Gold is money;
therefore a hedge against inflation and deflation

Hubert Moolman
Dec 15, 2008

Warren Buffett one of the world's most successful investors apparently once said the following about gold:

"It gets dug out in Africa or some place. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it.

It has no utility. Anyone watching from Mars would be scratching their head."

Well, Mr Buffett let me attempt to explain to you and the "Martians" why this is so, as well as correct your statement (if it was your statement) that it has no utility.

First of all, gold is money; it is not like other commodities that we use mostly in production, consumption etc. One of money's main functions is to store wealth. We therefore earn money, we hoard it, we guard it and then we exchange it for assets when needed.

Gold is the premier store of wealth that this world has known for the last 3000 plus years. Even the fact that gold is not the official currency in the countries of the world has not changed this fact. I know of no place in the world, now or many years before, where gold is not known and not highly valued.

So in summary, gold is money and it derives its usefulness from being money and therefore people dig it out, melt it down and guard it like they would guard money.

Storing wealth during a financial crisis

It is especially during an economic crisis that one needs an effective preserver of wealth or buying power. Let us see whether gold has done its job as a preserver of wealth during this credit/financial crisis so far.

Before the crisis hit, the Dow was at 14 000 (19 Jul 2007), gold was at $674. Therefore the Dow/gold ratio was at about 20.8. Put another way, 1 oz of gold could buy 4.8% (674/14 000) of the Dow average.

On Friday 12 December 2008, the Dow Jones was at 8 630 and gold was at $821 giving a ratio 10.51. That is now 1 oz of gold can buy 9.51% (821/8630) of the Dow. That is almost 100% increase in buying power since 19 July 2007 if you are buying shares on the Dow with gold. Expect the Dow/gold ratio to continue going down.

Gold's performance is no different against most, if not all, stock exchanges of the world during this crisis.

In a similar fashion gold can now buy you more of most, if not all, commodities including oil and food stuff than before this financial crisis hit. For example against oil gold has increased its buying power from a gold/oil ratio of under 10 before 31 December 2007 to where it is just more than 17. So it seems so far so good for gold's performance as money.

Gold has reached an all time high in a number of currencies during this financial crisis. These currencies include the South African rand, the Australian dollar, the British pound, the Canadian dollar as well as the Indian rupee.

For more on this see Mr James Turk's article here: http://www.goldmoney.com/en/commentary/2008-10-18.html

Now some might point out that gold's performance against the US dollar for example has not been that great. Let us examine this.

First of all, gold is up on a year on year basis in dollar terms. This is despite it losing ground when the crisis started to take hold of the world economy. On 12 December 2007 gold was trading at $814 that is up to $821 on 12 December 2008. I expect gold to outperform the dollar from here on (more on this below). This is whether we get global "inflation" or "deflation" of asset prices.

The average (on daily basis) price of gold during 2007 was $695 whereas for 2008 it is currently $872. That is a 25.6% increase in the average price of gold in dollars. This is an extremely relevant number when looking at gold's performance as money. Why? Because money is accumulated over time: daily or monthly, not once a year or so.

So it is clear that gold has done its job so far during this financial crisis. It has done exactly as one would expect a good store of wealth to do whether there is a crisis or not.

Now what about going forward from here?

Deflation, Inflation and Gold

If deflation of asset prices continues, from here gold might (a big maybe) temporarily underperform the dollar but as deflation (of asset prices) increases, gold will win this battle effortlessly in the end. Why? Because gold is money and it is a capital (real) claim on assets. The dollar is "parading" as money since it is a "debt claim" on tangible assets.

During deflation of asset prices, confidence in paper assets (debt claims) are questioned and they are impaired and sometimes removed from the system as the deflation gets worse (confidence deteriorates). Capital claims cannot be removed from the system by deflation, and deflation can also generally not impair its usefulness. The paper value of capital claims might be impaired but that does not mean its underlying value (usefulness) is impaired.

There have already been a few currency failures or impairments during this crisis and it might continue and in the extreme lead to the death of the dollar and other major currencies; and therefore the end of the world monetary system as we know it.

If deflation of asset prices continues, more and more debt is removed from the world financial system. In fact the market is trying to get rid of the debt in the world financial system. Remember that all paper money is also debt, it is not capital. Paper money is a "debt claim" on tangible assets, parading as a real (capital) claim.

Let me explain the difference between a debt claim and a capital claim with an example.

1. M Botha has a farm that is paid up. He exchanges his farm for a big house in the city. He therefore has traded his claim on the farm for a claim on the city house. Both claims are capital claims, and they provide stability and confidence. The chances of him losing the house or farm are small.
2. M Botha has a farm that is paid up. He buys a big house in the city which he finances with a loan from the bank. He has a capital claim on the farm but he has a debt claim on the house. (Note this is exactly how paper money is created, by credit extension).

What is different here to 1? Stability and confidence is threatened since his chances of losing the house are greater than in 1. Keeping the house is dependent on him being able to pay the bank as his obligations become due. If he cannot pay then the credit is removed from the system and the house is repossessed/sold off. The result if he defaults is less or no debt and eventually a lower asset price.

Note that the value of the debt claim is dependent on his or the bank's confidence that he would be able to pay his obligations. The value could eventually fall to zero should he default or the bank recalls the loan. In the same way the value of paper money is dependent on confidence. In 1 above the capital claims are not subject to this risk.

So in the extreme, if deflation of asset prices should run its full course which the central banks want to prevent, there will be no debt and no more paper assets (including paper money) in the system and therefore also no prices in paper terms. All that will be left standing is tangible assets and therefore assets will be priced in terms of other assets (barter). The paper prices of tangible assets will have first gone down until pricing in paper terms will become meaningless or non-existent.

However assets that have monetary properties will trade at a premium because they are more useful when moving from one asset class to another. Therefore gold and eventually silver will shine even more. So a word of advice: if deflation continues remember to stop looking at paper prices when evaluating your wealth and making economic decisions, but rather look at how much tangible assets you have (You should do this in any case, irrespective). To read more about this you can follow this link:

http://www.oreconsultants.com/upload/docs/How_do_you_measure_your_wealth_final.pdf [pdf]

We can already see that this is what has been happening since deflation of asset prices has taken a hold of the world economy. Initially gold was falling with other commodities against the dollar, however as the crisis continued gold started to behave differently to other commodities, and has until recently actually made up those initial losses against the dollar. This is just the beginning phase of a falling confidence in paper assets.

What we do not know in this crisis is: how extreme could this deflation get and how "successful" (in preventing deflation from running its full course) the central banks' various interventions will be.

Inflation of asset prices is no different to deflation of asset prices in that when it runs its full course (that is the end of hyper inflation) the only things left standing are tangible assets. Paper currency is then worthless thus it is no more, as well as debt denominated in that currency is worthless and is thus no more. Prices in paper currency terms are naturally also no more. In fact the currency is gone because no one wants it anymore. All assets is then priced in terms of other assets (barter - look at Zimbabwe where there is increase in barter). Assets that have monetary properties will trade at a premium because they are more useful in asset exchange transactions. Therefore gold and silver shines even more.

So if the central banks manage to avoid deflation of asset prices we will have high asset price inflation which will push gold prices extremely high. What we do not know is whether their intervention will cause hyperinflation that leads to the death of paper currency.

Conclusion

Gold is money. Real money maintains its purchasing power. Real money is a hedge against inflation (increase in credit and paper money supply) and its effects as well as deflation (decrease in credit and paper money supply) and its effects.

Gold is a hedge against inflation and deflation otherwise it would not be real money.

###

Dec 15, 2008
Hubert Moolman CA (SA)
Cape Town
South Africa
email: hubert@hgmandassociates.co.za
blog: http://blogs.24.com/hubertmooolman

Hubert Moolman is a Partner at ProAct Chartered Accountants and the owner of HGM & Associates.

321gold Ltd