With the US federal deficit running at 17% of gross domestic product (GDP), gold has become an indispensable portfolio hedge against a severe deterioration in US government finances.

Gold jumped from US$800 to $1,000 an ounce after the 2008 world financial crisis as the US deficit briefly touched 10% of GDP. With the US economy still dependent on multi-trillion dollar demand infusions, gold broke out to a new record.

The favorite in next month’s US presidential election, Joe Biden, looks at the federal budget the way a birthday boy looks at a piñata.

Household consumption contributes 70% to the US economy, compared to an average of 60% among industrial nations. The Covid-19 pandemic forced the government to support consumer spending. That in return requires the US Treasury to borrow unprecedented amounts of money.

Foreigners have effectively stopped lending to the US. In contrast to 2008-09, when foreign holdings of US Treasury securities jumped by half, there have been almost no net purchases by foreigners in 2020. If US citizens buy Treasuries, then they spend less on consumption. So the Federal Reserve expanded its assets by $3 trillion between March and October.

The US is now in the position of Britain after World War II. The pound sterling still was an important reserve currency, as the dollar is now, which meant that Britain got free loans from the reserve balances held by the rest of the world.

Britain, like the US, has a chronic current account deficit, which means that the British spend more than they save, including on a lot of imported goods. Britain’s chronic deficits gradually destroyed sterling’s usefulness as a reserve currency, and as such, it depreciated drastically. One pound bought 4 US dollars at the outbreak of World War II; it last traded at $1.30.

Britain’s stock market quintupled in price between 1983 and 1997. It now trades exactly where it did in 1997, which means that it has lost about half its value after inflation.

Why own gold and not just a stronger currency—the euro, for example, or China’s renminbi? There’s a limit to how much a currency can appreciate against the dollar.

If the euro rises by 25%, European exporters will have trouble selling goods to a world that still mostly trades in dollars. But gold isn’t a currency unless central banks trade it like a currency, which they no longer do.

Gold today is a put option on the US dollar with an indefinite tenor (that is, it lasts indefinitely), and a strike price of zero value for the dollar. A couple of charts illustrate the point:

During the past year, we observe a close linear relationship between expected inflation as measured by the yield difference between ordinary US 10-year Treasury bonds and inflation-indexed 10-year Treasury bonds, or their German equivalents.

When inflation expectations crashed during the outbreak of Covid-19 in March, the US dollar index (DXY) stood at 102. The massive fiscal and monetary stimulus in response to the crisis pushed expected inflation over a 10-year horizon from 0.4% to about 1.7%.

Correspondingly, the dollar depreciated from around 102 to around 92, or about 10%.

Gold, meanwhile, rose by 26%. Gold’s price tends to trade in tandem with the yield on inflation-indexed Treasury securities, or TIPS. Both TIPS and gold offer a form of insurance against big changes in the value of the US dollar, including a rapid depreciation against goods and the consumer price index.

Something disturbing happened during the past several months as gold traded around $2,000 an ounce: the gold price rose even while TIPS yields barely moved.

That’s the sort of thing the Fed doesn’t want to happen. In this case, the simplest explanation is that the Fed’s commitment to an overnight interest rate of zero braked the fall of TIPS yields into deeply negative territory.

But inflation-protected securities don’t always offer a sufficient hedge against unexpected currency depreciation and inflation. If the US Treasury has to issue too many of them, investors may stop buying them and buy gold instead.

In effect, the Treasury is selling you insurance against the depreciation of the US dollar. At some point, that will be like buying life insurance from the captain of the Titanic.

There’s no theoretical cap on the price of gold. If the US federal deficit remains out of control, and the dollar continues to decline, the price of insurance can rise to an arbitrarily high level. And gold remains the best form of insurance.