Gold has a Weird Reputation, But It Tells Us Something Interesting About the U.S. Economy
More and more American investors have been looking for the one magical place in the economy where their money is risk-free, while still generating a healthy return. Whenever investors perceive instability in the financial markets or when the inflation is too high, the demand for gold increases.
The past two weeks have been particularly tumultuous for the American financial sector: stock indexes dropped after news that Silicon Valley Bank had become insolvent. In what has been dubbed the “largest failure since the financial crisis,” the bank was seized by regulators after a huge bank run (customers withdrawing money) made it impossible for the bank to restructure its debts. The case of SVB is a particularly good case to explain the problems with inflation. Silicon Valley Bank’s debts were caused by the decline in value of the government bonds on its balance sheet. Government bonds are basically government loans with interest from banks and investors. The traded value of bonds declines when their interest (the extra money the government has to pay back) falls below the interest rates of the economy. Then these bonds become worthless in the short term. SVB’s reserves were tied into these government bonds, and they could not hold on to them (which would have made a profit later on). To pay off their short-term debts, SVB was forced to sell their bonds at the current market value, creating a huge loss. This whole problem had to do with inflation from past year and this year. In the first place, government bonds were so low in value because the Federal Reserve had raised the interest rate in the American economy to combat inflation. This then led to the demise of SVB, who depended on these bonds. That is why investors have been looking into a safe haven, which often is gold. Concerns around the banking sector have directly influenced the price of gold and gold futures (speculative gold assets), making them surge in times of uncertainty. Both the war in Ukraine (a risk for the American and global economy) and the problems of other banks like Credit Suisse and First Republic caused a one-year high in the global gold price. Although some analysts say that both gold and cash are safe havens, other analysts just prefer gold because it does well in bad times.
It is not a new phenomenon that people love owning gold when stuff hits the fan. Some investors long for the golden era in which the value of the dollar was actually tied to the value of gold. This was the period before the United States went off the gold standard in 1933. The gold standard meant that a specific amount of dollars could be converted to gold and vice versa. But the government could not catch up with the demand for gold during the Great Depression. The public had lost faith in the value of paper money, and the masses wanted to convert their money back to gold. But the gold reserves were limited, and the US government did not want to deplete the reserves and risk bankruptcy. With the help of an agricultural economist who convinced Roosevelt that commodity prices were very unstable under the gold standard, Roosevelt unhooked the value of the dollar from the value of gold.
In later studies this was confirmed: the price that consumers paid for the same goods would vary drastically under the gold standard. There was actually much more volatility during these years: prices would go up and down, hovering from around -10% inflation to 5% inflation for consumer goods in just a couple years time. Besides, nominal gold prices might have been constant before 1933, but the actual gold price varied. When the prices were corrected, gold’s inflation-adjusted value declined in various periods. Like from around 1940 to 1971 and from 1980 to 1994, when gold’s inflation-adjusted decline was much worse than its nominal decline (what an investor would pay in the stock market). So investing in gold at these times when the American economy did well, would return less than if you had just left your cash alone. If corrected for inflation, the value of the dollar declined by 53% in the period from 1980 to 2001. Ironically that was a smaller decline than gold, which would decline by 84% for the same period.
Economic crises were also much more severe under the gold standard. This is another indicator that gold is not as reliable as people claim it is. The financial crisis of the Great Depression took 45 months with government intervention, while the Global Financial Crisis of 2008 took 18 months with government intervention. But during these financial crises, the demand for gold always went up, because the idea of a safe haven was a lot more tempting than keeping your money in something like stocks. However, gold’s actual yield or return on investment is quite bad. When the economy starts to do better again, prices fall drastically. That is why in times like these when inflation is high, and there are troubles in the financial sector, gold becomes more attractive. In the short term, investors will see better returns with gold because more investors are looking for a safe haven, driving up the price. That is why we saw a one-year high in gold prices this month. Several banks like Silicon Valley Bank, Credit Suisse and First Republic had a hard time or went bankrupt. This spooked the financial sector with fears of another economic meltdown. That did not happen eventually, but that fear of catastrophe does raise the price of gold. Together with the Fed raising interest rates by another 0.25% on March 22nd, gold is expected to do better this year compared to most stocks, which are down by a lot. However, in the long term, gold is not a good protection against inflation, nor is it a good investment. Its demand mainly rises when short-term expectations of the economy are bad and outlooks are uncertain.
Inflation will unfortunately always be a part of our lives, but nonetheless a manageable evil. Both nostalgia for the gold standard and the idea of gold protecting your money, are unrealistic. However, the inflation of the US dollar has been exceptionally high in the past year, and even when it comes down eventually, it will have affected American households and the US economy. In the meantime, gold is a good indicator for market sentiment about the near future. Gold trading functions as a poll for the amount of people who are looking for a safe haven. If there is a lot of demand and the price increases, more investors want to have a safe haven. Gold’s value is expected to steadily increase in the coming months. That means that less and less investors are putting their trust in the American economy. We can expect some bad times ahead for the US economy.
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