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By | May 20, 2012

Dear Toolkit,

Your recent column about "the Dow" prompted me to ask an equally esoteric question about another macro-economics topic: gold! My banker, to whom I lose a weekly golf match, insists that gold is a better indicator of inflation than a dozen expensive economists armed with state-of-the-art computer models. In an effort to appear a more competent businessman than golfer, I always nod in agreement but I haven't a clue what he means. Can you enlighten an ignorant entrepreneur?

Thanks,

Double Duffer

Dear Double Duffer,

You are a prudent man, indeed! Letting your banker beat you at golf and agreeing with his economic pronouncements should assure the continued success of your small business without any further advice from Ask Toolkit. But to humor your thirst for knowledge, we will attempt to give you a short course on gold—that rare and useful element you can spend, wear, and even chew with.

It all began some 100 million years ago when all that goo that formed our planet congealed, much like my Hollandaise sauce often does. And since it's mostly inert, moth and rust did not corrupt gold, so it's all still here somewhere. About 6,000 years ago people started digging it up and making jewelry and other decorations with it. It's so malleable that one ounce can be extruded into five miles of wire or pounded into a 100-square-foot sheet of foil, so you can see that a little bit went a long way in those olden, golden days. But it was hard to come by, so folks held it dear and even hired alchemists to try to make it out of the more abundant base metals.

Nowadays you can truly turn iron into gold and you don't need an alchemist, you only need a cyclotron; but, needless to say, it's not a cost effective thing to do. And now people dig up gold and then turn around and bury it again in underground vaults for safekeeping. (Go figure!) But it's still a rare element. It takes 17 tons of ore to get one measly ounce of gold by using an expensive, time-consuming and environmentally unfriendly process. And if you gathered all the gold ever mined in all the world through all of history, it would total only about 102,000 tons or enough to form a cube measuring 19 yards on a side.

So you can see that its value is all a matter of supply and demand; gold is rare and therefore expensive, just as sand is plentiful and therefore cheap. And, unlike many commodities, it doesn't get consumed—like grain or oil, for example. If the supply of grain and oil remained constant like the supply of gold, price stability would reign supreme. But crops fail and oil gets embargoed, and when these diminishments in supply occur, demand (and prices) will rise. Yet the supply and value of gold remains constant.

But when folks got tired of hauling stuff around to barter, paper money was invented, and the potential for inflation was born. Paper money is not a commodity. It has no intrinsic value. It's only worth what a government says it's worth, and it can be printed in endless quantities. At first this was not a problem. There was a kind of gentleman's agreement that you wouldn't print money unless you had the gold supply to back it up. Theoretically, you could take a printed bill and redeem it for actual gold.

In modern times, this arrangement became known as the "gold standard," an international system started in the 1800s. (The U.S. joined it in 1900 as trade with other nations was increasing.) The gold standard assured a constant, stable supply of money to facilitate international trade. But along came World War I and all those European countries had to scramble to finance the hostilities. And as was true in all past wars back to the Roman Empire and very likely before, there were two ways to pay for WWI—levy taxes or print money. (Of course the Romans merely diluted the gold or silver content of their coins since true paper money didn't arrive until the Middle Ages.) Need we tell you which choice was made?

Now when a government prints money for which there is no gold in reserve, the money supply increases and its value decreases and guess what that's called! Yes, indeed—it's called inflation! You can still use the money to buy goods, but the guy who owns the goods is going to raise his price because your money is worth less, so you'll have to give him more of it before he'll make the sale. Voila, inflation!

In 1914, the World War I era began and Europe fell off the gold standard. The U.S. kept the faith (and the gold reserves) and, as a result, the dollar became the de facto standard. When the U.S. called in all gold coins in 1934, the price of gold was $20.67 per ounce. The price was soon set at $35 per ounce.

In 1944, the International Monetary Fund (IMF) was formed as an agency of the United Nations to stabilize exchange rates and combat trade problems, but gold prices were unchanged until President Nixon took the U.S. off the gold standard in 1971. In 1973 the IMF set a fixed rate of $42.22 for their "paper gold," or Special Drawing Rights, and the free market rate for gold rose to $65 that same year.

Finally, in 1978, all gold was permitted to be traded on the free market and it rose to $226. And ever since, gold price movements have predicted the probable future direction of inflation, at least in the eyes of many analysts and, of course, your banker. But in this 21st century that relationship is not so crystal clear.

The free market for gold is, by tradition, centered in London. The other four major trading centers (New York, Zurich, Tokyo and Hong Kong) communicate with London and a new market price is fixed twice daily. Hence, you may hear the term "London Fix" on your local radio market reports when you tune into hear the weather or sports.

But we digress. Returning to the topic of gold as inflation predictor, in 1980, for example, gold was $800 an ounce, but when Fed Chairman Paul Volcker shifted his policy toward disinflation, the price dropped to $300 by 1985. This "tight money" cure was painful. Some loyal readers may remember interest rates in the high teens and unemployment rampant during the early 1980s.

After fluctuating for a year, gold lurched back down to $400 in October 1986, just before inflation dropped to 1.2 percent two months later. In October 1987 gold rose sharply back up to $465, the month before inflation peaked at 4.6 percent (and the month before the stock market crashed). Pretty good predicting! By the end of 2008, the price had increased to about $782, and it has continued to trend upward since then.

As of mid-2012, gold is approaching $1,600 an ounce, which suggests that inflation may be starting to rear its ugly head and, as a consequence. Indeed, the Fed continues to hold interest rates at the current low levels. With our now global market and the severe credit crunch that began in 2008, who knows how gold may behave in the long run? All nations are sending cheap products into the US to capture market share and this causes US businesses to keep their prices competitive, possibly slowing the inflation effect regardless of gold's price movement.

According to the old rules, if you see the price of gold zoom much higher, keep an eye out for rampant inflation to follow and the stock market to drop, because the movement of inflation and equities are always in an inverse relationship. That's when the "Fed" may ride in to rescue the greenback by bumping interest rates way up—or NOT! To stem recession they'd have to reduce interest rates; to stem inflation they'd have to increase them. And so goes the dance of cranking the money supply up and down to help keep our economy on an even keel. In short, your guess is as good as mine....or your banker's!

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