Investing in gold

Should you be looking at gold as an investment?

“Buy land,” Will Rogers advised. “They ain’t making any more of the stuff.”

There’s something to that, actually. If people spend a constant fraction of their income on land, and the supply is fixed, over the very long run, the price of land should rise at the same rate as nominal income, or about 3% faster than inflation.

You might expect something similar to hold for gold. The metal has some unique properties that ensure that it will always be valued. However, unlike land, they are making more of the stuff– production from mining adds to the stock by about 2% per year. That’s not as fast as real economic growth, and some gold is destroyed by certain industrial uses. So one might expect gold’s price also to rise a little faster than overall inflation, though perhaps not as fast as real estate.


But, as the graph from Mahalanobis at the right reveals, over the last quarter century gold hasn’t even kept up with inflation; see also Division of Labor on this. Besides, other investments that appreciate with inflation also generate income for you while you’re waiting for the capital gain– real estate yields rent, corporate stocks pay dividends, inflation-indexed Treasuries give you a coupon. But gold you can only look at.

Of course, the graph also reveals that there were a few historical occasions– the late 1970′s being the most spectacular example– in which the gold bugs were rewarded most handsomely. Historically much of the demand for gold came from its central role in monetary standards, and the roaring U.S. inflation of the late 1970′s fueled a keen interest in gold as an alternative to dollars. Jewelry demand is ultimately a matter of fashion, and the idea of having jewelry that was also a store of value and inflation hedge also contributed to that price spike.


And gold prices are up 18% so far in 2005. But anyone banking on a replay of 1979 is sure to be disappointed. The surge in inflation in the 1970′s had little to do with oil prices and was caused predominantly by rapid money growth. Fed Chair Paul Volcker’s determination to eliminate inflation proved to be a disaster for the gold bugs. And today’s Fed looks to me even more committed than Volcker was to preventing even the smallest whiff of inflation.

In any case, if you did want to bet on inflation, there are better vehicles out there for doing so, such as going short 10-year bonds and long on inflation-indexed securities.

Some investors are always going to be drawn by the allure of this pretty metal. But it’s not for me.


42 thoughts on “Investing in gold

  1. KipEsquire

    The supply of land is fixed? Been to Manhattan recently?
    And there is no such thing as “investing in gold.” One speculates in gold, one invests in a gold mining company.

  2. Asymmetrical Information

    There’s gold in them thar hills

    James Hamilton takes on the gold bugs: there were a few historical occasions– the late 1970′s being the most spectacular example– in which the gold bugs were rewarded most handsomely. Historically much of the demand for gold came from its central rol…

  3. dryfly

    I heard an investor interviewed on TV about gold once… doncan’t remember the guys name… it was back in the 80s and if I recall it was during the huge gold run up… I believe it was on Louis R’s “Wall Street Week”… dates me I know…
    The investor was asked if gold should be part of a portfolio… his reply was ‘yes but not like you think’… He told the story how his family (Jewish) had escaped Nazi Germany because his father (banker/investor) had hidden gold around the country… hidden in train lockers on a round about path to Switzerland… used it to bribe guards & officials. So even after Krystallnacht when it became almost impossible for Jews to get control of their ‘normal’ assets… he had his own personal ‘liquid assets’ stashed that he used to get out. Most of their families friends did not and later went up the chimneys of Auschwitz, Bergen Belsen, etc.
    His point wasn’t that this would happen again… or certainly not EXACTLY like the Holocaust. But that things do happen and that gold is one of the worlds truly liquid assets. And as such has some intrinsic value regardless of price fluctuations. The key is YOU have to hold it… if you turn it over to a fund to manager then you might as well own paper instead… you won’t be able to get it if & when you really need it.
    The reason we save & invest is for future security… like squirrels save nuts in fall. Mostly for regular economic security & regular savings & investments are fine for that.
    But no one knows what exactly the future will bring… so diversity in the portfolio is absolutely critical. Gold should be looked at as a ‘last resort’ investment… right up there with currency you stash away in a foreign bank.
    To be honest I am pretty sure that is why some of the foreign money is flowing into the US today… from Asia & the Middle East… People are planning their escape should they ever need it… hopefully they won’t but if they should… the paths out & safe houses are already set up.
    Many hold gold & have accounts outside their country for these reasons just as much because they think it might be a good ‘current investment’… It would be wise for Americans to do some of the same. Not go crazy paranoid but just make sure they have a backstop. No society is immune from the future… it all happens given enough time. Whether it happens to you or somebody else is only a matter of the specific timing & luck.
    Next question – do I do this myself – do I eat my own cooking? Not yet… but I’m looking at it MUCH harder… I’ve actually researched where it would be wise to squirrel away foreign currency & liquid assets just in case… something I would have never done 10 years ago.

  4. PaulO

    I hope we all can see this post for what it is: nothing more than an attempt to start controversy.
    JDH waltzes around touting himself as a serious economist and THIS is the depth of his analysis of this topic?
    I won’t even go into the discussions of the overvalued dollar, current account and fiscal deficits, pension accounting in corporate profit numbers, looming entitlement program obligations, rising emerging economies looking to invest savings, you know, all the -real- economic issues that constitute the argument for a move in the gold price. Most of us here are aware of and understand these topics, whatever our particular beliefs may be.
    All that needs be said here is that JDH should be embarrassed and ashamed.

  5. The Prudent Investor

    Gold beats the Dow since the clsoing of the gold window comfortably. It beats all equity indexes since 2000. And when I think of the strong correlaton of gold and inflation I find another reason to own physical gold. In his last testimonial to Congress Greenspan also said that in times of extreme crises gold remains as the only accepted form of international payments. It has been the universally accepted currency of 6000 years, the last 35 and a few coming years will be seen as a blip in history. So far every fiat currency has come back to its intrinsic value within a human’s lifespan.
    Add in the context that the 2 coming superpowers are India (importing 600+ tons of gold p.a.) and China (strong indivdual demand) and compare this with the US debt, backed by nothing than a diminishing belief that it can be repaid without being inflated and I will stick to gold. This year’s recovery of the dollar was just a bear market rally.

  6. Fred Hapgood

    > “Buy land,” Will Rogers advised. “They ain’t
    > making any more of the stuff.”
    The number of tunnel boring machines working at any one moment has been doubling every decade
    since 1960 and the trend is, if anything, accelerating.

  7. Tim

    This is a fine example of the contemporary view of gold by economists today. I, for one, fail to understand how so much history and so many imbalances can be ignored. It’s clear that most economists believe that our fiat money system has been mastered, and everything from here on out consists of minor tweaks – time will tell. Are there any economists out there that have some gold coins tucked away somewhere – just in case?

  8. John

    I think the case for gold is it is uncorrelated with other assets: in fact, historically, it has negative return correlation.
    Therefore in creating the efficient portfolio, gold has a role as a diversifier.
    Gold equities do *not* have that role as far as I know, although empirically I believe they are low beta (but positively correlated with other equities).
    In practice, gold equities tend to behave like a warrant on the gold price, and they tend to anticipate moves in the gold price.
    (analogy here to owning REITs vs. owning the underlying property assets– REITs have a much higher correlation with the stock market).

  9. John

    On land, the key factor is *zoning density*. The southeastern UK has a land shortage, but not because it is overcrowded, but because the Green Belt restriction prevents London sprawling outside the M25 ring motorway. Over 20 million people live within 100 miles of Big Ben– so 1/3rd of the UK’s population in less than 1% of its’ land area.
    My borough in London, population about 250,000 in 10 square miles, would rank as something like the UK’s 40th or so largest municipality. The highest building we have in the burough is about 10 stories– we all live in terraced (row) houses and blocks of flats, typically 5-6 stories.
    So if the world were all packed into the density of Tokyo (a city mostly of small villages, rather than a Manhattan or a Hong Kong), we could fit the world’s population into an area the size of California (I’d have to check, but Tokyo has a population of c. 40k people per square mile I believe, and manages to pack in 30 million people– remember that 2% of Tokyo’s surface is actually still farmland).
    On land as an asset, because it is a real asset, one would expect its price to rise with real GDP growth. However because it generates utility (you can live on it) you would expect its returns to be below other real assets like stocks.
    Which, empiricaly, is true, from the data we have. Shiller shows that real housing prices in the US since 1890 have risen by about 0.9%, whereas real stock prices have risen by something like 3% pa (not sure about the exact latter number).

  10. calmo

    PaulO gets my attention. No incites me and I demand a retraction. Sedatives. Damage awards in the Kazillions. Something.
    No, I get it now.
    So clever. Excuse my dunderheadednessitydomdedom.
    Like the arsonist announcing his intentions to the Fire Chief and not being able to persuade him that he was serious. “Look: matches. Look: gasoline. I’m gonna burn down the house.”
    The matches are that gold is above $500. The gasoline is the currency uncertainty brought on by the growing deficits (but could be exponential credit issuance, could be).
    The narrative is slightly less incendiary than “Burning down the house”, but it is early with those drafts, no? The coming shift in the senior currency, the possible merger of the dollar with the euro, the possible merger with the yen, the history of the last senior currency (the pound) and its transition, –all these drafts are in their early stages waiting for capable minds…like PaulO’s maybe.

  11. JDH

    As always, those are great insights, John. Thanks much for always adding a great deal of useful knowledge and perceptions to the discussion.
    Though if all one wants is an asset that is uncorrelated with equities, placing a bet at the horse races would accomplish the same task. And the chart suggests that if you’d been placing horse bets since 1980, you’d probably be better off (and perhaps have had more fun) than if you’d put the money into gold.

  12. Tim

    From today’s WSJ
    “Market experts contend that gold has partially broken away from the dollar and is rising on its own demand fundamentals. That, in turn, will keep the price of gold sustainable at the $500 level, said Michael Cuggino, president and chief executive of Permanent Portfolio Family of Funds.
    “We are seeing a slow devaluation of the unit value of the dollar and are seeing assets like gold and silver appreciating,” said Mr. Cuggino, whose portfolio structure is 20% gold-based.”
    It is fascinating to watch the mainstream financial media and economists talk about gold these days.

  13. Ken Houghton

    I think you’re seeing why your “if the price of oil were going to be $200/bbl” argument fails, actually. It’s only a premium (suprainflationary) asset if it’s not fungible. The growth of alternative methods of enhanced conductivity reduced the optionality portion of gold’s value.
    The peace dividend was, in no small way, a reduction in the real price of gold. Which one could not predict with certainty in the days of Bonfire of the Vanities and the Giscard. So the best method of shorting remained that old investment standard: do nothing.

  14. Don

    I love the way the chart makes such a strong case for gold. The chart on gold returns for the last 25 years is reminiscent of a chart of the Dow in 1950, 20 years after the depression, or in 1979, when Newsweek published the article, “The Death of Equities”. I argue that this chart should make everyone very excited about investing in gold or gold mining stocks.
    With asian banks printing outlandish amounts of money to keep their export-led economies alive, and with the USA stuck in a stalemated war – wars are always paid for with a big inflation at the end – and with a trade war brewing between the USA and asia – this is a perfect storm favoring investment in portable wealth that a central bank cannot print.

    Moreover, precisely because the returns on stocks and housing have “exceeded their means” for the past 25 years – and gold “hasn’t reverted to its mean”, this is a BIG argument for a correction in the value of gold vs. these other classes of wealth. The big inflations that Bush & Asia are attempting to create are just an icing on a cake that looks very grim going forward. See this article for a good counter-argument in favor of gold
    Remember that when Britain lost its super power status in the 1910′s, gold was a SUPERB investment for brits – and the owners of british perpetual gilts got NUKED.

  15. John East

    Gold is a barbarous relic, yields no interest, and is a waste of time as an investment.

    This makes 4 anti- and 3 pro-gold posts on this thread.

    I expect gold to have peaked when everyone is euphoric concerning its prospects. I don’t want the gold bull to enter it’s blow off phase just yet as I’m still making a lot of money from it, and plan to make a lot more.

  16. Dan

    How much of the demand curve of gold is luxury (jewelry) and how much is industry?
    I would expect the industry demand for gold to rise just slightly less than the whole economy. Gold is needed for various applications, but manufacturers are always figuring out ways of using less of it. Recycling is possible but probably not really relevant since I expect extracting the gold from most products is difficult.
    Gold as a luxury is much harder to predict. Obviously, a better economy is correlated with more jewlery, but there are also population pressures invovled as well:
    1. a person can only wear so much physical gold at a time. They may spend more money to have jewelry designed in a better fashion, but that doesn’t require greater amounts of jewelry
    2. there is a build up of antique jewlery, which is very easily re-used, both as an existing product and also to recycle the components.
    3. Like other entertainment components of the economy, it is very vulnerable to fashion. If platinum takes off over white gold, the luxury demand will plummet.
    So back to my original question: how much gold is consumed by each component?

  17. HW

    Consider; When political entities collapse, which,without exception, they all do,The paper IOU’s (money,bonds,etc) become worthless.Most of the time,shortly before the collapse,anything known about or visible gets taken by the political types and their thugs. North Korea,Nazi Germany,Vietnam,China,it is a long list.Therefor any paper investment is a calculated bet that the umbrella political covering that investment will be fair and honor property rights.How much do you trust your politcians? Oh yeah. Pay taxes on the appreciation of gold? Perhaps if one owns hundreds of pounds, otherwise everything is on a(paper) cash basis.At 229 years, the US is the oldest Democracy around. How much longer? I had 30% of the value of my propery confiscated by rent control and the politicians are constantly coming up with new ways to buy votes at the expense of visible owners. 55% when you die will be spent by our favorite polticians. GOLD passes the math test for most of us.

  18. John

    I’d be interested in seeing your horse betting data!
    In the UK, where you bet through fixed-odds marketmakers who take a rake each way, (this is before internet gambling), the net gain to the betters has to be negative. Ladbrokes, Paddy Power etc. are highly profitable stock exchange listed businesses.
    Horse racing is entertainment rather than investment at least here in the UK. There is evidence that skill counts, but markets are efficient: even a skilled better has to make his bets early, and take a lot of losses, to offset the rapid convergence of consensus on the actual outcome (see The Wisdom of Crowds by James Suroweicki).
    On gold, or any asset, an argument that past returns are bad is not prima facie an argument that they are a poor asset class. Because most assets display reversion to the mean.
    The problem with gold is that there is very little consumption of gold, most of the gold ever mined is out there, somewhere. So a big price rise brings a supply response (high elasticity of supply).
    Gold is, in effect, a financial asset not an industrial commodity.
    The other thing about gold is that we now live in a world of limited exchange controls, lower F/X transaction costs (Everbank will open you up a euro account), and inflation-linked bonds. It is easier to diversify purchasing power risk, so substitutes have risen to reduce the attractiveness of gold as a store of wealth and inflation hedge.

  19. John East

    To argue along the lines, “And how have the gold bugs done who bought gold around 1980?…..they went bankrupt and have not remotely recovered since.” is very silly. You can lose your shirt on any and every investment if your timing is wrong. Your argument is irrelevent.
    Jewelry and industrial usage are not the keys to the gold price which most certainly hasn’t doubled over the last few years from these drivers. Central banks, speculators, investors in Asia, and the possibility of inflation are the keys. Jewelry may account for 75%, but the tails I listed wag the jewelry dog.

  20. Jack Miller

    The fact is that Gold does well when real interest rates are negative and it rolls-over to poor performance after global real interest rates turn positive. Folks hold gold for a lot of reasons but carrying costs compound when real interest rates are high.
    Today it was Canada and Indonesia that raised short rates. Recently it was Taiwan and the ECB. Gold will flow “out of the woodwork” as the cost to carry gradually hits home.
    I always love to hear all the problems caused by the trade deficit. Typically these problems are just terrible in countries with trade surpluses and just terrible in countries with deficits. How is it that trade surpluses and trade deficits are always bad?
    The reason gold bugs and others over-estimate inflation is because they focus on the price of individual items rather than the basket of consumption that is constantly changing. This basket includes items that are no longer needed making the new cost zero! (Many folks no longer purchase a daily newspaper.)

  21. Don

    If any of you guys believe the official USA inflation numbers, then I have a bridge in Manhatten that I can sell you REAL CHEAP.
    There is every reason in the world for the US Government to lie about inflation, and NO reason to come clean on the true inflation rate. When the US Government understates inflation, (a) Taxes go up (tax brackets are supposedly indexed to inflation), (b) Liabilities (e.g. social security costs) go down. The government has spent the past 20 years defining new people as “employed” (e.g. the military in 1984), and getting “assets that are undergoing hyperinflation” out of the CPI index.
    Have you seen the recent Federal Reserve work entitled, “Hedonic Improvements in Clothes Dryers?” We now today have major appliances that are so much better that that CPI has now been adjusted down by .1% annually !! I mean, get real, your clothes are either dry or they aren’t !! They’re either washed or they aren’t !! That’s utter bullshit, imho.
    Gold doesn’t lie, and inflation, indeed, is out of control. Omit gold from your portfolio at your own peril!! Cheers!!

  22. Barkley Rosser

    John East,
    I was responding to earlier individuals who were cherry picking time points to “prove” that gold was some great long term investment. I was doing so to prove the irrelevance of their arguments. If you agree that their arguments are irrelevant, I am perfectly willing to grant that mine are also.

  23. Dan

    I didn’t mean to say that industry and jewelry set the price; merely that they played big parts of the demand curve.
    Still, hearing that jewelry is 75% of consumption blows my mind. Something isn’t adding up for me so I need to spend some time looking at these markets from a few different directions.

  24. Herdsford

    ["...if you did want to bet on inflation, there are better vehicles out there for doing so, such as going short 10-year bonds and long on inflation-indexed securities."]
    …that depends on inflation proceeding at ‘customary’
    American historical rates — however, hyper-inflation and full collapse of the U.S. Dollar are well within possibility.
    Investing in ‘Dollar-denominated’ bonds/securities will
    not protect an investor against stormier financial seas, no matter what the guaranteed interest rate — he will merely own ‘more’ worthless U.S. Government fiat money… with little or no actual purchasing power.
    It is quite conceivable that a future U.S. Congress, mired in unrepayable debt… will choose the easy route for themselves — and issue a completely new replacement U.S. fiat currency, while paying off its huge debts with the old (…and now worthless greenback Dollars).
    Economic chaos would abound, for sure — but GOLD
    would certainly buy your next meal.

  25. Joe Rotger

    Gold used to be very attractive because of its properties, which allowed it to concentrate negative wealth.
    It didn’t decay with time; it’s ratio of value/ volume was excellent, which reduced storage and facilitated transportation; and, it could be used to make jewlery.
    Nowadays, bits and bytes have done away with these financial advantages. With the push of a button, thousands of tons worth of gold can be moved to the other side of the world at the speed of light. And, bytes don’t decay.
    So, it’s used for jewlery…
    Nowadays all commodities are rising in price.
    Could it be that there is excess liquidity in the world, and this is being reflected by high asset prices?
    I think so…
    When I see the Nazis coming, I’ll buy gold. In the meantime, I’ll stick with oil. They say it won’t last long…

  26. Julia

    In regards to jewelry, local Indian merchants sells 22 K jewelry at around 130% of the gold price. Much is intricately made and I’m surer the margins are lower overseas.
    As westerners see this stuff our demand may rise.

  27. John

    My washing machine and clothes dryer (Bosch) are light years ahead of my parents’ ones (which are 30 years old).
    A European washing machine (front loader) uses half the water of an American one. Both of these machines are also significantly quieter and faster than my parents’ 30 year old N American GE model. And they use less electricity.
    ( a related problem is reliability. Cars are certainly more reliable, but also more complex and so more to go wrong and harder to fix. Not sure about home appliances).
    So yes, there is technical progress which raises standards of living. My computer in 1981 was less capable than my cellphone is now and had less memory. And in 1981 you couldn’t buy groceries in the middle of the night, (24 hour grocery stores only appeared in Canada in the early 80s, and in Britain not until the 90s), nor have Amazon deliver books to your doorstep. Flying across the Atlantic in a modern Airbus is a completely different experience than flying in a 707 in 1981– and the seat cost half as much.
    The point you raise is that for an individual, planning to retire, service costs rise faster than general inflation: healthcare, nursing home care, restaurants etc. Also the CPI doesn’t measure the price of housing directly (they use a rental measure) so the recent house price inflation is not caught (rents have been static).
    Whether gold is a good hedge against this I don’t know.

  28. PaulO

    Barkley -
    I’m not sure what the relevance, if any, of your comment is. Pick any investment and I’ll show you a time period where you get rich and another where you go “bankrupt” (as you say).
    I bought a ton of gold in 1999 and have made more money than all my other investments and my job combined over the time period from then to now
    Gold is inherently neither a better nor a worse investment than stocks or anything else. You just have to know how to time it. At some point it’ll be time to sell and jump into something else. With a strong dollar, outrageous deficits, and an aggregate debt we’ll never be able to pay off, that time is not now.
    It’s a shame an “economist” such as JDH put his positions above good economics.
    You’ll get much more valid, unbiased economic discussion from Altig or Setser.

  29. John East

    When you say, “I bought a ton of gold….” do you mean this literally, or was it a figure of speech???
    You raise a good point about knowing when to buy and sell. When to buy was the easy bit. When gold was ignored or rubbished by the media, and it became obvious that fiat was in serious trouble. However, I already have sleepless nights trying to decide what criteria to use to decide when to sell. Yes, I know it’s just a reverse of the buy signals, and we probably have several years to go yet. However, the extreme volatility of this market, and the greed factor that comes into play near a market top, makes the psychology very daunting.

  30. Marius

    1. Gold is bad news. There is one and only reason for rising price of gold and it has been the same for last few thousand years. High gold price means that political and/or social order will be challenged.
    2. Bull markets in gold are infrequent (and violent). On average 3 in one century. This is the reason why investing in gold seems frustrating.
    3. The year to exit gold: 2011 .

  31. John East

    I think that you have summed up exactly why most commentators and financial journalists ignore the elephant which is sat in the middle of the room. Acknowledging the gold bull challenges everything that these people stand for, all of their goldilocks economy spin would collapse, and their core belief that the US can borrow its way to prosperity would be revealed as the sad joke that it is.

  32. PaulO

    John East:
    No, I don’t own a literal ton, sadly! Just shy of a two hundred pounds.
    Yes, I agree the buy call was pretty clear, but when to sell is less obvious. But I get the sense when you look at this runup, which has been essentially nothing but up with really no true sell-offs to speak of on the way, that something bigger is happening. I wonder if it’s the beginning of the diversification out of the dollar everyone’s been waiting for.
    Fascinating times.

  33. PaulO

    Marius -
    I think that’s an excellent point. Gold only goes up a lot when bad things are going on or on the horizon it seems. If you think about it, who wants to own jewelry metal? It makes much more sense to own good profitable companies.
    I don’t mind profiting from price adjustments, but the reasons they have to happen is sometimes sad from a humanistic standpoint, and I’d much rather be profiting from a nice company that made environmentally-friendly energy sources say.

  34. Idaho_Spud

    “Fed Chair Paul Volcker’s determination to eliminate inflation proved to be a disaster for the gold bugs. And today’s Fed looks to me even more committed than Volcker was to preventing even the smallest whiff of inflation.”
    What kool-aid has this guy been drinking? I want some, if it’s legal!!!
    Easy Al and Helicopter Ben are *not* Paul Volcker. In fact, dear Ben believes in a ‘targeted’ inflation rate. What we have right now suits him just fine.
    And I don’t mind owning a little barbarous relic insurance, because
    A) these smart guys might not have all the right answers in advance.
    B) they might do what’s politically expedient rather than what’s best (like lowering interest rates to 1% until the next general election)

  35. Anonymous

    the author has a point. gold can not be destroyed so it’s supply always increases so it can not be the best investment

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