The Myths & Realities of Gold and Inflation

August 24 2015

Gold investors are often labeled as doomsayers. In the past few years, gold was frequently recommended by investment gurus whom feared rampant inflation. Their predictions did not become reality, weakening the reputation of holding gold as an investment. Is that justified? Is gold really only a good investment when we are faced with an imminent economic collapse?

We will come to understand that the two most popular definitions of inflation are inadequate, leading to incorrect forecasts.

By definition, we cannot forecast inflation with certainty. Yet, every investor must have a decent understanding of inflation (and deflation); either to protect his or her capital adequately, or in order to make a deliberate speculative investment.

How the Reputation of Holding Gold as an Investment Was Harmed

When central banks turned on the printing press in 2008, some investment gurus screamed blue murder. They feared rampant inflation and buying gold was, according to them, the only way to save oneself.

However, the doomsday scenario that they feared did not become reality.

It’s true that the world economy did experience some bad years, and that people who bought gold in 2008 made a pretty penny.

Still, these pessimistic forecasts have affected the reputation of gold investments. Is that justified? Is gold truly only a good investment when we are faced with an imminent economic collapse?

The Three Aspects of Inflation

One of the reasons why inflation forecasts are often wrong is because people use definitions of inflation that do not match with what people mean by the term inflation.

When people say that there is strong inflation in a country, they think about the following three things:

  1. The prices of consumer goods rise.
  2. People in debt profit at the expense of their creditors.
  3. Businesses collectively make high accounting profits, but simultaneously experience higher replacement costs.
The classic example is Germany during the early 1920s: eggs cost you billions, people whom had borrowed money were able to pay their debts with paper money that had become worthless, and businesses made profits in the billions but could barely continue production. 

What Inflation Really Is

These three aspects of inflation can only occur simultaneously if the amount of euro’s spent in a country during a year increases. Economists use the term 'volume of spending' for this.

The volume of spending equals the amount of euros on bank accounts and in wallets — the money supply — times the average frequency with which a unit of money is annually spent (economist use the term 'velocity of circulation' for this).

If companies and individuals have 10 billion euros on their bank accounts and in their wallets, and each euro is spent an average of 5 times a year — the velocity of circulation equals 5 — then the volume of spending is equal to 50 billion euros.

If the volume of spending increases, this means that:

  1. More is spent on products.
  2. Paying back debts is easier, considering there are more euros to be earned annually in the economy.
  3. Companies obtain higher returns and therewith book higher accounting profits.

The word 'inflation' should therefore only be used to refer to an increasing volume of spending.

However, most people use the term inflation in two different ways. This can put students working on an economics course, but also investors or investment gurus, on the wrong path.

Why a Higher Consumer Price Index (CPI) Is Not the Same as Inflation

The most popular definition of inflation, the Consumer Price Index (CPI), only looks at the first aspect of inflation.

 

Usually rising consumer prices are the result of a larger volume of spending, but prices may also rise when production slows down. For example, as a result of: failed harvests, wars, strikes, trade embargoes and a whole range of other things.

 

Inflation figures reported in newspapers only cover a part of what we mean with the term inflation. Furthermore, as we have seen last week, the CPI is, by necessity, a rough estimation of price increases or decreases. 

 

Why an Increasing Money Supply Is Not the Same as Inflation

Due to the unavoidable inaccuracy of the CPI, there are people who define inflation as an increase in the money supply. They reason that when the money supply increases by 10%, prices will also increase by about 10%.

This is why some people screamed blue murder when central banks started their 'quantitative easing,' or when ECB chairman Mario Draghi launched his famous 'bazooka.'

Several gurus urged people to buy gold before it was too late.

Why Did Predictions Fail to Come True?

As we now know, inflation means a higher volume of spending. In other words, that there are more euros spent in a country. This can be the result of an increased money supply, but also due to a higher velocity of circulation.

After the 2008 credit crunch, central banks in the entire world increased the money supply immensely. At the same time, the demand for cash rose sharply; business and individuals were hoarding their cash. In other words, the velocity of circulation slowed down.

The combination of an increase in the money supply, and a slower velocity of circulation, resulted in a more or less equal amount of euros spent in the economy. This means that the volume of spending did not increase; or in other words, there was no inflation!

The Achilles Heel of Central Banking: the Velocity of Money

In order to forecast inflation, you would have to know what the velocity of circulation would be next year. In order to control inflation, you would have to be able to control the velocity of circulation.

 

This is the Achilles heel of inflation forecasts and central banking.

 

The velocity of circulation — how fast people and businesses spend their money, to what extent people are hoarding their cash — is a mass phenomenon. No one controls it. No one is able to take a look in the future to know how high the velocity will be.

 

The list of factors that influence the velocity of circulation is long: the availability of credit, the interest rates, the percentage change in the money supply, consumer confidence, investors’ sentiment, inflation expectations, and so on. 

 

Central banks try to influence these factors in order to reach their 'inflation targets.' In the case of the ECB, this means an annual average price increase of consumer’s goods of 2%.

 

In order to realize that 2% price increase, the volume of spending has to rise with two percent more than the increase in production that year.

 

In the years before the crisis, many economists thought that the velocity of circulation — and thereby the spending volume — was relatively stable in nature and could therefore be controlled.

What Was about to Happen During the Credit Crunch

In 2008, these economists were in for a surprise; companies, financial institutions and individuals were all hoarding their cash. The volume of spending was about to collapse. Or in other words, deflation was near.

Deflation is the inverse of inflation:

  1. Falling prices
  2. Paying back debts becomes more difficult
  3. Companies collectively endure losses

This is a scenario that central banks absolutely wanted to avoid. Their policies were twofold: increase the money supply, and try to raise the velocity of circulation.

But in case the velocity of circulation starts to grow too fast, and the spending of volume would surpass the inflation targets, central banks will try to hit the brakes again.

What Investors Need to Know about Inflation

Now, what can gold investors take away from this?

 

Inflation cannot be forecasted with certainty; you can safely ignore scare stories. 

 

Central banks will try to control the velocity of circulation and the volume of spending towards their inflation targets, but they might lose control.

 

Losing control in the direction of deflation is unlikely, considering central banks have the power to raise the money supply indefinitely.

But a loss of control in the direction of inflation may happen. Financial history provides us several examples. In the banana republics this has led to hyperinflation in the past.

The situation won’t get that bad in the western world. But a scenario similar to what happened in the United States in the early 70s can potentially happen; an official inflation figure in the double digits.

Especially considering that 'a steady dose of inflation' is explicitly mentioned in IMF reports as one of the ways to solve the excess public indebtedness in the Western world.

But we don’t have to fear extreme doomsday scenarios. Indeed, recommending gold for this reason is nonsense.

However, strong inflation could occur at any time and that is something investors need to keep into account. Gold is one of the ways in which investors can protect themselves against these kinds of scenarios. It also provides opportunities for speculative investments in gold. 

What Inflation Means for Speculating Investors

Investors willing to take risks could speculate on these kinds of developments by investing a significant part of their capital in gold.

 

Considering the extent in which economists talk about financial repression, this is not unreasonable thing to do.

 

But investors should remember that there is no certainty. An increase in the money supply doesn’t automatically cause inflation.

 

There is however no necessity for investors to flee to gold when inflation increases. This is quite likely to happen, but other scenarios may equally happen.

What Inflation Means for Risk-Averse Investors

For investors that would like to grow their capital steadily without experiencing many ups and downs, knowledge about inflation is of crucial importance.

The potential unpredictability of inflation and the disastrous impact it has on fixed-income securities, render an adequate protection against inflation strongly desirable.

This is what gold has to offer to a risk-averse investor:

  1. Protection against inflation which may always occur unexpectedly
  2. Protection against a potential financial repression
Diversification: gold responds differently to events in the (financial) world than regular investments like stocks and bonds do.

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