Investing in gold is controversial. The reason I prefer gold as an investment is that it is a reliable counter against inflation. Many argue that inflation is not a problem, especially during a recession, but I believe inflation can still be a problem during economic downturns. A second counter is that the federal reserve will not inflate. I believe that the FED will inflate. A third counter is that gold is not a good inflation hedge. While there are times in the recent past when gold did not perform well, I believe times have currently changed for the better for gold (and for the worse for our economy).
The first objection is that inflation is not a problem during a recession. The argument is that during an economic downturn, aggregate demand falls which puts downward pressure on prices. Empirical evidence points to falling prices during the Great Depression. To a certain extent I agree with this analysis. I believe that the overall level of prices is determined by the supply and demand for money. Let's assume that the supply of money is fixed. During a recession, private consumption falls and private savings increases. Part of the increase in savings constitutes physical money and thus during a recession the demand for money increases. An increase in the demand for money increases the value (or the price) of money which means that the price of everything else falls relative to money. Thus, I would agree that prices fall during a recession, assuming that the supply of money is constant.
The important premise is that the supply of money is constant. I do not believe that the government will stand idly by and keep the money supply constant while the economy falls into recession. Milton Friedman wrote that the Great Depression was caused because the FED allowed the money supply to fall, which reduced prices and the reduction in prices caused the economic downturn (I'll write another blog about this idea later). Thus, mainstream economists believe that expanding the money supply to offset the fall in prices helps an economy out of an economic downturn. The newly printed money can be used to buy things which stimulates aggregate demand. The increase in money supply can cause prices to stop falling, and if enough money is printed, to rise. The rise in prices is expected to help the economy by reducing the demand for money which will increase the demand for goods and services. Also, there is a belief among economists that a weak currency helps economic growth by stimulating exports and reducing imports. In my other blog (economyandpolicyreport.blogspot.com) I have written against this idea, but it is generally held.
In addition to economic reasons, the government has its own special interest in causing as much inflation as possible while attempting to under-report it. First, capital gains taxes are not indexed for inflation, so as the values of stocks and bonds increases due to inflation, these are taxed. Second, inflation eventually trickles down to wages and will cause bracket creep. Although tax brackets are indexed to inflation, if the government under-reports inflation, it will benefit. Finally, the government is a huge debtor and causing inflation reduces the burden of that debt. Thus, the government stands to gain large benefits by creating as much inflation as possible, while under-reporting it.
While there are a great deal of costs that inflation imposes on an economy, an increase in economic uncertainty and a lower standard of living especially for the poor and middle class, the government can usually deflect criticism of higher prices away from itself. The usual suspects are Wall Street speculators, large corporations making huge profits, and foreigners either demanding more or supplying less. Most of the citizenry and even most economists do not understand that it is the government that is ultimately responsible for higher prices by printing money.
Thus, it is my opinion that the combination of academic arguments, government self-interest, and minimum downside for the government will combine to cause the government to print a great deal of money to try to stimulate out of the current deep recession. This money printing will overwhelm the increase in the demand for money and cause inflation. Gold is one of the best hedges for inflation and that is why I like gold as an investment.
One counterargument to the gold thesis is that there is a great deal of debt deflation. The argument is that the total amount of debt is decreasing because banks are becoming more restrictive in giving out mortgages, car loans, and credit card loans. While I am not sure how much this is decreasing over the past 4 years since the crisis started (or whether the decrease has been continuous), I do not believe this affects the gold argument at all. These are all credit instruments and credit is not money and should not be considered when calculating the money supply. When a loan is made, the money is transferred from one person to another. A person cannot loan money and spend it at the same time. Thus, loans do not add to the money supply, and the reduction of loans do not reduce the money supply. Of course checking accounts do allow individuals to both loan money to the bank and spend it at the same time, and therefore checking accounts do increase the money supply. For more on this, please research the True Money Supply.
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