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Inflation is rising. Time to buy gold?

Analysis: Here’s why popular beliefs about gold are dangerous.

Gold inflation bubbleEnlarge
An Emirati man tries the 'Gold to Go' vending machine at the Emirates Palace Hotel in Abu Dhabi in May, 2010. The well-heeled in the Gulf can now grab 'gold to go' from a hotel lobby in the United Arab Emirates, when the need for a quick ingot strikes. The machine, itself covered in 24-carat gold, dispenses one, five and 10 gram bars as well as one ounce bars of gold. (Ebrahim Adawi/AFP/Getty Images)

BOSTON — Inflation, that nasty beast, the great destroyer of wealth, is making a comeback.

People across the globe are beginning to feel the pain. In Europe, prices increased at a two-and-a-half year high in April, pressuring the European Central Bank to increase interest rates. In China and Brazil concerns over inflation have caused stocks to slump. American prices have risen as well, for now at a rate that many economists are comfortable with, but that is bound to change eventually.

Inflation is the enemy of wealth, because it picks the pockets of society’s most industrious, essentially by degrading savings. If you work hard to put, say, $50,000 in the bank and prices double, it’s as if you only had $25,000.

Buying gold is often touted as a way to protect against inflation. The theory is that gold retains its value regardless of the mistakes and malfeasance of decision makers, making it a good way of storing value.

So is it time to pour your savings into the yellow metal?

Some high-profile investors think so. For the first time in two decades, central banks have been buying more than they sold, according to the Financial Times. India, Saudi Arabia, Russia, the Philippines and Mexico are believed to be stocking up. China has doubled its gold reserves, to more than a thousand metric tons. Iran is reportedly buying bullion, although this is partly out of concern that assets denominated in dollars or euros risk being confiscated.

Both short- and long-term investors have profited from gold. Despite recent headlines about sharp drops, over the past week or so gold has recovered much of its losses. The price is up about 5 percent for the year. If you had bought bullion in 2005, you would have more than tripled your money.

In uncertain times, there’s something psychologically reassuring about holding high-value assets that you can actually look at and touch. The logic behind buying gold is that you’re not relying on anyone else to pay back a loan or otherwise make good on the investment (assuming you hold the actual metal in your own vault).

As a hedge against inflation, it makes sense to buy assets that people need. A home bought in the 1960s, for example, would have skyrocketed in value during the 1970s, when inflation was high.

But here’s the key question: what will the price do in the future? If inflation rises, will gold rise more quickly? Since gold doesn’t pay interest or dividends, its wild ascent means that investors are betting the price will forge ever higher, or at least that it will fare better than other investments. With gold, you’re essentially buying the hope that at some future date, someone will be willing to buy it from you at a higher price than you paid.

After all, it’s largely useless unless you can trade it. You can’t eat it. You can’t even bring it to Wal-mart to buy supplies; although Utah’s state House passed a bill recognizing it as legal tender, in all practicality it would be about as easy to give a cashier some slivers of the precious metal as it would to trade a cow for a tank of gas.

So in the realm of physical assets, it’s important to keep in mind that there’s a big difference between owning something essential, like a home, and owning gold: people need homes. People may want gold, to adorn themselves for example, but very few people actually need it.

Despite gold’s reputation as a storehouse of value, it is actually a highly discretionary purchase. Investors — aka speculators — currently hold more than half of the world’s gold, according to the World Gold Council, an industry association. Of the rest, jewelry accounts for about 80 percent.

The risk of betting your future on something that people like but don’t need gets even higher as inflation casts its nefarious spell on the economy. That’s because when prices go up, the Federal Reserve is almost certain to raise interest rates — the higher the inflation, the higher the rates. The Fed, after all, has a mandate to fight inflation. To do so, it has to put the brakes on the economy, which it does by raising interest rates, making it more costly for people to borrow.

As interest rates rise, holding the yellow metal gets less attractive. Why? Although goldbugs denigrate “fiat currency” — the government-issued money that the global economy runs on — there are several advantages to keeping your wealth in the currency-denominated world. A big one is that people will rent it from you.

http://www.globalpost.com/dispatch/news/business-tech/global-economy/110517/inflation-gold-investing-warren-buffet