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Inflation is rising. Time to buy gold?

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

When you buy a stock or a bond, you basically let a company or a government borrow your excess savings. In return, they pay you rent, in the form of dividends or interest, or by increasing the value of the stock you’ve purchased (if you had purchased Apple stock in early 2009, for example, your investment would have tripled, even though Apple hasn’t paid dividends in a long time). As the Fed raises interest rates, the rent you get by lending your savings goes up. 

In contrast, when you hold gold, rather than earning interest, you may need to pay insurance and storage fees. So would you rather put your $50,000 in gold, or in a CD or bond which, in a high-interest economy, could yield $5,000 or more each year? If you choose gold you’d better hope that a lot of other people do too, because if the masses get tempted by those interest rates, the value of your gold will collapse. 

This is the scenario that played out during the administrations of presidents Jimmy Carter and Ronald Reagan. In the early 1980s, with inflation well above 10 percent, the Fed unleashed its anti-inflation arsenal. It raised its benchmark interest rate as high as 18 percent. As expected people shifted their money into high-interest fixed investments, such as bonds. Gold crashed, losing more than 50 percent of its value by 1982. If you had bought gold in 1980, when inflation was high you would have lost a lot of money.

Of course, it’s important to point out that people did earn a handsome return buying gold in the mid-1970s, just before inflation got out of control. When inflation was rising, the price of gold soared from about $100 in 1976 to more than $850 in 1980. That’s a very nice gain indeed.

But the situation back then was not entirely analogous to today. Until 1971, the U.S. dollar was officially tied to the price of gold, meaning that the Fed didn’t control interest rates the way it does today. When inflation rose in the late 1970s, Fed officials had much less experience in fighting it. In the decades since then, they have become much better at anticipating inflation and keeping it under control. So the gold bubble of the late 1970s — caused largely by investor anxiety — may not be replicated in the near future. Another key point is that, despite its reputation, gold didn’t perform as a citadel of value. It rose, and then plummeted.

As Warren Buffet said at Berkshire Hathaway’s April 30 annual shareholder meeting, if you owned all of the world’s $7 trillion worth of gold, you could melt it and form a cube measuring 67 feet on each side. “You could get a ladder and climb on top of it and say ‘I’m sitting on top of the world.’ You could fondle it, you could polish it, you could stare at it.” But Buffet explained that, unlike spending that same $7 trillion buying all the farmland in America or several ExxonMobils or other “earning assets,” owning all that gold is a speculative exercise: you buy it not because it produces value, but because you hope someone else will come along and pay more for it.

As with any bubble, gold is a fine investment as long as you sell before the price drops. Inflation — and the high interest rates that come with it — could kick off that avalanche.

Follow writer David Case on Twitter at @DavidCaseReport