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When uncertainty about the economic future and the perceived probability of market downturns rise, investors often turn to so-called “safe havens” to protect their savings. Especially when these factors are combined with concerns about increasing inflation, gold often gains centre stage in safe haven consideration. In the aftermath of the Financial Crisis and during the Euro Crisis, the gold price surged to levels not seen since the beginning of the 80s (in real terms). However, although uncertainty arguably has not decreased after the Brexit referendum in June and the election of Trump in November and with the referendum on constitutional reform in Italy this Sunday (December 4) looming, gold prices have been falling since July of this year. What is driving these developments? What are the reasons for and against investing in gold? Does it make sense to invest in gold at the moment? Before I investigate these questions, let us take a brief look at the history of gold as a financial tool.
Gold’s lustre, malleability, density, chemical inactivity and scarcity have always spurred people’s fascination, both practically and spiritually. During the first millennia of human civilisation, gold was mostly used for ceremonial purposes and was predominantly owned by monarchs and priests. And while it was used as jewellery, it was not yet commonly perceived as money. But as trade increased, due to its properties and also its uselessness for practical application, gold soon began its monetary career and was first cast into gold bars by the Egyptians 4000 BC and formed into coins about 700 BC in today’s Turkey. With the rise of coinage also came the state monopoly over the creation of money and with it the temptation of currency debasement. In times when governments not yet had the powerful tool of the printing press at their disposal, when public expenditures exceeded the extraction of gold, they often chose to mix the precious metals for the coins with other, more readily available metals, thus creating a mixture of fiat and commodity money. After the fall of the Roman empire, human innovation stalled throughout the Dark Ages and so did the development of monetary systems. Subsequently, while the looting of the newly discovered American continent, mainly by Spain, increased the amount of precious metals in Europe five-fold during the 16th century, private paper-money instruments started to gain traction for payments between merchants during the same period. It seems that paper as currency has first emerged in the 9th century in China, but it took Europe somewhat longer to follow suit. By the end of the 18th century, paper money, issued by private institutions, had to a large degree substituted the coinage of the government in daily circulation. This meant that the money supply was now determined by the volume of credit provided by the privately owned banking system, quite similar to the situation today. The linkage between currency and gold was soon officially abandoned and economies were now finally operating completely on paper currency, detached from the moderating gold supply (Bernstein, 2012).
At the beginning of the 19th century, the costly Napoleonic Wars led to a phase of high inflation rates and suspension of convertibility. Longing for more financial stability, by 1821, Britain became the first country to officially adopt a gold standard, meaning that its currency, the pound, was based on and could be converted at a fixed rate into gold (The lesson that a paper currency should be backed by real value was one learned by the Chinese already in the 12th century; see Bernstein, 2012). Subsequently, the expansion of Europe’s trade in the 1860s raised the appeal of an international gold standard. And while an international conference in 1867 in Paris failed to establish such a standard, the individual decisions of the nation states soon accomplished it: Germany moved to the gold standard in 1871 and caused a chain reaction which reached the United States in 1879, and by the beginning of the 20th century, except for a few cases, the whole world had established gold as the de facto sole standard for their coin and paper currencies. The gold standard also meant that the central banks had to back their currencies with gold, either fully or at certain ratios. Technically, money supply and consequently inflation could thus only grow as much as new gold extractions allowed. Due to this, the time of the global gold standard from 1880 to 1914 is still romanticised today as one of price and exchange rate stability. However, this is not clear empirically, as countries did not necessarily always comply with reserve restrictions, abandoned the gold standard in times of economic distress and as inflation was driven by unpredictable gold discoveries. In any case, the gold standard could not prevent global financial crises in 1884, 1890, 1893, and 1907. And while the gold standard featured very stable exchange rates for an expanded period of time, the causal relationship behind this phenomenon remains unclear. Nevertheless, the so-called “heyday of the gold standard”, characterised by rapid economic growth, the free flow of labour and capital across political borders, virtually free trade and, in general, world peace can still be seen as a remarkable episode in (economic) history (Bordo, 1981).
Then came the Great War and the economic and political turmoil that followed it. With government deficits exploding and inflation skyrocketing, one country after another saw itself forced to abandon gold convertibility and often to confiscate its citizens’ gold, and by 1936, the gold standard was through (Eichengreen & Flandreau, 1997). After the devastating Second World War, a new global monetary order was established, the Bretton Woods System, named after the mountain resort in New Hampshire where it was designed in 1944, mainly by John Maynard Keynes of the British Treasury and his US counterpart Harry White. Under this system, only the US dollar was convertible into gold (a privilege now limited to national treasuries and central banks, however) at a fixed rate of $ 35 per ounce, while all other currencies where pegged to the dollar with legal room for adjustment in case of extraordinary events. The dollar was backed by 75 percent of the world’s stock of monetary gold, amassed by the huge deficits US allies had run during the war. But US inflation and the steady shrinking of US monetary gold reserves soon led to a decline in confidence in the credibility of the Bretton Woods System. The pressure on the United States rose, especially due to the efforts of French president Charles de Gaulle who wanted to end the special position of the Americans who, unlike any other country, could offset their deficit in international transactions simply by paying over their own currency. With inflation further climbing and foreign treasuries demanding large amounts of gold, on August 15 in 1971, US president Richard Nixon unilaterally announced that the United States would no longer convert dollars to gold at a fixed value, effectively ending the Bretton Woods System (known as the “Nixon Shock”). While the dollar remained the centre piece of the world monetary order, gold became, within a few years, what it still is today: a traded commodity with a special history.
In an environment of high inflation rates and the oil price shock, many investors turned to gold, prices began to climb, and by January 1980, the gold market saw one of the most extreme months in financial history and the gold price reached its all-time high in real terms (Bernstein, 2012). This was followed by a steady decline in price until the turn of the millennium. Subsequently, the gold price began to rise again and, spurred by uncertainty and economic recession, reached its peak in September 2011. Since then, gold has been on a downward trend that has been interrupted if not disrupted in the first half of this year.
Now that it has lost its leading role in the world financial system, what are the pros and cons of investing in gold today? Let us start with some of the obvious disadvantages of a gold investment. Unlike stocks or bonds, gold does not generate income in the form of dividends or yields. There are various different ways to invest in gold. ETFs, gold certificates and other financial instruments all provide exposure to the gold price, but carry default and legal risks to different extents. Even banks that are fully reserved (i.e. hold enough gold to meet all liabilities) may face difficulties to service all gold claims in a seriously disruptive event. Buying physical gold (e.g. in the form of bars or coins) on the other hand involves high fees (especially if one buys small amounts) and storage costs. Thus, to provide the same income, physical gold in practice has to outperform other investments. Additionally, physical gold is less liquid than most forms of investment in a normally functioning market. Lastly, an investment in gold may be ethically questionable due to the negative externalities that gold mining can have on societies and the environment (see e.g. Garvin et al. (2009) for a case study on Ghana).
Probably the most commonly mentioned advantage of gold is that it is uncorrelated or even negatively correlated with other assets. This makes gold a potential hedge in normal times and a safe haven in times of a market crash. Baur & Lucey (2010) find that gold works as both for stocks (but only in the short run), a finding supported by Hood & Malik (2013) and Coudert & Raymond (2011). Capie, Mills & Wood (2005) conclude that gold is a hedge against the dollar, but that it varies in its quality as such. Arguably the most important benefit of gold (only in physical form) is that it is an insurance against a collapse of the financial or monetary system. On a historic scale, no currency that was not deeply rooted in a commodity has survived for a long time without being debased to finance excess government spending or being made obsolete by political subversion. Today, paper currencies are not backed by anything tangible, the only thing a central bank is obliged to give in return for its paper currency is paper currency. Only the promise of a share of future production, channelled through the government’s power to collect taxes, gives paper currency its value. If this promise loses its credibility, money loses all its value since the latter is not of an intrinsic nature. However, in a situation where the existing monetary system collapses or is in danger to do so, gold might not work as the intended insurance due to other extreme circumstances. One example is the Gold Reserve Act of 1934 and a number of preceding Presidential Executive Orders which outlawed the possession of larger amounts of gold in the US in order to allow the Federal Reserve to increase its money supply, invalidating gold clauses and rendering the gold standard somewhat redundant.
It is uncertain whether a collapse of the current monetary system in the developed world might happen anytime soon. But there are some signs of distress. Today, a currency is no longer debased by mixing other metals to the precious metals used for coinage, but by simply expanding the supply of paper and digital money. The supply of central bank currency has multiplied in most developed countries since the financial crisis due to asset purchase programs and cheap credit in order to fuel a stalling economy (Sometimes it almost seems as though some of the central banks try to hide this fact with their opaque database organisation; I am looking at you, Bank of England). So far, this has not led to high inflation rates, quite the opposite. But should the velocity of money increase and all the newly created money flood the markets, it might become difficult for the central banks to tame inflation without risking a deep recession. Should this become the case, the price for gold will most likely surge.
Nevertheless, at the moment the gold price is on a downward trend that began after it peaked in the beginning of August and has accelerated since the US election. Despite the fact that stock market futures plummeted during the election night as Trump surprised most forecasters, the markets went on to rally to all-time highs ever since. This was probably driven by expectations that a Trump administration may roll back financial regulations and the anticipated interest rate hike that the Fed will likely announce in mid-December. Usually, when interest rates rise, the gold price falls since its lack of income becomes relatively more important and inflation expectations fall. Adding to this, gold demand by central banks fell by 51 percent and demand for jewellery by 21 percent in the third quarter of 2016 (World Gold Council, 2016). Unlike most other commodities, the price of gold is mostly driven by investment demand (by private investors and central banks) and the expectations of future demand and not so much by supply or consumption (for jewellery, technology and dental use), which tend to be more stable (gold supply is currently averaging 4000 tonnes a year, with 2/3 of that coming from mining and the rest being recycled gold – the extracted gold stock in the world is estimated at circa 187,000 tonnes according to the World Gold Council).
Historically, the gold price is strongly correlated to the oil price (Shafiee & Topal, 2010). Since a new preliminary OPEC agreement that was reached this week might signal rising oil prices, this could lend some support to the gold price. Furthermore, with many central banks still caught in a liquidity trap and monetary bases surging (The ECB is still buying $ 80 billion worth of assets each month and is unlikely to stop in the near future), fears about monetary stability will most likely keep on having an upward pressure on the gold price. It would however not be surprising to see the gold price fall further for a while as markets bet on a brighter future.
In any case, speculations about future price developments are exactly that: speculations. But independent of short-term fluctuations, gold can work as an insurance against a collapse of the monetary system. In the long run, gold has always performed better than constructed currencies. In normal times, gold is predominantly a bet that someone (“a greater fool”) will pay more for it in the future. Since this speculative strategy is not based on productivity growth, it has to perform worse than other assets on average and one should hence not put all money into gold. However, in extraordinary times when systems fail, the ones who have invested part of their savings in gold do not lose everything and can benefit from substantial relative gains. (Note that other tangible assets such as houses share the same property. However, these assets are not as liquid as gold and can usually not serve as an emergency currency.) Together with gold’s risk-diversifying properties, this insurance quality can certainly motivate an investment of a fraction (an often cited rule of thumb is maximum 10 percent) of one’s money into physical gold. Or one might buy it for the same reason people have been fascinated with it for millennia: it looks pretty cool.
For this year, one more article is planned for mid-December, in which I look at financial cycles and their recent developments in various countries and analyse how central banks’ interest rate policies might influence them.
Baur, D. G., & Lucey, B. M. (2010). Is gold a hedge or a safe haven? An analysis of stocks, bonds and gold. Financial Review, 45(2), 217-229.
Bernstein, P. L. (2012). The power of gold: the history of an obsession. John Wiley & Sons.
Bordo, M. (1981). The classical gold standard: some lessons for today. Federal Reserve Bank of St. Louis Review, (May), 2-17.
Capie, F., Mills, T. C., & Wood, G. (2005). Gold as a hedge against the dollar. Journal of International Financial Markets, Institutions and Money,15(4), 343-352.
Coudert, V., & Raymond, H. (2011). Gold and financial assets: are there any safe havens in bear markets. Economics Bulletin, 31(2), 1613-1622.
Eichengreen, B. J., & Flandreau, M. (1997). The gold standard in theory and history. Psychology Press.
Garvin, T., McGee, T. K., Smoyer-Tomic, K. E., & Aubynn, E. A. (2009). Community–company relations in gold mining in Ghana. Journal of environmental management, 90(1), 571-586.
Hood, M., & Malik, F. (2013). Is gold the best hedge and a safe haven under changing stock market volatility?. Review of Financial Economics, 22(2), 47-52.
Shafiee, S., & Topal, E. (2010). An overview of global gold market and gold price forecasting. Resources Policy, 35(3), 178-189.
World Gold Council. (2016). Gold Demand Trends – Third quarter 2016.
written by Jonas