Lauren Rudd

Sunday, April 13, 2014

It May Be Shiny But It Is Not Money

Whenever the efficacy of using gold as a way to generate superior real (excluding inflation) returns is questioned, the response tends to be the following: Since 1971 (when we went off the gold standard), gold is up 3,900 percent as compared to a 1,626 percent gain for stocks (without dividends) and since 2000, gold is up 366 percent as compared to a mere 10 percent gain in stocks (the S&P 500 index).

Not a valid comparison because gold was held at an artificially low price prior to 1971. A fairer comparison is to use $100 as the starting point in 1971. Now gold is up 1,110 percent, as compared to 1,626 percent for stocks without dividends reinvested, or 6,034 percent with dividends.

If we use $183 as the starting point - reasonable considering the initial move - the return is 665 percent. Using the midpoint of about $140, we get a 900 percent return. It's not even a contest.

When former Federal Reserve Chairman Ben Bernanke was asked why a central bank would hold gold, he was befuddled. When asked if gold was money, Bernanke replied, "No, it's a precious metal." Pressed harder, Bernanke went on to say it is an asset. He likened gold to Treasury securities, stating that “I don't think that they are money either, but they are financial assets."

So why do central banks hold gold if it is not a form of money? Why do they hold diamonds? "Well, it is tradition," Bernanke said, "Long term tradition."

In his book Basic Economics, Thomas Sowell argued that over the long-term gold does not hold value well. Consider that in real terms, meaning discounting inflation, a dollar invested in bonds in 1801 would be worth nearly a thousand dollars by 1998. A dollar invested in stocks that same year would be worth more than half a million dollars. Meanwhile, a dollar invested in gold in 1801 would be worth just 78 cents by 1998.

If we compare the returns of some of America's best businesses to gold, the evidence is even stronger. Coca-Cola (KO) closed at $.91 (adjusted for splits) on the first trading day of 1971. Since then, Coke is up 4,353 percent without dividends. Procter & Gamble (PG) was worth $1.83 in 1971, providing investors with a 4,111 percent, dividend-excluded return. Investors in Exxon-Mobil (XOM) are up 4,036 percent.

Yes, gold jewelry is pretty to look at, gold is chemically inert and it is the preferred metal of the electronics industry due to its low electrical resistance. But does gold really have anything to offer investors? The only logical answer is simply the desire to possess it. However, unlike real estate, equities, bonds or other dividend, interest, or rent paying investments, gold does not produce income.

Meanwhile, some political platforms advocate a return to a dollar backed by gold. Sorry, but such a conversion would be physically impossible due to the amount of gold physically required. Moreover, having talked with countless gold owners, I have reached the conclusion many people buy gold to protect against hyperinflation and devaluation of the dollar.

While it is generally understand that a falling price level is a bad thing, few understand that moderate inflation serves a several useful purposes. It's good for the economy when an overhang of debt is holding back growth and job creation.

Moreover, reasonable inflation encourages people to spend rather than sit on cash - again, a good thing in a depressed economy. And it can serve as a kind of economic lubricant, making it easier to adjust wages and prices in the face of shifting demand.

But what degree of inflation is appropriate? Would it be enough to get back to 2 percent, the official inflation target in both Europe and the United States? Past thinking held that 2 percent was enough to make liquidity traps, periods when even an interest rate of zero isn't low enough to restore full employment, very rare. However, we been in a liquidity trap for more than five years. Clearly, the experts were wrong.