Ask Mint | Why people turn to gold during turbulent times

Ask Mint | Why people turn to gold during turbulent times
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First Published: Mon, Mar 09 2009. 12 03 AM IST

Updated: Mon, Mar 09 2009. 12 03 AM IST
In a machine-created vacuum, paper currencies and gold would fall at the same velocity under the influence of gravity. But in a market-created vacuum, paper currencies may fall like dry leaves, but gold still manages to float around. Ever wondered what makes gold a currency of last resort or a final store of value? It is surely not just its glitter or its unique chemical composition. It is our faith which makes gold what it is. Let’s take a peek into the long history of this unique metal.
Johnny: What is so unique about gold, Jinny, that everybody wants to jump on to the gold bandwagon?
Jinny: Gold, over thousands of years, has acquired a unique status in our lives. It is the one commodity that can also be conveniently used as a monetary asset, something that you can readily use like money for buying other goods and services. No other commodity enjoys such a privilege. Other precious metals such as silver or bronze have long tried, but none can match gold in attracting greed and fear. Before the use of paper currencies, the world only understood the language of gold. We used gold coins of certified purity as a medium of exchange. People accepted this arrangement without any compulsion. Gold, unlike other commodities, doesn’t perish easily and its supply doesn’t cause floods in the market. It served as a unique store of value—something that would remain as valuable tomorrow as it is today.
Things started to change with the advent of new money. For a long time, paper currencies just worked like certificates of gold lying in the vaults. But gradually, paper currencies became a medium of exchange in their own right. Currently, paper currencies work as money because governments stand solidly behind them.
Illustration: Jayachandran / Mint
Johnny: It seems that gold has managed to retain its charm even without a powerful uncle. What makes gold so precious, Jinny?
Jinny: Certain fundamental factors seem to be in gold’s favour. First, the total stock of gold on earth is limited, so unlike paper money, the supply of gold can’t be increased at the whim and fancy of governments. While a money-printing spree of a government may bring down the value of paper money, the existing stock of gold, in the long run, is likely to retain its value. Gold can, in fact, serve as an effective hedge against the decrease in the value of paper money.
Second, gold enjoys a longer life, which means that the existing stock is not likely to be depleted by the forces of nature. So you don’t have to worry about your existing stocks of gold being eaten by moths, for instance. Third, it can be recycled easily, which means that the present demand can be met easily by using old stock. You can easily convert your old bangles into new forms without much trouble.
Fourth, gold is fungible, like currency notes. Just as you exchange a currency note of one denomination with another note of the same denomination, you can exchange one stock of gold with another stock of the same purity.
Johnny: I think there could be several other advantages also. But tell me, Jinny, why does the price of gold go up and down like any other commodity’s?
Jinny: Well, more than the supply and demand, it is our perception that determines the price of gold. The world currently holds a stock of about 161,000 tonnes of gold extracted from mines so far. Two-thirds of our total stock represents investment as a store of value and one-third represents actual consumption for different purposes, ranging from electrical equipment to dentistry. The central banks of all the countries together hold about one-fifth of the total stock of gold as reserves. Every year, on an average, we add about 2,500 tonnes of newly mined gold to our already existing stock of gold above ground. The existing stock plus every ounce of gold extracted every year is more than enough to take care of all our existing consumption.
In recent years, whenever there has been a surge in the demand for actual consumption, the central banks and other investors have been coming forward to meet it. Such cyclical fluctuations get ironed out easily. But sometimes we may actually see an astronomical surge in gold prices.
What causes such wild jumps? More than supply or demand, it is our perception of the economy that determines such surges. Whenever there is trouble in the financial markets, or whenever countries go to war, or face high inflation, bank insolvencies, and so on, we see a flight to safety. Gold has been our long-trusted currency of last resort. The existing holders tightly hold their gold while new investors join in, pushing the price through the roof. But once things calm down, the price is bound to get back to normal.
Johnny: That’s true, Jinny. Ultimately, long-term averages win over short-term fluctuations.
What: Gold is a commodity that can also be used as a monetary asset.
Why: Gold is popular as a monetary asset because it can be used as a hedge against a decline in the value of other assets.
How: The price of gold is determined by fundamental factors such as the general outlook of the economy, inflation, etc.
Who: India is the largest consumer of gold.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Mon, Mar 09 2009. 12 03 AM IST