The Internet is full of apocalyptic stories about the US economy. If you believed everything you read you would think that the US dollar is about to be dethroned, our debt situation will get out of control, and hyperinflation will ensue. But as Adam Smith once said, "there is a great deal of ruin in a nation." What Smith meant is that economies can absorb quite a bit of punishment and keep on ticking. Here I'll explain how despite America's very real and serious problems, investors should be skeptical of get-rich-quick schemes suggesting that gold is a good hedge for the turmoil ahead.
Let's start with the national debt, which by one measure is as large as our GDP. If you look at the part of the debt actually held by the public, however, it's a bit over 70% of GDP, which is not unusual for a developed country. The budget deficit, which is the net increase in the debt over one year, has fallen to about 3% of GDP, also similar to many other countries. Even better for the Treasury, interest rates are relatively low and likely to rise only modestly. This means the cost of financing the national debt is not too burdensome, and long term rates will stay fairly low (about 2% to 4%) even as short term rates rise.
So we don't currently face a public debt crisis. On the other hand, the retirement of baby boomers will soon lead to large increases in spending on programs like Medicare and Social Security. So there are some long-term issues that need to be addressed, but in my view we will be able to adapt to the changing demographics through a combination of a higher retirement age, cost controls in healthcare, and slightly higher taxes.
I've emphasized the public debt issue because many of the other concerns are linked to this one key problem. For instance, those who claim that hyperinflation is on the way often suggest that the government will be forced to "monetize the debt" which means printing money to pay off government bonds. In the past, countries that have done this have often suffered from extremely high inflation. Printing money to pay for deficit spending largely explains the very high inflation suffered by places like Brazil and Argentina during the 1980s and the more recent hyperinflation in Zimbabwe.
There are lots of good reasons to doubt whether this scenario will play out in the US. First of all, investors in 30-year Treasury bonds obviously don't fear hyperinflation, or they wouldn't be willing to lend money for such a long time period at 3% interest rates. Even better, those low interest rates make a debt crisis much less likely as it means the national debt can be financed at an interest cost of roughly 2% of GDP.
Second, there are other developed countries that have dramatically worse public debt problems, measured as a share of GDP. In Japan public debt is about 240% GDP, or 140% in net terms, double the US level. Yet the Japanese continue to borrow money at very low interest rates, despite this large public debt. It would take many decades for the US to reach the debt situation of Japan today, and not only does Japan not have hyperinflation, they're even falling short of their 2% inflation target. China’s official public debt is not too large, but the Chinese government is widely seen as being responsible for a dramatic increase in debt issued by state-owned banks and local governments. Total debt in China is higher than in the US as a share of GDP.
What about Greece? This is the example that people cite who are concerned about excess debt. Greece actually has three problems that are interrelated: excess debt, no ability to control their own currency, and a deep depression that led to roughly 25% unemployment. This is nothing like the situation faced by the US, where unemployment is only 5.5% and trending downwards, and which has a Federal Reserve that can print money if we are in recession. Borrowers understand this distinction, which is why countries with their own central bank have not suffered from the sort of debt crises that hit the southern European countries.
Some people claim that the US is only able to borrow so much because the dollar is internationally recognized as a reserve currency. The fact that Treasury bonds are a preferred international reserve might allow Uncle Sam to borrow at slightly lower interest rates, but it’s only a slight advantage at best. For example, many other developed countries, such as Japan, Germany, and France, have large amounts of public debt outstanding and pay even lower interest rates than the United States. The Australian dollar is not widely used as an international reserve, and yet Australia has run trade deficits comparable to the US for many, many decades.
And even if the US dollar’s reserve status does lower borrowing costs, there is no plausible alternative out there for the foreseeable future. The euro is a mess and likely to be plagued by periodic crises due to the decision to impose a single currency on many vastly different countries. In the first decade of the euro’s existence there was a modest shift out of dollars, and the US dollar share of international reserves fell from the low 70s to just over 60%. But in recent years the euro has slipped back, and now comprises only 22% of international reserves, while the dollars share has leveled off at over 60%. No other currency is even close.
China is growing rapidly, but its currency is still heavily regulated through capital controls. Because foreigners cannot freely move Chinese yuan in and out of China, it is not a very attractive option as an international reserve currency. While China’s economic influence will gradually increase over time, the US dollar will remain the dominant reserve currency for many more decades. In some respects the US is like Britain in the late 1800s; it will still have the world’s most sophisticated financial markets even if China’s total GDP is larger.
If none of these apocalyptic theories of dollar collapse are true, then what does drive the international gold market? Gold tends to do well during periods of extreme economic stress, such as very high inflation or depression, and also during periods of very low real interest rates. (Real rates are the actual market interest rate (nominal) minus the rate of inflation.) This needs a bit of explanation, because some people might recall that gold did very well during the late 1970s when interest rates were high. Yes, but that was due to high inflation; real rates were not high. Investors bought gold as a hedge against risk of high inflation. When inflation is 13%/year, even a 15% nominal interest rate means only a 2% real interest rate. Even though nominal interest rates fell in the 1980s, inflation fell even faster, so real interest rates actually increased. That’s why gold prices fell after 1980. With the Fed now targeting inflation at 2%, it's unlikely that we'll see a repeat of the highly inflationary late 1970s.
A better argument is that low real interest rates help the gold market because they make other alternative investments such as bonds look less attractive. However, the US is gradually moving out of the depressed period of the early 2010s, and the Fed is expected to raise interest rates sometime in the second half of this year. In my view, the Fed rate increase might come a little bit later than some people expect, but I do think interest rates will gradually rise over the next few years, probably beginning in late 2015 or early 2016 at the latest. Higher interest rates take away one of the factors that underpinned the bull market in gold a few years ago. Indeed gold prices declined in 2013 on just a mention of the Fed’s intention to “taper” its purchases of bonds, aka “QE.”
Some commentators had falsely hyped a risk of high inflation due to quantitative easing and near-zero interest rates. In fact, there was never much risk that QE would lead to high inflation, because unlike previous hyperinflationary episodes, most of the new money went right into interest-bearing bank reserve accounts at the Fed. The Fed was not dumping trillions of dollars of paper money directly into circulation. Economic recovery and higher interest rates in the US will also diminish any latent fears of inflation. As interest rates rise the Fed will remove some of the excess reserves from circulation and immobilize the rest by paying a higher rate of interest on reserves. That policy did not even exist in the 1970s.
There might be some international factors pushing gold up in the short run, such as "Grexit”, which means Greece leaving the euro. Even if that occurs, and it's not at all clear that it will, any effects are likely to be short-lived. Greece is less than 2% of the Eurozone economy. Back at home there is a deadlock between the two political parties, which some believe is actually good for growth as it stops Congress and the President from greatly expanding the size of government. The world’s key central banks (Fed, ECB, Bank of Japan, People’s Bank of China) are all focused on maintaining steady growth with low inflation. As I indicated, the low interest rates have been a positive for gold, but that factor is already priced in. From this point forward rates are more likely to rise than fall.
Over the long run, stocks have done far better than gold. That doesn't mean gold is a bad investment; people care about more than just the average rate of return. Some people cite gold as a hedge against risk. But gold is itself a very risky asset, with a price that is highly volatile over time. To make an argument in favor of gold you need to show that gold does well when other assets are doing poorly. Someone worried about another Great Depression or double-digit inflation might be tempted to invest in gold as a hedge.
In my view, however, the problems of the 21st century will look different from those of the 20th century. Instead of depression or hyperinflation, the risk is economic stagnation—especially in countries with falling populations. And in that environment gold is not a particular good hedge. Stagnation will be less of a problem in the US due to factors like a growing population (immigration) and new technologies such as fracking which remove the previous fear that “peak oil” would inhibit economic growth. Again, gold does not do particularly well when there is low inflation and steady growth.
This is not to say that gold prices won't go higher over time; the long-term trend has obviously been positive, and there is growing demand in Asia. But don't forget that much of this merely reflects the effects of inflation. Gold prices are about 60 times higher than in 1900, but the cost of living has increased roughly 30-fold. So the increase in purchasing power of someone who invested in gold is about 2-fold, but that’s over 115 years! This is a much lower return than you would've seen in alternative investments.