Buying Gold: Trick, or Treat?

About a month ago, I received an email from a client asking how I felt about her 18-year-old nephew investing in gold. (I received permission from my client to discuss that email in this article.)

My first reaction was maybe her nephew was a fan of Ron Paul, for whenever I watch cable news I see a commercial where former Texas congressman and presidential candidate Ron Paul urges viewers to go to his website, where they can watch a video of Dr. Paul stewing over all the money-printing by the Federal Reserve and how it is allegedly going to fuel inflation and lead to a financial crisis worse than the Great Depression. The video ends with Dr. Paul recommending that viewers protect themselves by ordering from him a “blueprint plan,” a part of which urges investors to buy gold. (Gold has been one of his biggest beefs ever since President Nixon ended the U.S. dollar’s direct convertibility to gold in 1971—the “Nixon Shock” that jolted Paul into running for Congress.)

A couple of days after receiving my client’s email, I ran across a Bloomberg article scrutinizing the performance of a hedge fund run by legendary fund-manager David Einhorn. The reporter pinned the fund’s poor performance on its 10% allocation to gold, which has declined in value from $1,400 an ounce in 2014 to around $1,088 an ounce today—a 22% drop.

In his 2013 first-quarter letter, Einhorn wrote, “Investors are currently complacent about the unintended consequences of central bank money printing… Under the circumstances, it is curious that gold is not doing better.”[1]

The next day, I came across a Bloomberg article having to do with Bank of America yanking money from a poor-performing hedge fund run by John Paulson. Paulson had made billions betting against the subprime mortgage market, after which he made a bet on gold for the same reasons Einhorn did: money-printing by central banks, leading to inflation.[2]

By reversing how money gets into the economy Einhorn, Paulson, and especially Paul exaggerate the inflation risk. They all believe money enters the economy when the Federal Reserve prints money that they then give to the banks. However, for that money to actually get into the economy, a customer of banks must borrow, and that decision is independent of how much money is in the banking system.

Think of the last time you borrowed money. Did any of your concerns have to do with how much money was in the banking system? Of course not. Nor is it much of a concern for the banks. Moreover, after the bursting of the housing bubble, many customers are less inclined to borrow, no matter how much money the Fed gives to banks.

With most of the new money trapped in the banking system, and with inflation falling, their other theory that gold is still an inflation hedge remains untested. Under the gold standard the U.S. had in some form until 1971, owners of dollars could exchange them for a certain amount of gold. This convertibility forced governments and central banks to buy more gold, thus making that precious metal an antidote for money-printing and inflation.

Proponents of a return to the gold standard, such as Dr. Paul, worry that today’s dollars are fiat that is backed only by a government’s promise to pay. However, when the U.S. and Great Britain were on the gold standard, the amount of gold someone received in return for their dollars or pounds was an arbitrary number created by the government. So it, too, was just a promise to pay a certain quantity of gold.

Also, when gold was in coins, e.g., during the Roman Empire, financial experts such as David Graeber, in his book Debt: The First 5,000 Years,[3] as well as Geoffrey Ingham in his, The Nature of Money,[4] point out that the value of the coins was independent of their gold content and instead was based on a government’s promise to pay.

So why should anyone own gold when its connection to money is founded in part on folklore and a gold standard that no longer exists? Well, first of all, economics and finance are not physics—a lot of it is ruled by mythology, rules of thumb, and superstitions. And as long as investors, politicians and governments are influenced by these folktales (Russia’s central bank, for example, is buying gold) gold just might remain a hedge if inflation returns.

These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.

[1] Basak, Sonali, and Simone Foxman. “Einhorn Punished by Gold as Greenlight Re Drops 16% in 2015.” BloombergBusiness, July 28, 2015. http://www.bloomberg.com/news/articles/2015-07-28/einhorn-punished-by-gold-as-greenlight-re-tumbles-16-this-year

[2] Burton, Katherine, and Hugh Son. “Bank of America Pulling Clients’ Money From Paulson Fund.” BloombergBusiness, Aug. 5, 2015. http://www.bloomberg.com/news/articles/2015-08-05/bank-of-america-pulling-client-money-from-paulson-fund

[3] Graeber, David. Debt: The First 5,000 years. New York: Melville House, 2011.

[4] Ingham, Geoffrey. The Nature of Money. Cambridge, U.K., and Malden, Mass.: Polity Press, 2004.