Monday, May 17, 2004

$$$SHOW ME THE MONEY$$$ - The history of Gold


Before we launch into a discussion of the modern gold market and where it's going, first let's discuss the history of the gold market.

This article from the Fifth International Gold Symposium describes the world-wide gold market.

Now most people have heard about the Gold Standard (Wikipedia).

There is a great deal of misunderstanding about what the gold market really is, so let me carefully explain how it works.
1. We are still on a gold standard.
2. The gold market is a managed market, and managed by the central banks of the world.
3. All fiat currency is allowed effectively to float against gold and other precious metals and commodities.
4. Central banks manage the gold supply in order to manage their fiat (printed at will) currencies.
5. What was abandoned in 1971 by Nixon was the currency peg to gold which meant that the United States no longer converted US dollars to gold at a fixed rate but rather paid the going market rate.


Gold is denominated in US dollars, but effectively is a managed reserve commodity against which the basket of world currencies are measured against in terms of two factors that drive the gold market speculation (1) political risk and instability and (2) currency inflation.

If countries become destabilized and their fiat currencies carry risk of default, the typical benefactor is another country's currency. This is because central banks across the world manage the overall gold supply to stabilize their currencies by selling or leasing gold as necessary to maintain its price stability. Only when a very large country destabilizes or a large region destabilizes or international financial relationships are themselves threatened, does the price of gold move in a speculative fashion. The other factor is inflation, if inflation enters into a single country the price of gold isn't going to be moved that much. If however a group of countries were to experience inflation, perhaps because their central banks this was the lesser evil, then and only then would one expect a move in the price of gold.

The rest of the time, the price of gold is going to move mostly on fundamentals and over the past twenty some years gold has proven a very poor investment because central banks have strengthened their currencies in order to give them more monetary policy freedom by allowing extraordinary shorts in the price of gold.

The singular exception to all of this is the United States itself, because gold is directly denominated in US dollars and therefore a currency shift in the dollar with all other things being equal requires a shift in the price of gold. The US economy is also something like 30% of the world GDP, and as such a huge player inflationary changes in the US economy would be expected to reflect on the price of gold.


In the current situation we have to central banks - the People's Bank of China and the US Federal Reserve because of the currency peg situation having essentially a linked monetary policy / interest rate regime. China cannot raise its interest rates until the US does, and has been discussed the Federal Reserve is promoting GDP growth over inflationary control by being deliberately behind the curve.

This means that China has to take regulatory steps - raising taxes, tightening credit standards, etc. - or else risk seeing their economy overheat and inflation spiral out of countrol. To resort to monetary policy prematurely would be to break their peg and fixed currency ratio to the United States.

Because together China and the USA are such a huge portion of the world economy, then we can see that this situation creates the possibility of a play on gold.

This is an unusual situation because except for the past couple of years, gold has been an abysmal long term investment because of the central bank policy of managing the supply to exceed demand to strengthen their fiat currencies.

This is moreover, exactly what they should have done. The fiat currency regime is only possible by using this managed float on gold, and people who say we've "gone off the gold standard" really don't understand the nature of how the international FOREX system is really built on a foundation of floating currencies versus gold and other commodity prices.

You can read about the people who complain about this system at the Gold Anti-Trust Association. However the alternative is not a pure fiat system, but either switching to another commodity (Platinum?)to manage currencies against or going back to a rigid pegged system instead of floating currencies against a managed supply of gold.

The real discussion is whether the system is properly managed or whether it is mismanaged. One could argue that it would be more effective to manage fiat currencies by floating them against a basket of commodities such as among things Saffron - the cooking spice that is more expensive than gold when bought by weight.

More seriously they could create a futures market based upon the CRB or in other words a weighted basket of commodities futures, see here the Financial Times 05-13-04 commodities summary [Adobe PDF file].

So now that we've discussed the history of gold and its general relevance to the currency markets, and why it is relavant to the current incipient economic move I'll continue blogging about the more exact moves in detail one would expect from the market.

However first before that, I'd like to in my next few articles touch back on oil and introduce the Chinese blogs that specialize in discussing that country.

My more clever readers will have by now realize that I'm beginning to suggest that because the gold-market is managed that oil has become through a slow evolutiona and shift the defacto new commodity that currencies are traded against - except that this market is not managed for currency stability - which introduces interesting possibilities. "Black gold" indeed!


At September 18, 2006 at 9:07 AM, Blogger TradingCourses said...

Good info. Thanks.

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