Sunday, January 17, 2010
EVER since the financial tsunami hit the United States and then the whole world, the price of gold had been close to reaching the $1,000 per ounce ceiling. In December 2009, it not only broke through that barrier but also reached a record of $1,216.75 an ounce -- a rise of more than 30% in one year. Now some analysts are predicting that this trend will continue in 2010 and that gold price may soon reach $2,000 an ounce.
Gold has always been considered a precious metal. Since the dawn of civilisation, it has attracted human attention. People in Mesopotamia and Egypt used gold for decorative and ornamental purposes as far back as the fifth millennium B.C. Although some gold coins from this period have been discovered, it is widely believed that the large-scale use of gold for monetary purposes did not start until the sixth century B.C. in Lydia, modern-day Turkey.
As far as we know, under King Croesus (560-546B.C.), coins made of pure gold with his royal emblem were used for the first time as the standard of exchange for worldwide trade and commerce. Although gold coins are no longer the standard of exchange for international trade, gold is probably the only material which continues, even today, to be universally accepted in exchange for goods and services because of its unique characteristics.
In 1821, the United Kingdom started using gold as the standard, or the single reference metal, to back its paper currency system. Under the gold standard, a single unit of currency was freely convertible at home or abroad into a fixed amount of gold. In the 1870s, this system was adopted by other trading nations like Germany, France and the United States. This system called for fixed exchange rates among the participating currencies. It was designed to bring automatic adjustment to balance of payment imbalances.
The gold standard had two main advantages. First, it gave a stable monetary framework for international trade and investment, and second, it minimised the risk of internal inflation. But the system also had great disadvantages. Besides the risk and cost involved in shipping gold from one country to another, the system required the participating countries to give absolute priority to external adjustments.
Domestic objectives focused on the resolution of problems like recession, unemployment and inflation, and were secondary. Because of the limited supply of freshly mined gold, the system was also not sufficiently flexible to supply enough money to meet the growing needs of the world economy.
The outbreak of World War I brought an end to the full gold standard. Severe restrictions on gold export were placed by most trading nations. After the end of the war, the system was replaced by a gold-exchange standard under which the participating countries could maintain their currencies convertible into gold at a stable rate of exchange, without having to keep as large a gold reserve as was required under the full gold standard. They could supplement their central bank gold reserves with reserve currencies, like the United States dollar, which were convertible into gold at a stable rate of exchange. The Great Depression of the 1930s brought this system to an end.
The United States came out of World War II as the most powerful nation on earth and the United States dollar, in effect, became the principal reserve currency of the world. In 1958, most major European countries accepted free convertibility of their currencies into dollars or gold at fixed exchange rates. But the Vietnam War and the consequent runaway deficit in the US balance of payments forced the United States in 1971 to abandon this system of free convertibility of dollars into gold at fixed exchange rates. Thus gold's central role in the world currency system came to an end.
If gold has lost its central role in the international monetary system, why do financial analysts still keep monitoring the price of gold so closely? Because, in the current worldwide recession, the relative strength or weakness of the world's number one reserve currency, the trillions of dollars worth of stimulus packages pumped into fragile economies, the expanding deficits in the US and Europe, the low interest rates, the fear of runaway inflation and the price of gold have, in more than one way, become interconnected.
It is difficult, if not impossible, to assess exactly how these factors influence each other. But past experience has shown that in times of economic recession in the United States (by far the largest economy of the world), there is a tendency for gold prices to rise and as soon as the recession is over, gold prices tend to fall. In other words, in times of crisis, gold is used as a hedge against uncertainties.
In this context, the other factor to be considered is that though gold has lost its central role in the monetary system, central banks across the world still hold significant quantities of gold as part of their reserves. For example, it is estimated that the value of gold held by the United States Federal Reserve at current price equals approximately 15% of the US monetary base. In 2009, India, Russia, Sri Lanka purchased substantial quantities of gold, which, no doubt, had an impact on current gold prices.
So what is the conclusion? Will the gold price keep rising in the future or will it fall when the dollar becomes stable and the economic recession is over? Most probably, it will fall. After all, in January 1980, when political and economic uncertainties caused by the Soviet invasion of Afghanistan and the Islamic Revolution in Iran forced the gold price to hit a record of $850 an ounce (equal to inflation-adjusted $2,200 of today), many people thought that it would never come down. Twenty years after that record price, the price of gold today, even after the recent rises, barely reaches the $1,100 mark.
