What is the Real Value of Gold?

Source : The Star
What is the real value of gold? Gold has industrial uses, especially in the electronics industry where it is used for electrical wiring due to its high conductivity. However, close to two-thirds of its demand is for jewellery, particularly in India and China.


Increasingly, it is being used again as a store of wealth as investors lose confidence in paper money, hedge against inflation or worry about economic and political turmoils. Other than buying physical gold, investors can invest in gold exchange traded funds (ETFs). SPDR Gold Trust, the largest gold ETF with a market capitalisation of over US$41bil, holds over 1,100 tonnes of gold.

Money could as well be in the form of sea shells and indeed Pacific islanders used sea shells as money. Before paper money, what constituted money came in many forms – sea shells, salt, leather, copper, silver and gold. Money was used as a store of wealth which could be used to purchase goods and services without resorting to barter trade. It was in the world’s oldest civilisation, Mesopotamia (in modern Iraq), where metal coins were introduced around 2500 BC. Gold is valuable only because it is perceived so in the collective psyche of the human race, hence its value is subjective and relative to other alternatives. To be valuable, something has to be rare and desired.

In all of history, only 161,000 tonnes of gold have been mined, barely enough to fill two Olympic-size swimming pools, according to a January 2009 National Geographic article. To be valuable and used as money, it has to be something durable. That would exclude fair maidens as their perceived value in the eyes of lustful men may diminish with age. Still, without the demand of gold from the fairer sex, its value would be much lower.

In Einstein’s theory of special relativity, time is relative to speed but if we apply the theory of relativity to the perception of value, the relative value of goods and services is determined by comparing the desirability of one versus another just as we compare the relative attractiveness of bonds, real estate, gold and stocks.

Even within the same asset class like stocks, we apply the relative yardstick – should we buy DiGi or Maxis? The relative attractiveness is determined by supply and demand, interest rates, growth and dividends for stocks, personal preferences and many other factors. The fact that the prices of stocks, bonds and commodities quoted on exchanges are so volatile is a reflection of not only genuine supply and demand but also human psychological factors which cause irrational exuberance or pessimism.

The Chinese introduced paper money during the Tang Dynasty (618-907) and with that they also invented hyperinflation when a large amount of paper money was introduced.

How does printing money cause inflation? In a simple hypothetical world where US$100,000 of paper money can only buy you a bar of gold or a house, doubling the paper money to US$200,000 does not create new wealth but merely causes the value of the bar of gold and the house to rise from US$100,000 to US$200,000, an inflation of 100%.

Wealth transfer

Printing of money merely results in a wealth transfer from the saver (who can buy less with paper money) to the government (as it can use the freshly created money) and borrowers (decline in the real value pf debt). Gold is perceived as an inflation hedge and a store of value. (See chart) Its price spiked in the late 1970s when the US and world inflation surged. The price is surging again due to diminishing confidence in paper money.

World governments are all undertaking fiscal stimulus to counter the economic slowdown. These large budget deficits eventually have to be financed by higher taxes but with unemployment in the United States at over 10%, politicians with an eye on getting re-elected may be tempted to print money to finance the budget deficits and bailouts.

Hence it is not surprising that with the United States, British and Japanese governments printing money, investors are flocking to buy gold or commodities which are a better store of value as their supply does not grow as fast as printed paper money.

The printing of money by the US government also puts other currencies at risk as over 60% of foreign reserves are held in US dollars. As the gold standard has been abolished, paper money cannot be converted to gold. No wonder the Indian government has decided to sell some of their US dollar reserves for gold. Perhaps the currencies of larger countries like Australia are relatively safer as they are sitting on large yet-to-be-mined gold reserves even as their US dollar reserves lose value.

So, should the fair price of gold be relative to paper money? Though the value of gold may be subjective in the minds of investors, the reality is that the amount of gold in the world is finite, but there is no limit to the quantity of paper currency which can be issued.

Therefore it is not surprising that the value of gold is at a record high as more money is being printed. All this is premised on the assumption that we will continue to treasure gold, which is likely to be the case as we have done so for millennia.

Choong Khuat Hock is head of research at Kumpulan Sentiasa Cemerlang Sdn Bhd