Bringing Gold Beyond the Inflation Hedge

The price of gold has increased dramatically over the past decade as astute investors, concerned about the devaluation of all fiat currencies (and rightly so), have been investing in the metal as a hedge against inflation. This brief article will attempt to demonstrate that despite the likelihood of extreme volatility, investing in gold represents a rare investment opportunity based not on inflation expectations, but rather the potential for the breakdown of the dollar's hegemony as the world's reserve currency.

First, investors who saw inflation coming have ridden the gold bull market up over the past 11 years and will continue to do so in all likelihood. The global inflation genie is out of the bottle.

In countries like India the inflation rate is 30% and rising, and in China, over 15%. Despite the U.S. government patting itself on the back because of all the "benefits" derived from quantitative easing, all of us who don't have access to free money like the banks and Wall Street firms, or don't have a huge equity portfolio are worse off now than before QE1 and QE2. Don't believe it? Compare your grocery bill last week to that of a year ago. The results are sobering. Low interest rates push more dollars into the system, increasing inflation and punishing prudent savers while rewarding leverage and speculation.

Think you missed the boat? Think again. Investing in gold is eerily similar to the subprime mortgage market pre-2008. Media coverage of the situation was omnipresent, but very few were in a position to profit from it. Statistically speaking, less that 1% of the assets deployed globally by investors are invested in gold or gold equities, much less than during other periods of high inflation.

However, investors buying gold for the same reason they might invest in corn, copper, and oil, (only as an inflation hedge) are not seeing the full picture. As a result, if price volatility increases, investors may miss a truly historic opportunity to make outsized returns as they "lock-in" profits by selling their positions. The U.S. money supply has skyrocketed an obscene 221% from $842 billion in 2006 to $2.7 trillion after QE2. As all of this supply makes its way through the financial system it will not take much for a spark to ignite massive dollar depreciation which will lead, in turn, to substantial price inflation and serious calls for the dollar to be replaced as the global reserve currency.

However, current proposals such as using a basket of currencies or potentially the yuan as the new reserve currency fall short. A basket of currencies will inevitably price itself off of the strongest of the group and the Chinese political, social, and financial infrastructures are too immature at this point to establish enough confidence among global trading partners. As worldwide governments and corporations shun the dollar as a store of value, the U.S. government will have little choice but to replace our fiat monetary system with a hard money (gold exchange) system similar to the one the U.S. had pre-1971.

As a quick refresher, in 1944, the Bretton Woods Monetary Agreement was enacted. It allowed major global currencies to be exchanged into U.S. dollars, which in turn could be exchanged into gold at $35 per ounce. The system was primarily designed to eradicate unsound monetary policies and reduce the probability of hyper-inflation (a condition experienced by the Weimer Republic in Germany, which contributed to the rise of the Nazi Party and Hitler in the early thirties). It would also have the effect of firmly establishing the dollar as the sole reserve currency for the world.

Until the late 1960s, this agreement worked quite well as global inflation was a non-event. Savers were rewarded for saving as their nest eggs earned a positive rate of return over the rate of inflation. However, as the U.S. ran up huge deficits from the Vietnam War and expanding entitlement programs, U.S. trade partners began exchanging their dollar reserves for US gold holdings.

In 1971, after U.S. gold reserves had plunged from over 21,000 to 8,300 metric tons, President Nixon defaulted on the gold for dollars exchange. Dollars and all other global currencies had officially lost their asset-backed status and became fiat, the issuance of which is limited only by political restraint (uh-oh) or more recently, the cramping of Fed Chairman Bernanke's fingers (none so far).

At any rate, if the U.S. switches back to a gold exchange system, the price per ounce of the metal will increase dramatically. Gold is currently held on the books of the U.S. Treasury at a price of $42/oz. By using calculations similar to those used in the Bretton Woods Agreement in establishing the $35 per ounce dollar/gold exchange rate (U.S. monetary base/official U.S. gold holdings), gold is currently worth approximately $10,000 per ounce.

If the U.S. pegged the dollar to gold at this level, it would fully reserve dollar-denominated debt and thereby, fully de-lever the economy. This would be neither inflationary, nor deflationary as the monetary base would stay constant in nominal terms. Further, this solution has the added benefit of allowing the U.S. to regain control of global monetary policy as it would again peg the dollar to physical gold.

The timing on this scenario is admittedly nebulous, as is the probability of it occurring. After all, as stated above, there currently is no other alternative to the dollar as the world's reserve currency and the U.S. could continue to rely on the "we have no other choice" wave the rest of world is presently (yet ever more reluctantly) riding.

Further, Chairman Bernanke is openly opposed to a return to the gold standard (as are most politicians, as debt helps pay for campaign promises), so it will take an extraordinary set of circumstances to force his hand. That being said, given the above-mentioned explosion in money supply coupled with the U.S.'s unsustainable debt levels, an extraordinary event seems perched on the horizon. In addition, former Fed Chairman Alan Greenspan has recently thrown his support behind returning to a gold standard.

What does all this mean? Well, while surely more gains from owning gold are in the offing based upon the aforementioned inevitable inflation, investors might do well to hold onto their positions in the metal as price volatility sets in over time. At even half of the potential $10,000 per ounce, the upside is well worth the risk.