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James Turk replies: The basic premise that UK investors are taking a USD/GBP exchange rate risk by buying gold captures exactly the muddled thinking about money so prevalent today.
What investors need to hedge against is the loss of purchasing power, which can arise the following ways:
1) Inflation - For decades central banks have been expanding the supply of money at a rate greater than the demand for money with the inevitable result that prices of goods and services rise, meaning the currency loses purchasing power. I recently wrote the following article on this point.
http://www.kitco.com/ind/Turk/turk_jul272009.html
2) Exchange rate fluctuations - Purchasing power is lost in this case when the exchange rate of one currency falls against another currency. A good example is the huge drop in the British pound against the euro over the past couple of years.
3) Counterparty risk - In this case, the entire purchasing power of the currency you hold is lost if the counterparty where you have deposited that money goes bankrupt. We almost saw this event happen with Northern Rock, but it was a regular feature during the Great Depression.
There is basically only one way to hedge against all of the above risks. It is to buy gold.
I refer to the following chart which clearly illustrates that gold is money.
The above chart presents a base-100 analysis of crude oil prices in terms of four different currencies and goldgrams, i.e., grams of gold. In other words, to establish the useful comparison depicted above, the analysis presented in this chart assumes that one barrel of crude oil equals 100 in each of these currencies as of January 1950. It thereafter calculates the month-end price based on the actual dollar price of crude oil and the prevailing dollar-to-currency rate of exchange.
Throughout this 60-year period the goldgram price of crude oil has remained essentially unchanged. The price of crude oil in these national currencies only remained unchanged when they were linked under a fixed rate regime to the dollar, which itself was defined as a weight of gold. When the currency fixed-rate regime and the dollar’s link to gold were ended in August 1971, the discipline previously imposed on the supply of dollars and other currencies also ended, and the inflationary increases in the price of crude oil and other goods and services since then has been the result.
Had the gold standard not been abandoned in 1971, nobody today would be talking about the rising price of crude oil simply because the price of crude oil would not be rising.
This chart makes clear that gold preserves purchasing power over long periods of time. My insight is not new.
The world is today re-learning what Britain learned from the Bullion Committee formed by Parliament during the Napoleonic Wars. The following quote makes this point. It is from Henry Thornton, An Enquiry Into the Nature and Effects of the Paper Credit of Great Britain (1802).
“We naturally imagine that the spot on which we ourselves stand is fixed, and that the things around us move. The man who is in a boat seems to see the shore departing from him, and it was the doctrine of the first philosophers that the sun moved round the earth, and not the earth round the sun. In consequence of a similar prejudice, we assume that the currency which is in all our hands, and with which we ourselves are, as it were, identified, is fixed, and that the price of bullion moves; whereas in truth, it is the currency of each nation that moves, and it is bullion, the larger article serving for the commerce of the world, which is the more fixed.”
The book is online at the following link.
http://oll.libertyfund.org/index.php?option=com_staticxt&staticfile=show.php%3Ftitle=2041&layout=html
Gold and the pound were one and the same when they were linked by the British sovereign coin (pound notes were redeemable into gold sovereigns). Today the pound and gold are obviously different, so there is only one way to get a true picture of what is happening to a currency's purchasing power. The price of goods and services has to be measured in terms of both the currency and gold, as I have done in the above chart.
Therefore, UK investors should properly be focusing on hedging the loss of purchasing power. The best way to do that is to buy gold, and I mean physical gold - only physical gold eliminates counterparty risk (#3 above). Paper gold products like certificates, ETFs, ETCs, etc. have counterparty risk. With paper gold you only own exposure to the gold price - you do not own gold. And that exposure to the gold price is contingent upon someone making good on their promise, which is the counterparty risk.
Lastly, there are only two ways to buy physical gold. You buy it and store yourself or you buy it and have someone store it for you, which is what we do in the company I founded, GoldMoney. We're now storing over US$670 million worth of precious metals owned by our customers. << Back
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