Should You Buy Gold To Hedge Against U.S. Debt?

By Tim Begany | May 15, 2011 AAA

Talk about owing some big bucks. Right now, the federal government is in the hole for around $14 trillion - roughly $46,000 for every American citizen.

If you think that has something to do with the rush to invest in gold, you're absolutely right. Investors have been flocking to precious metals like gold because they're nervous. Many see gold as a safe haven from the potential hazards of our ballooning debt, particularly inflation.

TUTORIAL: Investor's Guide to Inflation



Inflation Fears
Our indebtedness could trigger severe inflation as the government continually prints more money to help cover what it owes. With the printing presses working overtime, the money supply may enlarge to the point that our currency begins to rapidly lose value.

Severe inflation hasn't developed yet. But if it did, gold investors figure they'd be ready because the value of the yellow metal tends to rise with inflation. They also believe they'd be as prepared as possible for the worst case scenario: inflation that's so bad that the dollar becomes virtually worthless. In that situation, they reason gold would be a valuable alternative currency. (Since the beginning of time, gold has had a special place in history. For more, see A Holistic Approach To Trading Gold.)

Credit Rating Downgrades
Other events have heightened investors' concern, making them want gold all the more. For example, credit rating agency Standard & Poors (S&P) recently downgraded its outlook for the U.S. government to negative. That means S&P is considering reducing the government's credit rating from AAA, the highest possible, for the first time ever. Such a thing was once considered inconceivable because the U.S. has been considered the safest, most reliable borrower in the world for so long.

In addition, the debt crises in Greece, Portugal, Spain and Ireland are making many investors anxious. So are other troubles such as political unrest in the Middle East and northern Africa, and the economic and environmental aftereffects of the recent earthquakes in Japan. (For more, see A Look At Government Bonds And National Debt.)

Moreover, Bill Gross, a renowned investor who runs the world's largest bond mutual fund (PIMCO Total Return), has publicly declared his bearishness on the U.S. and repeatedly warned of the inflationary impact of America's deficit spending habits. This is not just bluster, as he has sold all of his fund's investments in U.S. government-related debt. That's like Warren Buffett saying he won't hold U.S. stocks anymore.

The Right Strategy?

Given America's debt situation and the current economic climate, piling into gold might seem like a no-brainer. But it isn't quite that simple.

Whether or not gold is a good investment right now depends on who you believe - those like Gross who say high inflation is likely or those like Buffett who have faith in the U.S. and say it'll resolve its debt troubles. If you're in the former camp, holding a lot of gold would seem entirely reasonable. In the setting of high inflation, gold would likely gain value even though its price is already near record highs.

But if your long-term outlook on the U.S. is bullish like Buffett's, you might be better off making gold a very small portion of your investment portfolio or excluding it altogether. If the U.S. is prospering and stocks are doing well, investors might feel much less of a need for a safe haven like gold. In that case, it may not gain all that much value in the long term. If things really turned around and the economy picked up sharply, the price of gold just might go way down and stay there for many years. (For more, see Gold: The Other Currency.)

The Bottom Line

Gold's a tough call right now because it's not clear which direction the U.S. is headed. Since nobody can predict the future, consider a strategy financial advisors have long recommended - diversification. Make gold and other precious metals part of an overall portfolio that includes a variety of other types of investments. That way, you'll benefit if gold does well. If it doesn't, you'll have plenty of other investments to pick up the slack. (For more, see Precious Metals: A Golden Opportunity?)

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