Last Updated :
11 January 2010 at 16:50 IST
Why gold is currency and inflation hedge
This Gold exchange rate was maintained by a complex system of transferring Gold from New York to London. Creating a system of checks and balances that should have prevented the onset of inflation.
This worked fairly well until other countries began abandoning their Gold standard to finance the First World War. The U. S. entered the war late and was able to maintain its gold standard.
However because other countries currencies "floated" against the dollar the true value of the dollar also floated and inflation still occurred (basically other countries were able to export their inflation to the U.S.).
Remember at that time people spent gold and silver coins. Even though the price of Gold was fixed other prices weren't fixed and so the amount of goods people could buy with their Gold could still fluctuate.
The other reason Gold is rising now is that it is acting its role as a "crisis hedge". Back in 1980 the real reason gold prices were rising was the international crisis arising from the Soviet invasion of Afghanistan and the Islamic Revolution in Iran. The world was in turmoil and inflation was out of control so everyone was scared. When people are scared a paper IOU is not enough.
Three thousand year old traditions of hoarding stores of wealth that are physical, portable and easily devisable are hard to break.
The key is that during times of crisis and fear Gold rises and individual governments can't stop it. During more peaceful times governments are able to maintain control and keep a lid on the price of Gold. This causes Gold to move up in a sort of "stair step" fashion.
When I say "Crisis Hedge" I mean wars, and longer term fear of governments etc. In 2008, we had a "Liquidity Crisis" and Gold did not fare as well. The main reason is that everyone was trying to increase their liquidity at the same time and so were forced to sell their quality assets in order to cover the losses in their junk. Unfortunately, this dragged down the price of quality assets along with the junk.
With Inputs from Inflationdata.com
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