by Josef A

Created on: November 29, 2009   Last Updated: November 30, 2009

Gold has always been a very fascinating object to humanity. On the one hand, it is a symbol of wealth and prosperity. On the other hand, gold has gradually lost its role as an exchange object, a function that is today served by printed paper money and coins. Gold was the ideal object to facilitate good exchanges without having to barter. Most importantly, it is a scarce resource and the circulating amount cannot be increased arbitrarily. After a transition period when paper money needed to backed by gold, paper money has entirely replaced the function of gold. However, paper money is not scarce at all, it can be arbitrarily increased by central banks. Its value is built on trust. When governments do not keep their promise of guaranteeing a stable value of money, we get something known as inflation.

Technically, gold is now a commodity as any other, with most of its demand coming from the jewelry industry. Why is gold now considered an investment? For one, it does not stand alone in a row including almost any standard commodity that has now been discovered as an investment object. This is partly owing to speculation and partly due to the potentially stabilizing function of commodities in a portfolio. A promise that has not been delivered during the financial crisis of 2007-2009. In addition, gold is inherently considered an insurance against crises. This notion comes from its historical role as money together with its scarcity. The argument goes that in a total collapse of the financial system gold will remain a valuable asset.

Accordingly, three main scenarios are favorable for an investment in gold:

High inflation: This implies that money loses relative value, so the price in gold will rise. A total collapse of the financial system: Scenarios like a currency reform that could basically make currencies worthless. Wars or similar historical events: In that case governments would not be able to provide stable institutions and gold might indeed be a safe haven

If you happen to live in a stable democracy, the third option does not seem realistic and a total collapse of the financial system is a far cry. Hence, the backdrop for investing in gold should be high inflation. A greatly increased monetary basis makes such a future scenario closer to reality, despite currently looming deflationary tendencies. In any case, a certain percentage of gold can stabilize every portfolio, but it does not yield any returns in forms of dividends or interest. Unless you are convinced the world is on the eve of destruction you should not invest everything in gold.

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