Gold as a System Hedge
Last week we focused on the idea that gold is not an inflation hedge. Today, we will develop this notion even further. If we're talking about gold as a hedge, it is rather a system-hedge than an inflation-hedge. Since 1973, when the dollar was allowed to float, gold has confirmed this view.
When it is wanted as a dollar alternative, the price of gold goes up. This takes place when the trust in the dollar plummets, or actually when the trust in the dollar-dominated-system plummets. Gold rose during the end of the 1970s because of expressively high inflation. But it was not only inflation that was decisive. This high inflation led to distrust in the dollar, therefore, gold became the alternative. The general trend of gold looks a lot like increasing CPI:
After the 1980s recession and end of the short-lived gold bubble Volcker tamed the dollar, which renew trust in it. The next 20 years were times of a noticeably strong dollar and stronger faith in this paper money. The conditions also paved the way for enormous increases in debt of the economy, which transformed the United States into the greatest debtor in the history of human civilization. During that time despite positive inflation gold was dropped as a "currency alternative", therefore lost its value. The dollar was drained by mild inflationary forces; gold did not keep the pace and went down:
With oversupply of US dollars, the credit situation was reversed in the 21st century. Over indebtedness in the American economy has shaken the trust in the dollar-dominated system (especially due to agency debt and private debt). As Paul Samuelson called it, the "run on dollar" was triggered from 2001. This was visible in the decline of the dollar against other currencies, and also gold became a reliable alternative. The pace of inflation was overall no more impressive than it was for the previous 20 years. Yet suddenly the relation between gold and dollar had shifted, and the price of gold grew at a much higher pace than the dollar was losing value. Why? Because of the system dynamics and lowered trust in the dollar.
In any case gold is not really an inflation-hedge. It is a special investment vehicle that requires careful focus and analysis separate from only inflationary forces. Those forces no doubt affect the gold market. But not in a way many people often suggest, and in a way which may lead to misplaced investments.