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Does gold hedge against inflation?

Tuesday, 27th September 2011

Yes, depending on what you mean by inflation. Most people assume it means increases in the CPI - Consumer Price Index. Using this argument, gold's high of USD$852 per ounce in 1980 should equate to an inflation-adjusted high of about $2,400 today. But gold is not a currency that you spend at the grocery store. Therefore, it does not hedge against a decline in the purchasing power of the dollar, euro or peso.

Gold is a store of wealth, a financial asset used to hedge against a drop in value in other financial assets. What has happened to the supply of other financial assets since gold hit its previous high in 1980? Let's look at US Total Credit Market Debt. In 1980, it was $4.725 trillion at year end. All of this debt was an asset on the books of lenders and investors. To back these assets and protect debt holders from default or rising interest rates, it would have taken a gold price of nearly $17,000 per ounce for gold to provide a 100% cover for total US debt. Gold peaked at $852, providing coverage of about 5%.

Today, US Total Credit Market Debt is $52.554 trillion, an increase of 1,012% since 1980.  Meanwhile, the US gold reserve (282 million ounces) has increased in value by about 100%. It would now take a gold price of more than $186,000 per ounce for US gold reserves to provide 100% coverage of total US debt or about $9,300 per ounce for the 5% cover of 1980.

We do not know how much confidence investors in US credit markets will lose and how much insurance coverage they will demand. The risks must seem rather low to them at present and there are other ways to Credit Default Swaps which are issued in vast and unregulated quantities by banks and hedge funds. But debt has grown much faster than the economy which must service and back this debt.

Total Credit Market Deb As % of GDP

From 1980 to 2010, the US economy grew 406% in nominal terms while total credit market debt increased 1,012% -nearly 3 times faster. Can the value of this huge debt load be maintained? We think not. Too much debt has gone to support consumption and non-productive investment. Credit creation is faltering when it must continue to grow rapidly just to roll over existing debt and keep the game going. The conclusion must be default either by restructuring/repudiating the debt or eroding its value through monetary debasement.

Credit expansion is the inflation that, in our view, gold must eventually back in the event of a collapse of confidence in credit markets. The question is, what will the owners of $52.6 trillion in debt-based 'assets' pay for the one asset that backs itself, cannot be printed and cannot default? It does not seem unreasonable to us to think that debt holders will want a 5% cover once again, creating an enormous demand for gold.