Gold is a commodity which is used in increasing amounts in the technologically advanced industries and for medical and associated purposes; with the rise in real incomes, gold is also increasingly demanded for making into jewelry and personal adornments; in addition, gold has been an important form of private saving. Unlike almost all other metals—with the exception of silver—gold has also had a long and somewhat glamorous history as a commodity used for monetary purposes. It is a universally acceptable medium of exchange for the payment of debts between countries, and, formerly, within countries. It is also regarded as an important, if not particularly lucrative, store of value for official purposes and is, therefore, an important component of countries’ international reserve assets. Gold is also used as a common denominator for expressing currency values—i.e., it is what specialists call the numeraire of the international monetary system, in terms of which all currencies are expressed—and thereby facilitates the measurement of the value of one currency in terms of another. The value of the special drawing right is also defined in terms of gold, and the value of the Fund’s assets is maintained in terms of gold.
The monetary function of gold arose largely because of its relative scarcity over the long run, and therefore upon its ability broadly to maintain its relative value in terms of other commodities. However, the abandonment of gold as a monetary asset in the form of a domestic medium of exchange and, more recently, its relative decline in importance as an international asset, are directly attributable to the increasing scarcity of the metal at a relatively fixed price. Unlike silver, which was demonetized because it was becoming too plentiful and too cheap in terms of commodities, the supply of gold over the long run might be too scarce to meet both private and official needs without successive increases in the price. However, it would not be conducive to the stability of the international monetary system if continued heavy reliance on gold in the system could be ensured only by successive increases in its price in terms of currencies. The smooth working of the international monetary system requires not only an appropriate long-run increase in the level of international liquidity—external reserves—but also requires that increases in international reserve assets should take place in the future as in the past, without the necessity of periodic changes in their relative value.
During the last decade it became increasingly difficult to accommodate the private demand for gold, as well as meet the growing need for international reserves in the form of higher gold holdings, and also maintain the price of gold unchanged. The industrial and artistic demand for gold increased swiftly throughout most of the 1960s, not only because of growing technological use of gold—especially in the defense and aerospace industries—but also because gold was a relatively cheap metal, whose price had been fixed at $35 an ounce since the early 1930s. As a consequence, the amount of gold flowing into official reserves was diminishing, as can be seen in Chart 1. The small increases, and periodic decreases, in official gold stocks were causing certain strains in the international monetary system. These strains were largely of two types: first, the decline of gold holdings relative to other reserve assets raised some problems regarding the convertibility of other assets into gold; and second, it was feared that the narrowing of the gold base of the total of international reserves might constrict the growth of total liquidity. As a consequence of these developments, speculation arose regarding the continued stability of the official price of gold, and this in turn increased private demand for the metal—thereby further reducing the flow of gold into official reserves. Speculative activity in the gold markets also tended to affect conditions in the foreign exchange markets, on the assumption that any change in the official price of gold might not be uniformly followed by all countries, and would thereby result in a change in the relationship between currencies, i.e., a change in exchange rates.
Chart 1.Level and Composition of Reserves
Against this background of rising private demand for gold and diminishing official stocks of gold two significant developments occurred during the latter part of the 1960s—the crisis of 1967/68, which led to the establishment of a two-tier price system for gold, and the creation of the special drawing right facility in 1969. These two developments have crucially affected the subsequent working of the gold markets.
Establishment of the Two-Tier System
In late 1967 an intense speculative crisis erupted in both the private gold markets and foreign exchange markets. The crisis in the foreign exchange markets was largely associated with the problems of sterling, which was devalued in November 1967. The devaluation of sterling induced widespread expectations that the official price—i.e., the U.S. dollar price—for gold would be increased, thereby leading not only to a general change in par values but also to relative changes in currency relationships. As a consequence, large-scale private purchases of gold occurred. Between the beginning of October 1967 and mid-March 1968 it has been estimated that private interests purchased the equivalent of about $3 billion of gold, the bulk of which was supplied to the private market at the then official price of US$35 per fine ounce by seven leading central banks acting as a gold pool (see Chart 2).
Chart 2.Gold: Estimated New Supplies and Absorption
1/ Including purchases by mainland China amounting to the equivalent of $150 million in 1965, $75 million in 1966, $20 million in 1967, $43 million in 1968, and $17 million in 1969.
2/ Excluding CMEA countries, mainland China, etc.
In view of these losses, the Governors of the seven central banks—those of the United States, the United Kingdom, Belgium, Germany, Italy, the Netherlands, and Switzerland—met in Washington on the weekend of March 17, 1968. They decided that they would no longer intervene in the private gold markets to maintain the price of gold in those markets within 1 per cent of the official price of $35 an ounce—i.e., they would no longer sell gold to the private markets. Furthermore, in view of the prospective establishment of the special drawing right facility they believed the then existing stock of monetary gold was sufficient and they no longer felt it necessary to buy gold from the market. They also agreed that they would not sell gold to monetary authorities to replace gold sold in private markets. Finally, they invited the cooperation of other monetary authorities in following these policies.
The agreement of March 17, 1968 led to a separation of the official gold market—in which transactions would take place at the official price of $35 per fine ounce—and the private gold market—in which the price for gold would be freely determined in accordance with supply and demand conditions. The two-tier gold market was thereby established.
Creation of the Special Drawing Right Facility
During the latter part of the 1960s, a second important development occurred which, over time, was expected to change the relative importance of gold in the international monetary system—namely, the creation of the special drawing right (SDR) facility. International negotiations and discussions about such a facility took place between 1966 and 1968. The facility was formally adopted in July 1969 when the amendment of the Articles of Agreement of the Fund became effective. It was decided by international agreement to establish a new international gold type reserve asset, the value of which is fixed in terms of gold (the unit of special drawing rights is equivalent to 0.888671 gram of fine gold by Article XXI, Section 2 of the Fund Agreement). The amount of SDRs to be created was to be determined by global need for international liquidity. On January 1, 1970 the first allocation of SDRs took place, and was followed by further allocations on January 1, 1971 and January 1, 1972. Activation of the SDR facility effectively removed the specter of a possible shortage of international liquidity, and also ensured an increase in a gold type international monetary asset, the price of which is fixed in terms of gold.
Effects of the Two-Tier Gold System
The agreement of March 17, 1968 radically transformed both the private international gold markets and official gold policies. First, the price of gold would fluctuate in the international private markets and could diverge from its official price as the leading central banks would no longer stabilize prices at or close to $35 an ounce. Second, it could be expected that all newly mined gold would be sold in the private markets notwithstanding a decision taken by the Fund in September 1951 which stated that “sound gold and exchange policy of members continues to require that to the maximum extent practicable, gold should be held in official reserves rather than go into private hoards.”1 Third, the international monetary functions of gold were to be maintained on the basis of the then existing official holdings of gold; the gold reserves of central banks would change mainly as a result of official transactions between themselves and not as a result of transactions between central banks and the private markets. Private speculation in gold would no longer affect the total of world liquidity and newly mined gold and private gold holdings would in principle be treated in private markets as are other commodities.
In these circumstances, it would be expected that the total amount of monetary gold would remain unchanged. However, South Africa, by far the largest producer of gold, maintained that it was not obliged to sell all its output on the private markets but could sell it to the Fund, in accordance with Article V, Section 6(a); hold it in its reserves; or otherwise dispose of it. Agreement regarding South African sales of gold was not reached until December 1969, when the Fund, as a matter of policy, decided that South Africa could sell gold to the Fund under certain circumstances.
For two weeks following the March 17 agreement, the gold market in London, the leading international gold market, was closed. Upon its reopening on April 1, 1968, gold prices were fixed by the five bullion brokers at $38 per fine ounce—a premium of almost 9 per cent above its official price. This price was in line with the price for gold quoted in the Zürich bullion market which, unlike the London market, had reopened for business immediately following the March 17 agreement.
The London bullion market was the most important international gold market largely because it had traditionally handled the bulk of South Africa’s gold output, but also because since 1961 the bank of England had intervened—as agent for a number of central banks which, together with the bank of England itself, comprised a gold pool—in the market to maintain the price of gold at or close to $35 per fine ounce. This was achieved by buying gold from the market at or close to $35 an ounce if the private supply was greater than demand or by supplying the market if the reverse was the case. Gold prices in the other leading markets which placed no restrictions on the import or export of gold were kept in line with the London price by the import of sufficient gold to meet requirements.
However, after the gold pool operations ceased, the leading bullion brokers in London were called upon to fix the price of gold in the light of the supply of gold on offer and the private demand for it. In these changed circumstances, the bullion brokers in London decided to have a gold fixing twice daily—at the traditional time of 10:30 a.m. and again at 3 p.m. At those times, the price for gold is set—or fixed—at a level which satisfies demand. However, transactions take place at prices other than the fixing price during the day, though these trading prices are normally closely related to the fixing price.
Furthermore, partly in view of the ending of the gold pool operations and of the fluctuating free market price of gold, the London market lost its pre-eminence as an international gold market. The Zürich bullion market, for instance, gained in relative importance, especially because of the role of the leading Swiss commercial banks in dealing in gold, but also because the gold producing countries sometimes found it advantageous—both in terms of price and cost of shipment—to sell gold in markets other than London.
Long-Run Developments Affecting the Private Gold Markets
One of the factors influencing the gold market has already been noted—the increasing demand for gold. In most fields of technology, no substitute for gold appears to be in sight so that rising prices do not appear to affect the demand very greatly. In addition, both artistic and long-term hoarding demands for gold seem relatively more responsive to changes in the level of real incomes and in social habits than to changes in the price of gold. Thus, the increase in demand seems likely to continue.
In contrast to the continued rise in demand for gold, the outlook for increases in the supply of newly mined gold is less certain. Old mines are being worked out, and few new gold discoveries are being made. The volume of gold production since 1965 has been relatively stable or, in some years, has fallen. In addition, there is no assurance that a higher gold price would greatly stimulate over the short run an increase in production; it would seem more likely to have the effect of maintaining output over the longer run. In short, then, the outlook seems to be of a long-run quantitative rise in the demand for gold and, possibly, a stable, if not falling, gold output. Under such conditions, some long-term upward pressure on prices would seem probable.
A second consideration exerting an influence on the working of the gold market is the future role for gold in the international monetary system over the long term. This has two main aspects which concern first, the official price of gold and second, the role of gold in the international payments system.2 In principle, the official price for gold should not exert any marked influence on the private gold markets (and vice versa) since the private and official gold markets have been separated since March 1968. In practice, uncertainty regarding the official price has had a continuing influence on the private gold markets.
The official gold price partly represents a symbol of stability of exchange rate relationships in the international monetary system. Instability in exchange markets gives rise to the possibility of changes in the official gold price as a means of restoring stability in exchange rate relationships, even though such adjustments can more appropriately be achieved by other means. Gold has also been a significant element in the total of official external reserves and has been extensively used in financing international transactions. While the announcement of August 15, 1971, which suspended the convertibility of the U.S. dollar into gold, has cast doubt on the continued use of gold in the system in its previous form, the gold markets have to take into account the large stocks of gold in official institutions, which amount to the equivalent of about SDR 41 billion, and how those stocks might be used in the future.
For example, on the one hand, a deliberate demonetization of gold, or prolonged running down of these stocks by sales of gold in the free market, would fundamentally alter the balance of supply in the gold markets and lead to a fall in prices. On the other hand, heavy reliance on gold in official international settlements would raise the issue of whether there are sufficient stocks of gold for this purpose—and this too has implications for the long-run future official price of gold. between these extreme positions there are, of course, a number of alternatives regarding the appropriate role that gold might play in international official settlements, each of which has implications for the future official price of gold.
In this connection it is interesting to note that the increase in the U.S. dollar price of gold from $35 to $38 an ounce, and the associated changes in the exchange rates of other leading currencies resulting from the Smithsonian Agreement of December 18, 1971, left the weighted average official price of gold practically unchanged.
Gold Price Cycles
Over the past four years the free market price of gold rose from $35 per fine ounce on March 14, 1968 to a peak of $70 in early August 1972. However, the price of gold has fluctuated considerably since the two-tier system was instituted. As can be seen in Chart 3, the free market price for gold shows three distinct changes between March 1968 and August 1972.
Chart 3.Gold: Prices in London, April 1968–August 1972
For the first 16 months following the establishment of the two-tier gold system, gold prices generally rose in the private markets—from about $38 per fine ounce on April 1, 1968 to almost $44 per fine ounce during the first five months of 1969. However, during this period of rising prices, substantial falls in prices also occurred, particularly during the summer and early autumn of 1968. Furthermore, during most of 1968, day-by-day price changes were comparatively large.
The sharp fluctuations in price reflected the unprecedented situation in the private market. As a result of the March 17, 1968 agreement, and for the first time in recent monetary history, the private gold markets functioned without official intervention by some of the leading central banks and under conditions of great uncertainty with regard to the price for gold. A number of other factors also led to considerable uncertainty in the private gold markets after the establishment of the two-tier system. As South Africa, which accounted for over 70 per cent of the western world’s gold production, was not a party to the March 17 agreement, the means by which that country would dispose of its gold production were unclear. In addition, the large amount of gold bought in the private markets in the six months preceding the agreement of March 17 would, if offered for sale, no longer be absorbed by official buyers and therefore overhung the market. A further uncertainty was whether, and in what manner, the two-tier gold system would in fact work; and, in particular, whether other central banks would, as invited by the March 17 agreement, cooperate with the signatories of the agreement. Finally, uncertainty about the maintenance of the official price of gold at $35 influenced the working of the free gold markets not only directly, but also indirectly through developments in the foreign exchange markets.
In fact, during most of 1968 and early 1969, the demand for gold was relatively strong in view of comparatively unstable conditions in the foreign exchange markets. During May/June 1968 the French franc and sterling were under heavy selling pressure; in October/November 1968 widespread expectations arose concerning possible changes in the exchange rates for the French franc and deutsche mark; and, the markets were again disturbed in February/March 1969. The chief significance for the private gold market of developments in the foreign exchange markets was, as noted earlier, the likely effects that possible exchange rate changes might have had on the official price of gold. Hitherto, crises in the foreign exchange markets had led to changes in the level of official stocks of gold; henceforth such crises would be reflected in the private market price for gold. This development led to somewhat distorted conditions in the markets and induced considerable market speculation which led to unsustainably high prices for gold.
Conditions in the private gold markets began to change significantly during the second half of 1969 and a dramatic fall in prices occurred. between the end of May 1969 and the end of December 1969, the price for gold in London fell from $43,225 per fine ounce to its then official price of $35 per fine ounce. In early January 1970, the price fell to $34.75 and then moved fairly closely around its official price until about September 1970.
This rapid and prolonged fall in prices was due to a number of factors which influenced both the demand for, and supply of, gold on the market. Four developments in particular may be noted: (1) the prospective activation of the SDR facility, following the amendments of the Articles of Agreement of the Fund in July 1969; (2) the growing balance of payments deficit of South Africa and the increasing amounts of gold being offered for sale on the private market which, in the absence of heavy short-term speculative demand, were more than sufficient to meet normal industrial and long-term hoarding demand; (3) the prospects of agreement on the disposal of South Africa’s newly mined gold and particularly the extent to which it might sell gold to the Fund; and (4) developments in the international money markets—Euro-dollar rates increased sharply thereby increasing the effective cost of holding gold—and the greater stability in the foreign exchange markets following the devaluation of the French franc in August 1969, the appreciation of the deutsche mark during the summer of 1969 prior to the establishment of the new par value in late October 1969, and the shift into overall surplus of the U.S. balance of payments.
These developments affected the outlook for a possible change in the official price of gold—which had been the dominant factor influencing the international gold markets since prior to the devaluation of sterling in November 1967. In particular, the activation of the SDR facility not only dispelled uncertainty regarding a possible global shortage of international reserves, but also ensured that a part of the growth of international reserves would be in the form of a gold type asset. Furthermore, the Executive Directors of the Fund on December 30, 1969 decided that South Africa could sell gold to the Fund in certain circumstances—in particular, with regard to the price for gold in the London market, when it fell to its official price of $35 per fine ounce, and to the balance of payments position of South Africa. As a consequence of this decision, some gold would possibly flow into official reserves; furthermore, an effective floor price was established in the London market at $35 per fine ounce.
The third significant change in prices began in the autumn of 1970 when prices began to rise. between that time and the summer of 1972, the trend of prices was generally sharply upward, with only comparatively short periods of relative stability and small technical declines in prices. Taking the period as a whole, prices rose from about $36 per fine ounce at the beginning of September 1970 to $70 per fine ounce by the first week of August 1972. During the first five months of 1972—and especially during May and June 1972—the rise in prices accelerated sharply.
For most of this period the international monetary system was under increasing strain. After August 15, 1971—when the United States suspended the convertibility of the U. S. dollar into gold and other reserve assets—the system experienced its greatest crisis since the abandonment of the gold standard in the early 1930s. An analysis of this crisis cannot be given here. However, a few points can be noted with respect to the reaction of the private gold market and the free market price for gold during this period of strain and eventual crisis in the system.
First, and most important, was the pervasive influence of speculation—induced by growing instability in the exchange markets—regarding the official price of gold. Instability in the exchange markets was exemplified by the exchange rate changes of May 1971; the massive movements of short-term funds which moved not only, or even largely, in response to international differentials in interest rates but also in expectation of changes in exchange rates; and the general floating of currencies following the August 15, 1971 announcement.
Second, over the last two years the leading international gold markets have become “thinner” in the sense that the volume of readily tradable gold at a given price has diminished. The supply of gold on the market is now determined largely by the amount of gold offered by the gold producing countries, sales by the U.S.S.R. and East European countries, and by short-term speculative gold holders who trade in response to expected price changes. The large overhang of gold which characterized the market for about two years after the inception of the two-tier system has been partly absorbed by industrial and other users, while a large part of the remainder has disappeared into hoards and is unlikely to be reoffered to the market. The fundamental change in the supply position of gold in the private markets has resulted in sharp movements in prices when even relatively small changes in demand have occurred. In this sense the private gold markets have become relatively more unstable over time.
Third, to a far greater extent than hitherto, a rise in prices has tended to accelerate as speculative activity has fed upon itself. However, subsequent declines in prices have not largely been in reaction to fundamental changes in expectations and demand, but have resulted from technical adjustments to temporarily overbought positions and other factors essentially of a short-term financial nature (e.g., changes in Euro-dollar deposit rates). In conditions of relative calm, prices have not fallen, as might have been expected, but have remained steady.
This “step-like” rise in prices can be observed in Chart 3. For example, after a period of relatively stable prices between the end of January and the end of April 1971, a sharp acceleration in prices occurred during May, followed by a short technical reaction in the first half of June 1971. A similar reaction can be observed between mid-June and the end of August 1971 and again between the end of August and December 20, 1971 (immediately following the Smithsonian Agreement on the realignment of currencies). However, between the end of December 1971 and August 1972, except for a period of relatively stable prices between early February and the latter part of April 1972, an unprecedented acceleration occurred in the rate of price increases. The rise in gold prices between early May and early August, which amounted to over $20 a fine ounce, was altogether exceptional.
To some extent, of course, part of the rise in prices can be attributed to a reduction in the supply of gold offered on the market, particularly by South Africa, at a time when demand for the metal—especially for industrial purposes—was buoyant. However, the relatively high price of gold in the private markets in the middle months of 1972 reflected a large premium in the light of the uncertainty regarding future developments in the international monetary system.
As a result of the establishment of the two-tier system in March 1968, the level of official gold reserves no longer changes as a result of fluctuations in the private demand for gold nor, except to the extent that the Fund purchases gold from South Africa, as a result of fluctuations in world gold output. The official supply of gold is relatively fixed. Furthermore, after the United States suspended the convertibility of the U. S. dollar into gold and other reserve assets on August 15, 1971, and after the subsequent large rise in the private market price of gold, countries have become reluctant to use gold in official international settlements. Indeed, the future role of gold in the international monetary system—as a medium of exchange, as a significant component of international reserves, and as a standard of reference for the valuation of currencies—is uncertain.
In the private markets, fluctuations in the price of gold have reflected reactions to developments in the international monetary system and, in particular, to the future official role of gold in the system. Such fluctuations are, perhaps, explainable not only because of the relatively large official stocks of gold in existence—equivalent to about 30 years output—but also because of the possibility (which took place on May 8, 1972) of changes in the official price of gold.
Furthermore, since the inception of the two-tier system, the supply of gold placed on the market is falling in relation to demand because central banks no longer generally sell gold in the market. Under conditions of crisis or acute uncertainty, reaction in the private gold market tends to be exaggerated and the price of gold shows a rapid rise. In this sense the private gold markets are relatively unstable markets.
The private gold markets are unlikely to function in broadly the same manner as other commodity markets until, at least, the psychological link between the private and official gold markets is broken. To a considerable extent this will depend on the relative importance of the future role of gold as a monetary asset.
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International Monetary Fund, Selected Decisions of the Executive Directors and Selected Documents, 5th issue, 1971, p. 13.
For an authoritative analysis of this matter see Reform of the International Monetary System: A Report by the Executive Directors to the Board of Governors, (IMF, Washington, D.C., 1972), pp. 34-36.