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Tuesday, February 20, 2007 1:59 AM

Is Gold an Inflation Hedge?

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There was an interesting Q&A last Wednesday on Minyanville between Professor Scott Reamer and a fellow Minyan. Professor Reamer fielded this question on gold's role as an inflation hedge.

Prof. Reamer,
I always have a problem understanding what makes gold go up. Is it mainly the inverse relationship between gold and the dollar? If that's the case then if it is also an inflation hedge, that would mean rates would have to be raised and the dollar would rise. Help me out on this one.
Professor Reamer's Reply
The correlation between gold and the US dollar index (DXY) (the average of six major currencies vs. the USD) is minus 0.42 over the last two years, minus 0.44 over the last nine years and minus 0.28 over the last 17 years. A +1 correlation means perfect correlation (gold goes up, dollar goes up), a -1 correlation means perfectly anti-correlated (dollar goes up, gold goes down), and a 0 correlation means no correlation whatsoever. What the above tells you is that the widely held belief that gold goes up when the dollar goes down is not supported by the statistics: a -0.28 correlation is a weak correlation at best and is certainly within the normal volatility that these two date series exhibit.

So, in the US, M3 has gone up by something like 207% over the last 20 years while gold has gone up in USD terms by 58%. So has gold been a hedge against inflation over this time frame? Of course not - stocks have been a better hedge against inflation than gold, and property even more of a hedge than that.

But that is not to say that gold doesn't have its uses: gold will likely be a fantastic wealth preservation vehicle once the fiat currency regime (the post Bretton Woods system with the US as global economic hegemon) comes to a grinding and ignominious end (a certainty approaching 1 on the probability scale - timing less certain). I would encourage you to read the book The Golden Constant by Roy W Jastram - it makes the unintuitive case (with a look over the historical data from 1560-1976) that gold performs better (in appreciation terms) under deflationary regimes rather than inflationary ones, thus throwing a significant wrench into the idea that gold protects under inflationary regimes (dollar down, gold up).

As for the 'reason' why gold acts as it does, I would only point you to the ideas presented by Amos Tversky and Dan Kahneman whose research on behavioral finance tells us that economic agents make persistently irrational decisions - my hypothesis is that they are using their limbic systems rather than their cortexes and thus are driven by emotion and not a utility-maximizing function. This has massive implications for understanding WHY markets behave as they do. I couldn't encourage you more to investigate this idea further.

Thanks Scott. It is great to see you posting more frequently on Minyanville. The book to which you refer "The Golden Constant" is out of print. There is however, some discussion on Mises: Jastram's Classic Study of Gold's Purchasing Power.
This seminal work rigorously analyzes the purchasing power of gold in England and the United States from 1560 to 1976, employing a meticulous methodology that:
  • constructs unified series of the price of gold since 1560;
  • constructs unified series representing the level of wholesale commodity prices in every year since 1560
  • determines the statistical relationship between these two series in such a way as to measure the purchasing power of gold since 1560;
  • analyzes the behavior of that purchasing power in periods of inflation and deflation; and
  • assesses the extent to which gold served as a hedge during inflationary periods and a conservator of purchasing power during deflationary periods.
The Golden Constant demonstrates conclusively that gold holds its purchasing power remarkably well over time. It concludes that gold prices do not chase after commodities, but rather that commodity prices return to the index level of gold, over and over, and that gold provides an effective refuge in times of upheaval.
There is a link in the Mises article to a PDF version of the book, but unfortunately the target is not found.

A Dissenting Dissection

An even better discussion of how gold acts in inflation and deflation was presented in the article Gold and Deflation: A Dissenting Dissection by Bob Landis.

Landis takes apart the thesis that gold is a hedge against inflation, relying on the work of Jastram to do so. Let's Dig In.
The Inflation Hedge Thesis vs. The Golden Constant

The Golden Constant examined Anglo-American price data over a period of 416 years, establishing a statistical relationship between a price series constructed for gold, on the one hand, and a price series constructed for wholesale commodities, on the other. It concluded that [p. 175]:
  • Gold is a poor hedge against major inflations.
  • Gold appreciates in operational wealth in major deflations.
  • Gold is an ineffective hedge against yearly commodity price increases.
  • Nevertheless, gold does maintain its purchasing power over long periods of time.
The intriguing aspect of this conclusion is that it is not because gold eventually moves toward commodity prices but because commodity prices move toward gold.

The work is refreshingly free of bias: Professor Jastram approached the study without an agenda. He was neither an apologist for the fiat monetary system, nor a gold bug. Indeed, he explicitly noted that “… we are accustomed to thinking of gold, itself, as money. It is not.”


In relation to The Golden Constant, the inflation hedge thesis is little more than an old wives’ tale. Unfortunately, that hasn’t stopped it sprouting like a weed. Lacking dispassionate empirical support, it rests instead on other theories that at root are political rather than economic.


While we get no joy from his view that gold is not money, we take comfort from his empirical evidence that gold acts like money. We turn also to common sense, and note the fundamental economic difference between other commodities and gold: all other commodities are produced for consumption, whereas gold, precisely as a function of its money-like qualities, is produced for accumulation. [10] Virtually all the gold ever produced still exists somewhere, albeit not necessarily where governments claim it does. Set aside for the moment the massive empirical evidence marshaled by Professor Jastram that demonstrates how differently gold and other commodities have behaved over time. How is it even reasonable to expect such fundamentally different things to act alike?

The Silver Example

Mr. Saville suggests that silver’s record during the deflation of the 1930’s shows what gold may be expected to do under similar circumstances. The comparison, it seems to us, is inapposite. Silver is different. It has had a unique and difficult history as money, exacerbated by the negative consequences of fixed ratio bimetallism, prolonged government intervention and massive private market manipulation. [12] More important, it is a commodity with an enormous number of industrial applications. It is thus produced both for consumption, as it is used up in military and industrial processes, and for accumulation. We don’t doubt that it too will someday make a comeback as a monetary metal. We can even speculate that it may do so as gold’s nearer equal in value than has been the case historically, as a result of scarcity caused by the exhaustion of above-ground stockpiles over the years. [13] Indeed, silver is currently the basis for Mr. Salinas Price’s important monetary reform effort in Mexico. [14] However, both its history and its nature are so unique as to make it a questionable guide to gold’s behavior in a deflationary setting.

The Japanese Example

Mr. Saville suggests also that gold’s performance in yen terms during the recent Japanese deflation provides further guidance as to how gold will behave in a dollar-denominated deflation. The comparison is original and provocative, but troubling in several respects.
to consider in isolation the yen-gold price in the context of that still-functioning dollar-based global monetary system seems unlikely to yield analytically useful information. Gold is, and was during the period considered by Mr. Saville, priced globally in dollars. Accordingly, to show that it took fewer yen to buy gold is tantamount to showing that it took fewer yen to buy the dollars needed to buy gold; this ratio seems merely to be a more roundabout way of expressing the dollar-yen exchange rate.

Come Firewalk with Me

But our biggest problem with the inflation hedge thesis is that it takes our eye off the ball. The critical question today is not whether we face deflation or inflation, but whether and when we face monetary collapse.

What is relevant is gold’s traditional role in the context of monetary collapse. This role is not, to our knowledge, in question. Gold is what you want when they seal the borders and you need to get across; it’s what’s accepted when there’s blood in the streets and nothing else flies.

Whatever can be argued about its implications for gold's behavior in inflation, the abrogation of Bretton Woods in 1971 did not change the fact that gold is the only money when the chips are down. This was a major conclusion of Professor Jastram’s research. [22] For the continuing validity of this proposition, we cite as an authority none other than Lord Greenspan, Tsar of All the Monies, Defender of the Fiat, Best Friend of Leveraged Speculators, who testified as recently as 1999 that [23]

... gold still represents the ultimate form of payment in the world. It's interesting that Germany could buy materials during the war only with gold. In extremis fiat money is accepted by nobody and gold is always accepted and is the ultimate means of payment…

Do I think it merely possible that our fiat dollar will someday collapse? If yes, then I should own gold. How much? As much as I can comfortably rationalize, perhaps using some sort of calculation of the gravity of the harm -- i.e., financial wipeout -- discounted by my sense of the probability of its occurrence.

Do I think it inevitable that our fiat dollar will suffer the fate of all paper currencies throughout history? If yes, then I am a gold bug, and it is my dollar exposure, not my gold “investment,” that I must rationalize.
Those were short excerpts from a well written and very educational piece. I highly recommend reading the complete article.


Charts speak better than words. Are professor Reamer, Bob Landis, and Jastram right or is gold some sort of inflation hedge in general? I asked Nick Laird (Sharefin) at Sharelynx Gold to shed some light on the situation. Following are a collection of charts, some of which he specifically created for this article.

US Dollar Index vs. Gold

US$ Index vs. Gold (annual rate of change)

US$ Index vs. Gold
(annual rate of change - revised scale)

Gold Vs. Inverse US$ index (annual rate of change)

Gold Vs. Inverse US$ index
(annual rate of change - revised scale)

As professor Reamer suggests, there is indeed an inverse correlation between gold and the US$ but that correlation is not especially strong. The correlation is also prone to wild extremes at times yet at other times one has to exaggerate the scales on one side of the comparison to see the relationships clearly.

Is Gold An Inflation Hedge?

Let's now turn to the question "Is gold an inflation hedge?" Of course this now begs the question "What is inflation?" To some inflation is a sustained rise in prices, to others inflation is a decline in the purchasing power in the dollar, but I am sticking with the Austrian definition that inflation is an expansion in money and credit. In that regard, I use M3 as a measure of expansion of money and credit.

Gold Vs. M3 (Annual rate of change)

Gold Vs. M3

That last chart is crystal clear. Gold is simply not an inflation hedge for periods as long as 22 years and perhaps much much longer. Those using other measures of inflation instead of M3 should see a similar thing. If you disagree, please send me a chart.

Charts for this article were custom made by Nick Laird (Sharefin) at Sharelynx Gold. The opinions expressed in this article are mine and do not necessarily reflect the thoughts of Sharefin. Nick graciously provided the charts, the interpretations are mine.

Final Thoughts

Gold in many timeframes is not much of an inflation hedge.
In terms of real price, gold is a better deflation hedge than an inflation hedge. The reasons...
  1. Gold is money. Proof of that statement can be found in the market behavior of gold. The markets treat gold as if it was money (not only now but on a historical basis). On that basis gold must be considered money regardless what the central banks say.
  2. Money is worth more in terms of other goods and services during periods of deflation. During periods of disinflation "cash is trash" and that helps explain why gold dropped from over 800 to 250 even though we had a positive (although falling) rate of inflation for much of that timeframe.
  3. Gold is stateless and has no liabilities attached to it. It is the only money that won't be touched by whatever measures the authorities decide to take to combat deflation.
In addition to being a deflation hedge, gold may also play a role in a panic flight to safety scenario. For example: If the US dollar were to suddenly collapse and/or if fiat currencies were totally repudiated in general, gold would be a huge beneficiary.

Given the current underlying conditions, with increasing chances of a deflationary credit implosion related to housing, along with some chances of a collapse in the dollar, Yen, or fiat currencies in general, the incentive to store wealth in the form of gold is massive.

Mike Shedlock / Mish

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