When the major currencies abandoned the gold standard (that is, when the paper currencies of these countries were no longer redeemable or convertible into gold), a disconnect occurred. To this day, some economists believe that severing the link between precious metals and fiat currency is regrettable, as it affords a far more capricious approach to monetary expansion (and therefore the possibility of inflation) than before. Increasing the money supply by 10% under a gold standard could only happen if the supply of precious metal was comparably increased. This requirement imposed a discipline on governments and politicians which, under most modern forms of monetary creation and expansion, is unthinkable (or at least unnecessary).

Some economists have even gone so far as to suggest that for every X units of currency printed and spent by the government, there should be placed on deposit Y bricks. This does not refer to a brick or ingot of gold or silver, but to an ordinary masonry brick. Even though it may sound like a rather odd idea, the presumption is that at least there would be some restraint imposed on the monetary authorities.

Gold continues to be a global investment vehicle—for both individuals and countries. Robert Mundell tells us that gold is second only to the U.S. Dollar as a reserve asset of the world’s central banks and monetary authorities.

Why would an investor want to hold gold? Gold has been identified as playing the dual role as a harbinger of inflation and as a possible hedge against such a general rise in the price level. After all, when we see the price of gold rise from USD 400 to USD 450, our natural thought may be that the shiny yellow metal has gone up in price or strengthened, but it can alternatively be said that the U.S. Dollar has weakened or gone down. Anyone with assets fixed in U.S. Dollar terms will lose purchasing power as the aggregate level of prices rises, but people invested in gold (whose price would presumably move with that of all the other goods and services) could preserve the relative level of their wealth.

Also, since gold is not highly correlated with other asset classes, it has been identified as an attractive diversification component for one’s portfolio.

Whether it is rational or not, gold continues to dazzle and draw investors.

In an earlier chapter, we documented some FX crises; there is no dearth of disasters in the world of metals. In a recent article by Rose-Smith and Barber,³ two of the top five trading blowups of all time (out of an eclectically chosen 30) were metals-related (though one was copper-based, and therefore could be exempted as a commodity crisis).

The other involved the attempt (and in large part, success) by the Hunt brothers (Bunker and Herbert) to corner the silver market throughout the 1970s. At one point, the Hunts were said to own half of the world’s deliverable supply. Changes in margin requirements by the Chicago Board of Trade (CBOT) and the Commodity Exchange (COMEX) in New York, reduced maximum contract position size on the exchanges, and the explicit support of regulators eventually helped “burst the bubble.” Nevertheless, gold and silver continue to have a staunch following.

How important gold will be in the future, from an economic perspective, will depend on demand and supply. Gold maintains interest as an investment; gold apparently continues to matter to central banks; and gold has real uses in electronics products, jewelry, dental work, and so on. On the financial front, interest in gold and the other precious metals (silver, platinum, palladium) may depend on the expectation of inflation, the belief that gold and its cousins will protect one’s wealth from those seemingly ever increasing prices (and even those fickle paper securities), the deterioration of the Dollar, and the degree of risk-aversion in the economy. Back to faith!

In order to understand the appeal for gold and other precious metals, we don’t have to make reference to Fred C. Dobbs (Humphrey Bogart’s character in the movie The Treasure of the Sierra Madre), gold fever, or alternative behavioral-finance explanations. One web site that currently advocates investing in hard gold states:⁴

These marketing statements contain the most commonly articulated defense for gold as an investment: that, unlike traditional securities denominated in traditional currency units, gold will preserve your purchasing power and serve as a hedge against inflation.

Although many people have gotten used to continuously rising prices, we might ask the questions, “How bad is inflation, really?” and “Is inflation really that devastating?” Let me quote three authorities on inflation. Robert Mundell, one of the foremost authorities on the relationship between gold and the global monetary system, has written,

Alan Greenspan has said,

Milton and Rose Friedman have a succinct answer to the two questions posed above:

Will gold continue to matter as we move to a world of plastic and electronic money? It remains to be seen. To the extent that there is more gold in the basement of the New York Fed than anywhere else, to the extent that the ECB holds gold reserves against the Euro (even if those reserves are not actively managed), to the extent that the European Central Bank Gold Agreement was renewed in 2004 (for five more years), and to the extent that central banks still consider gold a “currency” of its own, the precious metals aren’t going to go away overnight and will likely not lose their luster for some time to come, but the longer-term prospects are less clear. When was the last time you came across some wampum? While there is certainly no apparent or impending (financial, economic, or political) need for a return to a commodity money at this time, gold will, no doubt, continue to have its proponents:

One way or the other, it will be fun to watch!