SERIOUS MONEY: The Financial Timesweekend edition of December 13th, 1997, carried a special cover story entitled "The Death of Gold". The newspaper concluded that gold "has fallen from grace and is now a mere metal and a bad investment". The pessimism proved misplaced. The precious metal, which was trading below $300 an ounce a decade ago, has advanced by almost 150 per cent since then and recently recorded its highest daily close since the bubble-fuelled highs of January 1980.
Importantly, the monthly average price exceeded $700 for the first time in September, causing technical analysts to salivate over the prospect for further gains. The gold renaissance is in full swing.
Gold is typically misunderstood. It is not simply a commodity; it is money. Indeed, it is the only form of money that cannot be debased by the authorities that print paper currency. It is both rare and durable. It has been discovered on every continent, yet all of the gold ever mined amounts to less than one week's aluminium production. Roughly 80 per cent, or circa 155,000 tonnes of gold, still exists today, most of which could come back to the market under appropriate conditions. The annual flow of newly-mined gold of 2,500 tonnes adds little to the existing stock. Consequently, the price of gold, just like paper currency, is determined by the outstanding stock and not the annual flow.
The role of gold as a monetary asset means that it competes directly with foreign currencies, most notably the dollar, the euro and the yen. As gold pays no interest, investors must compare gold's return with that available from investing currencies in short-term monetary instruments. As the real interest rate falls, the opportunity cost of holding the precious metal declines and consequently its relative appeal rises. Negative real interest rates in the 1970s were an important factor behind gold's strong performance during that period when annualised gains materially outpaced the dismal returns from stocks and bonds.
Gold's role as a monetary asset was consistently undermined for more than three decades. Its official role as an anchor for the international monetary system ended on August 15th, 1971, when Richard Nixon announced that the gold window was closed - the dollar was no longer exchangeable into gold. Persistent central bank sales of their gold reserves since the late-1980s further undermined the metal. Blow after blow was delivered to the market, including Gordon Brown's sale of more than half of Britain's reserves at just $275 an ounce.
Some semblance of order was brought to the market with the signing of the five-year Washington agreement on September 26th, 1999, and its subsequent renewal in 2004, which limits the collective sales of 15 European central banks, including the European Central Bank. Signatories to the agreement combined with those countries and official institutions that are known to be opposed to gold sales, account for more than 80 per cent of the official sector's holdings of about 28,000 tonnes.
The order brought to the market by these agreements helped to bring the 20-year bear market to an end but the official sector may play a more positive role in the years ahead as central banks outside of the western world look set to purchase gold.
Why would central banks consider purchasing gold? The precious metal is the ultimate hedge against economic and political uncertainty.
During the 1990s the dollar was typically the chief benefactor of a flight to quality but more recently, concerns about the sustainability of American households' debt-fuelled consumption binge has seen gold resume its mantle as the premier safe haven.
The recent half-percentage point cut in short-term interest rates implemented by the Federal Reserve has not only reduced the opportunity cost of holding but, combined with growing concerns that an economic downturn is imminent, has served to undermine the dollar, which recently dropped to a record low on a trade-weighted basis.
Given that the greenback accounts for two-thirds of the foreign exchange reserves of central banks, surely monetary authorities will seek to protect the value of their reserves, and the natural hedge to the dollar is gold.
Importantly, the oil exporters alongside east Asian countries and China in particular have been large buyers of dollars in recent years, yet most of them hold very little gold despite their cultural affinity to it. Russia has already announced its intention to increase its reserves to 10 per cent. Others may follow. The repercussions for the gold price could be substantial.
The optimists believe central banks won't favour gold over dollars but there is historical precedent. France under Charles de Gaulle increasingly sold its dollar reserves for gold in the mid- to late-1960s and ultimately forced the US to default on its obligation to convert dollars into gold in 1971. So began the greatest bull market for gold in recorded history. The past looks set to repeat.
The national motto of the US, "In God we trust", first appeared on paper currency in 1957. Half a century later, perhaps this should be changed to "In gold we trust ".
