Reply #38: Pegging the dollar or peglegging gold [View All]

[54anickel]

http://www.mineweb.net/sections/gold_silver/333740.htm

Prior to 1971, gold was central to the international monetary system. The dollar was exchangeable into gold and central banks held a large proportion of their foreign reserves in bullion. This system collapsed because investors came to distrust the dollar. Faced with the prospect that they would not be able to meet the demand for gold, central banks demonetised gold. This, however, did not stop it from reaching very high prices during the 1970’s, rising to a peak of over $800 in 1980.


In the early 1980’s a new economic paradigm developed. Monetary policy was conducted more prudently and markets operated more freely. Consequently, inflation was largely eliminated and trust in currencies was restored. Gold reverted to being purely a commodity consumed mainly in jewellery. Central banks, having a big inventory of gold as a legacy of the fixed exchange rate regime, became major sellers. By 1999 the price was pushed so low it became impossible to develop new gold mines profitably. Predictably, the market started to correct this mispricing. Under the Washington agreement, the European central banks agreed to co-ordinate their sales and gold has been on an upward trend ever since.


Over the past year a renewed interest in gold as a store of value and as a hedge against financial instability has changed the character of the gold market. No longer driven by the demand for jewellery the gold price is being determined by speculators and investors who are increasingly worried about the dollar. The similarities to the early 1970’s are uncanny – poorly conducted monetary policy, crisis in the Middle East, an American president who does not command confidence outside the United States and the emergence of a new economic power in Asia.


Confidence in the dollar is being eroded by the United States’ huge current account deficit. The US has had an adverse balance of payments for the past 22 years, which up to now it has been able to finance it by attracting investment funds from the rest of the world. This has become difficult both because the deficit is now so large and the focus of private sector investment is increasingly on Asia.

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Where is this going to end? The simple answer is that no one knows. The scale of the imbalance between the US and the rest of the world is huge and the longer intervention prevents necessary adjustments, the greater the dislocation will be when the inevitable correction occurs.


In the face of these uncertainties, some people are again buying gold as a store of value. They do not know what is going to happen but sense great dangers ahead. Some remember that it took more than a decade to correct the policy mistakes of the 1960s. The rising price of gold reflects increasing concerns about the future of the existing economic order.

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