What Is the Bullion Market Trying to Tell Us?

More than 2,000 years of monetary history came to an end on August 15 1971 when Richard Nixon went on prime-time television, displacing Bonanza on a Sunday night.

Gold bars
Tom Grill | Iconica | Getty Images
Gold bars

“I have directed the secretary of the Treasury to take the action necessary to defend the dollar against speculators,” the US president gravely announced. “I have directed secretary [John] Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets.”

Since that day, advocating a role for gold in the world’s monetary system has become a quixotic cause, on a par with Esperanto, corporal punishment and hats. But this week Robert Zoellick, the president of the World Bank, suggested that the precious metal might be ready for a comeback.

As part of a collection of reforms to the international financial system, Mr Zoellick proposed that policymakers “should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values”.

“Gold is now being viewed as an alternative monetary asset,” Mr Zoellick said. But he added that he was not calling for a return to a gold standard, like the pre-1971 system under which currency was convertible into gold.

His intervention is well timed. Some policymakers think it is dangerous to rely on a single reserve currency, the dollar, from an economy that needs to borrow heavily from abroad. Amid Friday’s failure of the Group of 20 industrial and emerging nations to reach any meaningful accord on global imbalances, France has promised as part of its G20 presidency next year to start a debate about the world’s future monetary arrangements.

Yet none of the obvious options looks immediately practical. There is almost no appetite for a wholesale return to a fixed exchange rate system. Possible alternative or supplementary reserve currencies have their own problems – the eurozone has a fractured bond market and questions about its future given the travails of Greece and Ireland, while China’s renminbi is not freely traded.

Underlying Mr Zoellick’s comments is a concern that the dramatic rise in the price of gold, from a 21-year low of $250 a troy ounce in mid-1999 to more than $1,400 today, reflects a loss of confidence in the paper money issued by central banks and is a signal of future inflation. That has been fuelled by the use of unconventional monetary policy – such as the new $600bn round of quantitative easing just launched by the US Federal Reserve – to try to cope with the financial crisis and recession.

To casual observers, central bank policy looks like printing money; the beauty of gold has always been that no one can make any more of it than what is already under lock and key or remains in the ground.

The very extent of the rise in its price, however, shows the difficulty of using gold as money. Since the turn of the millennium, the Fed’s favourite price index has risen by 22 per cent, while over the same period the price of gold in dollars has risen by 498 per cent. Put another way: if there were no dollar, and US shoppers paid for their groceries with gold coins, since 2000 the amount of gold needed to buy a loaf of bread or rent an apartment would have fallen by three-quarters.

Deflation of 75 per cent in a decade is not an ideal characteristic for money. From a central banker’s point of view, the problem is that the rise in the gold price has not done a good job at predicting rises in the price of everything else. “Gold is a very poor reference point because it fluctuates so widely,” says Fred Bergsten of Washington’s Peterson Institute for International Economics.

Mr Zoellick’s argument is that policymakers can use the gold price as a measure of investor anxiety about the future value of their dollars, euros or pounds. But in judging whether gold is a useful guide to these expectations of future inflation, an important question is whether the ascent of gold reflects factors specific to the yellow metal or more general concerns.

Among fundamental factors, traders highlight stagnant mine output in spite of record high prices.

Global gold production hit a peak of about 2,645 tonnes in 2001 and stayed below that level until this year, according to estimates from GFMS, a consultancy. Worse, mining output is shifting to riskier producers in Africa and central Asia and away from the four traditional – and now mature – producing regions: South Africa, the US, Canada and Australia. Their combined output fell to 756 tonnes last year from 1,260 tonnes in 2000.

Only a surge in gold scrap, as owners of old jewellery cashed in on high prices, has cushioned the drop in mine output. Demand has also been robust as the growing middle class in countries such as India turns some of its new wealth into golden baubles.

Such factors are specific to gold and say nothing about wider inflationary pressure. But there have also been dramatic changes to financial buying of gold. New investors – such as pension funds and insurance companies – have piled into gold through novel instruments known as exchange traded funds, which make it easier to buy and sell bullion.

The largest bullion-backed ETF, the SPDR Gold Shares, was launched only six years ago but today holds more gold than most central banks and is worth almost $58bn. Many of those investors bought gold as a way to diversify their portfolio away from stocks and bonds, rather than out of any inflation terror.

But more recently, some of the world’s largest hedge funds have bought gold as an explicit bet against central banks’ willingness to preserve the value of paper money.

David Einhorn of Greenlight Capital and John Paulson of Paulson and Co, both heading hedge funds that made money during the financial crisis, have bought gold and created classes of shares in their funds that are denominated in gold. “The size of the Fed’s balance sheet is exploding and the currency is being debased. Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed,” Mr Einhorn wrote in a letter to his investors last year.

“Our instinct is that gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself.”

Mr Einhorn’s conviction is hard to reconcile with the tendency of gold to move up and down with little connection to the price of things that people actually buy, such as television sets, bread and cars.

It implies a belief that Ben Bernanke, Fed chairman, will break – or be unable to keep – his promise that the Fed will not push inflation above its objective of about 2 per cent.

Yet there are a couple of arguments that may mean gold is saying something useful about the value of money. One is if you think a proper definition of inflation should include asset prices.

The consumer price index does not include the value of bonds, shares or – at least directly – the value of houses. Yet if you need somewhere to live, or you want to save for your retirement, the cost of these assets makes a big difference. One of Mr Bernanke’s stated goals for quantitative easingis to drive up stock and bond prices.

“Gold along with other asset prices can tell us if there is an erosion in the general purchasing power of money rather than just the cost of current consumption,” says Derry Pickford, chief economist at Sloane Robinson, a London hedge fund manager.

It has also become more practical for investors to hold gold because a historical problem – that the metal provides no income – barely matters any more because interest rates are so low that neither does cash.

Another idea is that investors are buying gold because they want to buy renminbi but China will not let them. Danny Gabay at Fathom, a London economic consultancy, notes that the inflation-gold price relationship broke down in the early 2000s just as international pressure ratcheted up on the Chinese to allow the renminbi to appreciate. He reckons that gold is in effect acting as a proxy for the Chinese currency.

“Investors have become increasingly concerned about sovereign default and they think that most currencies should fall against the renminbi,” he says. “But since non-convertibility means they can’t buy the renminbi, they buy gold instead, which can’t be debased.”

That ties in with one of Mr Zoellick’s comments. “Gold has become a reference point because holders of money see weak or uncertain growth prospects in all currencies other than the renminbi, and the renminbi is not free for exchange,” the World Bank chief said.

If either of these arguments is true, the gold price may contain useful information and central banks should pay heed to it. It is hard to imagine, however, that they could go any further and turn the gold price to some practical use. “Gold’s informational content doesn’t mean it should become an operational target,” says Mr Pickford.

While it may be useful to know that investors would prefer to own renminbi rather than dollars or euros, it is difficult to do anything about it.

“Fed critics who cite the rise in the price of gold as a signal of incipient higher inflation have to acknowledge that they are in effect calling for the Fed to tighten policy,” warns John Makin, resident scholar at the American Enterprise Institute in Washington. “They need to consider the profoundly negative impact on asset prices and economic growth that would follow.”

Even setting aside that alarming prospect, there remains an allure as enduring as ever. As the “new romantics” of Spandau Ballet once put it:

You’ve got the power to know.

You’re indestructible.

Always believe in,

because you are Gold.