Is gold really a safe haven?

Is gold really a safe haven?
04 August 2011

THE recent debt furore in the euro zone and United States has lead to a good deal of economic uncertainty of late.

It’s at such times that precious metals, such as gold, have historically been looked to as a haven for investors and a hedge against inflation. Here, cashy looks into why...

A brief history of money

As early as the 16th century, goldsmiths in Europe would store gold in their vaults and issue receipts to depositors. Due to the convenience of carrying these receipts relative to the gold they represented, people came to use them to trade and the roots of paper money were planted.

In this way, paper money represented a stable store of value as it was tied directly to precious metals, such as gold and silver. One of the key benefits of this gold standard was long-term price stability as the money supply could only increase at the rate that these precious metals increased, making inflation unlikely. Up until 1971, every dollar in the US could be redeemed for its value in gold.

What happened in 1971?

On August 15th of 1971 the US unilaterally terminated the convertibility of the dollar to gold. As a result, the dollar became the reserve currency of the world, and a fiat currency not pegged to the value of any precious metal.

What is fiat currency?

Fiat money is money that derives its value from government regulation or law. Whilst the dollar was previously redeemable in gold or silver, it is now fiat money issued by the US central bank. Referred to as ‘legal tender’, it is redeemable only for another fiat dollar.

The advantage to the US government is that it can now print as much money as it likes as the increase in the money supply is no longer linked to the value of gold. However, a consequence of this policy has been an increase in inflation, and it is likely because of policies such as this that history has time and again demonstrated the inevitable collapse of fiat currency.

What is inflation?

Many people understand inflation to be an increase in the price of goods and services. This kind of rudimentary explanation is akin to describing a Ferrari as a ‘red car’. The truth is that inflation occurs as a consequence of a currency declining in value. Inflation is not, then, caused by rising prices; rising prices are instead a symptom of inflation.

Inflating the money supply relative to the availability of a finite supply of goods and services will always erode the value of savings, and the currency as a whole. Some have even gone so far as to describe inflation as a stealth tax that robs the wealth of the middle class and diverts it to the wealthy.

Why is there too much money?

The problem stems from an economic system based on usury. Usury is the practice of charging interest on loans. The practice used to be banned in Christian societies, and is still considered a sin in Islam.

A consequence of a debt-based, usurious economy is that the money earned through interest ends up devaluing the currency as no industry has been used to produce it. The problem is exacerbated because this falsely created money begets more falsely created money in an ongoing cycle

Also, any time the government engages in deficit spending it creates the conditions for inflation. However, when this deficit spending is used for productive means, such as infrastructure projects, then that spending will eventually pay for itself.

The real danger comes when deficit spending is used to fund wars as vast sums of money enter the domestic economy for products that, rather than providing productive domestic utility, are used for foreign destructive purposes. This is why, historically, inflation has always increased during times of war.

What about bailouts?

The slew of bailouts and quantitative easing we have seen first in the US and now in Europe have generated wave after wave of printed money in an attempt to quell the fiscal inferno that threatened to engulf their economies.

Unfortunately, it may be the case that using more debt to solve a debt problem may only serve to add fuel to the fire. And this leads to my main point: in such unprecedented times, it makes sense for people to take their money and invest it in assets that hold real value.

If the US gets downgraded, the knock-on effects will inevitably affect the stock and bond markets, and the dollar would most certainly take a tumble.

The last ten years alone have shown an increase in the value of gold from some $200 an ounce in 2001 to around $1,600 in 2011.

It should also be noted that gold and the dollar exhibit an inverse relationship when tracked over a 12-month period. When the dollar weakens on the exchange market over an extended period, the US gold price will generally rise over the same period, and vice versa. With the real purchasing power of a dollar being some 4% of what it was 100 years ago, it makes more sense to invest in precious metals or commodities as they have always been used as a determinant of real value.

Pic credit: Salvatore Vuono/ FreeDigitalPhotos.net

What do you think? Is gold a safe haven, or a bubble about to burst?

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Market data specialist
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