1/17/2008

Good as Gold? What is the Price of Gold Telling Us?


By Dr. Mark W. Hendrickson

Gold has opened 2008 with a bang. The price of the yellow metal has soared to all-time nominal highs, surpassing $900 per ounce. “So what?” you may ask. “Unless one works for a mining company or a jeweler, gold is a trivial or nonexistent factor in one’s life.” True. But do you use dollars for your money? If so, then you ought to be concerned about the rising price of gold (POG).

Gold is sometimes known as an inflation barometer. I prefer to characterize it as the most reliable indicator of confidence in our currency. When confidence in the U.S. dollar is high and people desire to hold dollars, then POG is low in dollar terms. Conversely, when confidence in the dollar is low and people’s desire to hold dollars has ebbed, then POG is high in dollar terms.

Why is gold a reliable monetary indicator? Historically, gold emerged as the preferred choice of money in countries around the world. Because of the painful hyperinflation of the Continental currency during the Revolutionary War, our Founding Fathers made the U.S. dollar a fixed quantity of gold. Indeed, that was the case for most of our history; thus, the saying as late as in the mid-1900s that “the dollar is as good as gold.”

From our everyday perspective, in which we habitually express economic value in terms of dollars, gold appears to fluctuate greatly in value. This, however, is an illusion, comparable to the illusion that the sun orbits the earth. If we change our frame of reference from the dollar to gold, we note that gold has maintained roughly the same purchasing power for centuries, and it is paper money that fluctuates wildly in value. Federal Reserve Notes, for example, have less than five percent of the purchasing power they had when introduced in 1914; yet, in not too many years, we will look back longingly on paying “only” three Federal Reserve Notes for a gallon of gas.

POG is telling us in no uncertain terms that confidence in the dollar is falling. As explained in my Dec. 27 “Anatomy of a Financial Crisis,” U.S. policymakers decided to sacrifice the dollar to keep the financial markets from grinding to a halt. Even before that crisis emerged, the demise of the Federal Reserve Note could be foretold. Americans are drowning in debt. Individuals and corporations hold record amounts of debt, but the greatest debtor of all is Uncle Sam. Only the na├»ve would think that Uncle Sam can indefinitely finance his $9 trillion of officially acknowledged debt, his other trillions of off-budget debt, and the tens of trillions of unfunded liabilities for Medicare, Social Security, etc. The only viable political option is to have the Fed inflate the money supply, thereby reducing the exchange value of each currency unit, and repay creditors with cheapened dollars.

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