The reason why the gold prices are galloping
By Dr Bharat Jhunjhunwala
The global investors are today looking for an alternative storehouse to keep their wealth. They want to exit the Dollar, Euro and Yen. This alternative storehouse they are finding in Gold. Thus, the price of gold is likely to increase more in the near future.
It will be plainly understood by the reader that the value of the paper, on which a 1,000-rupee note is printed or the paper on which a cheque of Rs. 1crore is written, is scarcely 1 paisa. Or, the value of the paper, on which a property valued at Rs. 10crore is registered, may only be a few lakh rupees. The value of these papers arises from the backing of the matter written thereon. The 1,000-rupee note is valuable because the Reserve Bank of India guarantees to redeem it. A cheque is valuable because the bank is ready to honour it. The document of a property is valuable because the police are committed to restore possession of the owner. It will be clear from the foregoing that value of a currency arises from the ability of the central bank to back it with real assets.
The American dollar was backed by the US government in this manner after the Second World War. The American Federal Reserve Bank guaranteed that it would provide an ounce of gold for $35 to anyone who demanded this. In this situation it was profitable for people to keep their wealth in form of dollars instead of in gold. They could deposit the dollars in a bank and earn interest on it. They could withdraw the dollars from the bank and convert them into gold whenever they wanted. Keeping wealth in form of gold did not earn interest. This was the reason that the dollar acquired the status of the "world currency".
The situation changed dramatically in 1971. Oil-producing countries of West Asia formed a cartel by the name of OPEC and raised the price of oil overnight from about $1-2 a barrel to $11. Subsequently, they raised it to about $21 a barrel. The American economy started feeling the pressure of expensive oil. People were worried whether the Federal Reserve Bank would be able to honour its guarantee of exchanging $35 into an ounce of gold. There was a run on the dollar. This forced the Federal Reserve Bank to withdraw the guarantee. The gold standard was abandoned. The dollar was no longer freely convertible into gold. This was the beginning of the end of dollar supremacy. The writ of the dollar continued, however, because the United States accounted for more than one-third of the global economy at that time.
The US economy began to crumble in the nineties in large measure due to the wars in Iraq and Afghanistan. The American government did not have the money to wage these wars. American people also did not have the income to consume goods produced by rest of the world. America adopted Charvaka's dictum: "Borrow and Drink Ghee". The Federal Reserve Bank sold US Treasury Bonds in large quantities to raise moneys for the wars and for consumption by the American people.
Coincidentally, China was seeking modern technologies at the same time. China invited American multinationals to come with frontline technologies and establish manufacturing facilities in China to produce goods for exports to their home country. China provided these multinationals with cheap labour having virtually no protection of labour laws and cheap electricity and minerals. The multinationals exploited these cheap resources and exported goods to America. The problem was that America did not have the money to pay for these imported goods. China stepped in and started buying US Treasury Bonds. China provided the money to America to buy Chinese goods much like automobile companies provide loans to buyers. America sold US Government Treasury Bonds and bought goods from China and waged wars on Iraq and Afghanistan. In the last decade, this led to China accumulating US Treasuries to the tune of $1,400 billion. This accumulation of US Treasuries was okay as long as the US economy was strong.
There were limits to this policy of borrowing for consumption, however. Last two years have seen this truth dawning upon global investors including China that the US was living beyond its means. Most expect the dollar to decline further. Investors stopped investing in dollar-denominated assets. The extent of decline of the US economy can be gauged from the fact that the price of Gold has increased from $35 to $1,000 an ounce between 1971 and 2009.
This decline of the US economy is not clearly visible today. The dollar has risen against the rupee, for example. Four years ago, the price of a dollar was Rs. 40 as against Rs. 48 today. But this is deceptive for two reasons. One, the Indian rupee has decline parallel to the dollar because the Indian government has been as profligate as the American government. Both are declining as two persons holding each other drown in the river together. Secondly, American companies have brought back investments made by them in foreign countries after the crisis has struck at home. This inflow of dollars is temporarily pushing up the value of dollar against other currencies. The rise in dollar against the rupee, therefore, does not cancel the long-term decline in the dollar, which is plainly visible in the steep increase in the price of gold since 1971.
The decline of the dollar has removed the only 'safe' storehouse of wealth. The dollar was considered safe in the last 60 years after the Second World War. The value was reduced to one-half upon abandonment of the gold standard in 1971. The American economy continued to dominate the world, however, because it was the largest and technologically most advanced. The remaining value of the dollar has declined in the last two decades, in part, because of the wars launched by that country. The global investors are reluctant to invest their money in dollar-denominated assets like US Treasury Bonds, property in Manhattan or shares of US companies because the future of the US economy and value of the dollar are no longer stable. My assessment is that the world economy will face another crisis, perhaps worse than the present one, in the coming two-three years. The US Dollar, European Euro and Japanese Yen will all crumble because the high wages of these economies are no longer sustainable against the high-technology low-wage combination wielded by India and China.
The global investors are today looking for an alternative storehouse to keep their wealth. They want to exit the dollar, euro and yen. This alternative storehouse they are finding in GOLD. Thus, the price of gold is likely to increase more in the near future. There may be a temporary decline for a year or so as the Western economies grow on the back of the stimulus packages. But this facade will collapse as soon as the time comes to pay for the stimulus packages. Therefore, GOLD is likely to shine in the times to come.
From Wikipedia, the free encyclopedia
| Dr. Bharat Jhunjhunwala |
| Born | 1950 |
| Education | University of Florida, Kanpur University |
| Occupation | Columnist and consultant |
Dr. Bharat Jhunjhunwala acquired his Bachelor's Degree in Science (Physics, Chemistry and Mathematics) from Kanpur University and doctorate in Food and Resource Economics from University of Florida in 1973 at the age of 23. He has published academic papers in The American Economist and the Southern Economic Journal.
He was Assistant Professor of Economics at the Indian Institute of Management, Bangalore. He has been a freelance columnist and consultant to donors and NGOs since 1993.
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