Few assets both confound and fascinate investors or politicians like gold. Like stocks, there is a great deal of conventional wisdom and many rules of thumb regarding what makes gold tick, but many of these notions fail careful inspection. Gold is an inconsistent hedge of inflation and hardly an international proxy for "real money," but it does seem to be a global decree on the current state of government policies and the near-term economic outlook. The past 10 years have offered up a lot of evidence and anecdotes as to what really matters when it comes to government actions ultimately influencing the price of gold. (For more on gold, read 8 Reasons To Own Gold.)

TUTORIAL: Inflation

In the Beginning
Looking at a long term chart of gold, the price really started to get going around mid-2001. One of the first things that President Bush did in his administration was to pass a major tax cut; a cut that even in the day looked to reverse a lot of the fiscal solvency achieved during the prior Clinton administration. When the September 11 attacks occurred later that year, gold prices spiked again on a rather more familiar "global chaos" trade.

As time went on, there was more and more concern about deficits and government profligacy. Then-Vice President Cheney's comment that "deficits don't matter" arguably highlighted this concern, while the U.S. government began a program of heavy deficit spending to fund new counter-terror military efforts.

At the same time, China began to emerge on the stage as a larger influence in the global economy and the commodity markets. Incremental emerging market demand led to major gains in commodity prices and fears of inflation began to emerge.

Said differently, the threat of inflation came out of hibernation for the first time in many years; investors reacted to the sudden disappearance of budget surpluses and a credible path towards much less national debt, and the entire world was faced with the very real threat of a multi-year war on terror.

The Credit Crisis Exposes More Flaws
As commodity prices and housing prices marched steadily upward through the 2000s, gold went along for the ride. Then came the collapse of the housing market and the resulting credit crisis. Gold actually had a curious performance as the crisis developed. As prices collapsed and banks, hedge funds, insurance companies and other financial institutions teetered, gold jumped.

Curiously, gold briefly gave a lot of that back. Whether it was optimism that the Bush administration was moving aggressively to stem the damage of the subprime collapse, confidence in measures like interest rate cuts and explicit government support, or a belief that housing prices would soon stabilize, gold prices traded broadly lower until the collapse of Lehman brothers, the November elections and the passage of TARP in the fall of 2008.

The fall of 2008 is also when Europe began to dominate the story. Iceland began to nationalize its failing banks and the impact of the financial crisis began to show in countries like Greece and Ireland - countries that used their membership in the eurozone to gorge on low-rate debt when growth was flush. These fears continued to accelerate and reached a fever pitch in 2010, all the while, spot price of gold jumped from around $870 to almost $1,400 an ounce.

In a nutshell, what happened was the realization that many national governments had built spending and debt infrastructures predicated on unsustainable asset valuations and tax flows. As the revenue dried up in the recession, the question of how (or even if) governments could maintain their debt payments rose to the fore - potential defaults (and still more bank failures) dominated the discussion and gold was buoyed by a fear trade predicated on the collapse of the eurozone system, the possibility of multiple national defaults in Europe, and further knock-on bank failures. At the same time, global central banks may have exacerbated the gold trade by entering the market to repurchase gold sold many years before, in an attempt to show support for their currencies and restore confidence. (To learn more about the correlation between gold and currencies, check out How Gold Affects Currencies.)

The Debt Ceiling Puts a Head on the Story
While the European debt crisis is far from over, gold has picked up more momentum from the foibles and failings of the U.S. government. The wrangling in the summer of 2011 offers a good microcosm of some of the issues that seem to be driving more momentum in gold.

The U.S. government has raised its debt ceiling many times with no appreciable correlation in gold prices. Several things were different this time around. First, while there have been rancorous debates in the past about debt ceilings, the rhetoric was even more heated this last time and there was sober discussion of the U.S. defaulting on its debt for the first time in decades. With the prospect of technical default on the world's largest investment class (U.S. government bonds), the default immunity of gold became even more attractive.

At the same time, the debate over the debt ceiling highlighted the parlous state of the U.S. national balance sheet - huge deficits, an increasingly dangerous national debt, and truly intimidating future liabilities from programs like Medicare. With the presumption that the U.S. would ultimately have to deal with that debt through economically crippling tax increases and spending cuts or rampant inflation, the gold-as-inflation-hedge story got another boost.

Arguably worse still, the dialog in Washington fed into one of the key motives of many gold investors. Gold historically trades higher when investors are most concerned about the global economic outlook and government commitment to solvent and sustainable policy. As the wrangling within Congress seemed to suggest that workable compromise was out of reach and economic policy would take the form of either rampant deficit spending or draconian spending cuts, gold continued to run on the fear that the U.S. dollar would continue to lose value, inflation would get out of control and economic growth would be hamstrung for years (if not decades) to come - a situation very much like the past peak in gold in the early 1980s.

The Bottom Line
Gold does poorly when governments appear rational and responsible and the global growth outlook is positive (but not overheated). In the past 10 years, much of that scenario has crumbled. Governments in the U.S., Greece, Ireland and other countries gorged on cheap debt that was seldom put to productive or sustainable use. The rise of major emerging economies, and their robust demand for raw materials, resurrected widespread fear of demand-driven inflation and investors began to fear that widespread monetary stimulus, currency depreciation and stagnant growth would be the new world order.

Gold has a dodgy history as an inflation play, but it has a rather more glorious history as a proxy and hedge for fear and feckless government. While a return to sound fiscal policies and a period of balance sheet recovery would likely be bad news for the price of gold, investors who believe there will be yet more fear, uncertainty and government half-measures could yet see gold outperform on an ongoing "fear trade." (To learn more about the stability of gold, see The Gold Standard Revisited.)

Related Articles
  1. Mutual Funds & ETFs

    Top 5 Precious Metals Mutual Funds

    Obtain information and analysis of some of the top-rated and most popular mutual funds that offer investors exposure to the precious metals industry.
  2. Chart Advisor

    Gold Struggles to Climb Higher and May Fall Soon

    Traders will be watching the price of gold over the coming weeks. We'll take a look at how a couple major moving averages are suggesting that the next move could be lower.
  3. Forex Strategies

    These Are The Best Hours To Trade the Euro

    Six popular currency pairs and numerous secondary crosses offer euro traders a wide variety of short- and long-term opportunities.
  4. Mutual Funds & ETFs

    4 Mutual Funds to Consider If Interest Rates Rise

    Learn what mutual funds will perform best if interest rates rise. Interest rates can rise due to inflation or to an improving economy.
  5. Markets

    The 4 Biggest Russian Mining Companies

    Discover information about the metals and mining industry in Russia, along with information on some of the largest Russian mining companies.
  6. Economics

    A Look at Greece’s Messy Fiscal Policy

    Investigate the muddy fiscal policy, tax problems, and inability to institute austerity that created the Greek crises in 2010 and 2015.
  7. Technical Indicators

    Key Financial Ratios to Analyze the Mining Industry

    Discover some the most important financial ratios used by investors and analysts to evaluate companies in the metals and mining industry.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares Gold Trust

    Learn about the SPDR Gold Shares ETF, how it tracks the price of gold, and what type of investors may want to hold shares in their portfolios.
  9. Professionals

    Holding Out for Capital Gains Could Be a Mistake

    Holding stocks for the sole purpose of avoiding short-term capital gains taxes may be a mistake, especially if all the signs say get out.
  10. Investing News

    Oil or Gold: Which Will Recover First?

    Not sure where oil and gold are headed? The answer is complex.
  1. Optimal Currency Area

    The geographic area in which a single currency would create the ...
  2. European Sovereign Debt Crisis

    A period of time in which several European countries faced the ...
  3. Sprexit

    Sprexit, or SPanish euRo exit, is the possible case of Spain ...
  4. Grexit

    Grexit, an abbreviation for "Greek exit," refers to Greece's ...
  5. Regional Asset Liquidation Agreement ...

    An agreement between an asset manager and the Federal Deposit ...
  6. Eurogroup

    Eurogroup is an informal, meeting of the finance ministers of ...
  1. Do negative externalities affect financial markets?

    In economics, a negative externality happens when a decision maker does not pay all the costs for his actions. Economists ... Read Full Answer >>
  2. What is the difference between disposable and discretionary income?

    According to the Bureau of Economic Analysis, or BEA, disposable income is the amount of money an individual takes home after ... Read Full Answer >>
  3. What are the major laws (acts) regulating financial institutions that were created ...

    Presidents George W. Bush and Barack Obama, in conjunction with Congress, signed into law several major legislative responses ... Read Full Answer >>
  4. What are the similarities and differences between the savings and loan (S&L) crisis ...

    The savings and loan crisis and the subprime mortgage crisis both began with banks creating new profit centers following ... Read Full Answer >>
  5. What measures could the U.S. Government take to prevent another crisis similar to ...

    Some of the measures that the U.S. government can take to prevent another crisis similar to the savings and loan (S&L) ... Read Full Answer >>
  6. How was the American Dream impacted by the housing market collapse in 2008?

    The American Dream was seriously damaged by the housing market collapse in 2008. In many ways, the American Dream is a self-fulfilling ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!