Can Gold Lose Value Even as the Dollar Weakens?

Until August 15, 1971, one U.S. dollar represented 1/35-ounce of gold. It wasn’t that gold’s “price was fixed,” as some liberal economists suggest, it was that a dollar was literally nothing more than the representation of 1/35-ounce of gold. But when President Nixon “closed the gold window,” it meant that the dollar was a purely fiat currency – and by the end of 1973, the dollar’s value had gone from 1/35-ounce of gold to just 1/64.

The dollar’s value has continued to decline. As measured by the government’s Consumer Price Index, the dollar has lost 81% of its value since 1971. When measured in gold, the dollar has fared even worse, losing more than 95% of its value. And why shouldn’t we measure the dollar in gold, since from 1792 to 1971, the dollar was understood to be a measurement of gold (and sometimes silver)?

But the point of this blog entry is not to belabor the dollar’s loss of value relative to gold but something a little more exotic: It is to ask the question, Can gold lose dollar value even as the dollar itself loses purchasing power? The answer is, surprisingly, yes.

Now how can this be so? If gold is “real money,” then wouldn’t it naturally increase in dollar-denominated value as the dollar weakened? Actually, wouldn’t this be the very definition of the dollar’s weakening? Normally, the answer to these questions would be yes, but we are now entering a perverse economic environment where both the dollar and gold may simultaneously weaken.

The Federal Reserve’s most recent monetary expansion first created the stock-market bubble that burst in March 2000. Then, all of that investment money (now in different hands!), along with much of the new money created by the Fed, went into the real-estate market, which hugely boosted home values in the early 2000s. As the real-estate bubble began to deflate, new money began flowing into commodities, including gold.

All during this time, gold appreciated against the dollar due to the dollar’s weakness, but at some point, gold’s gains exceeded the dollar’s losses and gold itself went into bubble mode. Gold peaked on March 17, closing above $1,011 an ounce and has since tumbled to $835 as of this writing. And believe it or not, gold could go lower still.

Of course, there are two surefire ways for the price of gold and all commodities to soar again:

  1. Inflation
  2. War

Or do I repeat myself?

The current drop in oil and gold prices is largely due to the economic slowdown the U.S. is experiencing. If the Federal Reserve decides to inflate the money supply – and Ben Bernanke has said this is what should have been done during the Great Depression – then the prices of all goods will rise in terms of dollars, which will be worth less post-inflation. This doesn’t mean you’ll get rich by owning gold, just that you’ll be poor by holding dollars.

A second, and unfortunately even more likely scenario, is that the U.S. and/or Israel will attack Iran. Many economists believe this will send oil to around $175 a barrel and gold upwards of $1,200 an ounce.

History tells us that war and/or inflation are more likely than stability and/or peace. Thus, gold will probably be on the rise, in terms of dollars, once again in the near future. But it is important to understand that demonetized gold is just another commodity and, as such, is subject to booms, bubbles, and busts.

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