Gold – Is the Bubble Bursting?

Gold prices have soared during the past couple of years as investors seek a safe haven to invest in. The gold price however, has fallen recently almost 25% off its peak. So what attracts people to invest in gold?

Mankind has been fascinated by gold for thousands of years. It started as an investment when farming advances led to surplus food production, so it became a medium of exchange. As it is inert it could also store value, and it became a display of power and status. Over the centuries its status has risen despite its trivial industrial use.

In the 19th and early 20th centuries gold played a key role in international monetary transactions. The gold standard was used to back currencies with the international value of currency being determined by its fixed relationship to gold. With gold being used to settle international transactions it reduced the trading risk between countries.

Countries with a trade deficit depleted their gold reserves, so they would have to reduce their money supply. This would result in a falling demand for imports and the lowering of prices would boost exports. So countries with inflation would lose gold and have to reduce spending. The British pound was used as a reserve currency. This worked well until the British economy was seriously weakened by the costs associated with the Second World War.

In 1944, the Bretton Woods Conference was held. This was the forerunner of the International Monetary Fund (IMF). At this conference they conceived a system wherein exchange rate stability was a prime goal. Gold production at that time was insufficient to meet the demands of growing international trade and investment. And a sizeable share of the world's known gold reserves were located in the Soviet Union.

The only currency strong enough at the time to meet the rising demands for international currency transactions was the United States dollar. The strength of the U.S. economy, the fixed relationship of the dollar to gold ($35 an ounce), and the commitment of the U.S. government to convert dollars into gold at that price made the dollar as good as gold. The US dollar was even better than gold as it earned interest. However to pay interest, more dollars needed to be created. In 1971, USA President Nixon unilaterally abandoned the gold standard. This may have been a deliberate ploy as Russia was a major player in controlling the supply of gold.

Gold is trading at high margins relative to its cost of production. Virtually all the gold ever produced still exists and can potentially come back onto the market. Actual production and demand for jewellery and industrial use is low relative to the huge supply.

History has shown that since 1971, gold has fluctuated markedly in price. It has had periods where the price has risen significantly, and other periods when it has fallen sharply. The demand for gold is more psychological than real. As interest rates are low there is a low opportunity cost of investing in gold. Once interest rates rise, on a rational basis gold prices should decline. The real question is not if, but when will they fall. By then, the television advertisements from gold traders may be memories of a passing fad.

Disclaimer

Steven Barton (FSP 32663) and Susan Pascoe Barton (FSP 32382) are Certified Financial Planners and Authorised Financial Advisers.  Their initial disclosure statements are available free of charge by contacting them on (07) 3060080 or they can be downloaded from www.pascoebarton.co.nz. This column is general in nature and should not be regarded as personalised investment advice.