Gold in World Economy - d

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Amity International Business School Management Of Forex Transactions

GOLD IN WORLD ECONOMY

A short history on gold production

Gold was one of the first metals humans excavated. This was party because gold was

found in pure form in the nature, it was easily workable by artisans and gold had aestheticvalue. History of gold began in Egypt and Nubia some 5000 years ago. These regionshave been the biggest gold producers throughout most of the history. In 1500 BC, gold became the recognized standard medium of exchange for international trade in theMiddle-East and made Egypt a wealthy nation. About 400 years later, 1091 BC, littleleaflets of gold became legalized money in China. It took another 450 years until Lydiaminted their own gold coins and in 58 AD, the Romans followed suit. By the timeEngland chose a monetary system which was based in gold and silver in 1377 AD, goldhad taken its place amongst silver as a medium of exchange. When Egypt and the RomanEmpire were in their full glory, gold was produced in the region of 1 tonne annually. Theproduction of gold fell back under less than a tonne annually in the Dark- and Middle

Ages (500 - 1400 AD). In 15th century, when the gold coast of Africa produced about 5to 8 tonnes annually, gold production grew notably. The discovery of America openednew possibilities for gold producers and Brazil started to produce gold in the early 18thcentury. The second era of gold production started in 1848 with the discovery of SuttersMill gold on the American River. This started the gold rush and output from Californiasoared, reaching 77 tonnes in 1851. Gold findings in Australia the same year raised worldproduction to 280 tonnes in 1852. In 1898 South Africa took the lead in gold productionand since produced about 40% of all the gold ever produced. (World Gold Council, 2006)

Gold standard

Gold standard is a monetary system where the standard economic unit of count is aweight of gold. It is ideally fixed and not subject to change. The amount of paper moneyissued is also either tightly or loosely tied to the central bank gold reserve. Under goldstandard, currency is in either coins struck in gold or paper money which the issuer isguaranteed to redeem in gold for and amount ideally fixed in advance. Gold standard canbe either internal or international. In internal gold standard, the holders of paper moneycan redeem it for gold and in international gold standard, only certain entities, forexample central banks, can demand the exchange. All the countries in gold standard havefixed exchange rates with each other. Amongst other things, it is one of the advantages ofgold standard. For example, countries can not press more money than they have gold intheir reserves and this prevents inflation and gives more creditability to the monetary

policy. England was the first nation to adapt full gold standard in 1844 and Bank ofEngland notes, fully backed by gold, were the legal standard at that time. It took almost30 years before the next nation, Germany, chose gold standard as their monetary system,in 1871. Germany funded their gold standard with gold shipped from South-Africa. Soonafter this, the rest of the Europe, including Finland, adapted gold standard. By the year1890, most of the word was in gold standard.The period from 1880 to 1913 is often called the "classical gold standard." It featured acore of nations, led by the Bank of England. Fixed gold price and continuous

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convertibility were sustained by the core nations and central banks were obliged, intheory, to adjust interest rates to maintain fixed exchange rate between the domesticcurrency and gold. However, the gold standard was not perfectly fixed. Central banks hadvarying degrees of competition and cooperation. There were loosely tied monetary unionsand tightly tied monetary unions where the currencies were tightly interlocked. The main

gold standard of Europe was maintained by the Bank of England. The Bank of Englandadjusted interest rates to maintain the price relationship of the pound to other majorcurrencies. During the peak period of the gold standard, composed of 360 months, theBank of England bank rate was adjusted over 200 times. Amongst others, Russia and theUnited States allowed significant internal deviations from gold standard. The US issuedsilver backed currency and Russia printed paper money and minted coins. The papermoney in Russia was selling at 60% to 75% of specie.

As gold standard was becoming more widely used, its network effects grew. Countriesoutside the gold standard had a hard time getting credit and exporting their goods and thisattracted more countries to use gold backed currencies. Also, one of the main benefits of

gold standard was the reduction in inflation volatility. This helped companies in planningtheir investments and other expenses and made the gold standard more popular. With theoutbreak of World War I, the United Kingdom had to make series of decisions which ledto its leaving from gold standard in 1914. This happened, because the war effort wasbeing funded by printing more money that could be backed by gold and this led toinflation. After the war, the Great Britain and the US tried to go back to the goldstandard, eventually resulting in giving up in 1931 by the Great Britain and in 1933 bythe US. However, international institutions were able to trade US dollar to gold until1974. This convertibility gave creditability to the US dollar during the Bretton Woodssystem. To prevent speculation, the citizens of the United States were prohibited to owngold during Bretton Woods system. This restriction was removed in 1974. Gold standard

has had many supporters after its fall, the former US Federal Reserve Chairman AlanGreenspan amongst the most famous. However, the common opinion at the moment isthat gold standard is not a viable alternative for the current system. The reasons why goldstandard was so successful for so long are the Great Britains leading role in the 1900century and its role in forcing the rules upon other members of gold standard. This led toa universal acceptance of the gold standard. And while the gold standard itself did notgive enough flexibility to monetary policy to avoid shocks, wages and prices wereflexible enough. (Bordo,1993)

The gold exchange standard

Towards the end of the 19th century some of the remaining silver standard countriesbegan to peg their silver coin units to the gold standards of the United Kingdom or theUSA. In 1898, British India pegged the silver rupee to the pound sterling at a fixed rate of1s 4d, while in 1906, the Straits Settlements adopted a gold exchange standard against thepound sterling with the silver Straits dollar being fixed at 2s 4d.Meanwhile at the turn of the century, the Philippines pegged the silver Peso/dollar to theUS dollar at 50 cents. A similar pegging at 50 cents occurred at around the same time

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with the silver Peso of Mexico and the silver Yen of Japan. When Siam adopted a goldexchange standard in 1908, this left only China and Hong Kong on the silver standard.

The gold bullion standard

The gold specie standard ended in the United Kingdom and the rest of the British Empireat the outbreak of World War I. Treasury notes replaced the circulation of the goldsovereigns and gold half sovereigns. However, legally the gold specie standard was notrepealed. The end of the gold standard was successfully effected by appeals to patriotismwhen somebody would request the Bank of England to redeem their paper money forgold specie. It was only in the year 1925 when Britain returned to the gold standard inconjunction with Australia and South Africa, that the gold specie standard was officiallyended.The British act of parliament that introduced the gold bullion standard in 1925simultaneously repealed the gold specie standard. The new gold bullion standard did notenvisage any return to the circulation of gold specie coins. Instead, the law compelled the

authorities to sell gold bullion on demand at a fixed price. This gold bullion standardlasted until 1931. In 1931, the United Kingdom was forced to suspend the gold bullionstandard due to large outflows of gold across the Atlantic Ocean. Australia and NewZealand had already been forced off the gold standard by the same pressures connectedwith the Great Depression, and Canada quickly followed suit with the United Kingdom

Gold trading

After the World War II, gold price was fixed to $35 per ounce. This gave creditability tothe US dollar during the Bretton Woods system. In the late 1960s, dollar suffered fromserious devaluation and inflation expectations and this lead into gold having two prices in

1968. One price was for private trade and the other for trade between central banks. In1971 the pressure was so high that the dollar gold fix was broken at $42.22 per ounce.Figure 1 presents the price of gold from 1971 to 2006. From the figure, one can see howthe oil crisis, floating exchange rates and the silver cornering have affected the price ofgold in late 70s and early 80s, right after the link was broken between gold and USdollar. This rapid price rally was followed by a decline of almost 20 years, but in the lasttwo years, this decline has changed to a rapid price rally once more. (Michaud, Michaud& Pulvermacher, 2006)

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The role of central banks

Central bank agreement on gold (CBGA) was signed in 26.9.1999 by the central banks ofEU and Switzerland, excluding Denmark and Greece. The agreement emphasizes theimportance of gold as a reserve asset.

The central banks agreed on limiting the sales of gold and only to follow thru thedeals that were already agreed on. These sales were however not allowed toexceed 400 tonnes a year and 2 000 tonnes in the following 5 years. After fiveyears, the agreement was to be reevaluated.

Countries also agreed to limit their gold leases to the level they have previouslyleased gold and not acquire more gold to their reserves. (European Central Bank,1999)

The USA, IMF and BIS promised to honour the agreement on their part and not to sell orbuy gold while the agreement was valid. After this promise, the agreement covered 85%of all reserve gold. (Cross, 2000) The agreement was renewed in 8.3.2004 and it coversthe following 5 years. The Great Britain did not sing the new agreement, but made astatement that it has no intention of selling or buying gold in the near future. Greece, whodid not sign the first agreement, signed the second one. The second agreement limited thesales of gold to 500 tonnes a year and 2 500 tonnes in the five year period. Gold leaseswould stay in the same limits as in the first agreement. (European Central Bank, 2004)The central banks signalled in the agreement that gold still had an important role in their

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reserve policies, even though their reserves are in a decline. These central banks haveapproximately 35% of their reserves in gold, while the optimal amount has beenrecognised to be around 10% to 12% (Mozhaiskov, 2004). According to DeputyChairman Oleg V. Mozhaiskov from the Bank of Russia, the gold stock is theinternational payment reserve for the whole country, for the state authorities, private

companies and corporations, as well as individual citizens. Like any reserve, it needs tobe conserved, in terms of both actual physical form and its value. To a lesser extent, onehas to be concerned about its liquidity, or more precisely, market price developments.The agreement affected gold price because it was believed that the massive gold reservesof central banks were an unlimited source of lent gold. This led to a price ceiling for goldand also for lent gold. If the price of gold would go up, more gold would make its way tothe market from the reserves and the price would drop back down. (Cross, 2000) Centralbanks hold 18% of all the worlds gold in the end of 2005. Bank of Finland has 49.1tonnes of gold in its reserves and it covers 13.8% of all the Finnish reserves. The UnitedStates has the most gold in their reserves, 8 133.5 tonnes and it covers 78.5% of theirreserves. These statistics are provided by International Monetary Funds International

Financial Statistics database. Figure 2 shows how the central bank gold reserves arespread amongst different regions.

According to The World Gold Council (2006b), central banks hold gold reservesbecause:

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Gold provides economical safety. Currencies are prone to bad decisions made bygovernments and their value change accordingly. Price of gold is unaffected bythese decisions. Fiat money2 could also see some rough devaluation when itsvalue as reserve money would collapse.

Gold provides physical safety. History has shown that many countries frequently

impose exchange controls affecting the free transfer of their currencies or, at theworst, total asset freezes which prevent other countries accessing their cash orsecurities. 2 Fiat money is a government issued note which value is not tied to anyspecie but its value is backed by the creditability of the issuer.

Unexpected changes in the world monetary system could lead to a collapse in thevalue of the reserves. No monetary system can last forever. War, hyperinflation,world wide currency crisis or any other major crisis could lead to full or partialcollapse of the present system. In this case, gold acts as an option for uncertainfuture.

World wide confidence towards gold is big. Public opinion polls show that if acountry has gold in their reserves, their citizens have more trust their money.

Gold offers diversification benefits to central banks portfolios. Income from lending gold has been notable.

Gold acts also as a store of value against inflation.

London gold fix

London has been the commercial centre for gold for the last 400 years. After the SecondWorld War, the Bank of England was determined to resurrect London as the maincommercial centre by making a deal with 7 South African mining companies forimporting gold to London for refining and reselling. N.M. Rothschild was the main dealeron those gold deals and on 12th September 1919, 11:00 AM took place the first gold fixwith 4.94 per ounce ($20.67). N.M. Rothschild & Sons, Mocatta & Goldsmid, SamuelMontagu & Co., Pixley & Abell and Sharps & Wilkins were the founding members ofLondon Gold Market Fixing Ltd. Until 1968, the fix was in Sterlings, but the dollar pricewas more important. After the Second World War, it was crucial to maintain a price of$35 per ounce but in 1968, it was not possible anymore and gold was left to float and thefix was changed to dollars. At the same time, an afternoon fix was introduced to serve thecustomers from New York. (London Gold Market Fixing Ltd, 2006) London gold fix iscarried out twice a day by the 5 members via a dedicated conference call facility. Thechairman is ScottiaMocatta and the members are HSBC, Deutche Bank AG London,Societe Generale Corporate & Investment Banking and Barclays Capita. Before everyfix, the chairman announces a starting price for the members and the members relay this

price to their customers. After this, the customers present themselves as sellers or buyers.Provided there are both seller and buyers, the members are then asked how many barsthey would like to trade. If there are either no sellers or buyers, or the amount of barsdoes not match, a new price is drawn. This procedure is repeated as long as a balance isachieved. Gold fix is achieved when the buyers and sellers are within 25 bars.Transactions made between the parties are principal to- principal transactions and tie bothparties. Gold fix price is also an international benchmark price which is used to valuederivatives. (London Gold Market Fixing Ltd, 2006)

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Investing in physical gold

Gold has been free from value added tax since 1.1.2000 in Finland. The Council of theEuropean Union approved the Directive concerning the VAT of investment grade gold in

1998. The Directive is aimed at promoting the use of gold as an investment in the Unionand to prevent the movement of gold markets out of the EU. Directive is also meant toremove the distortions of competition, caused by different tax treatments amongst themember states. (Finnish Government, 1999) The directive frees investment grade goldfrom VAT in the same way as other financial services are free in the current legislation.Transfers of ownership in physical investment grade gold and securities concerning goldare made free of tax. Also importing gold from the member states or outside of the Unionis free of value added tax. (Finnish Government, 1999)

Article 26b (A) of the Sixth Directive defines investment grade gold as follows;

gold, in the form of a bar or a wafer of weights accepted by the bullion markets,

of a purity equal to or greater than 995 thousandths, whether or not represented bysecurities. Member States may exclude from the scheme small bars or wafers of aweight of 1 g or less;

gold coins which,i. are of a purity equal to or greater than 900 thousandths,ii. are minted after 1800,iii. are or have been legal tender in the country of origin, andiv. are normally sold at a price which does not exceed the open market value of

the gold contained in the coins by more than 80%.

Banks that sell physical gold are called Bullion Banks. Only nine of these bullion banks

are concerned as market making banks. Their businesses include the selling, buying,storing and distribution of gold. The London gold fix has traditionally carried all of thesetasks out. Bullion banks also have an important part in creating credit for all thetransactions, develop the derivative products and bring credit and liquidity to derivativemarkets. Bullion banks also trade in their own account, a matter which has brought a lotof rumours about price manipulation. Bullion banks only trade in quantities over 1 000ounce and are mainly for business-to-business customers. (Cross, 2000) In Finland thereare only two places where one can buy physical gold, TAVEX OY and K.A.Rasmussen.One can also buy gold by a mail order from other countries where the premium is smallerbut the expenses might be larger. There are gold coins and small bars available forcustomers looking to buy only small amounts of gold. These are exempt from VAT.

Investing in physical gold is often viewed as protecting oneself for a bad day or a majorcatastrophe. These investors are often called gold bugs. Investing in physical gold isoften the first and the easiest choice for people interested in investing in gold. Goldaccounts are a way of owning physical gold. There are two kinds of gold accounts; anAllocated account is an account where the owner has certain marked coins or bars storedin the providers vault and the owner pays an insurance and storage for them. Or anUnallocated account, where the owner only has a certain amount of gold in the providersvault and the owner does not pay any storage or insurance fee. The owner of the

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Unallocated account bares the risk of bankruptcy by the service provider. Bullion banksand other financial institutions offer gold accounts to customers. Between owningphysical gold and owning gold funds are gold certificates. These are certificates issued bybanks, for example in Germany and Switzerland, which entitle the holder for a certainamount of gold in the banks vault. Certificates are a way of owning physical gold without

the storage fees, but with a very good liquidity. The holder of the certificate can call the bank at any time to buy more or sell the gold one owns. An Australian certificateprogram called Perth Mint is the only certificate that is backed by the government.

Gold derivatives, funds and stocks

Gold is traded in several stock exchanges around the world. These exchange traded goldor exchange traded funds (GETF) follow the price of gold perfectly, and are 100%backed by gold. Gold Bullion Securities was the first GETF launched in March 2003 inthe Australian Stock exchange. Its price is the same as one tenth of a gold ounce.Exchange traded gold has become more and more popular in the recent times and many

new GETFs have emerged. Exchange traded gold is aimed at investors who are lookingfor the benefits of physical gold with the ease of purchase and resell. However, in thecase of a financial crisis or war, some governments have retained the right to purchase thegold these funds own and therefore lowering the funds value. This makes GETFs have arare limited upside potential in some countries. Also if the fund goes into bankruptcy, theinvestor does not have the same rights as an owner of a gold certificate or a gold accountfor any of the gold the fund possesses and just becomes a normal debtor. By investing inmining stocks, one can enjoy the benefits of gold investments, but only to a certaindegree. If the price of gold goes up, it is quite probable that the stocks of gold miningcompanies go up and vice versa. However, there are more determinants than the price ofgold that determines the stock price of a gold mining company. The volatility of the

stocks is also greater than the volatility of gold. Mining companies also use derivatives toa great extend to cover their exposure to changes in the gold price and at the same timethey lower their beta against the gold price and increase it against other stocks. Chua etal. (1990) examined the correlation between gold stocks and S&P 500 and noticed thatthe correlation has increased notably from 1970s to 1980s. They found that the beta ofTSE gold index was 0.57 in the 70s and 1.12 in the 80s. This draws a conclusion thatgold stocks are not as good diversifications as physical gold. Commodity futures differfrom stocks and physical gold quite much. Commodity futures do not raise capital for thefirms and they do not preserve the value like gold. What they do, is they allow thecompanies to obtain insurance for the value of their future output or input. Investors incommodity futures, e.g. gold futures, receive compensation for bearing the risk of short-

term gold price fluctuations. Commodity futures do not represent direct exposure toactual commodities as futures prices represent bets on the expected future spot price.(Gorton and Rouwenhorst, 2006) Gold derivatives are plentiful and more are invented allthe time. Cross (2000) lists the most common ones.

Forwards

Fixed forward - The most basic forward contract that allows the seller to deliveran agreed volume of gold for an agreed price at a future agreed date.

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Floating gold rate forward - Standard forward contract in which the gold price andinterest rates are pre-agreed and locked-in. The gold lease rate is allowed to floatand is calculated at maturity based on its performance during the life of thecontract.

Floating forward - Forward contract in which the gold price is pre-agreed but the

interest rates and gold lease rates are allowed to float and are calculated atmaturity based on their performance during the life of the contract.

Spot deferred - Forward contract in which the gold price is pre-agreed. Interestrates and gold lease rates are allowed to float. The maturity date is deferrable.

Participating forward - Forward contract with a purchased call option attached.

Advance premium forward - A forward contract in which the contango is partlypayable in advance.

Short-term averaging forward - A forward contract locking in an average, not thespot price.

Options

Put option - A contract that gives the buyer the right but not the obligation to sellgold at a pre-agreed price at an agreed date. There is an obligation on the part ofthe option writer to take delivery of gold at the agreed price on the agreed dateshould the option be exercised.

Call option - A contract that gives the buyer the right but not the obligation to buygold at a pre-agreed price at an agreed date. There is an obligation on the part ofthe option writer to deliver gold at the agreed price on the agreed date should theoption be exercised.

Cap and Collar - An option strategy in which the user buys put options and writescall

options. Up and in barrier option - An option strategy in which the options (either calls or

puts) are triggered and come into being if a pre-agreed price level is broken at anystage of the contract life.

Down and out barrier option - An option strategy (can be either calls or puts) inwhich the options cease to exist if a pre-agreed price level is broken at any stageof the contract life. A rebate is usually payable if the option is knocked-out, theamount depending on the remaining life of the contract.

Convertible forward- This is an option strategy that involves the mining industryin buying a vanilla put option and selling a kick-in call option. A feature of thisstrategy is that the options have the same strike price. A variant of this product is

the purchase of the vanilla put with the writing of a knock-out call at a triggerlevel that is substantially below the option strike price.

Swaps Basic lease rate swap - A basic agreement in which gold is lent at a pre-agreed lease ratefor a pre-agreed period, usually 3 months. At the end of the period the average lease rateis compared to the contract rate and the differential is paid by the party in debit. Thecontract is then usually rolled for a further period.

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Keynes (1930) and Hicks (1939) made a theory about which side receives the riskpremium in a derivative deal. According to them, this premium goes more often to thebuyer than the seller. Their normal backwardation -theory says; that the producershedge their output and the speculators make this possible by buying futures and getting a

premium from this insurance. They get the premium by demanding the future price to belower than the future spot price. In gold futures, this is not the case for most of the time.Gold is almost always in contango where the future spot price is lower than the futureprice. Cross (2000) explains the basic principles of gold futures as follows:

Central banks loan the gold to bullion banks and receive a profit which is called the goldlease rate or GOFO (Gold Forward Offered Rate). GOFO is an interest which the centralbanks loan gold as a swap against US dollar. This makes liquidity to the market andmakes derivative market possible.1. If a producer wants to hedge itself from changes in gold price, buys the bullion bank a

future contract from the producer. To finance this transaction, the bullion bank sells

the same amount of gold which it lent from the central bank. The money the bullionbank receives from the sale it reinvests into the money markets and receives a normalinterest on it. The amount of gold in the market grows as the bullion bank sells itsgold to the market and it can affect the gold price if there is not enough demand.

2. When the futures contract ends, the producer delivers the gold to the bullion bankwhich it has either produced or bought from the market. After this, the bullion bankeither returns the gold to the central bank or keeps the gold and makes another futurecontract.

3. In case of a speculative shot-selling, the case is identical, but the timeframe is longer.4. The above ground stocks of gold are very large and are generally held in a form that

could readily come to market. Further, the willingness on the part of the holders of

this metal to participate in the market implies that the cost of borrowing gold remainsrelatively low compared with money market rates. This is one of the major reasonswhy the gold forward market is nearly always in contango (forward price higher thanspot price, offering a positive interest rate) and only very rarely lapses intobackwardation. This positive carry, available to the producer and speculator, meansthat the market is implicitly biased towards producer hedging and speculator selling.The transaction will be profitable for the miner or speculator unless the gold pricerises at faster rate than the contango.

5. In the last decade, lent gold has increased the amount of gold which is available tothe market and therefore it is believed is has affected the gold price.

In the wake of the new millennia, gold derivatives had a very high weight in bankscommodity baskets. In 2001 it was as high as 45%, but of all derivatives its share wasonly 0.3%. In 2006 it only accounted about 7% of all the commodities and 0.12% of allthe derivatives (Bank for International Settlements, 2006). It is believed that goldderivatives have been one of the reasons why gold price was so low for a long time. Thru1990s, the derivative market was growing at fast pace and central banks lent more goldto the market than the market paid it back. An estimate of 400 tonne gold was cominginto the markets from the central banks and it played its part in keeping the gold price

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down. However, this accelerated supply of gold is not the sole reason for the slump ofgold in the 1990s. (Neuberger, 2001)Also many exotic ways of investing exists in the gold markets. Companies like CantorIndex and IG Index for example, offer a way to bet on a price of almost any investments.This betting is called Spread betting. The betting company offers a quote on a price for a

certain market. For example $632.12 - $634.09 for gold. If the customer thinks that goldprice will rise, he buys gold at $634.09 and bets for example 10$/point on it. If the priceof gold goes down and the investor decides to cut losses and sells it at $615.12 - $617.09,he loses the difference of $632.12-$615.12 = $17 multiplied by the bet $10 which is$170. Spread betting is a high risk betting, but the profits from it are tax free and there areno commissions involved.

Gold as an investment

Hillier, Draper, and Faff (2006) survey the literature on the role of gold and other precious metals in financial markets. They categorize studies into five different

approaches. The first approach studies the investment and diversification properties ofprecious metals when combined with stock market investments in financial portfolios.The second approach concentrates on the role of gold as a potential hedging variable inintertemporal asset-pricing models. The third approach studies the properties of the returndistribution and the possibilities for earning excess returns in the gold and silver markets,i.e. the efficiency of these markets. The fourth approach studies the relationships of gold(and silver) to macroeconomic variables and government policy. The final approachconcentrates on the particular features and characteristics of gold (and silver) productionand market processes. We will look at some of these roles briefly in the following. Byitself, gold is quite a risky asset but its returns are generally independent of those on otherassets. This makes gold a good diversifier for portfolios. Chua et al. (1990) and Jaffe

(1998) examined the benefits of diversifying investment portfolios with gold stocks andgenerally observed a diversifying effect for gold. Chua et al. found, that the beta of goldbullion remained virtually indistinguishable from zero thru 1970s and 1980s and goldwas a meaningful investment for diversification for both long-run and short-run. By usingdata from 1971 to 1987, Jaffe constructed 4 portfolios mirroring allocations of typicallarge institutional portfolios with each being different in risk and return. He found thatadding 5% gold into all of these portfolios reduced the risk and increased the return ofthese portfolios and with 10% gold, the benefits increased even more. With more recentdata, Hillier et al. (2006) examined the diversification benefits of gold in the US marketsand international markets. They used data from period 1976-2004 for S&P 500 andEAFE and found that gold was especially useful diversifier in periods with high volatility

and poor performance. When comparing buy-and-hold strategy against switching strategywith gold they found that the former was superior and over the last 25 years, holding9.5% gold in portfolio was the optimal allocation. Capie et al. (2004) examined oneaspect of the second role of gold, gold as a hedge against US dollar. Using data from1971 to 2002, they applied a variety of statistical techniques to explore the relationshipsbetween gold and the exchange rates of various currencies against the US dollar, withparticular attention paid to the hedging properties of gold in episodes of economic orpolitical turmoil. The US dollar gold price was found to move in opposition to the US

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dollar and the movement was essentially contemporaneous. For each exchange rateconsidered, a typical weekly movement against the dollar generated a movement in thegold price of just under one dollar.Gold is also believed to be an effective hedge against inflation. With data from 1976 to2005, Levin and Wright (2006) found that the US price level and the price of gold moved

together in a statistically significant long-run relationship supporting the view that a onepercent increase in the general US price level leads to a one percent increase in the priceof gold. However, they found that there are short-run deviations from the long-runrelationship between the price of gold caused by short-run changes in the US inflationrate, inflation volatility, credit risk, the US dollar trade-weighted exchange rate and thegold lease rate.

Gold reserve

A gold reserve is the gold held by a central bank or nation intended as a store of valueand as a guarantee to redeem promises to pay depositors, note holders (e.g., paper

money), or trading peers, or to secure a currency. Today, gold reserves are almostexclusively, albeit rarely, used in the settlement of international transactions. At the endof 2004, central banks and investment funds held 19% of all above-ground gold as bankreserve assets. It has been estimated that all the gold mined by the end of 2009 totaled165,000 tonnes. At a price of US$1000/oz., exceeded in 2008 and 2009, one tonne ofgold has a value of approximately US$32.15 million. The total value of all gold evermined would exceed US$5 trillion at that valuation.

Determinants of the Gold Price

Econometric studies indicate that the price of gold is determined by two sets of factors:

"supply" and "macro-economic factors".Supply and the gold price are inversely related.Besides new mining supply, the available supply of gold in the market is made up ofthree major "above-ground sources":(1) reclaimed scrap, or gold reclaimed from jewelry and other industries such aselectronics and dentistry;(2) official, or central-bank, sales;(3) gold loans made to the market from official gold reserves for borrowing and lendingpurposes.In recent years, the growth in gold supply has come from "above-ground" sources. In thecase of "macro-economic factors", the U.S. dollar tends to be inversely related to gold,while inflation and gold tend to move in tandem with each other. Also, high real interest

rates are generally a negative factor for gold. Overall, the impact of the abovedeterminants on the gold price is judged to be neutral-to-slightly-positive at this time.

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IMPACT OF GOLD ON WORLD ECONOMY

There is very little, if any, effect on the economy from the price of gold. If anything, theopposite is usually true: perceptions about the economy can directly affect the price of

gold. The usefulness of gold as an economic indicator is questioned by some, but it is stillwidely recognized as a hedge against the U.S. dollar and as some measure of inflation.Gold is used in most electronic devices such as computers and cell phones, but in suchsmall quantities that fluctuations in the price of gold have very little impact on this sectorof the economy.

Gold and Inflation

Traditionally, the price of gold was seen to reflect monetary inflation, that is, inflation ofthe money supply. Because the fractional reserves banking system under the FederalReserve is inherently inflationary, the total amount of money in circulation tends to

expand, at times rather sharply. If monetary inflation exceeds real growth in products andservices, then the result will be price inflation, which is what is measure by governmentmeasures of inflation such as the Consumer Price Index (CPI) and Producer Price Index(PPI). The balance of supply and demand for gold tends to change relatively little fromyear to year, so, for decades, changes in the price were attributed to inflation. Becauserising inflation often coincides with a booming economy, a rise in the gold price issometimes coincident with a strong economy.

Gold and the Dollar

In a sense, the value of the dollar reflects the health of the US economy. However, in a

floating currency system where the dollar is only priced relative to other floatingcurrencies, it is increasingly difficult to use currency movements as a measure of theeconomy. Still, gold is a very popular hedge for large institutions against devaluation inthe US dollar. As the value of the dollar goes down relative to other major currencies, theprice of gold tends to move higher, though the correlation is not always perfect. Themovements in the dollar, however, can be as much attributable to changes in othernational economies than in the US itself. When the dollar is seen to be on the rise,investors tend to flee from gold, causing the price to drop rather precipitously, withoutnecessarily signaling a slowing of inflation.

Gold and Mining

The only real direct effect gold has on the economy is in the mining sector, whereindividual companies may be highly sensitive to any fluctuation. Because gold minersmake their profit from selling gold, their profit margins are largely determined by the prevailing market value of the commodity. In past decades, miners hedged theirproduction in the futures market to create some stability and transparency, but thatpractice largely ended in the first decade of the twenty-first decade as the volatility ofgold and its rising price made it unprofitable to do so.

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CASE STUDY

On the Role of Gold

(by Otto Scott)

Although The Wall Street Journal lists gold as a commodity, and scorns the concept ofgold as a currency, it continues to play its ancient role as the only true standard of valuein times of war or crisis. These are presumably times of peace, but in fact we are riddledwith cultural wars that continue to evoke murders, bombings, riots, and rebellions on theinternational stage.

A new level in this global conflict was reached fairly recently when Stuart Eizenstat, aformer senior Carter Administration official and until recently an Undersecretary ofCommerce, issued a report accusing Swiss banks of accepting "gold pulled fromHolocaust victim's teeth intermingled with central bank gold" during World War II, andlater refused to return the deposits of Holocaust victims to their heirs.

This Report escalated a campaign against Swiss banks led by former Fed Chairman PaulVolker, who has been appointed head of an Independent Committee of Eminent Persons,to audit the records of Swiss banks for the deposits of Holocaust victims. Lawsuitsclaiming very large sums have been filed, and the air is thick with charges hurled by theheadline-seeking Senator Alfonse D'Amato, indignant denials fading into apologeticoffers from the Swiss government, and the abrupt dimming of Switzerland formerreputation as a tiny, remarkable democracy, into a nation and system motivated byunconscionable greed.

Nazi gold, in other words, is not unimportant even after 57 years. All gold, in fact,remains immensely valuable in the views of all governments. That is why every centralbank of any significance buys and holds gold in reserve in a world of almost universalpaper money.

The reason for this is not mysterious. History tells us that only gold retains its valueduring wars and upheavals, changes of empires and governments, and times ofcrisis. Although now officially held to be of only industrial value, gold is the oldest andmost respected currency in the world and the only one respected when national papermonies lose value. Islam, the Orient, and citizens everywhere familiar with theuncertainties of governments such as in Italy, France, Asia, Africa, central Europe, and

Latin America, often bank gold in private repositories.

Some indication that such times loom today can be gained by the recent effort ofChancellor Helmut Kohl to improve Germany ability to help create a common Europeancurrency. This program, which instead of uniting has greatly divided Europeans forseveral years, and is encountering continuing difficulties. Its main sponsors France andGermany established certain requirements before the nations involved can weld theircurrencies and issue a new common currency. These requirements now embarrass both

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governments. Their unemployment statistics are insupportably high, and their debts arebeyond the minimums established for entry. Chancellor Kohl wanted to alter his nationeconomic statistics (though not circumstances) by raising the value of the 95 million troyounces of gold held in the reserves of his nation's central bank to its market price.

If the bankers had agreed, that would have allowed Kohl not only to balance his annualbudget, but would have made several billion marks available to fund his entry into theEuropean common currency as well as launch efforts to both save his welfare state and toplacate his unemployed with new programs. Although it is unlikely that the Chancellorthought about it, the fact is that his proposed solution exactly paralleled the one chosenby President Franklin Roosevelt when he first took office in 1933. The new president firstpersuaded Congress to enact enabling legislation granting his office the power to demandall gold held in private hands under pains of fines or imprisonment or both, and thenraised the price of gold. That launched an inflation that enabled the White House tolaunch its governmental employment programs, and become the idol of the poor andunemployed. Helmut Kohl was not as fortunate as President Roosevelt. Germany central

bank, irretrievably scarred by memories of not only the inflation of the early twenties butalso by the worthless paper left to the people by Hitler, brusquely refused to cooperate inchanging the official price of gold in reserve to the far higher price of gold in themarketplace.

In the meantime, however, the frugal Swiss, under intense bombardment by the AmericanJewish community, "released" some of their reserve gold and raised it to the market price,in order to fund a special effort to locate and repay survivors of the Holocaust from thedeposits they made during the thirties and forties if they (or their heirs) can bediscovered.

It is interesting to note that both steps one refused and one accepted treated gold ascurrency by cashing it in the marketplace. That is as close to a return to a gold standard asany German administration has come in fact since its recovery in post World War II.Switzerland, of course, has always been on a gold standard in the sense established afterWorld War I. It will of course be recalled that at one time the international financialcommunity relied upon a real gold standard. Paper currencies were issued, backed bygold. Citizens could present paper money to banks and receive gold coin in exchange.(The West in the U.S. used silver dollars.) Raw gold could be turned in to the Treasury,which would mint it and return it to the citizen. All that ended in World War I.

In the twenties the franc, dollar, and pound were backed by gold and therefore had a

relatively stable value. (That is one of the reasons why such a heavy exchange of propertytook place in Germany in the early twenties, when those citizens who had access to"hard" money were able to buy property at bargain prices from people beggared byinflation.) This was a factor in the rise of Hitler.

In the twenties, however, citizens no longer had access to gold through an exchange of paper currency with the banks. As the twenties extended, the post-World War Idepression was temporarily lifted by international loans and a credit inflation through the

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introduction of installment payments for both tangible (farms, houses, and goods) andintangible property (stocks and bonds), which created production based on promises topay. These promises collapsed in late 1929 with the declines in the stock exchanges andlosses in many banks. When payments were not met, bankruptcies almost halted production; jobs vanished and a global economic crisis occurred. The crisis was

especially severe in Germany when all banks failed.

The German debacle meant that World War I reparations, paid in the twenties byGermany from international loans, would cease. That brought a group of internationalbankers together in 1930 to create the world's first international bank. It was named theBank for International Settlements. It originally consisted of the central banks ofBelgium, France, Germany, Great Britain, Italy, and some commercial banks from theU.S. and Japan. In 1931 the Federal Reserve began active participation in the BIS, andsoon more than two-thirds of the BIS funds in America were held by the Federal Reserve.

All this resulted in the world first group of bankers operating internationally independent

of their governments. Only the German directors were, in this coalition, entirelycontrolled by their governments; later an exception of great value to Hitler. The charter ofthe new bank, approved by the various governments, certified its immunity from"expropriation, requisitions, seizure, confiscation, prohibition, or other restrictions ofgold or currency export or import, or any other similar measures."

The role of gold was central in the creation of the BIS. The new bank was authorized to"arrange with central banks to have gold earmarked for their account and transferable ontheir order, to open accounts through which central banks could transfer their assets fromone currency to another and to take such measures as the Board might think advisablewithin the limits of the powers granted. . . . Therefore the BIS was ready to lend gold

without delay. . ." That meant that gold transfers from one central bank to another couldbe made quite swiftly and did not have to lag behind physical transfers.

As the thirties extended and Hitler came into power, the situation of Switzerlandworsened. Gestapo agents were especially interested in Jewish properties and holdings,and began to make demands that Jewish deposits in Swiss banks be disclosed to Germanauthorities. In 1935, as a measure to protect German Jews, Swiss banks introduced secretnumbered accounts. These enabled the Swiss banks to prove that depositors were notidentified by name, and that therefore their identities could not be disclosed.

That practice amounted to an expansion of Switzerland's ancient role as the protector of

foreign funds deposited in Swiss banks safe from the pressures of tyrannicalgovernments. This tradition remains a very important one. Switzerland's name is almostsynonymous with secret accounts. It has always refused to open its books forinvestigation by foreign police in pursuit of refugees either political or financial fromother countries.

This has been a cause of increasing irritation to American authorities ever since WorldWar II, who have watched the steady increase of international depositors into Swiss

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banks. Washington's frustration with Switzerland has been deepened by the fact that itsinfluence in other nations has, since World War II and the end of the Cold War, grownenormous. Both nations have, in fact, grown increasingly apart in recent years. Theirdifferences are economic, political, and moral. The United States is in the midst of whatPresident Nixon launched and named a Drug War. This effort has led to the expansion of

American police authority to global levels. The Swiss believe that an effort to escapetaxes is human and understandable, and not basically criminal. In the U.S., despite itsformer reputation for individualism, paying taxes until recent expansions has beenconsidered the duty of every good person.

An equal conflict consists between the U.S. and Switzerland regarding banking rules. Inrecent years the Drug War, and the huge sums it entails, has led Washington to enact lawsnot only opening bank records of all transactions to the government, but rules that forcebanks to inform the authorities of any transaction beyond the ordinary. Switzerland's bank secrecy, created after the Vienna Conference of 1820 led by Metternich, wasdeliberately encouraged by the leading nations of Europe as an escape from the

confiscations of the type installed by the briefly-lived Napoleonic Empire.

World War II did nothing to lessen the Swiss belief that the inviolability of its banks wascrucial to its survival though that survival was by no means certain. "After Germanyinvaded Poland in September 1939, the Swiss army mobilized up to ten percent of thepopulation and throughout the war went through long periods when it expected imminentattack from the Germans. That Hitler wanted Switzerland as he wanted Europe for therest of his thousand-year Reich is well documented. As Gerard Weinberg writes in hishistory of the Second World War:

At 1:35 a.m. on June 25, 1940, the armistice between Germany and France went into

effect; a few hours later orders went out of the high command of the German army to prepare an invasion of Switzerland. . . .The plan was to crush Swiss resistancequickly. . . . It was never launched as more important projects came to the fore in Germanplanning. The end of Switzerland, that pimple on the face of Europe as Hitler described itin August 1942, would have to wait until Germany had defeated her European enemies.

"The estimate among Hitler's generals was that at least eighteen divisions were needed todislodge the Swiss from their redoubts, and after the failure to defeat Britain and theSoviet Union, the cost of a Swiss invasion became a mountain too far."

During the war the BIS became the center of international trades even between the

warring powers. Its directors were well acquainted and congenial, and shared someinteresting ties. Per Jacobson, economic director oft he bank, was the brother-in-law ofSir Archibald Nye, Vice Chief of the Imperial General Staff for the British Army.Meanwhile, President Roosevelt froze the gold holdings of most of the belligerent nationsin Fort Knox. At the same time, the governors of nearly all the European banks fromFrance, Hungary, Romania, Italy, Spain, and Portugal as well as Germany were regularvisitors to the BIS in Basle.

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Swiss National Bank vaults were, during this period, open to all trading nations. And as aneutral, Switzerland traded with all governments. If Germany wanted to sell gold forgrain or fuel, the Swiss National Bank moved the gold from Germany's share in theNational Vault to the section reserved for Portugal's gold. Meanwhile, while servingGermany's international needs, Switzerland was also dependent on Germany for its fuel

including coal and oil and most of its food. The tiny nation is, after all, landlocked, andGermany controlled all the land of Europe around it. Switzerland only direct trading routeby sea is down the Rhine river northward to the North Sea also controlled by Germany.Switzerland was technically independent, but in reality its freedom was precarious. Itsonly window of free commerce was a strip of territory from Geneva to Vichy France,which was severed when the Germans occupied all of France.

Yet Switzerland held some strong cards. If forced to fight, it could block access to itsnorth-south tunnels whose rail lines would have cut Germany's access to its forces inItaly. An invasion would also have ended the activities of the BIS bank, through whichGermany traded gold with the world beyond (and inside) Europe. The role of gold in

World War II was, obviously crucial. In March 1938, when Hitler marched into Vienna,"much of the gold of Austria was looted and packed into vaults controlled by the BIS.This gold was immediately credited to the Reichsbank accounts."

In March 1939 the Nazis invaded Czechoslovakia. Storm troopers, holding the bankers atgunpoint, ordered them to transfer their nation's national store of gold, which they hadplaced in a BIS account in the central bank of England, transferred to the Reichsbankaccount. Jacobson afterward said that the BIS learned only later that this transfer wasordered at gunpoint, but this statement can be disregarded as pro forma. The facts werethat the conquest of a small nation by a larger one is historically accompanied by alooting of assets, and Jacobson's added comment that "The Czechs never held this against

the BIS" can be taken as far more significant. Losers in a war seldom expect the world tobe shocked.

Neither was trading with Germany unique in World War II. Spain, for instance,cooperated with Nazi Germany, although Franco did manage to obtain the freedom fromGerman concentration camps for thousands of Jews descended from Sephardic families,whom he had returned to Spain for the first time in centuries. The Irish, who had no suchancient ties, not only traded with the Nazis but gave their submarines refuge at a timewhen their toll of Allied shipping was deadly. Sweden, which benefited economicallyfrom trading with both sides in World Wars I and II, allowed the German army to crossSweden without protest as part of this arrangement.

There is no question that fortunes in trading with and for Germany were also achieved bybusinessmen and institutions in Portugal as well as Spain, in some U.S. banking circlesand some large corporations as well as in Vichy France, Portugal, and Sweden. All thesenations, however, also rendered services to the Allies without which the war might wellhave tipped the German way. Switzerland, as not only the Dulles family but also WinstonChurchill pointed out, provided an invaluable listening post that kept the Allies apprisedof events, policies, and even plans inside the Reich.

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"Switzerland also protected its own 18,000 Jewish citizens completely, unlike France,which obediently deported thousands to Germany. Switzerland did more: it acceptedmore Jewish refugees, in terms of percentage of population, than any other country. AndSwitzerland was and is a very small country. Its population is only 7 million now, andwas probably less then. More than 14,000 Jews escaped Germany to Switzerland during

the same period that 55,000 left for the United States and 15,000 went to France . . .

[Switzerland also] accepted 50,000 French and Polish soldiers. In 1944 the SwissNational Assembly voted to admit up to 14,000 Jews who were trapped in Hungary andwere in the charge of Swedish diplomat Wallenberg. But Eichmann allowed only 1,400to leave."

To put this into perspective, "the United States accepted only 21,000 Jewish refugeesduring the war.". In fact, the United States, which retroactively assumes that its role inWorld War II was purely heroic, seldom admits that some of its bankers not only tradedwith the Nazis through the BIS all during the war, but that the entire nation remained

aloof when Britain fought Nazi Germany alone for two years. Even then, we did notdeclare war against Hitler: he declared war against us. Otherwise we might have foughtonly against Japan.

These points are made not to review the war, in which an estimated 40 million personsdied and more lost their homes, possessions, and relatives, but to broaden the frame ofreference beyond the fates of the bank deposits of only some sufferers in the largest of allthe world many tragedies. One later tragedy was surely the Soviet-inspired Cold War,which was unnecessary, frightening, and divisive for over a generation. In that long andexpensive continuation of war by other means, the role of gold continued to be central.The central banks continued to amass and hold massive gold reserves, but all the

governments functioned on paper money alone in the postwar world. From the end ofWorld War II until 1971, the world functioned with the United States pledge to buy goldat $35 an ounce, and to thereby maintain a dollar standard by which all other currencieswould be measured in the international marketplace.

In 1971, however, the Central Bank of France began to use its accumulated dollars toorder gold from the U.S. Treasury in immense quantities. The gold reserves in Fort Knoxbegan to fade like summer snowballs. The dollar was falling, imports began to soar andPresident Nixon grew alarmed. On August 15, 1971 he went on the air to announce a 10percent Job Development Credit for investments in new equipment, a 7 percent excise taxon automobiles to assist Detroit, a small tax break for individuals, a $4.7 billion cut in

federal spending, an additional 10 percent tax on imported goods a freeze on wages andprices for 90 days and a temporary suspension of the convertibility of the dollar intogold." (emphasis added.)

Only specialists seemed to grasp the importance of the end of the gold-backed dollar. Itmeant that from the 15th of August 1971 through today, the dollar has had nothingbehind it but the promise of politicians and the printing press. The media in 1971, aseconomically feckless then as now,18 seemed to consider a "floating dollar" as they

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labeled it simply another arcane measure of importance mainly to bankers andinternational speculators.

In reality it meant that a world currency was released to float as a balloon without limits,without roots, without stability, as high as the credulity of the world would carry it. One

result was the release of a flood of dollars that washed everywhere. The world eagerlyaccepted those dollars, because the memories of the immense power achieved by WorldWar II America had become imbedded in the mind of the globe. The legend of the dollarand the wealth of the U.S. dazzled the world long after the dollar became simply anotherpaper currency.

One result was that desperate people everywhere scrambled to obtain dollars that seemedto be safety nets from untrustworthy governments. Dollars "floated" abroad throughforeign "aid" programs, through loans to foreign businesses, to U.S. investments abroad,and from millions of prosperous American tourists who seemed to be visitors from aremote earthly paradise.

The Cold War made this appear a reasonable and even necessary situation. The mediadiscussed "Eurodollars" as though they were somehow separate from the dollars used athome, on the theory that despite the fact that they issued from our Treasury printingpresses, they were somehow different. In effect, the U.S. internationalized its welfarestate. American dollars rained upon virtually every nation in the world in an effort toprevail in the Cold War, even as they enlarged our welfare rolls to maintain domesticpolitical stability. This raised so attractive a lure to the world's poor that our borders werebesieged even while our guards were withdrawn or weakened by the Courts. As inprevious periods of hysterical inflation when paper money appeared to replace gold, fromthe history of China, the time of John Law in France, and the Tulip Craze in Holland, the

laws of economic gravity appeared to be repealed.

In 1975, a few years after President Nixon's amazing economic recklessness, the U.S.Government restored America right to own and trade in gold. Legal gold returned forcollectors. As the international price of the paper dollar declined, the international priceof physical gold rose. Greenspan, chairman of the Federal Reserve, a former follower ofAyn Rand, regards gold as a measure of the "strength" of the dollar. Since the purchasingvalue of today's dollar is roughly equal to a nickel in 1969, this does not mean much.

Meanwhile President Reagan, elected after President Carter watched the official U.S.interest rates rise to 20 percent and inflation soar, slowed official inflation by slowing the

Treasury's printing presses. He accomplished this, however, by switching the Treasurypresses to bond issues. These borrowings, slated to be repaid in the future, met withseemingly miraculous success in the international financial world. They crowd the vaultsof the central bank of Japan and many other nations, as well as the private holdings oftens of millions of patriotic Americans. Unfortunately, they are all payable indollars. What President Reagan accomplished was to halt the retail production of dollars,in exchange for wholesale borrowings.

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One result was that foreign nations could hardly refuse to subscribe to successive

new bond issues by Washington, lest such a refusal precipitate a drop in the price of

holdings already in their possession. Sales of these holdings may do the same. Such

runs could bring down the great global empire of paper dollars, which every

government lists as assets.

This situation has long since alarmed the central banks of Europe. That is the

reason for the European drive toward a common European "Euro" currency to

replace the dollar. The plan makes it clear that Western Europe does not want to be

inside the house that Washington built when the roof falls. This has led to a drive inboth European and American financial circles to industrialize the Orient, through amultitude of joint ventures, to avoid being caught in a global collapse. Meanwhile, everyfinancial center is neck-deep in paper currency except for Switzerland.

Switzerland alone has a gold-backed currency and bank secrecy. The Swiss franc is theonly existing alternative to fiat money floating everywhere else, whose purchasers (and

depositors) represent very conservative investors. That is the reason that Europe led byFrance and Germany has been attempting to put together a new global financial systemthat will continue the welfare state that is only possible with paper money and inflation.Such a system cannot succeed indefinitely of course. It might last as long as the tenure ofour present rulers and that is all that most rulers can conceive.

But Switzerland, with its real currency, is an alternative and reachable system. As itstands, outside NATO and outside GATT and outside the new Euro plans conceived inBerlin, Paris and Brussels, it remains in silent competition to a New World Order thatcannot be ignored. It is in that context that the campaign on behalf of Holocaust victimsand their deposits assumes an unexpected and unanticipated, but very timely, global

importance. That is why Washington has taken the rare step of supporting a minoritycampaign by threatening to freeze Swiss assets in the U.S. unless its banks placate theircritics. Switzerland cannot, in other words, be allowed to remain outside the Club. That iswhy the Swiss are understandably alarmed, because bankers rely upon reputations forhonesty and fairness and a campaign that attacks Swiss banks on moral issues can bedeeply injurious.

Therefore, the overall role of gold in the world economy today is even more importantthan ever before as a growing threat to the rulers of a paper empire.

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Gold in World Economy - d

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