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 1930's, 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.

In 1944, the newly established International Monetary Fund (IMF) selected the U.S dollar as its 'international reserve asset', which enshrined a quasi-gold standard to undergird global financial transactions. However, the inflationary policies of most governments caused the market gold price to rise above the official price of $35 an ounce.

In 1961, as the price of gold drifted higher relative to the dollar, the major central banks formed the London Gold Pool, a 'gentleman's club' to coordinate gold sales in order to stabilize gold prices. But by 1971, the dollar's devaluation had overwhelmed their coordinated interventions. Ultimately, President Nixon was compelled to break the dollar's last links to gold by closing the 'gold window' to other central banks. For the first time in human history, the world monetary system 'floated'.

Since then, major central banks have continued to debase their currencies at pace with the U.S. dollar. In 1978, via the IMF, they moved to demonetize gold, which stood to expose the true inflation rate.

This was first carried out by massive central bank sales of gold in exchange for Special Drawing Rights (SDR's) from the IMF. When this failed, the U.S. gained support, in 1999, for the Central Bank Gold Agreement (CBGA) to coordinate the release of central bank gold onto the market.

Officially, at least, this was meant to prevent central banks from dumping gold. However, it is highly suspicious that these nominally independent central banks would take coordinated action to support the gold price. This is especially true given that they've spent the last forty years trying to do the opposite. In my opinion, it is much more likely that the CBGA was designed to covertly time purchases and sales to magnify gold's price volatility, in order to dissuade investors from holding it over the long term.

I believe this intervention is the biggest factor currently distorting the gold market. But the precious metals investor should understand that central banks can only pressure the market, not dictate it. Gold will move up as the following dynamics unravel.

First, the dollar has benefited from its reserve status, which creates demand for dollars to complete various transactions. However, the conditions that put the dollar on the world monetary throne have already changed, and it's just a matter of time before it is forced to abdicate. Just as French endured as the international diplomatic language long after France waned as a world power, so too is the dollar coasting upon its former glory. When the dollar loses its reserve status, demand for the greenback will evaporate.

Second, many holders of surplus currency have diversified massively into the euro. But the euro is a tower built on unlevel ground. Already it is showing cracks as Greece, Ireland, Spain, and Portugal exhibit signs of economic failure. What's more, the EU is about to assume responsibility for basket-case Iceland. If the solvent states of the union succumb to pressure to bail out their weaker neighbors, the euro will lose all of its newfound credibility with investors.

Third, the U.S government has been successful in distorting the official inflation figures downward, reducing evidence of current inflation. Fortunately for the feds, people tend to think in 'nominal' rather than 'real' value terms. For example, investors still feel good buying stocks and bonds of American companies in U.S. dollars. They don't realize that when measured in terms of gold, or real money, the S&P has lost some 20 percent over the past ten years. Over the same period, the U.S. dollar has lost over 280 percent!

Fourth (and perhaps least understood), the massive inflation already created by the Fed remains hidden within the banking system. As long as banks are able to lend directly to the Fed and Treasury at no risk, they have no incentive to circulate their new dollars. Only when the banks leverage up and lend to industry, or are forced to do so, will the prices for consumer goods skyrocket.

Finally, by changing accounting standards for the banks' toxic assets and making self-congratulatory pronouncements, the government has created the impression that crisis has been averted and faith restored in paper currencies. This feeling of relief is flawed fundamentally. It will not be long before investors are brought to the devastating realization that true recovery from a credit boom requires tightening and recession - that Washington did not avert catastrophe, but ensured it.

As these dynamics unravel, the full consequences of U.S. profligacy will be felt around the world. The central bankers could sign any agreement they wish but it won't stem the meteoric rise of gold. By then, investors will understand that those left holding dollars will be left holding the bill.

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