Sunday, January 24, 2010

Buying Horses With Gold?

Buy Ketchup in May and Fly at Noon: A Guide to the Best Time to Buy This, Do That and Go There
Once again from "Buy Ketchup in May":
WHEN IS THE BEST TIME TO BUY GOLD? When the economy is stable. That’s when gold prices are lower. During a recession or a period of economic instability, the dollar decreases in value, and people tend to look to gold as an investment. The demand for gold drives up the price, and it’s not as good a deal then. Some gold investors point out that the value, or buying power, of gold hasn’t changed in more than 200 years. That means if you paid for a horse in the year 1809 with an ounce of gold, you could buy a horse in 2009 with an ounce of gold. (Gold price in 1808: $19 an ounce; in 2009: about $900 an ounce.)
(Read all of my posts on this book here.)

The best time to buy gold is not the focus of this post (though people often flock to gold during recessions because it is a "safe" asset, driving up the price). I was more interested in the comment about how much gold is required to buy a horse. Gold is indeed a stable asset. As a counterexample, if you held all of your money in dollars, you risk devaluation through inflation; if the government prints a lot more money, your dollars can't buy as much as they could before. Because we can't create more gold, there is no inflation risk. In fact, much of monetary history has revolved around the gold standard.

The nominal value of gold has risen about 4,600% in that 200-year span, according to the book. That sure sounds impressive, but the price level has also risen at a similar rate. So now your ounce of gold can get you $900 instead of $19, but that amount of money can still only buy one horse. It has the same "purchasing power."

Gold is indeed cheaper in a booming economy, but it is a poor bet for long-term economic growth, as it foregos any interest you could have made had you invested the money elsewhere. If you invest in other assets, such as stocks and bonds, you can expect a substantial real interest rate over such a long period. The average annual real interest rate from 1950 to 2008 was 6.8%. Assuming that this was about the same over the 200-year period, $19 invested in stocks in 1808 would be worth $9.8 million today, through the magic of compound interest. Now that could pay for quite a few horses.