The seemingly inexorable rise of gold is driven by a number of significant demand and supply-side factors, many of which are structural in nature and unlikely to change soon. On the demand side, the rise of gold purchases for investment purposes is a key driver. The historical parallel with the 1970s is particularly instructive given the extent to which investors lost confidence in government policy in an environment of high inflation, low growth, and a departure from the Bretton Woods framework of exchange rates in 1971. Gold prices rose at an annual 52 percent, from $36.07/oz. in 1970 to $614.6 in 1980. The current environment, similarly, is marked by unorthodox economy policy, negative real interest rates in most parts of the world, and exceptional risks because of high leverage levels, a risk that has been repeatedly highlighted by the vulnerable euro-zone economies. Even as investment demand for gold has risen, it remains far behind its historical proportions. Gold and gold-mining shares currently account for less than 1 percent of total global invested assets, having for decades stood at a quarter or so. This remains the case in spite of the fact that gold has become far easier to invest in due to product innovations such as exchange traded funds (ETFs) which are highly liquid and eliminate the need to store physical gold. Also jewelry demand is showing signs of becoming less price-elastic as consumers are seemingly ready to give up on the prospect of price corrections.

This anxiety weighing on the minds of ordinary investors has also prompted a change of heart by central banks which, after decades of divesting their gold holdings, have - especially in the case of some of the leading emerging economies - dramatically changed course. These decisions reflect concern about the sustainability of the current policies pursued by especially the US Federal Reserve and the potential erosion in the value of the large US dollar-denominated foreign exchange reserves. But they also seem to be linked to an occasionally articulated aspiration to move toward a new global exchange rate regime which would in some way formally involve gold. One example of this thinking was the recent suggestion by President Robert Zoellick of the World Bank that gold should play a role in informing exchange rates going forward.

But the persistent pressure on gold prices is just as much due to the increasingly acute difficulties of producing it. Many of the historically leading producer nations have been struggling to maintain their output levels and, over the past five years, the average recovery grade of gold ore has fallen by 30 percent as the quality of reserves deteriorates. The global gold stock of some 160,000 tons is rising at an annual rate of just over 1.5 percent whereas demand growth is in the double digits. Even the increased availability of scrap gold has done little to alter this fundamental dynamic.

In an environment of pervasive economic uncertainty, gold offers the prospect of enduring value but it by no means immune to the acute instability plaguing asset markets. In the cross-fire of unprecedented risks and aggressive stimulus measures, the levels of investor risk aversion have proven highly volatile. The secular increase in gold demand notwithstanding, the yellow metal has not lost is safe haven function. As a result, progress in bringing about a seemingly sustainable recovery would likely at least temporarily curb the momentum in gold prices. Nonetheless, an exceptional crisis is likely to be followed by an exceptional recovery. It is becoming increasingly clear that a return to sustainable growth will have to involve large-scale de-leveraging across the advanced economies. This can happen through fiscal consolidation, which is bound to have significant adverse implications for growth for several years. Or it can be done through increased inflation - a prospect increasingly recognized as a possibility given the scale of unconventional monetary stimulus measures. In this case, a 1970s-style scenario looks likely. In either case, confidence in economic policy and the prospects for the global economy are like to take a long time to return. And, as history, shown, in uncertainty people turn to gold in the absence of credible alternatives. Under the circumstances, even with occasional warnings of a gold bubble, a large number of analysts foresee an inexorable march toward the historical real peak of some $2,500/oz. and quite possibly even far beyond.
 
(Jarmo T. Kotilaine is chief economist at NCB Capital.)