Wisdom is better than silver or gold...

"Don't gain the world and lose your soul, wisdom is better than silver or gold..."

Bob Marley's message to the world clearly hasn't hit the financial markets. Gold seems to be acting as the most valuable substitute in the absence of any obvious wisdom. As the financial crisis has unfolded the price of gold has gradually edged upwards towards $1,000 per ounce (from $253 in 1999), as it's "safe haven" attributes have come to the fore. Historically, gold has retained the capacity to act as an effective hedge against inflation, and a declining dollar, and as a general store of value during times of geopolitical and financial market instability. All of the above would seem to fit the current circumstances.

When the US dollar replaced gold as the world's reserve currency, it might have been expected that the trend of using of gold as a store of value would have faded away. After all, gold, despite being useful in prolonging marriages, doesn't actually have much going for it. You can't eat it. You shouldn't drink it - as the Aztecs showed so creatively, and you are unlikely to be able to build a house out of it. Given the lack of attributes, why is it that gold still retains such a position in our financial system? In particular why does it still seem to be the "ultimate" store of value right now. This past week the US dollar has come under pressure as a reaction to plans in the US for potentially hyper-inflationary fiscal policy, and gold has shot up even further. Why?

The dollar is down 4.6% this month against a basket of six major currencies. Gold and the dollar, which have moved in tandem for most of 2009 as investors sought a haven from financial turmoil, have returned to an inverse relationship. There's a growing concern that the US monetary base is expanding - the Federal Reserve bought $7.5bn of Treasuries late last week, its first targeted purchases since the early 1960s. Benchmark interest rates are between 0-0.25% - which if there is any form of economic rebooting should be inflationary. Therein lies the explanation for gold's perpetual rise - the expectation of a falling dollar and increased inflation in the future.

The theory goes: the amount of gold in existence is relatively fixed - around 160,000 tonnes have ever been mined - and the proportion of gold to the money supply according to "the economics" should (in theory) remain relatively constant. Gold adds up to $4.7 trillion at the current $950-odd price per ounce, while notional money supply is at maybe $60 trillion. Consequently, the assumption is that gold must go up in price.

Once upon a time I would have agreed. Unfortunately this 'time' was well before I was born, so it was hard to participate in that discussion. The time that I mean was during the the various periods between the first adoption of the gold standard in the UK in 1717 (£1 was convertible at 7.32 grammes of fine gold), through to a looser international gold standard established by the Bretton Woods Agreements after the Second World War. Under that system, many countries fixed their exchange rates relative to the US dollar. The US promised to fix the price of gold at $35 per ounce. Implicitly, then, all currencies pegged to the dollar also had a fixed value in terms of gold.

Under the regime of Charles de Gaulle in the late 1960s, the French reduced their dollar reserves significantly, trading them for gold from the US government, thereby undermining US economic influence abroad. This, along with the fiscal strain of Lyndon Johnson's "Great Society" expenditures and the Vietnam War, led Richard Nixon to eliminate the fixed gold price in 1971, causing the Bretton Woods system to break down. Since that time, the gold standard has not been used by any country in the world.

Furthermore, many governments have systematically (or moronically in Gordon Brown's case) sold down their country's gold supplies. At the current time, the holdings of gold in direct (bullion) form, and indirect (gold mining companies, derivative contracts) of the world hedge fund community comfortably outweighs the 19% of overall supply that is held by the world's central banks. That seems a bit out of whack to me.

In that context, why has gold remained such a popular store of value, when it has been eschewed by those who run our economies? The truth for me is that it is merely a trend, albeit one that was once based in some form of grounding. Gold goes up in price when people expect inflation, in my view, because that's what people think it should do - it's purely based on expectations. These expectations are somewhat rational, as that is what has happened in the past, but the real economics no longer make any sense to me. If the world does proverbially "hit the fan" then I want to be in possession of "real assets" - food, water, firewood and the like. The usability of gold in those circumstances is not going to be up to much - the real reserve currency will be the items that sustain our existence. Farmland is better than gold for me in that case. If on the other hand the economic outlook improves, the gold price should fall, and quickly.

I would compare the gold price rises since the end of the Bretton Woods system to the "portfolio insurance" debacle that led to the market crash in 1987. Similarly, all very well in theory, but not great in practice.

Very simply "portfolio insurance" was where Phd. Mathematicians started to meddle with the worlds financial system. A group of 3 such "rocket scientists" formed LOR Associates in the early 1980s, and started selling a computer modelled trading strategy that helped big asset managers protect their gains on their large equity portfolios, in the event of market drops. The strategy worked by using a hedge - selling S&P futures, for example. If the portfolio increases in value and moves above a desired minimum floor value, the hedge is reduced, allowing the portfolio to enjoy a greater fraction of the market gain. If the portfolio declines in value, the hedge is increased, so that finally, if the portfolio value falls well below the floor value, the portfolio is completely hedged. The clever bit that these geniuses were selling was their model's output, which would tell the asset manager when, how much, and at what level to execute these hedges. In the early years the strategy was incredibly successful - and the business of portfolio insurance started to grow exponentially.

Between the period 1982-87, the Dow Jones Industrial Average almost tripled in value. As a consequence lots of asset managers had big gains that they were keen to insure against losing if the markets started to fall. By 1987 portfolio insurance was the driving force in trading decisions, with more than $60bn of assets being hedged with this technique. When the cracks started to appear in US equity markets in October '87, portfolio insurance based hedging started to kick-in. In the run-up to the market crashing more and more futures were being sold on the various equity indices that were being insured. These indices were usually relatively liquid - as in it was possible to do lots of these trades without moving the price. However as more and more hedging was required, as the markets fell, there was a tipping point where the liquidity in the system could not sustain the selling pressure, and the market capitulated. The Black Monday decline of October 19th was the single largest one day percentage decline in stock market history, with the DJIA dropping 22.6%.

To complete the comparison with gold - those who are using gold as the "perfect" hedge, aren't seeing the full picture - just as the portfolio insurers didn't see that liquidity in the futures market wasn't endless. In the case of gold, it may well appear to be a good "safe haven" because the price of gold continues to rise. For my money, though, that is only because of a trend, or expectations. If we really do hit the wall that the gold buying is protecting against, we will be in a completely different paradigm and gold won't have any "real" value. Hopefully we won't get there, but in that circumstance I'll take guns and butter every time thanks very much.