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Friday, February 11, 2011

Why gold goes up in value when there is a financial crisis

Gold goes up in value when there is a financial crisis because it protects against inflationary pressures, serves as a hedge against currency devaluation and assists central banks in preserving financial integrity. This is evident in a January 2010 report from the World Gold Council that recorded a sharp inflow of capital into gold related holdings during the financial crisis of 2009.(1)

Gold is a precious metal commodity
Gold holds value because of its limited supply in the world


In many cases gold holds its value better than multiple forms of liquid currency such as cash, stocks and mutual funds. However, in cases such as the Australian dollar, gold has been recorded to have a positive rather than negative correlation with currency because of the large amount of gold produced by the country.(3) This however, serves to support the notion that gold goes up in value during a financial crisis because the relationship between the Australian dollar and gold is based on the notion Australian currency is somewhat supported by gold mining output.

The relationship between gold and paper currency is established via correlation which is a statistical measure of related events and the statistical outputs themselves are tested for validity using additional indicators, for example P-values. Correlations have been measured between currency and gold numerous times, and generally indicate financial instability leads to a rise in gold prices. This is evident in history several periods of economic instability have occurred with simultaneous, or closely timed upswings in the price of gold.(2)

Since currency like the dollar is backed by the economic strength of its economy, it loses value when financial events occur that weakens its spending power. For example, printing too much money leads to an overabundance that causes inflationary pressure on costs such as a rise in the cost of goods and services. There are many factors that can lower the strength of a currency such as excess national debt, large trade deficit, government deficit spending, collapse of a key industry or economic sector or lack of competitiveness in the international marketplace. In such cases investors and consumers benefit from financial instruments that offer inflation protection.

To better understand why the value of gold goes up when there is a financial crisis it helps to be clear about what a financial crisis actually is. A Department of State Congressional Research Service study broadly concurs the definition of financial crisis is a tightening of credit to both households and businesses to the point of adversely affecting goods and services.(4) In such case the strength of an economy becomes questionable as both businesses and households experience financial difficulties that were previously not as present.

Even though central banks may try to make access to money more cost effective during a financial crisis, banks aren't necessarily as willing to follow through with the credit risk. This can exacerbate the problem of the financial crisis, leading to lower national spending due to weakened asset values which in turn can affect corporate employment statistics, and market performance. In such cases gold investing tends to increase because it is seen as a safe haven like bonds; this causes its value to rise.

Sources:

1. http://www.gold.org/assets/file/rs_archive/GID_Jan_2010.pdf
2. http://www.gold-eagle.com/editorials_05/milhouse021307.html
3. http://www.investopedia.com/articles/forex/06/CommodityCurrencies.asp
4. http://fpc.state.gov/documents/organization/103688.pdf

Image source: Kinross Gold