Goldbugs beware: Two flawed reasons for investing in Gold

British economist John Maynard Keynes referred to gold as the “Barbarous relic”; billionaire hedge fund manager George Soros described it as the “Ultimate Bubble”, and even the Sage of Omaha Warren Buffett believes it has no place in an investment portfolio. Despite a whole host of other prominent gold sceptics, such as the Financial Times, The Economist and CNN’s Fareed Zakaria; gold still remains an incredibly popular asset class. No other investment topic triggers such impassioned and fierce debates as gold. Gold bugs eternal enthusiasm for this shiny yellow metal has always puzzled me. Their justifications for holding gold simply do not stand up to scrutiny.

Two of the most often touted reasons for holding gold are that it’s a hedge against inflation and a protection against the potential collapse of our monetary system.

Inflation? What Inflation?

Firstly, the spectre of runaway inflation, predicted by many economists following quantitative easing hasn’t materialised. Consumer price index in the United States for January and February (2012) measured 2.9%, in Europe slightly lower at 2.73% for February. In the US, the spread between nominal and inflation index bonds remains low; according to Ben Bernanke this would suggest inflation of just 2% over the next 10 years. Recoveries from balance sheet recessions have historically been followed by a period of protracted and anaemic growth, a scenario most likely leading to a prolonged period of low inflation. Furthermore Europe and the United States will be in for a long period of tax rises and spending cuts to tackle their unsustainable deficits. This would imply years of stagnation or modest growth at best. Many economists fret about the inflationary side effects of unconventional monetary policy, but they are forgetting the vital role of the bond market in unwinding the effects of QE by pushing up long-term rates, this is called monetary austerity. All together this would suggest an extended period of low inflation, which is hardly a bullish scenario for gold.

Safe Haven?

Secondly, gold is viewed as a safe haven asset against the possible collapse of paper currency. The euro crisis strengthens their misguided belief that the state of fiat currency is at stake. Ironically the euro is very similar to a gold standard, and a gold standard has already been tested in the global economy and failed. In a modern economy, a gold standard is too rigid. By removing the safety valve of currency devaluation, it leaves only an internal devaluation as a method of restoring competitiveness. This usually results in a deflationary spiral, hence a reluctance to revert back to the gold standard. The crisis in the Euro is due to the inherent flaws within the common currency and a chronic lack of competitiveness, it is not a flaw of paper currency. Spain and Italy are beginning to introduce long-delayed structural reforms, as well as grapple with their enormous deficits, this crisis will eventually pass.

With respect to gold, investors are being “irrationally exuberant”. As it produces no income, owners of gold are hoping there’s a “greater fool” willing to pay a higher price for it, this cannot persist for ever. Today gold bugs seem to be endlessly propagating fear in the hope of drawing in new investors, in order to keep the bandwagon rolling. Have you ever seen an optimistic gold bug?

Adrian Frost, the fund manager of Artemis Income summed up his thoughts on gold eloquently, by saying:

“Gold is a club of collective terror where the people who hold it spread doom and gloom – and then invite you to buy the store of value that they own at a higher price than they have paid. It is an elaborate and enduring spoof, but one that has infinitely attractive characteristics.”

As a caveat to new investors thinking of investing in gold, remember the old proverb:

“What the wise man does in the beginning, the fool does in the end”.

Read More about economics on Stockopedia

Read more investing articles & commentary from Christopher OLeary