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Saturday, December 23, 2006

The Only True Inflation Hedge

Buy Gold! It's the only way to protect yourself against rising inflation.

Any one listening to talk radio has heard this mantra for the past year.

Inflation is the new buzzword, much like orange was once said to be the new black. It matters little that the core inflation rates in the US and in Europe are just as manageable as the sore neck caused by following the pundits’ elegant 180-degree turns.

There irony in the clamoring about inflation, coming as it does at a time when the US dollar seems to be near its cyclical decennial turning point. Against both euro and the yen the greenback has gained 15%. Which means that imports from the Eurozone and Japan have become correspondingly cheaper, translating into deflationary rather than inflationary pressure.

Undaunted, the bears have been scouring the markets for a suitable inflation hedge. Thank goodness gold is rising in price, so gold against the backdrop of nonexistent inflation must be a good inflation hedge.

Over the long term, and I mean in terms of 35, 30, 35, 15 and even 10 years, this argument can only be made if you avoid adjusting your gold prices for inflation. Once you adjust, however, you’ll find that gold has provided inflation-adjusted upside only in the past five years. (Details, details.) And that your hedge is not really a hedge but a capital gain that you hope will offset the inflation-driven loss of purchasing power residing in your investment.

Now, we have nothing at all against capital gains offsetting an inflation-driven loss of purchasing power. You don’t even have to buy gold to make capital gains: Index funds, pork bellies and stocks can provide the same upside (and downside) as gold. And then there’s that other classic “inflation hedge,” real estate.

Which brings me to the second way of beating inflation - and the only true “hedge”: spending money you don’t own today, hoping to pay it back with money that’s worth less (or even worthless) tomorrow.

You see, we haven’t experienced inflation worth mentioning in the States for so long that we have come to lose sight of the basics. Real-estate booms preceding the current one took place in high-inflation environments. It’s not that capital gains were all that much easier to be made when the greenback was losing purchasing power. But buying real estate then and now means borrowing a large chunk of money. It’s almost like shorting a stock: You borrow shares hoping they fall in value so when you cover your short position you can pocket the difference between the price that at which you borrowed them and the price at which you covered.

When inflation is around 10% to 15% a year - and the last time was not all that long ago - every US$100,000 you borrow loses US$10,000 to US$15,000 a year in value. If you can write off part of the interest you pay on your taxes and make up the rest through cost-of-living adjustments or capital gains, you can come out ahead even in the short term.

Here’s an example: Let’s say you bought a house for US$100,000 back in 1990, with 35% down. The US$65,000 mortgage you took out in 1990 would equal US$100,000 in today’s money. (Let’s forget about interest and tax deductions for the sake of clarity.) If you never paid a dime on principal for 15 years and decided to pay off that 65 grand today in 2005 dollars, that amount would correspond to US$42,648 in 1990 currency. The purchasing-power difference is US$22,352, or US$34,667 in today’s greenbacks! Now consider that a house going for US$100k in 1990 probably sells for US$300k today. That means your down payment of US$35,000 generated combined gross gains of US$235,000. Total interest paid over the 15 years would be US$68,250, a third of which - about 13,000 bucks - was subsidized by Uncle Sam’s mortgage interest deduction.

Capital gains on top of leveraged debt. Now that’s what I call a hedge!

But again: In this scenario, the inflation “hedge” proper is the debt you incur!

Which presents us with a conundrum: Bears who now see inflation lurking behind every bush also like to bash Americans who’re in debt up to their eyeballs and those Americans who like to shoot for speculative capital gains in real estate and stocks. (They call them the Lumpeninvestoriat.)

Are those Lumpen maybe on to something after all? Inflation and gold: Maybe we should borrow the money to pay for our Krugerrand hoard?

J. Christoph Amberger

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