The weight of paper

The recent sharp drop in the gold price has taken many investors by surprise, setting off a scramble to understand why, and what lies ahead.

The past years' series of crises and the onset of quantitative easing by the world's major central banks a few years ago invited new interest in gold. The thinking being that if excessive money printing unleashes significant inflation, gold is a currency that cannot be devalued. More than that, gold acts as a form of insurance against political and economic crises that send investors fleeing riskier assets.

So what lessons can be gleaned from gold's recent dramatic decline? Mainly that central banks have succeeded in stabilising the economies of the United States and Europe. Employment numbers are rising in the US, and so are housing prices. The European Central Bank seems to have printed enough euros and bought enough bonds to convince investors that Greece, Spain, Italy and company will not spiral into insolvency.

The Cyprus drama was a case in point. Even when the headlines were at their most hysterical, investors barely blinked. Cyprus did not incite fresh rounds of euro-zone panic.

Investors have been taking all this in. Essentially they have come to the view that the worst will not happen. Put another way, they need less insurance in the form of gold than they thought.

So there is something slightly counter-intuitive about the recent chain of events. Central banks responded to crises by printing boatloads of new money (the Bank of Japan has now joined the fray and is on track to print US$1 trillion of new yen, doubling the country's money supply). In normal times, such money printing would spark fears of inflation and send investors into fits of gold-buying. But quantitative easing has instead calmed investors' worst fears, luring them back into stocks and bonds, and out of gold.