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Gold: Commodity or Currency? - Outside View

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Gold: Commodity or Currency?
Jul 26, 2010

Today, gold is traded on commodity exchanges around the world and classed as such. However, the past tells us a different story. Throughout history, gold has been used as a monetary unit of exchange and as a store of value. This is prevalent in culture as well. Many Indian weddings involve transfer of gold jewelry from one party to another. The same gold will be used as a store of value by families, and then passed down to future generations. Our economic systems also used gold. Up until 1971, the value of the US Dollar was fixed to gold (at US$ 35/oz). Many other countries pegged their currencies to the US Dollar, so their currencies were effectively pegged to gold as well. This was known as the gold standard.

In 1971, the gold standard was abolished and the era of fiat currencies began. A fiat currency is one which is not backed by any physical metal, and can be freely printed by the issuing authority. In theory, gold should now be obsolete as a currency because we canít use it to buy or sell goods and its value against the US Dollar (and other currencies) freely fluctuates. Of course, gold does have a value; but then so do other commodities. What makes it different to copper for example? Both are non-perishable metals that can be stored as value. Yet when investors become fearful about economic prospects, copper (and other metals) will usually sell off, but gold will usually rise.

As a commodity, gold is primarily used to produce jewelry. It has little other uses. Compare this to crude oil, which is an incredibly important commodity that is used to create our electricity and fuel. If I examine my own lifestyle, Iíd be severely disadvantaged without crude oil (i.e. no electricity or fuel). If I had to be without gold, life would be no different (though my wife may disagree!).

Gold has staged an impressive rally over the last decade. From under US$ 300/oz in 2001 to around US$ 1200/oz today, this is a return of 300%. You certainly canít make this from the stock market! How can we explain such a large rally? If we look at gold as a commodity only, it would not make any sense. Demand for jewelry wonít have risen by this amount in such a short space of time. If demand for jewelry was the main driver of gold prices, we should have seen gold fall in the last three years (due to global recession) rather than a rise.

The only other explanation for the rise in gold is that it behaves like a currency rather than a commodity. Investors are buying gold as a store of value more than anything else. Effectively, this can only be justified by the fact that we expect that gold will always remain a store of value, and that investors will always be willing to pay for it. If we were to value gold as a commodity only, I doubt the current price would be justifiable.

This rise in the gold price has been most pronounced recently, as prices have approximately doubled in the last three years. This has been a direct response to the global financial crisis and subsequent economic slowdowns that have occurred across the world. Mainly, it has benefited from a safe haven effect. The second effect that gold is benefiting from is the debasement of currencies. The US Federal Reserve has been increasing the supply of US Dollars in the last couple of years, which has made gold more expensive in US Dollar terms. Many investors believe that the Fed will continue to print more money and gold will keep rising as a result. Most central banks around the world hold gold as part of their currency reserves. This trend looks likely to continue, as central banks continue to accumulate gold.

If we take the view that gold is a currency, continued quantitative easing by central banks should mean a higher gold price in the future. If we believe gold in the long run will behave more like a commodity, we could see a steep fall in prices. This is why if you ask someone for their long term gold price forecast, youíll often get wildly different numbers ranging from a few hundred to a few thousand dollars. In reality, gold is an asset which is very difficult to value.

Those who wish to invest in gold should ask themselves whether they are of the opinion that over the long term gold will behave more like a commodity or a currency. As it stands, here are the facts: Gold has historically been used as a currency. Officially, gold is no longer a currency but it still behaves and functions like one. Whether this currency like behavior will continue in the future is anyoneís guess. Two things however do differentiate it from conventional fiat currencies. First, it cannot be printed in indefinite amounts. Second, if gold prices do collapse, no central bank or government is going to step in to defend its value. Remember this last point when considering the risks of investing in the yellow metal! This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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