Monday, March 7, 2011

Gold, Inflation, and the American Saver

Quite a bit of ink has been spilled about gold, whether it does or doesn't have any intrinsic value and whether it is or isn't an appropriate investment.  Dr. Gary North had an interesting essay on this on Lew Rockwell's site on Friday (hat tip to Controlled Greed), which I generally agree with and that I recommend. 

There are a few points that Dr. North didn't make in that post and that I don't generally see discussed, but that I think are important for individual investors and generally for citizens interested in our nation's fiscal health.

1) First, and from an economics perspective most important, it is true that gold has no intrinsic value.  But as Dr. North pointed out neither does anything else.  And all of the points commonly made against gold - how do you value something with no cash flows, why is a metal with very little practical use so valuable, etc. - apply with equal force to dollars.

2) Second, dollars do have one very important intrinsic advantage over gold.  And that is the fact that the fixed price debts that are owed by most Americans - including mortgages and car loans - are denominated in dollars and not in gold.  To put this differently, if you are saving dollars to pay off a mortgage loan, your savings are at no risk as long as you are in fact going to put them towards paying off that mortgage loan.  Likewise, if you are saving a "rainy day" fund, on a rainy day that fund would likely be spent on fix-priced dollar-denominated obligations such as your mortgage or car payments.  If you convert those savings into gold, you are taking on risk - you can't use that gold to pay the mortgage loan, you first have to convert it back into dollars at the future exchange rate.  The point is that when people claim gold may be a conservative investment, that depends in large point on what the investment is for. 

3) Third, and related to point 2 above, if you truly expect hyper-inflation at some point in the near future, and if you think the market is under-estimating that risk, from a financial perspective borrowing money at a fixed rate to purchase farmland would be a great strategy.  So would simply going short the dollar.  And, likely, so would holding gold.  But there's nothing that naturally makes one strategy better than the other.  If what you're trying to buy is inflation insurance, those would likely all be effective methods, and the relevant question is how expensive is the insurance.   

4) Fourth, as Dr. North points out, gold has historically held value over long periods of time.  If the average Roman citizen in Ceasar's time left all of his gold to his children, and that bequest was passed down over the centuries, it would still have (likely considerable) value today. 

5) Fifth, if you save dollars over a long period of time, at that later time those dollars will still be good for paying off the same amount of fixed price dollar-denominated debt as they were good for when they were initially saved.  But unlike the Roman citizen's gold, they certainly won't be able to purchase the amount of other items as they could have purchased when they were saved.  How do I know that with certainty?  Because it is bi-partisan government policy for dollars to be worth less over time.  That's not conspiracy theory, that is a widely acknowledged fact.  It's the policy of the Obama administration, it was the policy of the Bush administration, and so on back through the beginning of the modern American welfare state during the Great Depression.  Again, that isn't a conspiracy theory - those policies are explicit and constantly acknowledged by relevant policymakers.  T 

6) Sixth, discussions about whether the federal government is supplying too many (conservatives saying this) or too few (liberals and sometimes some policymakers in conservative administrations saying this) dollars seem to me to be frankly silly and a little beside the point.  They are like arguments about how much grain American farms should produce.  Cash is a commodity just like any other, and its just as silly to talk about the "correct" amount of dollars as it is to talk about the "correct" amount of grain. 

If you take what Mr. Bernanke says at face value, he thinks there are currently too few dollars and that if more aren't created there will be adverse economic consequences.  And he may very well be right.  I doubt he is because of the terrible incentive that permitting the largest borrower in the nation to print the currency in which its debt is denominated gives the currency printer.  But it could be the case.  I can't analyze the question any better than I could anaylze the question of what is the correct amount of grain for the U.S. to produce.  The Soviet Union tried to let its experts answer that question and people starved.  The U.S. lets its experts answer the question in regards to money and we have violent business cycles.  I'm about as surprised by both of those facts as I was surprised to see the sun come up this morning.

So where does this leave an individual in the United States?  Frankly, in a bad place.  Suppose you want to be a saver rather than a speculator on asset prices.  Too bad!  Saving doesn't exist.  Why is that?  At least party because it's government policy for it not to exist.  Instead, the federal government has decided to impose a penalty tax on savings and distribute the proceeds of that tax to debtors (like itself) and exporters.  As I said before, that's a long term, bipartisan policy.  Whether you or I like it or not, the chances of it changing any time soon are extremely low.

My own personal rule is that if you're saving to repay fixed-rate dollar-denominated debt, such as a fixed-rate mortage loan in the United States, or if you're saving a rainy-day fund, then save dollars. (I personally use excess savings from a rainy-day fund to pay mortgage debt.  If you're just saving to pay a mortgage, there's a good question of why you're not immediately applying those dollars to the mortage so the interest doesn't accumulate.) To the extent you convert savings you plan to use for that type of purpose into gold, you are taking on risk and should be comfortable that you are receiving prospects for an adequately compensatory return.

With respect to my retirement savings, on the other hand, it is important to me that I at least maintain the current purchasing value of those savings.  And so for those purposes I do currently have some significant part of those retirement savings in gold (or rather, gold-related securities).  I would like to have a very conservative investment plan for my retirements savings, but as long as the government's policy is to quite rapidly reduce the value of the currency (as opposed to the slower reduction that's been the case in the past), I feel I don't have a choice.  To me gold currently seems like high-priced but nonetheless conservative insurance on the value of my retirement savings.  It has the added advantage of holding up just fine in deflation, also, which the markets have been signaling over the past few years is as or more possible than inflation.  (And for the record, it is not inconsistent for people to expect price inflation and deflation.)

What is the correct policy response to all of this mess?  To start, I believe that the answer is probably not for the currency monopolist to adopt a gold- or other metals-backed currency, at least not without other changes.  Mr. Bernanke is certainly right about one thing, which is that it can be a problem for there to be too little currency.  In fact, that can be a quite devastating problem.  This is why over the vast millenia when gold was the primary currency silver and other metals were used also - there simply isn't enough gold for it to be the only currency.

Instead, I believe the answer is for the government to give up its monopoly on producing the commodity that is currency.  To me, saying that is about as wacky as saying that government shouldn't produce grain - I think we should be able to stipulate that central planners don't have a great track record in predicting future demand for commodities.  Let people produce alternatives for themselves and let them sell their goods in those alternatives and market them as dollar alternatives if that's what they want to do.  The dollar would still have a huge advantage because taxes would need to be paid in dollars, but this would at least give U.S. citizens one more tool to protect themselves.  It would be sort of like the Soviet Union allowing people to trade their own grain.  (Note that this change likely wouldn't accomplish too much.  Because I have to pay taxes in dollars, and my employer has to send in withholding in dollars, I have to be paid in dollars, etc.  But it would be a very small step in the right direction.)   

A second improvement that I think conservatives should think about strongly is to require that a much larger part of the government's debt be inflation-indexed.  From an investor's point of view I worry about investing in TIPS as inflation protection for anything other than mild inflation because in a pinch the government will just default the old fashioned way.  But from the perspective of the country's finances, requiring the government to finance itself with inflation-protected securities would go some way towards curing the terrible incentives it currently has to steal from some of the least well-off members of society to finance its operations.

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