Economics: Rising conflict in the Lebanon, North Korean missile tests and terrorist bombings in Mumbai all have one thing in common. They have added fresh impetus to the price of gold, which has jumped by more than 15 per cent or almost $100 (€80) per ounce in the past two weeks. At the height of recent tensions last Monday, the metal reached a price of $675 per ounce, within reach of record levels.
As global tensions rise and with financial imbalances emanating from the US, a new bull market in gold is being born. However, this is only part of the story and a new generation would be well served to consider the virtues of gold as the ultimate hedge to the US dollar.
Gold has fascinated humans throughout history from ancient Egypt to the discovery of the Americas and beyond. Indeed, there are more than 400 references to the precious metal in the bible. Christopher Columbus wrote in 1503 that gold "can even get souls into Paradise". Yet, the allure of gold has been lost on an entire generation of central bankers and investors who have been schooled to believe that gold is "a barbarous relic" and nothing more than a commodity. It is much more than that: it is a mirror of the world economy. A previous oil price spike, coupled with similar tensions in the Middle East, pushed its price to a record high of $850 an ounce in 1980. By the time the dotcom boom was peaking, it had fallen to little more than $250 in 1999.
But those days are over. Gold is not simply a commodity; gold is money. Indeed, it is the only form of money that cannot be debased by the authorities that print paper currency. It is 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 about 155,000 tonnes of gold 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.
Gold is a store of value beyond comparison. It is said that in Babylon 2,500 years ago an ounce of gold would purchase 350 loaves of bread. That same ounce of gold today still buys the same number of loaves.
As a store of value, gold competes directly with paper money. A one dollar bill printed by the Federal Reserve founded in 1913 is worth just three cents today. An ounce of gold today buys the same basket of goods as it did 90 years ago - not only in the US but in all major industrialised nations. Despite gold's obvious attributes, its role as a monetary asset has been consistently undermined for more than three decades. Its official role as an anchor for the international monetary system ended on August 15th, 1971 when then US president Richard Nixon announced that the gold window was closed - the dollar was no longer exchangeable into gold. Persistent central bank sales of its gold reserves each year since the late-1980s further undermined the precious metal. Blow after blow was delivered to the market, including British chancellor Gordon Brown's sale of more than one-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 itself. 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 US dollar is the world's reserve currency and accounts for two-thirds of the foreign exchange reserves of central banks. But the long-term outlook for the dollar is grim. The US is a nation of spendthrifts with a gross national savings rate that is barely half the level that prevails in the rest of the world. Its current account deficit, a measure of the extent to which it lives beyond its current means, is 6.5 per cent of gross domestic product (GDP), almost twice as large in relative terms as its 20th century peak of 3.4 per cent in 1987.
In just a quarter of a century it has swung from being the world's largest creditor to its largest debtor - its net foreign liabilities account for almost one-quarter of GDP and are set to rise to more than half of GDP by 2010. Adjustment must occur at some point. The dollar needs to decline by 30 to 40 per cent on a trade-weighted basis to return the economy to a more sustainable path.
Pressure is already growing on the countries with which the US is running the largest deficits. China, which accounts for one-quarter of the deficit, is being coerced to let its currency appreciate relative to the dollar while protectionism is emanating from Washington with more than 20 anti-China bills before Congress. However, the very countries with which the US is running the largest deficits are awash with dollars. Central bank dollar reserves have been rising in countries such as China, Korea and Taiwan because they have been buying the currency to protect their own competitiveness. Reserves have also been increasing in Japan, Russia, India and the oil-producing countries of the Middle East.
Charlie Fell is an independent consultant and currently lectures finance and investment at University College Dublin and at the Institute of Bankers in Ireland.
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