COMMENTARY — An historic juncture for gold

Twenty-three years ago, on New Year’s Eve, 1974, it finally became legal for Americans to buy gold.

Ironically, just a few days earlier, on Christmas Day, all three gifts presented by the Magi to the newly born Jesus Christ had been illegal in the United States. Frankincense and myrrh were controlled substances. As for gold, it was still money, and Americans were barred from exchanging their dollars for it. But on New Year’s Eve, 1974, the transition of gold to a free market commodity was complete.

The American government’s profligate expansion of money supply during the 1960s had made it possible to keep the price of gold at a constant US$35 per oz. The collapse of the Bretton Woods Agreement ensured that gold, already demonized as the “barbarous relic,” was also de-monetized, a process similar to the way in which Ernest Hemingway once described going bankrupt: “Slowly, then all at once.”

Today, the market fears that the “all-at-once” point of the process has been reached. Both public and private sector gold suppliers find themselves at an historic juncture, and both camps should be making some concrete plans.

Miners need to face the prospect that they may have to live with low gold prices for some time to come. At the same time, those companies are still expected to create shareholder value. For their part, central bankers had better start thinking more carefully about the intertwining relationship gold has with national economies and financial markets.

Some history about the last time gold was this cheap will outline those considerations which are currently neglected.

In the financial markets, it is widely believed that gold is obsolete. Some still say that gold is the watchdog of monetary policy, but that the dog isn’t barking. Westerners seldom realize, however, that a billion people throughout Asia and the Middle East still keep much of their personal savings in the form of gold. Ironically, at a time when Asians need gold and other alternatives to local currencies, the International Monetary Fund (IMF) and its member nations may seek to sell more gold to raise the capital they fear may be needed to meet this new crisis.

Central banks, which control a vast supply of gold and, therefore, the financial security of a substantial portion of the world’s population, must coordinate their gold policies just as they are doing with policies that affect world financial markets. With most of Asia experiencing wide-scale economic transition, uncoordinated central bank gold sales (or, worse, a coordinated but poorly thought-out policy) could exacerbate the problems the region currently faces.

For decades, the gold market has needed both new mine supply and a dishoarding of central bank gold to satisfy market demand. Miners and fund managers have come to rely on the low financing costs associated with central bank gold loans. With more than 10 years of market demand in their vaults, official institutions could flood the market, leaving the private sector to implode in the short run, while setting a springboard for much higher future prices. Too large a flow from the vaults will put an end to future industry expansion, leaving the private sector less capable to meet demand a few years down the road.

Twenty years ago, the last time gold was this cheap, the United States and the IMF were steadily auctioning gold into the marketplace. These auctions kept the price of gold down for years. However, gold was then snapped up by investors and financial institutions, which reasoned that if the United States would no longer back its own dollar with gold, maybe private dollar-holders should back their own pile of cash with the yellow metal.

These people did not buy gold because they thought it would likely do well; rather, they bought gold because they were afraid it might do well.

There was such a demand for gold at that time that the IMF and United States eventually ceased such auctions. In a confluence of events largely forgotten today, the flood of official gold, and its subsequent cessation, proved to be the springboard that catapulted gold to US$800 per oz. in January 1980 from US$275 per oz. in mid-1979.

— The author is a senior economist at the accounting firm of Price Waterhouse.