Investing Daily

The ongoing financial problems in Europe’s peripheral economies and the long-term issues facing the US dollar are making the case for gold even more powerful. Add to this the structural problems of the UK economy and the stability of the British pound going forward, and suddenly the world is running out of strong currencies.

I’ve long maintained that gold is one of the main hedges long-only investors--especially for those with positions in emerging markets--can use to balance the long exposure. With the problems afflicting the world’s main currencies, such a hedge is of paramount importance.

I recently penned a piece on this subject for Global ETF Profits, a new investment advisory I work on with Benjamin Shepherd. Investors that understand the role gold will play in the financial markets stand to benefit tremendously.

Gold has been an object of ardor and a target of scorn throughout the centuries but has never been refused as a means of payment. Gold has no substitutes.

The yellow metal has three characteristics that make it one of the most unique assets in the world. It’s relatively scarce, it is easily broken apart and transported, and it’s almost impossible to destroy. Gold can perform well during inflationary as well as deflationary periods.

Gold’s utility during inflationary periods is well understood. Note, however, that gold performs the best during times of currency debasement. This is a real concern today, as governments around the world continue to spend a lot of money and print more in an effort to avoid deflation.

Because the US dollar is the world’s major currency, America is the focal point of the inflation-deflation debate. The US currency situation poses the greatest threat to the global economy, even as the American political-economic leadership has systematically abused the currency’s privileged position for years. What’s resulted is a gradual increase in the level of fear among accumulators of US dollars. China and other countries are starting to demand more assurances about the future of the US dollar before they commit increasing their holdings.

That being said, if inflation rears its head, gold, because it isn’t paper money and isn’t available in abundance, will perform at least in line with the growth in inflation. If US authorities fail in their efforts to return the dollar to its previous position of strength, the fiat currency system--where money is backed by the authority of the government--could be susceptible to destabilizing adjustments.

Although a total collapse of the system is not our base-case scenario, a structurally weaker dollar and a transformation from a dollar-based global financial system to a multiple-currency structure is now a distinct possibility. During such a transition gold will come to the forefront and enjoy universal acceptance as the ultimate store of value.

For now, though, the current situation will first feature a deflationary phase, during which people will choose to pay down debt (which is not really a productive use of capital in an economic sense) before they spend more money or invest. Although money does buy more goods during deflationary periods, the value of most assets also declines.

Gold will outperform other assets during a deflationary period because it will hold its value. To illustrate the store-of-value characteristics of precious metals, amid the deflationary period between 1927 and 1934 in the US, silver, which traded more freely than gold, especially after 1933, outperformed other asset classes such as the S&P 500, oil and copper.

As the global economy enters a phase in which the leadership of economic growth shifts once again, this time from the West to the East, the relevant government actors will accumulate more gold. In other words, the US dollar’s reserve status will diminish.

The US has the highest concentration of gold reserves in the world; 68.7 percent of its reserves are in the yellow metal. China, on the other hand, has only 1.5 percent of its reserves in gold. If India’s move at the end of 2009 to buy 8 percent (200 tons) of the global gold production in one day from the International Monetary Fund is any indication, there’s more to come. Economies like China and India will, at the very least, eventually have gold representing 10 percent of their total reserves. The corresponding impact on gold prices need hardly be mentioned. The upside could be explosive. SPDR Gold (NYSE: GLD) is a buy at current prices.