As the price of gold has pulled back from its recent run up to $1,200, many investors are left to ponder what exactly drives the movement of such an important and financially sensitive commodity. Most people are aware that gold prices respond to inflation expectations and that central banks, as the largest holders of gold, are big players in the market. But there is a very murky understanding as to why and how these players affect prices, and what their ultimate goal may be.
Although I profess no great insight into how central bankers from Bombay, Berlin and Beijing are looking to manage the global gold market, a better understanding of how our current system came to be provides some clue about gold's recent behavior.
The First World War was not only catastrophic to an entire generation of Europeans, but it also left the international financial system in tatters. After the war, the great powers met in Rome to re-establish a workable international financial system. The British pound sterling, which had always been fully convertible into gold, was selected as the official 'reserve currency.' Then, during the Great Crash of the 1930s, the collapse of Austrian and German banks triggered a run on sterling for conversion into gold. Unable to withstand the assault, sterling was replaced as the reserve by the U.S. dollar. Although the dollar was also convertible into gold, the Roosevelt administration had limited the risk to the U.S. Treasury by restricting redemption to central banks.
