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  1. rembrandt

    5,813 posts.
    Hmmm... BRW Daily...


    Gold fingered
    By David James
    Tuesday, January 28, 2003

    With the world economy facing either disinflation or outright deflation, the gold price would normally be expected to fall. But it is rising, and at $US347 an ounce it is 20% higher than a year ago. Some market observers expect the price to increase sharply in response to fears of deflation. Yet deflation might suggest a lower price. What is the reason for the apparent anomaly?

    And why are the central banks, particularly the US Federal Reserve, which has 58% of the world's gold reserves, not selling? Perhaps central banks think the price has further to rise, or that its growing status as a de facto currency is a reason to hold.

    The chairman of the US Federal Reserve Board, Alan Greenspan, describes gold as almost entirely a monetary demand phenomenon, a "store of value measure" that functions as a harbinger of inflation. Because the metal is not subject in a conventional way to supply and demand - it is mostly not "consumed", almost all the gold that has been produced still exists - it functions as a sign of what money is to be worth.

    That gold does not always behave as expected is not surprising. It is, after all, the most mysterious substance in financial markets. Peter Bernstein comments in his book The Power of Gold that the metal is a "mass of contradictions. People believe that gold is a refuge until it is taken seriously; then it becomes a curse."

    Most analysis of the gold price attempts to look at the pattern of supply and demand (especially central bank sales) and to cross-reference it with trading strategies (especially hedging strategies). During times of economic and financial stability, this represents a sound approach, if not necessarily an accurate one.

    The situation facing the world economy is anything but stable, however. Not only is there the prospect of war in the Middle East, massive financial and commercial imbalances are developing in the global economy. Japan continues to contract and deflate, the US economy is struggling to stave off deflation, Europe is facing more low growth, and Asia is having difficulty coping with the rising commercial might of China, the world's only positive growth story. Latin America is reeling from the effects of the Argentinian debt crisis, and Brazil is suffering from a weakening currency and the threat of a financial crisis.

    In such environments, the emphasis of investors tends to shift to wealth protection. Gold may be one of the assets least likely to fall. For once, it may live up to its reputation as a haven.

    Consider the possibilities. Real yields in the US are negative, putting downward pressure on the greenback and US assets. Japanese assets are only likely to fall further, unless the Japanese authorities start to do something serious about the country's ailing banking system. The euro may strengthen, but Europe's prospects of low growth hardly suggest a cornucopia of possibilities. China appears to be an attractive destination for investors, but getting profits out of the country remains problematic. Hard, liquid assets such as gold suddenly start to appear attractive.

    The potential buying pressure certainly exists. The foreign exchange reserves of the main Asian countries are more than $US1 trillion. Should they diversify into gold and move away from holding US dollars, it could easily push the price above $US400.

    There is also potential for a shift away from equities and towards gold. David Hale, chief global economist for Zurich Financial Services, comments that in 1980 the world's global stock of gold was worth more than the world's stockmarket capitalisation. Now, capitalisation is $US40 trillion, 20 times the value of the world's gold. Even a small shift away from paper shares to physical gold could profoundly influence the gold price.

    Gold may also be a way of positioning in the medium term for reflation. If Greenspan is right and gold tends to move up with inflation (although it does not appear to fall in advance of deflation), then when the US begins to address deflation, holding gold should be a wise strategy. It is even being speculated that central banks are talking about deflation in an attempt to encourage a gold price rise, which might, paradoxically, reduce the chance of the market bringing about deflation by panicking.

    Gold is a fascinating combination of old and new. It has been a premier precious metal for more than 3000 years, dating back to the ancient Egyptians. Yet the price of gold is marvellously post-modern: a pure sign, devoid of the realities of physical supply and demand.

    The behavior of the gold market reflects these tensions. The recent price rise reflects an almost primitive resort to "real" money at a time when the US economy, the world's growth engine, is sputtering and there is a possibility the US Federal Reserve could print money to get out of the problem. Such measures would imperil the global financial system; certainly many investors would lose out.

    But at the same time, the gold price is a dance conducted by central banks and investors; a complex interplay of "reality" and "perception", the virtual and the actual. And, of course, gold is a magnet for fear and greed. As the philosopher John Stuart Mill commented: "Gold, thou mayest safely touch; but if it stick unto thy hands then it woundeth to the quick."

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