GOLD, a store of wealth

King Midas and the Golden Touch King Midas  wished everything he touched would turn to gold but after  Dionysus granted him his wish, Midas soon saw the foolishness of his wish and asked Dionysus to release him the curse. To do so, Dionysus had Midas wash in the Pactolus River (in modern day Turkey). This is the mythological source of the real gold present in the river

Gold has been the subject of many myths and legends throughout history and it is clear that it has always  been considered very valuable. Historically gold was often used as a currency and when paper money was introduced it was regarded as a receipt convertible to fixed quantities of gold. In the monetary system known as the Gold Standard, the value of gold was used as a standard for many currencies. In 1934 a troy ounce of gold was valued at $35 US. At this rate, foreign governments and central banks were able to exchange dollars for gold. Bretton Woods established this  system of payments based on the dollar, in which all currencies were to be  defined in relation to the dollar, itself convertible into gold. The U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. The gold standard  was abandoned in the 1970s and gold was left to find its own free market level. Nowadays banks still hold gold reserves as a store of value but currencies no longer need to be backed by gold.

Gold is no longer used as currency and is now classified as a commodity. A commodity is generally defined as a good which is the same regardless of who produces it . Thus oil, gold,  wheat are commodities whereas stereos are not. However. gold is not being  priced as a commodity, people will pay a lot more for Gold than its commodity value.

WHY BUY GOLD?

Since 2001 Gold has tripled in value versus the USD. but gold is not defined as a currency. It is not classified as  an energy resource, or  a foodstuff. It does look good as jewelry and in assorted ornaments and generally everyone agrees that it is valuable. Yet with traders so willingly  investing such huge  amounts of money  in Gold, what are they buying exactly?

Gold is not consumed like petrol or foodstuff. It is not “useful” like aluminum and copper. It is estimated that in the history of mankind about 161,000 tonnes of gold have been mined just enough to fill 2 olympic- sized swimming pools. For the past 30 years the rate of growth of gold extractions from mines has matched the rate of the world’s population (roughly 2000 tonnes/year).  Gold quantities remain constant because gold is not truly “consumed”  . It simply gets recycled  again and again because it has always been too valuable.

What are the investors buying exactly?

Like any other commodity the price of gold is determined  in large part by supply and demand. However the demand for Gold is not the same as the demand for oil and copper. The increase in the demand for Gold invariably indicates that the more  conventional  types of investments are not producing the kind of returns  needed to protect the wealth of investors. Investors do expect a certain after tax return on their investments, and if it cannot be obtained in one type of investment they will seek it in another. The idea being always that once inflation and taxes are factored into the equation, an investor must  see a positive return on his investment otherwise he would see his assets and purchasing power steadily diminishing in value and that is,of course,  untenable in the long run.

Gold as a “store of wealth”

While it is true that inflation, the stock market and foreign exchange rates affect the price of Gold,  this is true in a certain given investment context. One has to refrain from being too literal in this interpretation. Hence just because the cost of automobiles has quadrupled in the past 30 years it does not mean that the price of gold must also quadruple to offer a hedge against inflation.

The demand for gold is a demand for a hedging instrument against inflation and the collapse in value of other types of investments. Gold fulfills this unique function by allowing investors to invest in an instrument that protects their wealth  and purchasing power. The increase in the price of Gold is not haphazard. It is not simply a case of gold “fever” or speculation that drives up the price of gold. Gold plays a unique role in protecting the  investors’ capital  against devaluation and as such its price will increase in the amount needed to preserve an investor’s purchasing power.

CONTROLLED EUPHORIA

The price of gold can increase and increase a lot, however it is always in a controlled fashion. if that were not the case then gold would not play the  role  it plays in the preservation  of investors’ purchasing power. Because gold is a hedge against inflation and the loss in value of  other assets,  the price of gold must move in a direction opposite that of other assets. Because gold is there to preserve the value of investors capital  when other investments  classes are losing value, its price has to vary inversely to that of the main types of financial assets.

The required yield theory states that the  after tax return  earnings on investments   must be viewed as minimum return  equal  to the GBP/capita long term growth rate plus expected inflation rate.The 1.5% constant turns out to be the long-run average real GDP/capita growth rate in major developed economies. In the US the historical long-term average GDP/capita growth has been 2.03% from 1929-2006. (see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=520382)

Now a decrease in the stock market alone is not sufficient to drive investors  to invest in gold. However a decrease in stock market  earnings  combined with high inflation and taxes would certainly incite investors’ to consider investing into gold. The increase in the price of gold is imminent only if the combination  of high inflation and taxes and a decrease in earnings from the other main  investment types are present. Gold increases  in price  only to the extent that its function is to preserve the wealth and purchasing power of investors, and anything else would defeat its purpose. The exception to this rule occurs in the case of war and when some countries default on their payments, However the effect there is merely temporary.

One can presume by looking at the chart comparing the performance of both gold and the S&P 500, that investors did not find the market performance of the stock market satisfactory enough and thus invested more heavily into gold to preserve the value of their capital. With stock markets under performing,  high energy costs,  deflation, and general bad news about the economy combine it becomes clear why the investors sought refuge in gold.

With the Us coming out of a deflationary period soon and a possible increase in interest rates by springtime, the markets will most likely provide better incentives for investors. When These things obtain we will see an increase in the USD and a corresponding decrease in the price of gold. The end of the year 2009 could provide interesting insight in what we are to expect in the new year. There is a strong chance that the USD will start appreciating by year’s end.

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