Gold: As Good As a Dollar?

Talk to serious investors about buying gold, and they will likely look at you as though you're a bit of a nut case. Gold attracts goofballs: shysters shilling shares of Peruvian mining operations, people predicting worldwide economic collapse, and various voices on the economic margins crying for a return to the gold standard.

The last group claims that gold is "real money" and that paper dollars are nothing more than "fiat money"-- just paper with no real backing. Consider the argument: Because paper money is controlled by central bankers, who insist upon inflation, the value of paper money is almost guaranteed to decline. And the declining dollar is one of the major reasons for the dramatic rise in the price of gold over the past four years. It is also one of the reasons I own gold -- through two exchange-traded funds: iSharesCOMEX Gold (AMEX: IAU  ) and StreettracksGold (NYSE: GLD  ) .

Paris on the cheap
In 2002, my wife and I were in Paris. We stayed at a four-star hotel room near the Latin Quarter, ate in wonderful restaurants, and enjoyed the good life. Thinking back, I remember it being incredibly cheap. The hotel was less than $80 a night, and dinner for two (avec le bon vin, bien sur) was about $35.

In retrospect, I have created a rule: When Paris is cheap, your currency is overvalued.

Four years ago, gold was selling for about $300 an ounce. Around that time, the dollar-to-euro exchange rate hit a low near $0.85 per euro. Since that time, the dollar has steadily declined compared to the euro, to a current level near $1.28 per euro. Assuming the price of gold held steady in euros, in dollars it would have risen to $450 an ounce, accounting for roughly half of the increase over the past four years.

A brief history
The connection between gold and the dollar has been playing out for a long time. Newmont Mining (NYSE: NEM  ) can give you the long history, but here's the short version. For the first hundred years or so of the U.S. dollar's history, dollars were backed by gold and could be exchanged for gold. The problem was that when the government needed money to engage in construction, stimulate the economy, or fund a war, the gold-backed currency supply was inflexible.

This led to the creation of the Federal Reserve in 1913, which was the first step in removing the interchangeability between the dollar and gold. For 20 years, the currency supply expanded more than the supply of gold. In 1933, Franklin Roosevelt banned the export of gold, halted the convertibility of dollars into gold, and ordered U.S. citizens to hand over their gold. In 1934, he fixed the price of gold at $35 an ounce, where it stayed for nearly 40 years.

After World War II, the nations of the world signed on to the Bretton Woods system, which set currency exchange rates in relation to gold and established the U.S. dollar as the world reserve currency. U.S. government spending, inflation, and trade deficits eventually undermined the fixed price of gold at $35 an ounce. Foreign countries began to increasingly prefer gold to dollars, and U.S. reserve gold coverage declined to 22%.

The rise of gold
In 1973, Richard Nixon officially removed the dollar from the gold standard. Prices were set by the market, and gold immediately shot up to $120 an ounce. In 1974, the ban on American individual ownership of gold was removed. During the bear market in stocks, rising interest rates, inflation, oil shocks, and the general political uncertainty of the 1970s, gold prices soared, hitting an all-time high of $870 an ounce (intraday) on Jan. 21, 1980.

The fall of gold
For the next 20 years, gold prices mostly declined. Gold as an investment vehicle or store of economic value was disparaged. In Stocks for the Long Run, Jeremy Siegel showed that the real, inflation-adjusted return on gold from 1802 to 2001 was 0.0%! Compare this with the real return per year on stocks for the same period of 6.9%, and it should be obvious that only a lunatic would own gold.

The future for gold and the dollar
A major driver of where gold prices will head for Americans in the next 10 years will be the value of the dollar. Obviously, if I knew where currency exchange rates were headed, I'd be running a hedge fund and taking 5% of assets and 20% of profits as a reward for my genius. Undeterred by the evident folly of predicting something as arcane as currency values, I will advance an opinion from my place in the cheap seats.

When the world powers talk about "unsustainable imbalances" and Chinese "currency manipulation," I interpret these code phrases to mean that the U.S. has too much debt and the Chinese currency needs to rise in value. Regarding the debt, the U.S. has a huge privilege that comes with it -- it is denominated in U.S. dollars. An easy way to reduce the debt burden is to allow the value of those dollars to decline. Regarding currency manipulation, a stronger Chinese currency and a devalued U.S. dollar will make American exports more competitive. The hope would be that this would reduce our soaring trade imbalance.

Does this mean the dollar will decline? No, but it sure points to a couple of huge incentives for the big shots to let it happen.

Conclusions
Obviously, the price of gold is driven by more than a simple relationship to the number of dollars in circulation or foreign exchange rates. In the future, I will take a look at some of the items that were present when gold soared in the 1970s, such as inflation. Leaving these aside for the moment, a declining dollar bodes well for gold, as investors holding dollar-denominated assets sell in search of another currency that will hold its value. Gold has been viewed as currency for thousands of years, and in times of uncertainty, people have preferred gold over paper.

Of course, there is no guarantee that the dollar will decline compared with other world currencies or that gold will return to its glory days of the 1970s. Bearing in mind the long-run returns on gold compared with stocks (unless you are a total lunatic, of course), an investment in gold should be considered only as a part of a well-diversified portfolio.

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Robert Aronen is only partially a lunatic. He owns shares of iShares COMEX Gold and Streettracks Gold. He found that much more convenient than burying the coins in his back yard. The Motley Fool has a disclosure policy.


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