The appeal of gold as an investment has been revived by the current economic climate of expanding fiat (government-backed) currencies and low or negative interest rates. This white paper examines the relationship between gold and the U.S. dollar throughout history, offers a modern context for the metal’s recent resurgence, and plots a course for the future of the metal.
A BRIEF HISTORY OF GOLD IN THE U.S. MONETARY SYSTEM
For more than a century, gold has provided a universal source of comfort to the world’s economy, especially during times of global monetary shock. We need to think about how gold has historically interacted with the dollar in order to comprehend its relevance now.
The American monetary system had a real gold standard during the middle of the nineteenth century, which meant that the value of paper money was closely correlated with the price of gold. By using this standard, the value of a nation’s currency is established using a fixed price for gold. (For instance, the value of a dollar would be equal to 1/500th of an ounce of gold if the U.S. fixed the price of gold at $500 per ounce.) This approach limits the expansion of U.S.-denominated notes to increases in the value of gold stocks.
HISTORICAL IMPACTS ON THE GOLD STANDARD
History has demonstrated that rigorous adherence to a gold standard is challenging to sustain during periods of inflation. The notion that dollar growth could be restricted to the increase of gold became impractical due to the occurrence of national and international events (such as wars and economic crises).
U.S. Civil War
The relationship between gold and “greenbacks” (as the dollar was then known) was briefly halted during the American Civil War because the growth and supply of gold were outpaced by the rise of U.S.-denominated notes brought on by war-related costs. After the Specie Payment Resumption Act of 1875, which caused what is now known as the “Great Depression of the 1870s,” the link was subsequently reestablished.
The gold premium to greenbacks ratio decreased to par once specie resumption was established in 1879, with the valued greenback boosting trust in the gold-backed dollar (Rothbard 2005, 160). The gold standard was in place from 1879 to 1914, during which time the majority of industrialised nations—including the United States—had a close relationship with gold.
World War I
This monetary system was once more in risk during World War I, the first significant conflict to take place following the restoration of the gold standard. Most European nations abandoned the gold standard at the start of the war because their inflation rates were substantially greater than those in the United States. In fact, the U.S. dollar was the only significant currency that continued to be convertible to gold during World War I. The United States emerged from the war as the most powerful nation at the time, both militarily and economically.
Many European nations attempted to restore the gold standard to its pre-World Conflict I levels after the war, but it was difficult and expensive to sustain. The majority of the major European nations had once more abandoned the gold standard by 1931.
The Great Depression
Bank failures during the American Great Depression terrified the populace into stockpiling gold. President Franklin D. Roosevelt utilised gold in 1933 because he knew that increasing a nation’s money supply is one of the best methods to stave off an economic crisis. Roosevelt understood that the Federal Reserve’s ability to inflate the money supply in the United States would expand if the amount of gold it kept could be raised.
Roosevelt imposed a countrywide bank embargo and prohibited banks from paying out or exporting gold in order to stop a run on American banks. He instructed people to turn in any gold coins, gold bullion, and gold certificates with a value of more than $100 to the Federal Reserve in exchange for other currency by Executive Order 6102, commonly known as the Gold Confiscation Act. He determined the price of gold to be $20.67 for each ounce. Gold coins worth $300 million and gold certificates worth $470 million were returned in 10 days.
The government increased the price of gold to $35 per ounce in 1934, which resulted in a 69 percent increase in the quantity of gold held on the Federal Reserve’s balance sheets and enabled the central bank to further expand the nation’s money supply. Executive Order 6102 was in force until 1974, when President Gerald Ford overturned the ban on owning gold and reinstated the sale and purchase of the metal by American residents.
World War II
Near the close of World War II, in 1944, world leaders gathered to consider creating a more stable international monetary system to break the deflation to inflation to hyperinflation cycle that had afflicted most of the world for the preceding 75 years. The Bretton Woods agreement required members to convert their official gold holdings abroad at predetermined par levels. However, many nations simply tied their currencies to the dollar, making the dollar the de facto currency because the majority of the world’s gold was kept in the United States.
Up until 1971, when US President Richard M. Nixon formally ended the dollar’s association with gold, Bretton Woods continued to function. As a result, the majority of other nations’ currencies were permitted to float in relation to the dollar, a situation that still exists today. Since that time, gold’s function in the global monetary system has vanished.
WHERE GOLD STANDS TODAY
Even though gold’s function as a monetary anchor was abolished in 1971, the metal has held its value as the dollar has fallen in value against other currencies. As a result, gold’s appeal tends to increase when the U.S. dollar is under pressure. Real interest rates in many industrialised nations, including the United States, are negative when adjusted for inflation, according to contemporary economics. It has been challenging to comprehend negative real interest rates, as well as negative nominal interest rates in some nations, which has fueled investors’ interest in buying and storing gold.
The price of gold has increased whenever the U.S. dollar has appreciated in relation to a basket of currencies, which is a collection of several currencies used to determine the market worth of another currency. Gold often loses value when the currency gets stronger. Therefore, gold may not be the most alluring asset class for long-term investment (see Chart 1, above).
REASONS FOR DECLINE IN THE U.S. DOLLAR
The amount of debt held by the United States has been increasing over the past fifty years. The use of harsh fiscal and monetary measures by the US government and other fiscal authorities to mitigate the detrimental economic effects of COVID-19 may have lately made this track unsustainable. The U.S. dollar’s present weakness against a basket of industrial country currencies is highlighted by the fact that the U.S. government has implemented the greatest fiscal reaction as a percentage of all major countries’ Gross Domestic Product (GDP).
As seen in Chart 2 below, the U.S. budgetary response to the epidemic has reached 12.3% (and is still increasing) of GDP to date, greatly above the 8% of GDP seen during the Great Financial Crisis of 2008–2009. This stimulus, which was funded with borrowed funds, basically increased the amount of money in circulation in the United States without causing an adequate rise in production.
Monetary policy is another factor contributing to the recent depreciation of the US currency. The Federal Reserve has the largest balance sheet in the industrialised world, which is approaching $7 trillion. The Fed’s balance sheet almost quadrupled in the two months leading up to May 2020 despite the COVID-19 epidemic as it continued the quantitative easing programme that was initiated after the Great Financial Crisis of 2008.
Investor demand drove the price of gold from $700 to $1,800 per troy ounce between 2009 and 2012 as the Fed added $4 trillion to its balance sheet. The United States is currently on course to surpass that amount in two-thirds less time. The link between the price of gold and the Fed’s balance sheet during the 2008 Great Financial Crisis and the ongoing COVID-19 epidemic is seen in Chart 3 below. A comparison between the current coronavirus outbreak and the Great Financial Crisis in 2008 is seen in Chart 4, which is also included below.
GOLD AND NEGATIVE REAL INTEREST RATES
Owners of gold have historically forfeited the money they could have received on time deposits since gold does not generate interest. However, this trade-off is less of a concern now that interest rates are at historic lows.
More investors are choosing to hold a zero-yielding gold bar over a zero-yielding dollar note despite the price volatility of gold. Additionally, real interest rates are really negative after accounting for inflation (see Chart 5, below).
WHERE WILL GOLD GO FROM HERE?
We’ve included both short- and long-term outlooks to help investors understand what the future of gold may entail.
NEAR-TO-INTERMEDIATE TERM OUTLOOK
The forecast for gold in the short-to-intermediate term is favourable. Current socio-political and economic conditions, which are expected to remain as the globe fights with the COVID-19 epidemic and central banks experiment with unconventional monetary measures, are indicative of a weakening US currency and extremely low interest rates today.
Negative real interest rates and oversized central bank balance sheets’ future is questionable in the meantime. Unwinding many of these programmes will be difficult once the economy returns to normal after the outbreak. Inflation risk is also a problem due to the system having trillions more in cash than it had prior to COVID. Despite the fact that gold serves no value as a medium of exchange, the logistical and political challenges that prevent gold’s abandonment seem insurmountable (Bernstein 2008, 213).
LONG-TERM OUTLOOK
50 years will have elapsed since President Nixon ended the use of the gold standard in 2021. This celebration may seem little in comparison to the U.S. dollar’s 100-year association with gold following the Industrial Revolution. But since then, contemporary technology has evolved quickly. Innovations in the banking and financial sectors like electronic payments and cryptocurrencies show that the digital revolution is extending beyond conventional limits. Gold will continue to compete with both new and established currencies like Bitcoin, the Euro, or the Chinese yuan, even if the global monetary system changes to build a new paradigm that does not use the U.S. dollar as its fundamental component.
Although gold’s long-term prospects are bleak, it will always be regarded as a sentimental relic. As a result, there will be times when gold’s value is raised emotionally. We are currently living in one of such periods. Investors can be tempted to take advantage of these emotional states by boosting their gold holdings. These stages, nevertheless, are just temporary and will end.
Conclusion
In the past, gold has mostly been utilised as an alternate payment method rather than as a type of investment. Gold has an endless shelf life and cannot be eaten, in contrast to conventional commodities like grain or oil. In addition, gold doesn’t yield anything, in contrast to assets with linked cash flows like stocks, bonds, or real estate. Because it takes money to store gold safely, its yield is negative. As a result, gold cannot be appraised using standards used for other assets.
However, the negative carry of gold disappears in a severe economic climate where depositors are receiving little or no interest, making this commodity appealing to investors. Despite this, gold is still not a secure investment when looking at market volatility. It is actually just as dangerous as investing in stocks. The returns on gold haven’t even come close to matching stock returns. Any assertions that gold is the “ultimate safe asset” are unfounded.
Although holding gold could occasionally be useful, it isn’t advised as a long-term financial plan. Permanent investments must always be supported by solid foundations and the prospect of future profitability. Investors should consider whether gold should be used as a permanent long-term fixture in a portfolio, even while it may be an alluring tactical investment used to boost portfolio returns on a short-to-intermediate term basis.
Ali
