The basics of Gold (page 1 of 2)

By Melinda Peer, Forbes.com

'Gold is a very effective hedge against uncertainty because even as investors are watching the value of their equity investments plummet, gold still has value. In that way, gold can help diversify away some of the risks in an investor's portfolio,' said Tom Pawlicki, a precious metals and energy analyst at MF Global. Gold, a scarce metal that has incited wars, expeditions and conquests throughout history, has retained its value and investment appeal largely because of the gold standard, which dictated that all paper money would be backed by gold reserves.

Even though US President Richard Nixon quashed the US dollar's direct convertibility to gold in 1971, the precious metal only gained popularity as a safe-haven investment since the double-digit level of inflation that plagued the economy during the period undermined the value of the dollar. In January 1980, gold hit $850 - its long-standing record until the current financial crisis led investors to run the price up to $1033.90.

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Inflationary threats have been supporting strong gold prices as investors become increasingly wary of the Fed's plans of pouring money into the financial system in hopes of rebuilding asset values and evading deflation.

The risk, of course, is that anti-deflationary actions will go too far, resulting in high levels of inflation or even hyperinflation.

The US Federal Reserve has been buying assets including government bonds to lower interest rates and ease the de-leveraging process. In order to mitigate the remaining debt that's clogging balance sheets, the Fed has the ability to increase the money supply until eventually enough inflation is created to absorb outstanding debt.

'However, it is not clear, with a failed banking system incapable of transmitting the Fed's 'high-powered money' into new loans, how well or quickly such a 'reflation' policy would work,' said UBS analyst Daniel Brebner. In such an instance, Brebner expects gold to track inflation since it isn't tied to currencies.

Dr John Mathis, a professor of global banking and finance at Thunderbird School of Global Management acknowledged that hyperinflation is a threat given the massive dollar value of bailout actions. He said the challenge for central banks will be determining the right rate at removing excess liquidity from the system.

Hyperinflation concerns are shared by Axel Merk, president and founder of Merk Investments. He remains very concerned that recent policy actions will spur high inflation that the government won't be able to tame.

'The amount of the stimulus is going to be much more than people predict.