Topic 2- Role of commodities in the modern era

Gold has an important role to play in the society through out the history of mankind. Ever since it was discovered, the ancient people had been using the precious metal for trading purposes, serving as the unofficial currencies of the world economies back then. In the 1900s, the role of gold has diminished substantially as the trading currency, even more so when the majority of the countries in the world adopt the current monetary policy of inflation targeting, which banks on the reputation of central banks around the world rather than the gold-backed greenback exercised in the early to mid 1900s.

With all these changes to the world monetary systems, gold’s role has been relegated to mainly of jewellery uses and futures trading purposes. However, with the recent resurfacing instability of the oil prices and the US dollars, on which gold price is based upon, its existence has taken a higher significance now.

The trade deficit in the US economy has kept on increasing for the past decade, and by logical measure, even if the Chinese devalues the yuan by 10% in the next decade, the gap is only going to get wider & wider. Many economists have predicted that this situation is not sustainable, and the USD will collapse sometime in the future because of the enormity of the debts it owes to many of its government bond holders. Even the richest man in the world, Chairman of Microsoft Corp. Bill Gates, has recently stated that he is hedging his bet against the USD. The question is, if the richest man in the world, plus a lot more of renowned economists, say so, is there a higher chance that the few brains in the White House get their prediction right that the deficit won’t cause any problems?

With this impending issue in mind, let’s analyze its impact on the gold prices. Gold prices have increased by more than 70% in the past 1 year, after remaining roughly constant for more than 6-7 years. It must be noted that the last big fluctuation was during the Asian economy crisis. The empirical evidence suggest that there is a steady equilibrium price for gold during normal times, but there will be an upward surge in price when the currencies are getting unstable, & it will return to its inflation-adjusted equilibrium price slowly after that.

The current upsurge in gold price suggests that investors are getting nervy about the USD, which has devalued by around 7% recently. The situation has also been exacerbated by the recent upsurge in oil prices due to the Iran standoff.

The role of gold as a stabilizer mechanism cannot be denied. In turbulent times, when government’s monetary policy is given less credibility, gold has stepped up and become the unofficial currency again. 1 kg of gold will have the price of 1 kg of gold when the crisis is over, but a 100 USD bill may only have half its value when the tide is gone. The other scenario, when the currency actually appreciates during the crisis, may also happen, but people would rather take the safer option of getting the same value for their ‘money’ by buying gold. Hence, gold plays the role of a hedging mechanism when this scenario occurs.
There is the question of why other commodities, such as oil, can’t have the same role as gold in the economy. To answer this, we have to divide all the other commodities into 2 broad categories: consumable and inconsumable. Consumables refer to commodities such as oil and aluminium, which has to be used everyday to ‘run the world’. Since it has to be used every single day, and it can’t be replenished easily, the choice to use it as a hedge would not make sense as its supply will run out one day. There is also the extra risk of being held hostage by oil producing countries like the OPEC and the Arab nations, which hold almost 75% of the proven oil reserves in the world.

Inconsumable refer to the commodities such as silver, diamonds, and gold. These are commodities that are used minimally in the industries (supply > industry use) and could potentially serve as hedges to the worsening currency crisis. However, since traditionally gold has been used as a currency before, people have the perception that it is a better commodity to use rather than silver which is less valuable in the monetary sense.

As explained above, the escalating gold prices will likely come to a stop in the future, but there is no guarantee that it will come down to its previous level because of the current situation with the oil crisis. It will most likely stay at a new higher equilibrium in the future, before its value is again reassessed in the next crisis.