Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 5th February 2012.
When reading stuff about the pros and cons of investing in gold we regularly come across two misguided assertions, the first being that changes in gold’s price in terms of a currency do little more than offset changes in the currency’s purchasing power. To put it another way, the first misguided assertion is that gold’s purchasing power is roughly constant over time, meaning that changes in its price are almost solely due to changes in the purchasing power of the money in which the price is denominated.
The following monthly chart of the inflation-adjusted (IA)* US$ gold price disproves the notion that gold’s purchasing power (pp) is roughly constant over time. In particular, it is clear from this chart that there was a huge increase in gold’s pp during 1971-1980, a huge decrease in gold’s pp during 1980-2001, and another huge increase in gold’s pp during 2001-2011. It’s likely that most of our readers were already aware of these 10-20 year swings in gold’s pp, but what is less widely appreciated is that gold’s pp is in a much longer-term upward trend. This ultra-long-term trend dates back to the severing of the last official link between the US$ and gold in 1971.
The fact is that an ounce of gold has about eight times more purchasing power today than it did when the final US$-gold link was severed in 1971. Furthermore, even if we make the not-unreasonable assumption that the first major leg of the gold rally of the 1970s was primarily a reaction to the gold price having been pegged at an artificially low level for a couple of decades, we still arrive at the conclusion that gold’s pp is in an ultra-long-term upward trend. The reason is that if we take the top of the 1971-1974 rally as our starting point we find that gold’s pp more than doubled over the intervening period.
*Our method of adjusting for inflation was outlined in an article in December of 2010. We make the assumption that over the long term the percentage decrease in the dollar’s purchasing power will be approximated by the percentage increase in its supply minus the percentage increase in the combination of population and productivity.
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