Gold nuggets

Everything you wanted to know about the yellow metal but were afraid to ask lest your friends think you are a crazy goldbug buying bullion for the financial Armageddon.

Precious, my precious. Gollum practically salivated in the presence of the gold ring at the heart of J.R.R. Tolkien's masterpiece. Of course, that story took place in fictional Middle Earth, but the yellow metal has fascinated real-world civilizations since its discovery thousands of years ago. Perhaps Ralph Waldo Emerson put it best: "the desire of gold is not for gold. It is for the means of freedom and benefit." Plus it does double duty, able to both build and display wealth. The ancient Egyptians did just that when they started making jewelry with it in 5000 BC. It remains popular, both for its beauty, rarity (gold is harder to find than diamonds) and cachet. Witness the baubles and bangles, gold-plated toilets and sculptures favoured by monarchs, oligarchs, sheiks, Donald Trump and the tabloid celebrities taking consumerism and extravagance into the stratosphere. Madonna has been spotted sporting a gold grill — not the best look for the quintessential "material girl" but certainly understandable for an aging pop star who still wants to shine, even if that glitter is the result of fancy dental work.

She is not alone. The demand for gold bars, coins and jewelry among regular folk hit dizzying heights globally in 2013, up 17% over 2012. Investors were not so enamoured. During the same time period, they sold off their gold ETFs, redeeming 881 tonnes of gold. As a group, central banks around the world purchased 369 tonnes of gold in 2013, slightly less than they did in 2012, while holding onto existing reserves. Talk about mixed messages.

To help provide a little context (and hopefully some fun) CPA Magazine decided to explore a few questions about gold as a store of value.

Where did gold as a store of value/medium of exchange get its start? A short retelling of a very long history

Since it's one of the only metals that can be found in a pure native state, it's not surprising that gold was one of the first metals discovered by ancient civilizations and the first to symbolize wealth and power. There is evidence that as far back as 5,000 to 6,000 years ago ancient civilizations were using gold as a store of value, says Christopher Kobrak, a professor of financial and Canadian business history at the University of Toronto Rotman School of Management. "The first time gold coins were used to facilitate trade was in Greece and Asia Minor. That was an important step to gold becoming a universally accepted medium of exchange." In fact, precious metal coinage got its start in Lydia (today part of western Turkey) thanks to Croesus, its last king ("rich as Croesus"). These first coins were made from electrum, a natural alloy of gold and silver. In 564 BC, King Croesus developed an improved refining technique that allowed him to mint the world's first standardized gold currency. Their uniform gold content allowed Croesids to be traded with confidence.

Making gold the standard: what is the gold standard?

The gold standard is a monetary system that directly ties the value of a nation's currency to gold. Countries that adopt a gold standard set a fixed price for gold and then proceed to buy and sell it. Sounds simple and for a while it was — and it was good.

England was the first country to adopt the gold standard in 1820. By the 1870s, France, Germany, Italy, Canada and the US were also on the gold standard. (China adopted the silver standard.) "That created a world we didn't know before and we haven't known since," says Kobrak. "It meant that currencies were completely convertible to gold on demand and it allowed for a period of price stability and deflation, new industry, crossborder financing, free movement of inputs and outputs and economic growth. That's why people look back nostalgically and wonder why we can't have that again. But the gold standard operated in a very different political era. The governments and central banks had one macroeconomic mission then: to preserve the gold standard. And they did what was necessary to achieve that objective. For example, in the 1890s the short-term interest rate in the US went up as high as 70% to keep the US on the gold standard and prevent people from fleeing with their gold. That could not happen today. It was a different political era."

Problems

As soon as the First World War broke out, countries suspended convertibility of their currencies. It was briefly reinstated from 1925 to 1931. Even though countries tried to pick up and resume relationships where they left off prior to the war, widespread tensions, inflation and the dramatic shift in economic power made returning to the gold standard slow and painful. The situation only got worse during the Great Depression, as its commitment to the gold standard meant the US could not use monetary policy to boost its weakening economy and the effects of its collapse spread globally. As a result, the gold standard crumbled in the 1930s.

An interim fix

In July 1944, 730 leading political and monetary experts from 44 countries, including John Maynard Keynes and Bank of Canada Governor Louis Rasminsky, gathered in Bretton Woods, NH, to create a quasi-gold standard called, appropriately, the Bretton Woods system, which made the US dollar the world's reserve currency and thereby the only currency convertible into gold. In exchange, the US government promised to redeem other central banks' holdings of dollars for gold at a fixed rate of US$35 an ounce. Other currencies would move toward convertibility over time. Bretton Woods was also where the World Bank and the International Monetary Fund were created to adjust exchange rates and help manage global money supply.

Bye-bye gold standard

Bretton Woods broke down on August 15, 1971, when then president Richard Nixon closed the cash window and announced the US would no longer redeem currency for gold. That was it for the gold standard. And there is little chance it will return because the political will to make it happen simply does not exist, says Kobrak. "People would have to believe that normal functions of government would cease otherwise." If that day ever came, the price of gold would have to skyrocket to thousands of dollars an ounce based on how much paper has been issued since the 1930s.

The start of gold- and silver-backed paper money

Did you know banks issued paper money before states generally did? In fact, the Bank of Scotland still issues its own money. People deposited their valuables, which very often were gold and silver, into bank vaults and the bank would issue them a paper receipt or certificate, which in short order started to function as money. The idea originated with goldsmiths who gave people receipts for their gold that could be exchanged at a later date for the actual gold.

Is gold a good hedge against inflation?

In periods of hyperinflation gold has functioned extremely well as a hedge. Joseph Fazzini, accountant, CFA, analyst of gold and precious metals equities with Dundee Capital Markets, argues that one of the reasons gold has underperformed recently is because there has been low-level inflation in North America, so investors aren't interested. Ian Ball, president of gold and silver producer McEwen Mining and history buff, agrees. "If you go back to 1930, you could buy a good suit for the price of one ounce of gold. That holds true today. Over the past 125 years, gold has done a good job tracking inflation, but not in a straight line. Ask Argentinians when the country defaulted on its debt, or Mexicans in the 1990s when the peso was devalued, whether they wished they'd had gold." That said, holding gold earns no interest and so there is no return beyond the price. "Right now, it's selling a little above the price it was in 1982," says Kobrak. "Personally, I'd rather invest in stocks whose cash flow tends to go up in times of inflation."

In 1933 the US government confiscated all the gold in the country and made it illegal to own anything but a small amount. Can this happen again, and what would it mean for holders of gold?

Never say never, but the reality was this happened at the peak of the Depression and governments were panicked and doing all sorts of illiberal things all over the world to find a solution. "A good many governments blocked funds in that period," says Kobrak. "Would the Canadian government ever prevent you from transferring funds from Canada to the US? That happened, too, around the 1930s. We think of these things as part of our financial past, but Argentina is forbidding people from transferring money right now because they are in desperate economic conditions. Still, of all things that might keep me up at night with our economy it's not this." Big holders of gold, however, aren't as secure. In fact, many gold and silver investors advocate the internationalization of bullion holdings to protect their wealth if just such a scenario were to happen, says Jeff Desjardins, president and CEO of Visual Capitalist, which educates investors about natural resources, and Tickerscores.com, which offers comprehensive independent research on more than 400 precious metals stocks. "If you are wealthy and hold much of your net worth in gold in one country, if such a crisis happened you'd be left with nothing. Holding gold in several different places reduces that risk." The upside: the price of gold would spike everywhere else because the perception would be that there is some sort of currency crisis.

Are some governments secretly purchasing bullion?

"Countries around the world are building up gold reserves, which makes sense with its drop in price. If you're sitting on a lot of US dollars and you want a more diversified portfolio, this is the time to do it," says Ball. "About five years ago, India bought more than [US]$6 billion of the International Monetary Fund's gold. Despite its research reports recommending investors sell their gold, [global bank] Goldman Sachs is buying gold. It recently made a deal to purchase US$1.8 billion of Venezuela's gold — a country that is running out of US dollars. Russia continues to buy. The US is not selling. Italy did not sell any of its gold when the EU had to bail the country out." Certainly the most mysterious country in this respect is China. "The last time China announced its gold holdings was in 2009, when it increased reserves from 459 tonnes to 1,059 tonnes [more than a 100% increase]," says Desjardins. "Many people speculate that China is secretly growing its reserves. This is because China does not export gold, yet it is the biggest gold producer each year." While China does not publish gold import data, its imports from Hong Kong registered at just more than 1,100 tonnes in 2013, up more than 70% from 2012. "One of the biggest reasons that a country like China may build up its gold reserves is to boost the 'perception' of its currency. If the yuan is to ever be a reserve currency, it will need to be perceived as a safe currency to hold by other players in the global market," says Desjardins.

Will gold hit $10,000 an ounce any time soon?

Not unless something catastrophic happens. At least that's what Fazzini thinks. "The heights it did hit [in 2011] were part of a super cycle. Things got overheated and gold peaked at an unsustainable level. Today it sits at $1,330 an ounce and our short-term expectation is that it will run between $1,300 and $1,400. That said, gold can be extremely volatile and it can hit highs or lows at a moment's notice. For gold to hit exceptional heights, it would be the result of a significantly weakening US dollar, general doom and gloom in the global economic landscape and a move away from conventional equities. When people took money out of gold this past year, they invested it in stocks in the broader market. Gold is the hedge to the rest of the economy."

Is that a gold coin in your pocket?

"All money today, whether banknotes or coins, is considered to be fiat money, in other words the value of the money comes from the confidence people have in its issuer," says Serge Pelletier, who covers all things numismatic for publications around the world and serves as public relations officer for the Royal Numismatic Association. "Under what conditions would gold coins make a return as a medium of exchange? In a Mad Max scenario, where banks and governments collapse and the value of something is truly based on supply and demand."

Quick Facts

Canada and the gold standard

  • 1854: Canada adopts the gold standard.
  • 1931: Canada officially breaks the link between the Canadian dollar and gold even though the Bank of Canada maintained a “gold mentality” throughout the Great Depression.
  • 1950: Canada moves to a flexible exchange rate — a precursor to the breakdown of the Bretton Woods system.

Olympic gold

  • six grams: the amount of gold found in the Sochi Winter Olympics gold medal.
  • 1912 Stockholm Summer Games: the last time Olympic gold medals were made from solid gold.
  • 20%: the decline in the value of the Olympic gold medal from London’s 2012 Summer Olympics, when it was pegged at US$708, to Sochi’s gold, which rang in at US$566.

All that glitters is not gold — in fact, most of what glitters is not gold

  • 174,100 tonnes: the world’s accumulated gold throughout history to present day.
  • 21m cubed: the size of cube that could hold all the world’s gold.
  • 3,756.1 tonnes: annual gold demand in 2013.
  • 29,282.1 tonnes: estimated global gold mine production.
  • 4,600 tonnes: the amount of gold held in Fort Knox, the US Bullion Depository.
  • 6,700 tonnes: the amount of gold the US Federal Reserve has in gold bars (530,000 bars).
  • US$1,328.05: cost of one ounce of gold on March 2, 2014.