Ohh my Gold…!

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Part 1: A brief history

Gold is the only currency used in the history of mankind that has intrinsic value. Owing to its physical properties, gold (and silver) has been one of the first investment instruments. Gold is tangible, durable, non-reactive, non-corrosive, ductile and malleable metal. This has allowed division of gold in denominations as small as 0.5 grams. This divisibility is one of the reasons why gold (and silver) was used as currency during medieval time. Apart from ductility and malleability it is a good conductor of electricity due to which it has various industrial applications.

There are various emotional and behavioural aspects to why people want to invest in gold. In India and many other countries, gold is seen as a sign of prosperity. Gold fascinates people from all strata and income groups. Royals, monarchs, kings and rulers all over the world have always resorted to gold to fill up their coffers. Liquidity owing to universal acceptance is also an important property of gold that makes it desirable.

Before August, 1971 when Nixon de-linked US $ from gold, the greenback was supported by gold at a rate fixed by the US government. The events that lead to and after the shift from gold standard to fiat currency are portrait of how a financially engineered economy and currency system may fail. Let us go back in time and understand history of gold.

1920-32– Rate of gold in USA was ~$20 per ounce

1933– $35/ ounce

However, 1929 marked the start of global recession & deflation. This led then US President Franklin D. Roosevelt pass the infamous, historic order 6102 which gave a period of mere 25 days from 5th April to 1st May 1933 for all citizens of USA to exchange their gold coins, bullion and certificates for a fixed sum of $20.67 per ounce. In the following year, the gold exchange rate was revised to $35/ ounce effectively de-valuating the dollar by 40.94%. This is the only event of government confiscation of public gold (although for a price), an effort to fuel inflation that failed miserably and it wasn’t until the Second World War when things started moving again as desired (in terms of inflation).

1944Bretton Woods Agreement– This agreement abolished exchange of gold in international trade for exchange in US$ which was the reserve currency. Each of the currency was pegged against gold based on the amount of gold reserves with the country. IMF was established to monitor interest rates and currency stability whereas World Bank was established to lend reserve currency and facilitate trade. It is estimated that almost 75% of the then declared world gold reserves were with the USA.

1968-73– Some 20 years after the Bretton Woods agreement, countries other than USA were holding more US $ than the US gold reserves. This resulted in risk of lack of confidence and possible run on US $. Eventually the Bretton Woods agreement was abolished and all the world currencies were floated against US$ and countries are now free to choose any exchange agreement. This was the beginning of gold being traded as a commodity.

Present day scenario

Since 43 years the arrangement of fiat currency has survived, albeit for a few major crisis. Fiat money is simply a government approved legal tender used for transactions. This is however not backed by any commodity such as gold but by a promise of the government that issues it. Hence today, a currency is as strong as faith in the government that issues it. Devaluation of currency results in appreciation of gold prices. This is because gold prices are expressed in US$. Hence any weakness in US$ results in rally in gold prices. However this doesn’t mean that gold is comparable to US$ as an investment instrument. US $ is again a fiat currency and is only as strong as the faith in US government which is backed by its ability to impose taxes on US citizens. Hence ultimately a fiat currency is as strong as tax paying ability of citizens in the country of issuance.

To be continued.. (Part 2: Gold Demand and Supply)

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