Coins DIG

One of the factors said to be driving these price rises is the view that gold is an inflation hedge. The US and some other governments are issuing very large amounts of debt, and the fear is that these debts will eventually be monetised, with rising inflation the result.

Gold's status as an inflation hedge dates from the time when gold coins formed the basis of many countries' monetary systems. King Croesus of Lydia was the first to mint gold coins more than 2500 years ago. Subsequently many a country's ruler used the trick of debasing the value of gold coins by adding other metals to their content. If the purity of gold in coins was diluted in this way then inflation would occur - more coins would be required to buy goods. But pure gold would retain its value, and hence pure gold was an inflation hedge.

Under the more recent classical gold standard period, from the late 19th century until the Great Depression, gold coins did not circulate but notes on issue were backed by gold held in the banking system.

In Australia and Britain each additional pound note in circulation had to be backed by 0.236 ounces of gold, and so the number of notes on issue, and hence inflation, rose and fell with international discoveries of gold. Under this system inflation occurred because gold was more plentiful and so the real value of gold fell when inflation rose. Rather than being a hedge, gold did poorly in real terms when inflation occurred.

After World War II the monetary system continued to be based on a modified gold standard. Under the ''Bretton Woods'' system, the US was supposed to maintain a gold price of $US35 an ounce, and the US Federal Reserve limited note issue consistent with this price. This system broke down during the Vietnam War, as excessive note issue by the US to finance the war made it obvious that the price of $US35 an ounce was not sustainable.

Gold was a very good inflation hedge during the 1970s. The US dollar price rose from $35 an ounce in 1971 to $850 an ounce in January 1980. In the US the price of goods and services doubled during this period, so investing in gold in the early 1970s was a spectacularly good investment. But the performance of gold since 1980 has shown clearly that gold is a pretty poor long-run hedge against inflation. Since 1980 goods prices have almost tripled in the US, and yet gold prices have only increased 20 per cent, even with the recent run-up in gold prices.

The problem for gold is that now that it does not form the basis of the global monetary system, the uses to which it can be put are quite limited when compared with many other commodities.

Between 2003 and 2007 almost 70 per cent of gold demand was related to jewellery production, while only 13 per cent of demand was for industrial purposes. It might be expected that demand for jewellery will grow as emerging economies become richer - in India, in particular, demand for gold jewellery is very strong. But one should expect that other commodities that are more useful in industry should see their prices grow more quickly, as has been the case in recent years.

As with many other commodities, the price of gold tends to be quite volatile, and it would be foolish to rule out further rises in gold prices. But the view that gold is a good inflation hedge is not supported by the facts.

Source: watoday.com.au