Inflation could force gold to be new global currency

August 8th, 2009

By Anthony Rowler

IT'S party time again, it seems, in world stock markets and revellers are beginning to sound as though the financial crash and the global recession were nothing more than a pause for breath.

Yet the 'ghost at the banquet' is the gold price which, at near US$1,000 an ounce, is an unwelcome guest to have around just when it seems the good times are ready to roll again.

Even as advanced and emerging equity markets hit their highest level for the year on Monday of this week, the gold price continued its upward climb and reached US$955 an ounce. What's more, even those investment managers who do not normally display a tendency toward hyperbole said it would hit US$2,000 an ounce soon and could go on to reach US$3,000.

So, what is the gold price trying to tell us from the elevated heights where it stands sentinel nowadays over securities markets? Presumably that all is not well with the current state of the world, and that things are not what they may seem to be in the investment universe.

Not that many people pay much attention to gold nowadays. It is seen as being just another commodity, or a 'barbarous relic' as John Maynard Keynes once described it. But whether viewed as an anachronism in a world of paper and electronic money or just a quasi currency, gold has an eerie way of being able to see into the future.

Gold coasted along at around US$250 an ounce throughout much of the 1990s, content, it seemed, in the knowledge that inflation was under control and that the oil shocks of previous decades were over. Its relatively low price was seen by some as evidence that gold had finally been relegated to a minor role in the monetary and investment firmament.

But once the new millennium dawned, and with it the boom and bust of the IT bubble (provoking a profligate monetary response by the US Federal Reserve and other equally panicked central banks), gold reverted to its barometric role of acting as a storm warning.

The price doubled quite quickly as gold scented inflation. Inflation did not come in the expected form of hikes in the prices of goods and services in the developed world, because China and other emerging economies were flooding the world market with cheap goods while India and others supplied outsourced services that also kept conventional measures of inflation in check.

Instead, 'asset inflation' reared its head as stocks and real estate reached for the sky.By the time the most recent crisis struck, gold had already signalled its mounting alarm at the dismal stewardship of the global economy and of the international financial system by moving inexorably upwards.

Then came the crash and with it the potential (and in some cases, such as that of Japan, actual) threat of deflation. With the steam knocked out of global demand and commodity prices in general collapsing, gold ought in theory to have slid back down again, safe in the knowledge that its inflation-hedging role was no longer needed, at least for the present.

Instead the gold price continued to climb. If this ancient store of value is not worried about actual inflation, what is keeping it awake around the 24-hour trading clock as its refuses to relax its vigilance?

The answer is the profligacy of central banks - the US Fed most of all - in printing money as if there were no tomorrow and of government (again the US) in spending that money. Such habits have led to hyper-inflation in the past and could again if a bubble in stocks and other assets coincides with an abundance of financial liquidity, as appears to be the case now.

Stock market bulls would do well to bear in mind the danger of inflation devouring wealth gains that stem from easy money rather than from hard slog.

Gold has more to worry about than a new great inflation. There is a widespread perception (going well beyond China) that the US has debauched its currency by printing so much of it and that its future value as the principal store of international reserves has been compromised as a result.

What will step into the breach if confidence in the dollar continues to wane? Not the euro, because as former Fed chairman Paul Volcker pointed out recently, it is not in the long-term interest of any single nation (or geographical region) to bear the burden of operating a global reserve currency.

Another candidate could be forced willy nilly to occupy the role of principal store of value and immutable medium of exchange - ie gold.

It has been playing these roles for thousands of years, even if forced to do so in a 'shadow' capacity recently by a belief that fiat currencies such as the dollar (and before that the pound) were as good as gold. This is why the gold price is where it is now. Be warned.

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