Gold Approaches Record Highs Again and Is Again Ready to Decline

Last Updated May 26, 2010 12:54 PM EDT

Gold is close to record highs once more, trading above $1,200 an ounce after gaining about $200 between early February and mid-May. Like many developments, gold's run is easy to understand yet somehow hard to make sense of. There is good reason to think that the price will decline.

Gold is an alternative form of money when the usual stuff is expected to lose its value, either due to inflation or to political or economic upheaval. When anxiety subsides and normal service is restored, the price comes back down.

The catalyst for the latest run to new highs is the plunge in the euro and the perceived threat to the economy and financial system in Europe, or at least the countries in the olive oil belt along the continent's southern edge.

Europe's straitened circumstances have resulted in the sort of overheated rhetoric, uttered by professionals who should know better, that often accompanies extreme market movements. It's becoming common to foretell, or even to announce the arrival of, the euro's demise as a global reserve currency, the rock-solid type of asset that central banks hold as a store of value.

Some commentators are going even further over the top. They contend that the deficits accumulated last year by governments around the world borrowing and spending to stimulate growth have tainted nearly all paper money, not just the euro, and have left gold as the only true currency.

Sounds scary. Fortunately, it also sounds absurd. Paper money spends just fine. In fact, it has held its value better in the last few years than in almost any period in nearly a century.

Consumer prices in the United States and Europe have risen at less than a 2 percent annual rate in the last two years. In fact, the U.S. consumer price index is lower than in the summer of 2008.

As investors have discovered, often painfully, asset prices have also been subdued, at best. The paper money whose worth the gold bugs believe is ebbing away buys more stocks, bonds and parcels of property than it did a couple of years ago.

But wait, hasn't gold done even better? Hasn't it been the best performer during the last decade among the major asset classes?

True, gold has roughly quadrupled in that time and global stock indexes are essentially flat. But why start the clock then, just when gold was awakening from a 20-year bear market? Since price controls were lifted on gold in 1973, it has gained just under 7 percent a year, while stocks have produced annual returns above 10 percent in the United States and 9 percent globally, even including the last dismal decade.

Over just about any long run, in fact - the last decade may be the only exception - gold has underperformed the other main investment categories. The reason is simple: Unlike stocks, bonds and real estate, gold plays almost no role in generating economic activity and so it has little intrinsic value.

That means gold is worth only what people are willing to pay for it, and they are only willing to pay a lot during periods when markets and economies aren't functioning properly. What gold bugs and others who were snapping up the metal at $1,200 an ounce don't realize is that the world functions well enough most of the time. Inflation is usually tame and crises always pass.

The serial crises of the last few years will pass too. The global economy will recover at some point and stock markets will again enjoy stable growth. Until then, cash will buy plenty, so why spend it on one of the few things that have become a lot more expensive?