Gold - The Standard And The Investment

Introduction

Gold has served as medium of exchange and a store of value since the days of the pharaohs, dating back nearly 5000 years. Gold coins were used by the Greeks and the Romans; this tradition passed on to the mercantile era into the nineteenth century where the great increase in trade led to a need for a formalized system of settling international trade balances. Thus, the “Gold Standard” was born.

Since the end of the Gold Standard in 1971, Governments have been free to print as much money as they please. In recessionary times, as the US is currently experiencing today, the return on bonds, equities and real estate is not adequately compensating investors for risk causing the demand for gold (and other commodities) to sky rocket. Following the rules dictated by supply and demand, gold has recently reached a record high of over $1000 per ounce.

It has been adopted as a standard of money, as a role in society’s customs, a preserver of value, a portfolio diversifier, a currency reserve and part of many industrial applications. In recent times, gold has served well as a hedge from falling equities вЂ" balancing out one’s portfolio reducing the risk in case of an economic slowdown. This holds true today and is a perfect reason why gold is and has been such a good investment choice.

The Gold Standard: Pre-WWI

The Gold Standard was a domestic standard, regulating the quantity and growth rate of a country's money supply. Since new production of gold would only add a small fraction to the accumulated stock, the Gold Standard assured that the money supply and thus, the price level would not vary much. It was also an international standard, because it allowed the valuation of a country’s currency in terms of other countries’ currencies вЂ" hence leading to a fixed exchange rate system.

Predating the “Gold Standard” was a silver standard which also had its heritage dating back thousands of years ago to assist in facilitating trade. This system remained the norm until basically the 1800’s following the Napoleonic Wars. The Bank of England established bank notes that served as legal tender as early as 1833. The Bank Charter Act of 1844 established that Bank of England notes which were fully backed by gold were the new legal standard.

Country after country set a par value for it’s currency in terms of gold and was widely accepted during the 1870’s in Western Europe. The USA soon adopted this system, pegging a value of $20.67 per ounce of gold. The British pound was given a value of Ð'Ј4.2474 per ounce and thus a fixed exchange rate between the countries was born at $4.8655/Ð'Ј. Throughout the 1870’s periodic demands for silver occurred that was caused by deflationary economics; but a general pressure towards a Gold Standard continued. By 1879, only gold coins were accepted by the Latin Monetary Union consisting of Switzerland, Italy, France, Belgium and Greece.

With this system, expansionary monetary policy was limited to a government’s supply of gold.

The Gold Standard worked adequately well until the outbreak of World War I. Trade flows and the free movement of gold were interrupted and thus the main trading nations were basically forced to suspend operation of the Gold Standard.

The Gold Standard: The Interwar Years

Currencies were allowed to fluctuate over fairly wide ranges in terms of gold and each other during World War I and the early 1920’s. Supply and demand for a country’s imports and exports dictated the exchange rates about a central equilibrium value вЂ" much the same as the original Gold Standard. Although, such flexibility allowed currency speculators to sell the weak currencies short, which caused further devaluation вЂ" and the opposite occurred with strong currencies. The volume of world trade did not grow during the 1920’s but instead declined to a very low level with the onset of the Great Depression in the 30’s.

In 1934, the United States adopted a modified Gold Standard вЂ" trading gold with only foreign central banks. Exchange rates were determined by each currency’s value in terms of gold. This remained until World War II, where many of the main currencies lost their convertibility, leaving only the US dollar to be the major trading currency.

The Gold Standard: Post World War II вЂ" Bretton Woods and The IMF

The Bretton Woods system sought to secure the advantages of the Gold Standard without its disadvantages. This was an attempt by the Allied Powers to create a new international monetary system. What emerged was the "pegged rate" currency regime. Members were required to establish a parity of their national currencies in terms of gold and to maintain exchange rates within plus or minus 1% by intervening; that is, buying or selling foreign money. Although, only the US dollar remained convertible to gold at $35 per ounce. This became known as the “gold-exchange standard”.

The International Monetary Fund (IMF) was the key institution in the new system. It was established for assisting member countries who may face a run on their currency and to supplement foreign exchange reserves through Special Drawing Rights (SDRs). The US dollar became the main reserve held by central banks which resulted in a growing balance of payment deficit because of the huge capital outflow. Until the early 1970’s, the Bretton Woods system was effective in controlling conflict and in achieving the common goals of the members, especially the US. Following the large expenditures in Vietnam by the US government, pressure against the dollar in gold continued. This was in addition to widely diverging monetary and fiscal policies, differential rates of inflation and various currency shocks. Eventually, foreigners who held the US dollars started to doubt that the US could meet it’s commitment to convert dollars to gold. This lack of confidence caused President Nixon to suspend purchases and sales of gold on August 15, 1971. Most currencies thereafter were allowed to float to levels determined by the market as of March 1973.

Gold: The Investment and the Hedge:

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