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Why Gold Should Be Avoided As An Investment Tool
Part 4 of 6
by James Nelson, originally published June 2007
The Long Term Prospects of the U.S. Dollar
As the U.S. Federal government prints more and more money beyond the underlying value of the goods and services of the American economy, two things happen. First, the value of the U.S. dollar in relation to other currencies goes down. As the value of the dollar goes down, people holding dollars begin to lose faith in it. The OPEC nations, for instance, are discussing with increasing frequency whether to demand Euros for their oil rather than U.S. dollars. Part of that is politics, but part of the motivation is the increasing distrust of the U.S. dollar.
This is not to say there is some sort of guarantee that the U.S. dollar will fail, but neither is there a guarantee that it will continue as a viable currency. As was said above, historically, all fiat currencies have eventually failed. (But as brokers like to remind us, past performance does not guarantee future results.) In this sense, there is a converse historical relationship between gold and the dollar. There is a long history to indicate that gold will maintain its value relative to goods and services. Similarly, there is a long history to indicate that fiat currencies (of which the U.S. dollar is one) ultimately become worthless.
Perception and Reality
There is a catch when trying to attach a true value to a fiat currency. Since the 1970s the value of most currencies "float" in relation to each other. No modern currency has an absolute set value and as a result the perception of strength and value can be far more important than any underlying reality. Even though the debt ratio has been increasing for three decades in the U.S., the U.S. Dollar remains the currency of choice in most of the world. As a result, the fundamentals (that is, the debt ratio) have had little effect on the actual price of the dollar. Consider the following chart of the US$ Index (which measures the US Dollar against other currencies).
The above chart shows prices from 1972 to mid-2007. The highs of the two spikes are in Feb. 1985 and Jan. 2002.
Right after the U.S. went off the gold standard in the early 1970s, there was a decline in the dollar. But it has remained remarkably stable in the last 30 years, with a typical trading range between 80¢ to 100¢. In fact, the dollar has had the ability to spike in price when things look bleak around the world. But once again the US Dollar is sitting at the bottom of it’s three decade trading range, and given the uncertainty surrounding the currency, one wonders if these support levels will hold?
And if the dollar does break through support . . . how low it can go?
Gross Domestic Product . . .
. . . The Dollar Index . . . And Now . . .
. . . INFLATION!
Based on the above information it would be easy to assume that things aren’t too bad. If the US Dollar has held its own against other currencies, the situation can’t be that bad. Right?
Wrong!!
Again, floating currencies against each other can be misleading, because the price of a particular currency is then determined more by perception than reality.
So, let’s return to a little bit of reality and bring the above discussion into focus.
Both monetary inflation and the US Dollar Index are a little bit slippery. They have no direct affect on our pocket books. They only affect us to the extent that they affect the perception of those who hold US Dollars.
Price Inflation
But there is another kind of inflation - price inflation - and this affects our pocket books directly. Price inflation is what happens to the price at the bottom of the receipt. For instance, when cleaning off the counter we find an old grocery receipt for milk, eggs, and bread. The total on the receipt is $4.22. Yesterday we went to the store and purchased the same three items and it cost us $5.12. That's an increase of 90¢, or 21%. That would be an inflation rate of 21% from the time of the first purchase to the second.
When the news talks about "inflation," it is almost always "price inflation" that is being talked about. It is what the Consumer Price Index seeks to measure. The CPI isn't a perfect measure, but it certainly gives us an idea of what's happening in terms of price inflation. Now, let's put price inflation into the context of the U.S. abandoning the Breton Woods accord in the early 70s. Robert C. Sahr, an economist and Professor of Political Science at Oregon State Univ, has studied price inflation in depth. His numbers indicate that the U.S. Dollar has lost 75% of its purchasing power in the 30* years since we've turned to a purely fiat currency. Said another way, a 2005 dollar can only purchase 24.7¢ worth of goods measured by 1972 dollar standards.
Monetary inflation is relatively invisible. Price Inflation, on the other hand, is what we see and complain about every day. Price inflation is the fact that milk, bread, cars, houses, electric bills, and candy bars keep costing more month after month. On average, something that cost a quarter in 1975 cost a dollar in 2005.
Maybe that needs to be rephrased and seen in a larger font, because that’s frightening.
In the 30+ years since we’ve completely disconnected the dollar from gold, the dollar has lost 75% of its purchasing power.
Copyright © 2007 James E. Nelson (Just Another Jim). All Rights Reserved.
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