Gold To Benefit As Currency Woes Continue 

Continued currency woes, further monetary easing and the potential for default are likely to further boost gold's appeal in 2011

Author: David Levenstein
Posted:  Monday , 24 Jan 2011



Since 2000, gold has been in a bull market that has driven the price of the yellow metal from around $250 an ounce to just over $1400 an ounce. Even though this impressive five-fold gain has occurred in the US dollar price of gold, the price has recorded major gains in almost every currency around the world. Although, after ten successive years of price increases, it may be tempting to ask if prices are peaking, I don't believe so. In fact I think this bull market has a long way still to go.

While the price of gold is influenced by a myriad of different factors, the main contributing factor over the last 10 years has been the declining values of the major currencies in particular the US dollar, which as measured by the Dollar index, has dropped from a high of 120 in 2001 to a low of just above 70 in April, 2008.... a loss of some 35%.

A quarter century of uninterrupted and unprecedented credit expansion begun by the US in the 1980's, came to an abrupt in August 2007 when global credit markets froze, precipitating an economic crisis the severity of which surprised all except those who expected it. And, in order to prevent a collapse of our financial system, central banks were forced to bail out numerous financial institutions. But, since these central banks did not have a stash of cash available, and could not borrow money from selling new issues of bonds, they were forced to print more money disguising this in a list of new terminologies like "quantitative easing."

A fiat currency is a medium of exchange composed of some intrinsically valueless substance which the issuer does not promise to redeem in a commodity or a fiduciary money. And, because a fiat currency has no direct legal connection to a commodity money (in terms of redemption) and, therefore, no real economic cost to its production, the supply of a fiat money can never be self-limiting.

Every country has its own currency to facilitate international trade and domestic business. However, when Nixon abolished the gold standard in 1971, he removed any intrinsic value to the US dollar. And, in 1973 the IMF officially abolished gold as part of the monetary system.  One of the problems of having a currency backed by gold is it restricts monetary expansion and as a consequence restricts economic growth. But, on the other hand when currencies are no longer backed by gold or silver for that matter, the value of these currencies really depends on the economic health of a country as well as the perception of stability and confidence in the political climate in those countries. As conditions change currency values fluctuate to reflect the new perceived value. Changes in currency valuations have a significant impact on governments, corporations, financial institutions and ultimately the individual.

The history of fiat money has been one of failure. It works well when economies are expanding, and have high levels of employment as well as strong GDP growth. But, when economic growth is contracting and central banks try to stimulate economies by pumping money into the system, the result of this action will lead to the debasement of the national currency and ultimately a period of hyperinflation. The most recent example of this was Zimbabwe. Not only did Mugabe's policies manage to debase the currency to the point where it became totally worthless, there was a shortage of the most basic essentials such as bread and clean water. Now, Zimbabwe does not even have a national currency and all domestic transactions are paid for in US dollars or South African Rands.

A government can only fund its expenses in three ways...from taxes of various kinds, from borrowing, and/or from printing more money. In recent months we have seen certain countries introduce new taxes, which will undoubtedly put pressure on tax payers who will be forced to reduce their spending. It is a vicious circle. The less disposable income available means the less the amount of money available to spend on goods and services which is not conducive to economic growth.   The other way is to borrow more money, but as we have seen in the case of Greece, Spain and Portugal, governments have to pay higher interest rates in order to entice investors to lend them money. But, these rising rates on government debt can only exacerbate their inability to service such debt.  And, of course if this does not work, governments can turn to their printing presses and crank out as much paper money as they require. However, the more money they print, the less their currency will be worth. And, this will result in an inflationary environment.

In the last year, prices of many staple commodities such as corn, wheat, soybeans, rice, oil, cotton etc., increased substantially not on account of bad weather, or a sudden massive escalation of demand, but on account of the dollar weakness against most other currencies. This is the beginning of an inflationary scenario that analysts talk about. Obviously, the current supply constraints will be given the blame, but these are only a part of the problem. 

Even as world economies slowly recover, this does not mean that the global currency crisis has been resolved. On the contrary. If you consider the size of the US national debt as well as that in the Eurozone, and add to this the massive budget deficits of most major western governments it is easy to see that governments are not going to be able to fund themselves from simply increasing taxes. And, already indebted countries cannot continue to lend money to other already indebted countries. In fact, I believe that the current debt to GDP of most countries is not going to contract, but will instead expand.

So, unless I am missing something, I don't see a solution to the global currency crisis, and I believe that what we will see is more monetary expansion by governments leading to further debasement of their currencies and ultimately high levels of inflation. We may even see a few countries default on their debt which will send bond holders sprinting for the hills. While I hope I am wrong such a scenario is looking more likely all the time. This is why it is more important than ever for investors to own gold and silver as a portion of their portfolios. Historically, it has been proven that gold has been an excellent way to preserve one's wealth. And, if we see the collapse of the international dollar system, then gold and silver may be the only viable currency for global trade.

Many individuals still have the misconception that gold is used only for jewellery, and have forgotten that gold is also a monetary metal as well as a global currency. It is not a barbaric relic as it is often referred to by analysts who don't understand this metal.

Gold is amoung the most liquid assets in the world. It can be readily bought or sold 24 hours a day in one or more markets around the world. Market makers, bullion dealers, coins dealers, as well as some banks trade gold with each other as well as with their clients. The main centers of the gold market are London, New York, Zurich with other smaller centers in Singapore, Hong Kong, India, and Dubai. Each day, mining companies, central banks, jeweler manufacturers, refineries as well investors and speculators do transactions through these centres. The typical deal size for a gold transaction between market makers will be between 5,000 and 10, 000 ounces so unless you are able to do transactions for these amounts don't quibble about the premium you pay when you buy one Krugerrand.


In the last two weeks we have seen some technical damage to the gold price as it has broken through the 50 day MA. While the long-term trend remains very much intact, we may see a test of the $1325 support level (S1) which also coincides with a 38.2% Fibonacci retracement.

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