In an environment of rising inflation, you may wonder how you can protect your purchasing power. While the recent injection of massive government stimulus may help to reboot the economy; over the long term, it can only lead to rising inflationary pressures. Let’s consider some reasons why this may be the case, and why gold will continue to be one of the safest hedge against inflation.
Fractional Reserve Banking Systems
When you deposit your money with the bank, you may think that your money is safely stashed away in the bank’s vault, ready for you to access at any time. However, in reality, this is far from the case.
The world’s commercial banking system is based on an interesting premise. It assumes that people are unlikely to cash in all of their deposits at once, and in general, this is true. Under normal circumstances, a bank really only has to hold a fraction of all deposits as cash on hand to cover the demand for withdrawals at any time. It can use the remainder of the deposit to lend out to businesses and consumers to make a profit. The amount required to be held by banks in its reserves, is usually determined by the central banks, and is known as the reserve ratio. It is generally quite low. For example, in the US, this number is far less than 10 percent.
How is this inflationary? Let’s consider an example of how this might work. Suppose a bank has a reserve ratio of 10 percent. Someone makes a deposit of $100. The bank keeps $10 in its reserves and loans out the other $90 to an industrial firm, which it then deposits in its account. Out of that $90 deposit, the bank keeps $9 in its reserves and loans out the other $81. This process is repeated until at some point, we will have added almost $1000 to the money supply out of the original $100 deposit.
As we can see from this example, fractional reserve banking has allowed the money supply to grow far beyond the underlying base money created by central banks. The multiplier effect of fractional reserve banking means that in effect, private banks are creating more money than the central banks themselves and inflating the money supply many times over. This is especially concerning when we consider the trillions of dollars that the US Federal Reserve has recently created out of thin air.
Printing money and inflation
In 2020, the COVID-19 global pandemic has resulted in a worldwide slowdown of the economy, as businesses have been forced to shutter in order to stop the spread of the virus. This has central banks around the world scrambling to prop up the economy by printing and distributing money in the form of massive stimulus packages in the trillions of dollars.
With previous quantitative easing, even though a large sum of money was injected into the money supply, the effect on inflation was negligible since it went directly into bank reserves through the purchase of US treasury bonds. The pandemic stimulus packages, however, are mainly aimed at getting money into the hands of the consumers. By giving individuals a lump sum of money, it is hoped that this money will then make its way back into the broader economy through consumer spending. In the US, consumer spending accounts for two thirds of the economy.
The pandemic, however, has created a unique situation in which there was a “forced shutdown” of the economy. Because businesses were shuttered and there was fear of contracting the virus, people had limited opportunity to go out and spend money. The result is that consumers have been hoarding cash in their bank accounts at record levels.
However, the combination of the massive printing of money in the form of stimulus checks and the pent-up demand from consumers unable to spend money creates the perfect scenario for rising inflation. According to the quantity theory of money, inflation is a function of both the growth in money supply and the velocity of money (i.e. the rate at which money changes hands). It states that an increase in money supply should theoretically lead to an increase in prices because there is more money chasing the same level of goods and services.
Once the general population has been vaccinated, and the economy resumes normal operation, the pent-up demand for goods and services will be unleashed. As the market becomes flooded with too much money chasing too few goods, the price of goods will rise and the result will be inflation and a decrease in the purchasing power of the dollar.
US dollar no longer backed by gold
At one time, the US dollar was backed by the gold standard, which meant that it was possible to redeem a US dollar for an equivalent amount of gold. Those using the currency could have full faith that the dollar would hold its value, and that when it came time to spend it, it would be accepted without question.
By pegging the dollar to gold, the government could not print money endlessly, as it had to ensure that it held an equivalent amount of gold in its reserves. Government spending was therefore limited to only what it can raise in taxes or borrow against its reserves. However, this is no longer the case as the pegging of the US dollar to the gold standard was abolished in 1971 by then president, Richard Nixon.
Without the backing of the gold standard (or anything else of real value), confidence in the US dollar is solely based on the trust that people have in the stability of that dollar. However, running up a huge debt can only erode the US dollar’s status as the world’s reserve currency, because the international demand for it is based on its perceived financial strength.
The more debt we incur by printing money, the more we jeopardize its status, as it reduces faith in the US dollar as a store of value. The result is that the dollar loses its purchasing power against other currencies, as well as its role as a safe haven during times of uncertainty.
Gold as a hedge against inflation
Why gold, you may ask? The value of this precious metal is tied to its scarcity. Each year, only a tiny fraction is added to the overall stock of gold through mining. Because of its limited supply, we do not see the price of gold fluctuate wildly. It tends to hold its value, and is therefore, widely regarded as a store of value. In fact, throughout 5000 years of human history, man has always considered gold to be, not only precious, but also valuable as a form of currency because it can be used to purchase goods.
Gold also acts as a hedge against inflation because its price in US dollars is variable. If the US dollar loses value as a result of inflation, gold becomes more expensive. In this way, the person owning gold is protected, or hedged, against a falling dollar because he is compensated with more dollars for every ounce of gold that he owns.
During times of uncertainty, gold has always been viewed as a safe haven. And times have never been more uncertain than now. The pandemic has created many unknowns in the economy. The printing of money, amounting to trillions of dollars, in the form of stimulus packages, is in uncharted territory. Whether this massive injection into the money supply will end well has yet to be seen. But whatever the outcome may be, investing in gold may well prove to be the best form of insurance there is.