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Man’s addiction to gold

People walk by a gold jewelry store in New York City. Gold’s role as an alternative currency will evolve and its price will reflect inflationary expectations. —AFP

I AM not a gold bug. Gold is an artefact from early history. So much so it is deeply rooted in the collective human consciousness.

The last time I wrote about it in this column was two years ago on Jan 16. Then, as now, I am not the most optimistic about gold as an investment. But I am a realist. Over past 50 years, capital gain on gold averaged 2%-5% annually over each decade. Stocks were a better investment about double to three times the gold “yield.” This is not surprising since gold has no real intrinsic value. It is sterile, making it difficult to value can’t assign a credible PE (price-earnings ratio).

So long there is love, lust and guilt, there is a demand for this “barbaric relic” (Lord Keynes). But in this uncertain world, many see it as a sexy investment. That’s why gold scams thrive. It is still scarce, readily malleable and will always command a price. Since the summer, even the darnest optimist got worried as prices lurched down to US$1,500 a troy ounce (from a Sept 2011 high of just above US$1,900), wondering whether the decade-long bull run had ended.

No longer. Since US Fed launched its third round of quantitative easing (QE3) in mid-September, gold has yet to catch its breath, rising 12.5% by Oct 6 to its highest level in nearly a year at US$1,795 per troy ounce. As reported, in terms of euro and Swiss franc, gold hit an all-time high this first week of October.

QE infinity

Sentiment in favour of gold has turned. Since the magic trio (the US Fed, European Central Bank and Bank of Japan) decided to create indefinite flows of liquidity (dubbed “QE infinity” i.e. they generate new streams of US dollars and euros with no limit), gold investors have re-focused their attention, based on fears of competitive devaluation, currency debasement and prospect of soaring inflation.

Bill Gross of US Pimco (world’s largest bond fund manager) warned: If the United States failed to put its finances in good order, “bonds would be burnt to a crisp (since yields will rise, implying a sharp fall in bond prices) and stocks would certainly be singed.”

He concluded: “Only gold and real assets could thrive.” That’s a clean dose of reality! Today, gold is a safe haven, a hedge and a speculative play. Whatever it is, gold has reached near mythical status.

To understand the role of gold in the international monetary system (IMS), it is important to appreciate its evolution since the 19th century. Under bi-metallism (1815-1873), gold and silver served as basic reserve assets with France and the United States managing the system.

Price ratio of gold and silver was fixed around 15:1, providing a fixed anchor exchange between nations on the gold and silver standards. But from 1862-1870, the United States left the gold standard (GS) after experiencing persistent inflation as gold flowed-in following trade surpluses.

In the 1870s, France and Germany went to war; so both left GS, thereby ending bi-metallism. Deflation set in as nations moved to GS, creating excess demand for gold (i.e. tight money) until 1896, when rising gold supplies following discovery of gold in South Africa exposed the world once again to inflation.

By 1914, Europe went off GS in order to fund deficit spending. So, gold flowed into the United States and the newly created Fed (US central bank) monetised the gold, forcing its price to double, followed by inflation.

From 1914-1924, the United States was the only major nation left on GS. US gross domestic product (GDP) was then equal to that of the United Kingdom, Germany and France combined. And so, other economies began to base their currencies on US dollar rather than on gold.

Germany went back to GS in 1924 to contain hyperinflation; the United Kingdom followed suit in 1925, and France in 1926. So the world returned to GS. Just as in 1914 when nations went off GS and created inflation, this time their return to GS created excess gold demand, thereby causing deflation leading eventually to the Great Depression (1929-1932).

Once again, the United Kingdom went off GS in 1931 and the United States in 1933. The US dollar devalued and the United States went back to GS in 1934 (and raised the gold price) and France followed in 1936. By 1937, gold became overvalued causing a US dollar shortage that lasted until 1948.

US dollar standard

The 1936 Tripartite Monetary Agreement established the new US dollar-gold standard, and US dollar became the only currency anchored to gold. The United States held 70% of world’s gold by 1948. This system lasted until 1971 when President Nixon took US dollar off gold in August. The world then moved to a regime of flexible exchange rates for a brief period, with US dollar as the main intervention currency. For the first time, the world moved to a pure US dollar standard (ignoring gold) by December 1971.

But the real challenge was that this only works if the main “reserve currency” nation stays rooted in monetary discipline. Not unexpectedly, the United States subsequently pursued a monetary policy that was too loose and hence, inflationary.

In February 1973, the US dollar devalued once more. Since then, more and more US dollar started flowing abroad and the euro-dollar market was born. Eventually, to counter the weakening US dollar, the deutschemark assumed European leadership.

By June 1973, the International Monetary Fund (IMF) moved the world to a regime of floating exchange rates to put a lid on inflation. The United States and Europe struggled to manage flexible exchange rates in the midst of facing the most inflationary peacetime monetary policies: US inflation in the 1970s rose to 13%-14% per annum and the price of gold shot up above US$50 per troy ounce in February 1980.

Fear that the United States has lost its monetary discipline and the US dollar would continue to depreciate forced Europeans to act decisively to counter US dollar weakness and maintain price stability, by launching of European Monetary System in 1978. It severed the world economy into two parts. Gold stocks in the European Union were nearly double that of the United States.

By 1985, the Plaza Accord moved the world’s exchange rate regime to a managed US dollar system of floating relative to European currencies. In the process, Japan was “forced” to appreciate the yen against US dollar.

Unlike what Nobel economics laureate M. Friedman had predicted that nations don’t need reserves under flexible exchange rates, economies in practice are needing more and more reserves today under a floating exchange regime than they ever needed under fixed exchange rates.

Gold and SDR

So much for the past. In the 21st century, US dollar remains the world’s predominant reserve currency as the euro is seen to struggle for survival. Today, it’s just too feeble and unstable to pose a major threat to US dollar’s reserve role.

Yuan of China (the world’s second-largest economy) will certainly take many years to become truly convertible, let alone assume the role of a proper reserve currency.

The Special Drawing Right (SDR) is a “book facility” created by the IMF in 1968 (i.e. providing a unit of account in its books) to act as a new reserve asset to de-emphasise gold. Despite much promotion, SDR has remained a “wallflower” of IMS. It was initially given a gold guarantee, which would have benefited it today. But this was “stripped” in early 1970s when the price of gold soared.

With high hopes for SDR, IMF and the United States sold-off part of their gold holdings. Others, however, held on to eventually reap huge unrealised capital gains when the price of gold rose in the late 1970s. A few nations (notably the Netherlands and Canada) sold gold to help finance their large budget deficits.

By and large, gold holdings of all central banks were maintained (at around one billion ounces). Despite attempts to demonetise it, gold has maintained its allure. The mystique of gold is intact. It just won’t go away.

Future of gold

Officially, the superpower of the day plays the central role in IMS. This has been true going back to the Roman denarius, Islamic dinar, etc as it has for the familiar pound sterling in the 19th century and the US dollar in the 20th century until today.

Indeed, the superpower holds the veto over the future of IMS. We saw this at Bretton Woods (BW) in 1944 when the “desired” creation of a world currency (“Unitas” proposed by the United States, and “Bancor” by the United Kingdom) fell prey to nationalist self interest.

As I see it, BW did not create a new IMS; it merely kept what was in place since 1934. To be fair, BW did create the IMF and World Bank to independently manage the IMS anchored on US dollar. It gave US dollar a new supranational status and a new legitimacy.

I agree with my friend Nobel laureate R. Mundell that in today’s world, neither the United States nor the European Union nor China will ever “fix their respective currencies to gold. More likely, gold will be deployed at some point (maybe in 10-15 years) when it has been banalised among central bankers, and they are not so timid to speak about its use as an asset that can circulate between central banks. Not necessarily at a fixed price, but at market price.”

Like it or not, the world stock of gold is going to continue to be regarded as a reserve asset. It can’t be wished away. If nothing else, it will remain to act as a useful warning signal on inflation.

Gold is here to stay. It’s going to be part of the structure of IMS in the 21st century. But not in the way as it had been historically as the centrepiece of GS. That’s the unique part of its history.

Even “gold bug” French President Charles de Gaulle admitted that “the gold exchange standard no longer corresponds to present realities.” But he maintained that a true IMS should act on “an undisputable monetary basis bearing the mark of no particular country.” He meant gold.

Gold’s role as an alternative currency will evolve and its price will reflect inflationary expectations. As of now, I don’t see gold price collapsing since real interest rate (adjusted for inflation) are already set by the Fed to hold until 2015.

But why this obsession with gold? Some believe tying money to gold prevents its over-issue. That’s not true. Historically, declaring a gold parity for currency has certainly not prevented governments from over-issuing currencies and experiencing price inflation. Again, others believe gold provides the discipline governments need to maintain price stability. Certainly not.

History is full of instances where mercantilist excesses led to inflation at home and deflation overseas, and vice-versa. Yet, there are those who believe gold provides a sustainable form of settlement for international payments. Not true. Growth of international commerce requires flexible access to an adequate money supply to meet its needs gold does not meet this need in any stable way.

Also, many believe gold serves as a good store of value. Again, no. Because it is sterile, it is not a good store of value compared with other assets. According to billionaire W. Buffett, US$100 invested in gold in 1965 is worth US$4,455 at the end of 2011; this same amount invested in S&P 500 stocks is worth US$6,072 after the same 46 years.

What, then, are we to do?

Gold is limited. Since old Egyptian days, the stock of gold in the world totalled less than 170,000 tonnes, worth US$9.5 trillion at today’s price. About one-third is parked in vaults of central banks; close to one-half is in jewellery and ornaments; the rest is in speculative hands.

According to the World Gold Council, two-thirds of today’s flow of gold ends up in China (26%) and India (40%). In India, it’s almost all in jewellery, whereas in China, it’s part jewellery, part investment.

Indian households hold the largest stock of gold in the world (18,000 tonnes or 11% of world stock). At today’s prices, that’s worth US$1 trillion or more than 50% of India’s GDP. Up to 8% of India’s household savings is held in gold. So, India’s obsession with gold reflects a unique fascination, not unlike in other parts of Asia.

That’s why Asians are often the target of bogus gold schemes and scams. We see this in Malaysia and Singapore where investors flock only to be cheated wholesale by so-called “gold guarantee” schemes that are clearly designed to defraud and sure to collapse. Simply because monies collected are unscrupulously invested in high risk, “get-rich” ventures that are fraudulent from the start and doomed to failure every time.

My advice: avoid investing in any of them at all cost!

Central banks will keep on printing money, having created US$9 trillion since the financial crisis. Inflationary expectations will evolve in time, off and on. And with it, occasional outbreaks in price of gold, leading to bond sales which drive-up interest rates. Use of gold for monetary purposes is an anachronism, capable of causing terrible damage because it is so utterly inappropriate in today’s world.

Yet, the reality is that the world will not be able to find genuine financial stability until it comes to terms with and accommodate the dominant position gold now holds in Asian economic life.

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