Reading time: 6 – 10 minutes

As the year 2009 progressed, fear of inflation increased.  This was reflected in the number of TV ads selling gold coins and bars.

By 2010, gold marketing dominated TV commercials.

G. Gordon Liddy, gold huckster

The well-known face of G. Gordon Liddy (4 years in prison for burglary, associate of Timothy Leary and Al Franken), earnestly advised people to buy gold as protection against the coming inflation.

Gold pitchmen presented gold as a bulwark against the loss of value of the currency. The ads avoided statements that might be untrue, saying instead, “The price of gold has never been zero” and “Over the last decade, the price of gold has more than doubled”.

Because the sale of gold coin and bars falls outside the jurisdiction of the SEC, ‘full disclosure’ is not required.

The question I try to answer here is simply this: “How far will gold protect you against inflation?”

Gold: the historical record

The graph, below, shows that in 35 of the last 50 years, gold did not offer protection against inflation.  Over the half-century,  gold has been highly speculative, fluctuating widely at times.

In fact, since 1960, there have been four periods during which an investor would have lost 50% of value by holding gold.

Gold has not always been the best investment.

On examining the graph, we find that gold appreciated in value rapidly during periods of ‘hot war’: the War in Vietnam (the Johnson-Nixon years) and the Iraq-Afghanistan War (the Bush II-Obama years).

During the Johnson years, the price of gold was stable, despite the burden of Vietnam and the ‘Great Society’, because the dollar was pegged to gold under the terms of Bretton Woods.

Richard Nixon untied the dollar from gold in 1971, allowing gold prices to escalate.

However, by 1971 the tie to gold was no longer sustainable. Nixon was forced to cut the dollar from gold, resulting in a rapid escalation in gold prices, reflecting prior excesses under Johnson and the still unfinished business in Vietnam.

Off the graph, history records the inflationary pressures of other US wars — the Revolutionary War, the Civil War, World War I, World War II, and the Korean War.

We now face a radical expansion of the Iraq-Afghanistan War with the entrance of Iran into the mix, leading, conceivably, to World War III. (See: War between Israel and Iran in 2010? ).

The ‘Big Government’ factor

The graph indicates that periods of ‘big government’ deficit spending also contribute to inflation and to the rise of the price of gold.

We see this under Lyndon Johnson (the ‘Great Society’ programs), Jimmy Carter (the formation of the Departments of Education and Energy), and under George W. Bush (lack of control of federal programs).

The election of Ronald Reagan collapsed the price of gold.

The election of Ronald Reagan brought a move towards restricting the size of government that led to an immediate collapse in the price of gold — at first, merely in anticipation.

Restrained government continued through the first Bush and the Clinton administrations.  The first Bush and Clinton years were additionally benefited by the end of the Cold War.

The gold-cost of living disconnect

The most striking thing about the above graph is that the red line (gold price adjusted for the cost of living) is not a horizontal line — except during the Kennedy-Johnson years when the dollar was pegged to gold.

After 1971, gold prices either increased faster or slower than inflation, often much faster or slower, exhibiting a striking volatility.

Inflation persisted almost throughout this whole period.  However, the price of gold simply did not follow the consumer price index.

A retiree, buying gold during the final months of the dismal Carter administration, and holding on for the next ten years, would have lost at least half of his or her purchasing power.

Gold seems to move in anticipation of bad days ahead, rather than the current reality.

During the years of Bush II, inflation was relatively mild, but gold prices rose steadily, reflecting unease over the costs of the Iraq-Afghanistan War and Congressional spending.

The price of gold fell during the Ford administration, although inflation was high.

In part, weak gold during the Ford years was due to the end of the Vietnam War and, in part, to the cessation of the extreme partisan political warfare that characterized the Watergate era.  President Ford did not come to office promising massive spending programs.  His administration was a return to ‘normalcy’ — a temporary reprieve from madness — until the still unexpected advent of the Carter years.

Will 2012 crash gold?

The current rise in gold reflects public discontent with President Obama’s economic policies, the continued Iraq-Afghanistan War, and the extraordinary lack of fiscal discipline of the Pelosi-Reid Congress. There is now a real possibility that Obama will be a one term president, like Jimmy Carter.

Will Obama's exit crash gold?

If the successor to Barack Obama is a conservative Republican, cast in the image of Ronald Reagan, the graph suggests that a return to sounder economic policies could crash the price of gold — well before inflation is actually under control.

On the other hand, the Iraq-Afghanistan War may not yet be over, and may have even morphed — thanks to the expansion of the Iran-Israel contention — into World War III — in which case, one might be happy to hold gold.

This analysis suggests that gold, rather than acting as a hedge against inflation, is actually a hedge against increasing economic and political uncertainty.  As this uncertainty diminishes, the price of gold is likely to fall, perhaps precipitously.

Does gold fit in your portfolio?

I‘ve lived many years under highly inflationary regimes. (See: How to survive runaway inflation.)   It seems to me that gold is a highly speculative investment, most useful in anticipation of hyper-inflation (not ordinary controlled inflation).

As the graph indicates, a reversal in gold prices can be swift and brutal.  When the general ambience of economic and political uncertainty passes, gold prices may suddenly plummet well before things get better.  The mindset that led one to get into gold may also lead one to hold on too long once better days return.

This suggests, that if one is to hold gold, it might be wise to also hold a hedge against the sudden fall in the price of gold.

If you have any ideas on how such a hedge might be best constructed, your comments are most welcome.