Rock, scissors, paper, gold

Rock, scissors, paper, gold

About a week after the Reserve Bank of India spent $6.7 billion to buy 200 tonnes of gold from the International Monetary Fund, prices of the yellow metal have hit a record in nominal terms, crossing $1,100 an ounce even though they are still below their 1980 peaks in inflation-adjusted terms. To cross the latter, gold will have to move beyond $1,885 an ounce.

It is interesting to see who has been buying to push up prices. The New York Times last week cited data from the World Gold Council to report that consumption of gold for jewellery dropped 20% in the second quarter of 2009 while investor demand increased 51%.

Gold bugs may be hoping for a return to the earlier era when gold was the currency of trade and exchange. But they are daydreaming. There is enough economic research to show that the inflexibilities of the gold standard made the Great Depression worse. Thus, nations that could not adjust their currencies were forced into protectionism, a move that made the 1930s crisis even worse.

An economy in a crisis needs extra liquidity and the supply of gold is fixed: No chances of quantitative easing there.

However, the current rally in gold prices does have quite a bit to do with the quantitative easing that many Western central banks have done to stave off a financial collapse. More paper money and the same amount of gold are bound to change the relative prices of these two assets. That is what is happening: A drop in the dollar is mirrored by the rise in gold prices.

The future direction of gold will depend on whether inflation rears its head and whether the dollar continues to decline.

Investor Jim Rogers bases his forecast that gold prices will double to $2,000 an ounce on these two assumptions. Economists such as Nouriel Roubini—who shot to fame earlier this decade when he became one of the first to warn about a coming financial collapse—rubbish Rogers’ price forecast. They expect deflation rather than inflation.

We do not share some of the more grand beliefs of the gold bugs. But if central banks continue to print money, we would not be surprised if gold prices continue to rise.

What does the rally in gold prices indicate? Tell us at