Leading article: As the credit crunch bites with new vigour, a 'barbaric relic' is revived

Saturday 15 March 2008 01:00 GMT
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Kelly Rissman

Kelly Rissman

US News Reporter

Warren Buffet, reputedly the richest man on the planet, has a simple motto; only put your money into things you can understand. The world seems to have taken that to heart recently, and with a vengeance. After a decade or more when financial instruments became so complicated that even investment bankers with degrees in rocket science (literally) couldn't get their heads round them, the markets are now fleeing towards the oldest store of value – gold, an easily comprehensible asset.

The price of gold has breached the $1,000 per troy ounce mark. It is at record levels, though it would need to double again before it exceeded, in real terms, the previous peak of $850, reached in 1980. It is possible, however. Then, as now, the world was fretting about rising inflation and incipient recession; the oil price was at record levels, driven higher by geopolitical tensions in the Middle East and Iran. Now we also have the credit crunch, a collapse in US property and a dollar in freefall. Plus the emerging economies of China and India are bidding up the price of every commodity – from pork belly to gold – thanks to the voracious appetites of their industries and populations.

Gold has historically prospered in times of war and inflation, and it has always been loved in Asia (India is the largest market), the fastest-growing part of the world economy. So, dramatic as it is, the gold boom shouldn't come as a surprise. Keynes called gold a "barbaric relic", but its appeal is that it is incapable of being debased by politicians or misunderstood for something else. At bottom, the gold story is a dollar story. Because the price of gold is denominated in dollars, there are technical reasons why the two prices are inversely rated.

That, however, is only part of the tale. Investors have good reason to believe that the United States has given up both on curbing inflation and on maintaining a strong dollar, with the Fed frantically cutting interest rates – another reduction is due on Tuesday – in an effort to forestall recession. They also believe that the Fed's efforts, and the US federal government's $156bn injection of demand, will succeed only partially against the credit crunch and housing slump. Unless these are corrected, confidence will not return, the dollar and equities will be unloved, and gold will carry on climbing.

Easing the credit markets back to normality will not be easy. Investors, with good reason, have grown sceptical of "asset backed securities" – bonds with the collateral of bundles of mortgages, credit card debts or commercial loans behind them (including those backed by American sub-prime mortgages). The idea was to diffuse risk. That worked all too well. Securitisation encouraged an "originate and distribute" model of banking, which meant off-loading risk as quickly as possible.

Banks lent large sums to unsuitable customers, safe in the knowledge that, by the time they defaulted, the loans would have been sold on, repackaged a few times with the interest payments swapped for some others and the debts "structured" according to their riskiness, often ending up on another continent.

From Germany to Australia, banks found themselves with exotic assets that were less secure than they thought. Large hedge funds, the most high-profile recent example being a Carlyle Group fund, invested billions in them, only to see their value evaporate. Banks then became wary of lending to each other. Hence the credit squeeze that brought down Northern Rock, and may even do the same to the American giant, Bear Stearns. Gold is as good place as any to be while the world tries to sort itself out.

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