During the only extended period of global deflation - the Great Depression of the 1930s – the gold price was fixed as most countries were on the gold standard making it difficult to analyse gold demand during the period. One way to get an idea of how gold might have performed if it had been allowed to trade freely is to look at how gold appreciated against individual country’s parity rates as countries went off the gold standard in the 1931-34 period. As can be seen in the (chart below), the gold price surged against most currencies once they freed themselves from the fixed rate, implying substantial pent-up demand built up during the deflationary years.
During the Great Depression when the gold price was fixed, demand for gold manifested itself in large declines in the government’s gold stocks as the public and investors (domestic and foreign) demanded gold in exchange for their dollars. Ultimately, as gold reserves fell towards mandatory minimum levels in early 1933, Roosevelt was forced to require the surrender of all gold held by the public at a pre-determined price, halt gold exports, and devalue the dollar against gold. It is important to emphasize that in the current situation, where there is no policy link to gold, there is no rationale for governments to confiscate gold as there is no artificial peg to gold restraining their policy options.
Today, with no major currency pegs to gold, there are no artificial constraints on monetary policies and therefore no need for governments to confiscate gold. While there are no gold pegs to break today, this does not mean that a similar gold price dynamic will not evolve. A likely scenario is a gradual but steady flow of assets away from paper currencies towards hard assets – particularly gold – as governments’ step-up reflationary policies and their debt levels build. Already this is being reflected in growing demand for physical gold as illustrated by the World Gold Council statistics (below).
Exchange Traded Commodities (ETCs) have become one of the main ways for investors and the public to gain access to physical gold. Assets in gold ETCs rose to over $30bn by the third-quarter of 2008, up from less than $5bn only three years ago (see below). Flows into ETCs have continued to build even during periods when the gold price was falling indicating that strategic investors are increasingly using ETCs to build long-term positions in gold.
The massive monetary stimulus being injected across world financial systems will eventually find its way into real economies and ultimately into prices. As the chart below shows, we are now seeing an unprecedented surge in US base money growth. If history is anything to go by, after a period of deflation, the world may swiftly move into a high inflation environment. If this scenario plays out, gold will likely be a strong outperformer for many years to come.
Nicholas Brooks is Head of Research and Investment Strategy at ETF Securities. The views expressed here are his own