Gold: A Precious Thermometer

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Paul Volcker, ex-Chairman of the Federal Reserve, once famously referred to gold as ‘the enemy’ of central banks and policy makers. In this article, I will explain the recent large swings in gold prices and, by doing so, explain why gold continues to be a precious thermometer for economic sentiment and the enemy of policy makers.

At a basic level, there are two opposing forces which drive gold price movements. The first is inflation. The second, and perhaps the more topical, is the general fear of economic collapse. I will now explain these two opposing forces and which is principally responsible for driving the current movements in gold prices.

The link between gold and inflation is underpinned by the fact that gold is a finite rare resource which cannot be produced in large quantities at short notice and at low cost. Money, on the other hand, can be printed at short notice at the mere cost of some paper and ink.

Assuming that a central bank decides to double the amount of money in the economy, the ratio of money to goods will double and, other things being equal, prices will double as a result.

To put this into context, if someone has £10,000 in cash savings, if the amount of money in the economy doubles, prices will double and, other things being equal, the purchasing power of his £10,000 will halve.

If someone has £10,000 worth of gold and the amount of money in the economy doubles, the doubling of prices should also double the value of his gold. Hence, his gold will now be worth £20,000 meaning the value of his savings (or what he can buy with them) will have been preserved. This is why gold is often seen as an effective store of wealth which offers protection from inflation.

The link between gold prices and catastrophe is much simpler. In the case of financial, political or economic collapse, we would most likely experience a ‘bank run’; that is, people queuing at banks to withdraw their cash and run for the hills. Banks, however, only hold a small proportion of its customers’ money in cash as the majority will be invested in the public markets, private businesses, personal loans and mortgages.

Hence, only a small proportion of people will make it to the banks in time to withdraw their money before a state of emergency is declared and withdrawals are frozen. More importantly, the bank run is most likely to happen when the value of banks’ investments (which it has acquired by using the very deposits people are trying to withdraw) are worth very little and, most probably, a lot less than the deposits it once held. That is, the bank will have lost the money people thought they had safely stored in their bank accounts.

If instead of holding cash in their bank accounts people were to buy gold and keep it at home, they would always be free to take their gold bar and run for the hills. Moreover, their gold would probably have gone up in value at that point given the demand for gold at times of crisis.

So why has gold almost doubled in price in the past twelve months? And why did it fall by over 10% in the past week?

The key to answering this question is to try and understand whether it is the fear of inflation or economic collapse which is driving gold prices at present. For this, we must look at the evidence.

As I’ve explained earlier, excess printing of money will typically lead to inflation in the long run (other things being equal). However, in the short run printing money (or quantitative easing, as termed by policy makers) also provides a short term boost to the economy by putting money in people’s pockets which will be spent, lent or invested thus providing a positive ripple effect in the economy.

So when quantitative easing is announced, general economic sentiment might improve in the short run thus causing less people to run for the hills (pushing gold prices down), but it will also create worries about inflation (pushing gold prices up).

In the past year, gold prices have almost doubled as fears of a global financial collapse surfaced. Simultaneously, we have witnessed an increase in the cost of living (or inflation).

Last week, there was a clear indication that western policy makers may be considering another round of quantitative easing. This led to the collapse in gold prices and a marked improvement in economic sentiment (signified by a growth in share prices). This very occurrence provided clear evidence that the unprecedented growth in gold prices experienced in the past year has been driven by genuine fears of a collapse in the political economic system as we know it.

Indeed, it may be a while until the global economic outlook settles to the point where fear of economic Armageddon falls away and the relationship between inflation and gold prices is restored. However, once this happens, I believe that we will face a period of high inflation as the economy comes to terms with all the money which has been printed. And as we have learnt from history, inflation has a habit of sticking around as wage negotiations and product price increases fuel each other into a vicious cycle. Hence, this will result in another increase in gold prices.

The Bank of England’s primary remit is to maintain price stability (or stop inflation from getting out of control). As a secondary remit, it is supposed to support the government’s economic growth policy. Hence, whilst another dose of quantitative easing might help with the latter, the Bank of England will have turned a blind eye to its central remit (given that inflation is already at very high levels). If it is not careful, this may well come back to bite later on in the form of uncontrollable inflation. And yet again, the precious ‘enemy’ will resurface.

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About Mark Birri

Corporate finance professional with six years experience in M&A. Interested in the UK economy, the political impacts of monetary and fiscal policy and free market versus interventionist theory.

Posted on September 29, 2011, in Comment, General, Looking Forward and tagged , , , . Bookmark the permalink. Leave a Comment.

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