History of gold with relation to currencies and its outlook by Mike Estrey.
Much has been written about the current bull market in gold and how it compares to previous moves, in particular during the 1970s when the metal soared to at the time unimaginable heights.
On this basis it is worth looking at the background to the value story on gold, and this may shed some light on why its bull market may have significantly further to go for CFD traders in coming years.
The gold standard
The UK, which at the time was the worldâ€™s dominant economic powerhouse, adopted a gold standard in the early 19th century. Other currencies then looked to have gold backing, and towards the end of the century, various European countries joined the standard, though some chose for a time use a joint gold and silver standard.
The emerging strength of the US saw it adopt the standard in 1879, by making "greenbacks" that had been issued during the Civil War period convertible into gold, and the gold standard was formalised by legislation in 1900. On the outbreak of World War One, it was accepted by the whole of the developed world. This called for fixed exchange rates, with parities set for participating currencies in terms of gold, and it provided that any paper currency could on demand be exchanged for gold by its central bank
The system worked well having been designed to make each country adjust in terms of external deficits or surpluses in transactions between countries. Any deficit country would then have to surrender gold to cover its deficit, with the result that the volume of its money would be reduced, leading to lower prices, while the influx of that gold into the surplus economy would expand the volume of that countryâ€™s money and lead to higher prices.
This meant that there were effective pegs in the foreign exchange market, so that exchange rates would fluctuate only within very narrow limits determined by the costs of shipping and insuring gold.
US and UK comparisons in terms of gold
Up until 1914, the parity between the U.S. dollar and sterling was approximately $4.87, based on a U.S. official gold price of $20.67 per ounce and a U.K. official gold price of Â£ 4.24 per ounce, and the exchange rate would not fluctuate beyond about three cents above and below the mint parity, which represented the cost of shipping and insuring gold, since otherwise there would be arbitrage potential.
Although there were some gold transfers under the system, it was easier to adjust monetary policy to attract currencies, which might offset the financial impact of any import excess. Higher interest rates would usually have a deflationary effect in the deficit country as well.
Under this system, participating countries needed to give an absolute priority to external adjustment over domestic objectives, so if there was a conflict between domestic and external objectives, policy tools might not be available to be used for domestic problems of recession, unemployment, or inflation. This reflected the prevailing economic philosophy that economies would tend naturally toward reasonably high levels of employment and reasonable price stability without such government policy actions.
The effect of the First World War
The four great economic powers, the US, UK, Germany, and France saw unchanged currency values up until the war. There were few barriers to gold shipments or capital controls in the major countries, and capital flows appeared to play a stabilising role.
After the outbreak of the First World War, each country needed to raise cash for the war effort, and at this stage they began to issue more and more bonds, some of which still exist today. These were domestically issued at the time and not backed by gold, but the promise to repay came from the central bank and was seen as rock solid. This was the beginning of what is known as fiat monetary policy, and which is widespread today.
The result of this was that as more and more paper was not backed by the common value of gold, floating exchange rates began. The US, which entered the war later than the others, had maintained gold convertibility, and soon the dollar floated against the other currencies, which were no longer convertible into dollars.
Dollar strength and weakness
Once the war ended there were significant economic problems in Europe, and exchange rates began to change rapidly, with many major currencies devaluing against the dollar.
This helped cement the US dominance of world trade, as the dollar had greatly improved its competitive strength over European currencies during the war.
In a reverse of what is happening today, within much of Europe and certainly in the UK there was a widespread desire to return to the stability of the gold standard, and growing concern over the attractiveness of the dollar, which was still convertible into gold, and of dollar-denominated assets. The pound thus went back on the gold standard, but this coincided with the Wall Street Crash and the beginning of the great depression, which highlighted the weaknesses in existing economic policy.
Following a disastrous five years back on the gold standard, the UK abandoned it in 1931, and others followed over the next few years. There were also problems in the US, and in 1933, President Franklin Roosevelt imposed a ban on US citizens buying, selling, or owning gold in order to kickstart the depressed economy. This was the birth of Keynesian policies which shaped much of economic policy in coming decades.
At the same rime, the Federal Reserve continued to sell gold to foreign central banks and government institutions, but the ban prevented hoarders from profiting after Congress devalued the dollar against gold in 1934.
This action raised the official price of gold by more than 65% to $35 per ounce. Only gold coins and certificates considered collectorsâ€™ items were exempt from this prohibition, and artistic and industrial users were allowed to deal in gold under a special Treasury license. Once the price rose, there was a mining boom, which saw major growth in gold output.
The license to print money had been conveniently forgotten, despite the widely remembered problems in Germanyâ€™s Weimar republic in the 1920s, and just fifty years later, in 1971, President Nixon ended US dollar convertibility to gold. On the 31st December of that year, gold stood at $43.8 per ounce.
This finally ended the central role of gold in world currency systems and it then began a spectacular bull market as inflation raged and the value of paper currencies fell. Gold enjoyed a nine year bull market, with the price hitting a record of $850 per ounce against a background of an international crisis arising from the Soviet invasion of Afghanistan and the Islamic Revolution in Iran. If this was rebased to today, the all time high would be equivalent to $2,100 per ounce.
Why gold could go a lot, lot higher
Goldâ€™s current bull market has lasted six years, during which it has risen around 200%. In the 1970s, gold peaked with a 2000% rise in just nine years, so this gives some food for thought.
Admittedly inflation at present is not the problem it was at the beginning of that decade, but donâ€™t bet against major changes in the value of gold against paper currencies in the years to come. For long and short term CFD traders this creates a major opportunity to profit from a potential further major revaluation.
About the Author:
Mike Estrey is the Head of Research for Blue Index, specialists CFD Brokers, providing seminars on how to trade CFDs and offering a Live Trading Simulator.
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