@eurodrama Where do you think the term pound *sterling* comes from? But that was centuries ago. Won’t come back.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama Rest of world has been preparing for the end of the dollar since the late 1970s. They have chosen gold. Is well

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama documented and was clearly communicated. Euro zone, OPEC, China agree. Silverbugs won’t be asked. #sorry

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama What matters is that savers (not debtors) will be in charge. The big savers (Europe, OPEC, Asia) have chosen gold

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama Who says CBs will be in charge? Some of the biggest savers have decided to introduce the Euro. The Euro is paper

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama and has a CB with the mandate to target its purchasing power (just under 2% consumer price inflation). This CB

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama also has gold as their major reserve at a *floating* price. This will one day cause a spontaneous change in the

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama international monetary system. Euro will be purchasing power stable in the short run, and gold will be used to

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama settle international balances and to store wealth for the very long run. With the introduction of the Euro this

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama transformation of the int’l monetary system is the path of least resistance and thus almost inevitable. #clever

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama You see the Euro at $1.30 and must be scratching your head. How can a failing currency whose CB prints money not

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama collapse? Answer: Because the savers in the rest of the world back it. They want gold for int’l settlement, take

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama away the oil privilege of the dollar, and have a currency without intrinsic inflation (Euro).

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama The old dollar system in contrast needs to suppress the balancing role of gold in international trade. Otherwise

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama the dollar would die. This is only possible with structural inflation (reserve creation if debt is the reserve).

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama The Rest of the World wants to get rid of this dollar system in which they overpay for oil whereas the US simply inflate.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama The savers have realized that you need two “currencies” is order to avoid the accumulation of int’l imbalances.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama One (gold) that settles international balances and whose real price fluctuations stabilize trade accounts.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama Another one (paper money, Euros) that is purchasing power stable for business. Need predictability.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama Hard money people often claim that you can use gold for both transactions(=business)and international settlement

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama To balance international trade accounts, the real price of gold must fluctuate. But if gold is your business

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama currency (wages, prices, etc.) you get regular bouts of inflation and deflation on the scale of +/-10% per year.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama This was common before WW1. But modern business and modern society don’t like strong price fluctuations.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama The savers who designed the Euro knew this and solved the problem. Now wait for dollar system to self-destruct.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama What about politicians’ addictive spending habits? Watch Greece and watch Cyprus. How can they spend more money

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama than they earn? Ooops. No longer currency issuers. Need to get used to living within their means.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama Other governments will have to learn the lesson, too. You see introduction of Euro has put the savers in charge.

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama Why not decades earlier? They threatened it in 1978 (IMF Belgrade meeting). But world was not ready. International

— Victor The Cleaner (@VictorCleaner) April 6, 2013

@eurodrama trade would have collapsed without the dollar. There was no other currency large enough. But they managed to

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@eurodrama pressure Volcker to stop inflating. In turn, they continued to support the dollar. It took 20 years to set up an

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@eurodrama alternative currency big enough for world trade: 1999 the Euro. Europe was ready to dump the dollar.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@eurodrama Take a look at the Washington Agreement on Gold, September 1999. For some reason, then China decided to support

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@eurodrama the dollar for another decade. Perhaps wanted to gain time, prepare? Europe apparently on board, gave them time.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@eurodrama Then end of 2012 price support for London gold stops (looks like it did) and Bundesbank releases all gold transactions.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@eurodrama Interpretation? Time’s up? We will find out.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 What needs to fluctuate is the *real* price of gold, i.e. in terms of goods and services. If A has a trade surplus with B,

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 B pays A in B$. A then sells B$ for gold. Goods flow from A to B. Gold flows from B to A. (“Oil and gold never flow in the

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 same direction” – Geek note: except into India) In A, there is now more gold per GDP. The price of A’s products in gold …

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 increases. Internationally, because settlement is in gold, A will become less competitive, counteracting its trade surplus.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 Opposite happens in B. International gold settlement balances international trade *because* it creates in-/deflation if

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 goods prices are in gold. The real price of gold fluctuates. The insight is that in my second tweet, it does not matter

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 whether the B$ is paper money or ounces of gold. If it is ounces, B gets inflation and deflation depending on trade flows.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 If B$ is paper, the CB of B can manage the B$ to be purchasing power stable (=Euro).Still gold balances international trade

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 When I said the B$ is paper, I meant that B$ is a fiat currency that fluctuates against gold (not credit denominated in oz)

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 Separation of B$ (purchasing power stable) from gold (international settlement) is Nash equilibrium. If A has trade surplus

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 with B and A receives B$ as payment, A can enforce final settlement by selling B$ for gold. But can A also chose to …

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 accumulate B$ in order to “manipulate” its currency and perpetuate its trade surplus? The answer is no.B’s CB can create B$

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 (=print) and use them to buy gold, thus mimicking what A’s companies should have done. The incentive for perpetuating

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 international imbalances is removed on *both* sides.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 What matters for int’l settlement is that settlement is in physical gold, but not in any form of paper (=debt), neither

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@michaelhunter81 bank notes or credit money of a gold standard currency nor a fiat currency that floats against gold.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@craig_slater No. If China export into Euro zone and European companies pay with Euros, someone in China ends up with more Euros. China can

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@craig_slater choose to sell Euros for gold (either their private sector or if they don’t, the PBoC).But what if the Chinese keep the Euros?

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@craig_slater In this case, the European imports would not cause the Euro to decline, and China would keep their competitive advantage in

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@craig_slater their trade with Europe. What can Europe do about it? Victim of a currency manipulator? Answer: No. The ECB can create Euro

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@craig_slater reserves for the Chinese to hold,but they must do it by purchasing gold in the market in order not to inhibit the adjustment.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@craig_slater This is one of the reasons why the ECB accounts for their gold at market price. If foreigners want to keep holding Euros, they

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@craig_slater can buy gold and print Euros in order to create reserves without going into debt and without preventing the adjustment process

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@craig_slater in international trade that results from fluctuations of the gold price.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@darenpa72 But it could go the other way, too. China (its private sector) can choose to hold either (1) Euros or (2) gold. Both choices have

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@darenpa72 different risk/return. (1) gets you stable purchasing power for Eurozone goods and services up to some small inflation target.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@darenpa72 (2) exposes you to gold price fluctuations. Euro price of gold may go up **or down**.It will go down, for example, if Eurozone

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@darenpa72 has net trade surplus because they export even more somewhere else than they import from China.

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@darenpa72 True even today. U.S. don’t have to accept China’s “currency manipulation”. US Treasury can create dollar reserves buy purchasing

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@darenpa72 gold in the market. This sterilizes the Chinese action if China holds dollar reserves. Then Fed can sell bonds for dollars and

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@darenpa72 sterilize the Chinese action if China holds bonds rather than dollar reserve (i.e. dollar central bank money). So why don’t they?

— Victor The Cleaner (@VictorCleaner) April 7, 2013

@darenpa72 The U.S. apparently like it when China buys their dollars and dollar assets. Question to the reader: Why is this?

— Victor The Cleaner (@VictorCleaner) April 7, 2013

Sources

The presentation focussing on the separation of gold (store of value) from the currency (medium of exchange) as a separation of the international reserve form the local currencies goes back to Blondie’s insistence that gold cannot have constant purchasing power if it is to function properly in international trade. The discussion took place in the comments section at FOFOA’s blog between costata, Blondie and myself between October 25, 2012 at 1:05 AM and November 10, 2012 at 9:10 PM. We returned to this topic on the Neuralnetwriter forum around 17 March 2013 where Blondie explained his point of view to MF. Blondie also reposted the relevant excerpts of the original discussion.

Further Discussion

In a private discussion, I wrote

Thinking that the real price of gold would be approximately stable is a hard money fantasy. Get rid of that baggage, gentlemen. No, I cannot predict exactly how much the real price of gold will fluctuate, but fluctuate it must.

The ECB will not use gold open market operations in order to target consumer prices. That would be unstable (and of course foolish as it would be pro-cyclic rather than counter-cyclic, precisely the same instability as that of the gold exchange standard). No, in order to target purchasing power, the ECB needs to target some money supply measures in the conventional way by influencing the credit creation in the banking system.

The only gold open market operations consistent with the framework of freegold are the sterilization of a capital inflow or its converse.

As DP and milamber remarked on twitter and on my page, it is the option of the ECB to act like this that enforces compliance of their trade partners (I called them ‘China’ in my examples). Just the threat that the ECB can do this is enough to create an incentive for ‘China’ (either the private sector or, if they for some reason don’t do it, the PBoC) to settle in gold whenever there is the threat that the Euro zone might end up a net importer of goods and services (ex gold), because this is precisely the situation in which the Euro would decline with respect to gold. This creates stability of capital flows in addition to the known stabilization of trade flows.

For some reason, no CB official uses the words ‘gold’, ‘oil’ or ‘exorbitant privilege’ any longer. The Europeans just speak of ‘international imbalances’. If you take this into account, Noyer’s announcement that the Euro would be purchasing power stable and his invitation to hold Euro central bank money as a safe store of value, given that you as an Asian central banker know that gold will be the international reserve, guides you to precisely one conclusion:

1. The ECB will target purchasing power of the Euro.
2. This means they will not target a specific real gold price (otherwise the Euro would be on a soft gold exchange standard)
3. Both 1 and 2 tell you that the ECB must sterilize any excessive inflow of capital by gold open market operations. Monetizing anything else would conflict with 1.
4. If Noyer invites you to hold Euro base money as a safe store of value, he must commit to 3. or be inconsistent.

Remember that I wrote above that in order to target consumer prices, the ECB needs to target a suitable measure of money supply.

In all of the European debt crisis, the ECB has demonstrated that they are doing precisely this. The Euro is effectively ‘hard’ money. Creditors and debtors are not bailed out at the expense of deviating from the mandate of price stability. The entire handling of the European debt crisis is a grand lesson on how the new financial system will look like.

You just need to listen to what the relevant ECB/BIS officials say (Noyer, Weidmann – see below) and watch what they are doing. They are pretty frank, aren’t they? Here is Jens Weidmann in a recent interview. Every other month they give you a clear statement that the Euro is not going to be devalued with respect to goods and services (not more than the announced 2%), but rather that they will enforce enough deleveraging to keep its purchasing power on target.

I cannot see that the ideas that

1. Gold will be purchasing power stable
2. The Euro will devalue with respect to goods and services (by more than the stated ECB mandate)

would have any sound foundation. The first is a hard money fallacy and the second is Anglo Saxon mainstream economics.

Finally some people seem to think that in view of the excessive debt it will not be possible to keep the purchasing power of the Euro stable. Well, there is a big difference between allowing the inevitable deleveraging and allowing consumer price deflation. With the Euro being paper money, not caring about the real price of gold, there is a new degree of freedom that allows the ECB to differentiate between the two, allow deleveraging but not deflation.

Another Snippet

In the new financial system, the CB basically has two options:

1) Manage the fiat currency in a way similar to the ECB, i.e. a sort of “hard paper money”. No inflation to expropriate savers, not preventing deleveraging, but they would print in order to fight deflation.

With such a CB, the currency becomes a store of value in Blondie’s sense. And yes, I still think the ECB can and will eventually target 0.5% inflation or even 0%. There is nothing bad about it.

It is reasonably safe for anyone to hold such a currency, at least if you can get hold of central bank money. If such a currency gets a capital inflow, their CB must buy gold.

2) Manage the currency with a higher or at least an unpredictable inflation rate. Savers will be reluctant to hold such a currency and go for gold more quickly. (Or perhaps buy Euros instead).

Following Blondie, I do think that once you take the oil privilege away from the dollar, and once you settle international balances in gold, not sterilizing the flow of gold, you will already have arrived in the new system. In this environment, it becomes possible to manage a fiat currency to have on average 0% consumer price inflation, and it would be safe to hold that currency.

In the earlier discussions about freegold, people used to claim that the savers would eventually (have to) withdraw all savings from all currencies, not hold curreny as savings at all and use gold as basically the only store of value. I now think that settling international balances in gold suffices. You can then still hold the Euro, it will be fine. You certainly want to avoid the dollar and all dollar anchored currencies because of what happens when it goes out of business as a reserve.

The only obstacle that prevents the world from transiting into this final Nash equilibrium of international gold settlement is a symbiosis between two parties that benefit from a different strategy: The U.S. keeping the dollar strong (where freegold says they ought to buy gold whenever they send currency abroad), and the oil producers demanding dollars for their oil, only exchanging a part of these dollars for gold. Once the oil producers accept an arbitrary currency and always convert all balances into gold, the new system has arrived.

On my claim that 0% inflation in fiat currency will be possible. Well, what happened before WW1? On time scales of 10-20 years, the currency was pretty exactly purchasing power stable. This worked because gold functioned internationally. But this caused wild price swings on a time scale of under 5-10 years. The real price of gold needs to fluctuate (wildly!) in order for gold to function.

What the modern economy doesn’t like is the wild fluctuations within 5 years. The fact that the currency was purchasing power stable over periods of 10-20 years and longer, wasn’t the issue. There is no reason why the economy would need structural inflation nor that anyone would benefit from it.

What went wrong starting with the Fed under the Harding administration around 1920 (see FOFOA’s “Once Upon A Time”) is that they didn’t like the strong price fluctuations due to the international function of gold. The Fed sterilized the inflow of gold in order to fight local price inflation. This was probably even well intended, but it contributed to the collapse of the international gold standard and thereby to the accumulation of imbalances.

Now if you have a fiat currency separate from gold, you can let gold fluctuate as is required by its international function while you can indeed fight inflation in your fiat currency locally (and deflation, too). Whether your fiat currency has a stable purchasing power over time frames of 10-20 years or whether it has 1.5%-2% inflation as per the Eurosystem’s current target, is a different question.

Since a 2% long term inflation target has no benefits, why not go for 0% and make your currency a proper store of value, too? As long as gold functions, there is no issue.

Speaking about gold’s function, remember Barsky-Summers. Gold will play that role again, too.

Of course, right now, the US dollar is running a high risk of hyperinflation, and in that case, the savers would indeed run away from the currency. But for the Euro zone, I don’t think it would be a problem for those who can hold base money (i.e. basically foreign CBs).

Yet Another Snippet

It is not the difference between a 2% inflation target and a potential 0.5% or even 0% inflation target what distinguishes soft money from hard money.

Under the old gold standard, a period of credit deleveraging always threatened the system by potentially triggering a chain reaction of credit collapse, falling consumer prices, recession, credit collapse, and so on. The inflation target of the ECB is going to prevent this from happening. It is just that the key is not the gradual difference between a 2% or a 0.5% target, but rather that they are committed to and also have the tools to avert a deflationary vicious circle.

The difference between the gold standard and a Euro with a 0% inflation target is qualitative. The difference between a Euro with a 2% target and a Euro with a 0.5% target is gradual. The former is a huge conceptual difference, the latter a technicality.

The following is one of the flaws in our thinking as of one or two years ago:

Q: Once the transition has happened and the new financial system is up and running, and the dust has settled, what will prevent savers from again saving the currency rather than gold. If the currency, say the Euro, is well managed for a few decades, people might again be tempted to accumulate currency savings. Will this destabilize the system?

A: The answer is not that obvious, isn’t it? If the Euro is well managed, why wouldn’t you hold it for the long run? Because you are still shocked by the transition? Alright, then let’s think about the generation of our grandchildren. They will know the transition only from our fireplace tales and hopefully from their Econ 101 textbooks. But they won’t be personally shocked. So will they keep in mind that they have to save in gold in order not to destabilize the system?

Isn’t it convenient for the missing answer that the ECB has a 2% inflation target, and so if our grandchildren are prudent, they would understand that this is not very nice for their savings in the very long run…. Does the ECB need to impose an inflation target strictly above zero just in order to keep the system stable? Yes or no?

The entire point is, of course, moot. The ECB can choose any reasonable inflation target, say, anything between perhaps -2% and +4%, as long as they act in a predictable fashion and don’t cause uncertainty and unnecessary friction in the economy. Freegold will work in any case, and this is because it separates two things:

1) International adjustments by market driven changes in the real price of gold

2) Domestic targeting of some reasonable value metric for your business currency. It is quite obvious that it is a good idea to manage your currency in such a way that there are only small changes to the general price level and to wages.

It is the separation of (1) from (2) that makes the new financial system viable. Conversely, both the gold exchange standard and the dollar system with a paper price of gold link (1) and (2) in a way that prevents you from accomplishing both international balance and purchasing power stability at the same time and in the long run.

Freegold already solves this because it sets gold free and allows it to function: (1). The precise inflation rate or “management style” that you choose for your fiat currency is a separate consideration.

Will the ECB cause some serious bloodshed by not letting the Euro inflate beyond 2% and thereby not relieving the pressure from debtors and savers? FOFOA (from memory) “If you think austerity riots are bad, wait until you see hyperinflation riots.”

I said the way the European debt crisis is being handled today is a grand lesson on how the future financial system will look like. Blondie said that if you want to understand how the ECB views the future financial system you need a point of view from which their actions are consistent. He is absolutely right. Just watch. They are demonstrating it to all of us.

Is the ECB causing a bloodshed in Greece, one that they would have avoided had they printed without limit? Answer: No. Greece enforced some 50% haircut on their bondholders in spring 2012. It is not that the debtors are treated like slaves. No, the creditors share the burden and take a haircut, too. Is this money really too hard? The past haircuts (Greek government debt, Cyprus’ bank deposits, some second tier Spanish bank debt) won’t be the only ones. More will follow. Eventually the investors will bear the majority of the losses. The losses won’t be socialized via inflation, but rather will the investors be “encouraged” to take responsibility and to think about what they are going to do with their savings.

This is as in the new financial system.

Three further Snippets

(21 April 2013)

The following are taken from the NeuralNetwriter Forum and only modified slightly:

One aspect that keeps impressing me is that the entire Eurosystem has been set up in such a way that it can operate under the new financial system without any single change of statutes or change of law. Politicians are not needed for the transition.

This is in contrast to the U.S. (or Japan, UK) where plenty of legal and procedural changes are required. Just think about the U.S. gold reserve and the certificates written against it at $42.22/oz that are on the Fed books. Think of their monetary policy goal of full employment, etc.

Now take a look at the following detail about the Eurosystem. The Treaty on the European Union says their primary goal is price stability:

http://www.ecb.int/mopo/intro/objective/html/index.en.html

Then the ECB Governing Council clarified this and specified that they are targeting consumer price inflation below, but close to 2% annually:

http://www.ecb.int/mopo/strategy/html/index.en.html

Oops. That would be easy to adjust down to 0.5% or even 0.0%, wouldn’t it? The numerical value is not in the Treaty, but it is rather a decision by the governors.

Why would they consider adjusting the inflation target down? Wrong question. The right question is, after the transition to the new financial system, where would they get 2% inflation from?

That would be far from easy. In the absence of any serious turbulences, velocity is approximately constant. Then there is basically one way you can get inflation. The total volume of fungible “money” that is available to purchase goods and services, has to increase. At present, this happens, for example, when commercial banks create credit and when this credit is used to purchase goods and services. It happens when a commercial bank borrows liquidity (=reserves) from the ECB and pledges government bonds as collateral. (This is because, in aggregate, this allows the governments to write additional bonds without exerting any pressure on the interest market and, in turn, makes new base money available) Thirdly, it happens when the ECB buys assets (e.g. government bonds) directly and pays with reserves (=Euro base money).

Now after the transition, do you think that
a) consumer loans will keep growing faster than GDP?
b) loans to governments will keep growing faster than GDP?
c) the ECB will keep printing money and hand it over to the governments?

No? You don’t think so, do you? Then where do you get 2% inflation from?

The answer is, you won’t.

If the Eurosystem can easily go for a 0.5% or even 0.0% inflation target, why haven’t they implemented it right in 1999 when the Euro started? Why only post-transition?

At this point, we need to recall the main pillar of the dollar system. If you are a third party and you need to buy oil, you face the difficulty that oil is sold only for dollars. Therefore, you first need a trade surplus of goods and services into the U.S. (or into some other countries who pay with dollars) in order to earn dollars. Then, you can use these dollars to purchase oil. Furthermore, the U.S. Saudi axis sometimes increase the dollar price of oil, and in this case, you would be in trouble unless you had a considerable reserve of dollars at hand. This is what keeps the dollar alive.

Now in which way has the Eurosystem escaped this dollar system?

They set up the Euro zone in such a way that it had a balanced trade and a balanced capital account in 1999. But the Euro zone is not a closed economy, it is rather the major trade hub of the planet. They import energy and resources while they export machinery and finished goods. The Euro zone will be independent of the dollar system as long as they receive for their exports the same currency that they need for their imports, and as long as their trade account is balanced, i.e. their balance of trade is small compared to their remaining dollar reserve.

But since oil is still sold only for dollars, the Euro zone needs to keep up its exports into dollar countries in order to keep their trade account balanced, or they fall back into the dependencies of the dollar-oil system. For this, the Euro should not appreciate too much compared with the dollar. Well, we have seen that the Euro can easily appreciate by 3% to 5% per year with respect to the dollar without compromising the balanced trade account of the Euro zone. But is shouldn’t increase substantially faster than that before the dollar-oil link breaks.

So how did the founders of the Euro arrive at their 2% inflation target? Perhaps they just estimated which inflation rate was necessary in order for the Euro to slowly decline together with the dollar such as not to destabilize their balance of trade. For example, with a 0% inflation target rather than 2%, taking purchasing power as the yardstick for the currencies, the Euro would now be at $1.70 rather than $1.30. That probably would make a difference for the Euro zone trade account.

You see that as long as the dollar-oil link is intact, the U.S. can basically force the entire world to inflate. Even the Euro zone is vulnerable to this forced inflation to some extent.

How would the Europeans prefer the dollar to end? The above thoughts tell me that they must prefer a resolution in which the link with oil breaks first because this would give them the scope to freely choose their policy. If, however, the dollar collapsed first in the foreign exchange markets, but oil merely adjusted the dollar price per barrel but otherwise remained dollar faithful, the Europeans would be in trouble and would have to start spending their dollar reserve or try to use their gold before the transition. This, in turn, might suggest that should the dollar decline substantially, the Europeans would actively break the dollar gold market, in order to force oil to move, too.

I think that most who have criticized Blondie’s idea (including FOFOA), have so far largely missed the point of that idea.

Blondie’s main point is not that Euros would be a better option for your savings than gold, that you should sell your gold and buy Euros instead, far from it.

What Blondie’s idea explains is the following. The real price of gold needs to fluctuate for gold to function internationally. For gold to function, all international balances need to be settled in gold. This includes capital balances, not merely trade balances.

This implies that when foreigners buy Euros (perhaps because of a dollar panic), the ECB has to sterilize this inflow of money (technically a capital export because Euros are purchased by foreigners) by purchasing gold and creating Euro reserves. This, in turn, told me that both parties of international trade can enforce settlement in gold.

If China (just an example) exports into the Euro zone, the Chinese exporters will at first receive Euros from the European importers. Now the Chinese, either the private sector, or if they don’t, the PBoC, can sell Euros and buy gold.

But even if the Chinese tried to “manipulate the currency” and kept accumulating the Euros in order to retain their competitive advantage, the ECB can just buy gold and create Euros (for the Chinese to hold). I.e. the ECB can act “on behalf of the Chinese” and enforce the international adjustment process that the Chinese forgot to enforce.

Furthermore, it tells you what the incentives are. If the Euro zone is a net importer (in aggregate, not just in trade with China), the ECB’s action would raise the gold price in Euros, and so the Chinese will be better off if they settle in gold right away rather than keep the Euros. Only if the Euro zone was a net exporter in aggregate while only with China they were an importer, would it be profitable for the Chinese to keep the Euros rather than settle in gold. In this case, the ECB would have an incentive to settle in gold on behalf of the Chinese rather quickly, because if they didn’t, some other trade partner might do it and the ECB would record a loss on their gold operations.

This was the first time that I understood that the new financial system is truly stable and that it can be enforced by either one of any two trade partners. Before Blondie’s argument, we always had to invoke something along the lines of “after the change, nobody will trust the currency as a store of value any longer, and so they will all purchase gold immediately”. That was a lot weaker than what we understand now.

It is finally a corollary that, once the new system is in effect, the ECB will have the option to target any consumer price inflation rate they like. There is no particular argument in favour of 2% as opposed to 0%.

This means, precisely as Blondie told us, that the currency can be managed in such a way that it is a store of value, too. Once gold functions (and fluctuates in real terms), the currency can indeed play all three of roles of money: medium of exchange, unit of account, and store of value.

If you are a wealthy family or even an OPEC country, this wouldn’t mean that you no longer converted a large part of your profits into gold right away. Recall that if you export into a currency area that is a net importer, it is the most profitable strategy to go for gold immediately. But it does mean that the OPEC country would have to accept fluctuations in the real price of gold (which includes the gold/oil ratio by the way). They would happily stomach it by the way.

But for an international company, for example, the fact that the Euro (and any other well-managed fiat currency) will be purchasing power stable, does make a big difference. They might prefer not to have exposure to the gold price which will fluctuate considerably in real terms.

Finally, for the near future in which you might be worried about an end of the dollar system, even if I was in the Euro zone, I would prefer gold over Euros, at least for the portion of my savings to which I don’t need access for a couple of years. With gold, you would be able to capture the revaluation windfall, but with Euros, you wouldn’t. On the other hand, I can well imagine that holding Euros will be possible and the ECB will not deviate from their 2% and perhaps later even 0% inflation target.

If in the Euro zone, you should also take into consideration that the only base money that you as a private person can hold, is tangible cash. Foreign CBs and commercial banks can also hold reserves (Euro base money) at the ECB, but you cannot. Everything other than tangible cash that you can hold, is credit money and does involve counterparty risk as people in Cyprus and Spain just had to learn – and plenty of others soon will.

This, finally, is the next advantage of Blondie’s point of view. It allows us to view the present actions in the Euro zone in the light of the future financial system in which the Euro is purchasing power stable and in which gold fluctuates. Let us see which point of view explains the European actions better.

Yet Another Snippet (YAS)

(29 April 2013, originally written here)

The issue with the terminology “store of value” arose because of the three functions of money: MoE, SoV, UoA.

We said that the dollar will ultimately fail to play the role of a store of value, i.e. fail to preserve its real value relative to goods and services inside the U.S., firstly because of its overextended international position and secondly because of the anticipated political reaction to a loss of confidence in dollar debt. I suppose we all agree on this part.

This raises the question of whether every fiat currency will fail as a store of value during the transition and, secondly, whether fiat currencies AG will still be doomed to failure as a store of value.

In my opinion, the answer to both questions is ‘no’, not only for theoretical reasons (there is no argument that would prevent a fiat currency from being well managed) but I also think this will most likely be demonstrated in practice, right from the start and right through the transition: by the Euro.

In other words, the dollar will fail (as a store of value) not because it is fiat, but rather because of the past abuse of its role as a reserve currency and because of the alignment of the current political interests that have a clear incentive to exploit the benefits of the international reserve role up to the very last minute, thereby destroy the old system and then to completely abandon the old dollar the next second.

As Blondie explained, AG a fiat currency can (!) be managed in such a way that it fulfils all three role of money including SoV. The ‘can‘ is a conceptual insight – that’s the main point here. Why ‘can’ it? Because there is a reserve (gold) that can absorb (‘store’) all surplus equity (I like Blondie’s termininology here) and balance trade and capital flows. For the reserve to function, its real value must fluctuate and cannot be expected to be constant. So, according to the standard definition of the three roles of money, gold is not a store of value. (I am saying this, knowing that, for example, resource exporters as well as individual people who “save” for their retirement, will most likely purchase gold – in order to store their surplus “equity”).

Once you are there, you can ask, given that a fiat currency can be managed to preserve purchasing power, whether there are incentives that it will be managed in this way. I answered with yes and then was “educated” by some FOFOA followers who kept explaining the benefits of inflation to me, even if AG the major source of systemic inflation will obviously be absent. This argument is a waste of time. Once systemic inflation is absent from the system, nobody will fall over himself to create any.

The only question that makes for an interesting debate is the question of when the ECB will adjust their inflation target of 2.0% down. They might do this first in practice, tacitly, and only officially announce it much later. Why not?

I don’t know why people don’t like this idea. Perhaps they fear, deep down in their heart, that gold’s purchasing power will vary considerably, making it somewhat difficult to handle in the short run AG. If the CB would then artificially make gold superior simply by making the fiat a poor store of value, it would relieve them from this burden of dealing with the reality of gold. I still think it ain’t gonna happen, dude, and this idea of short-term stable gold is ultimately yet another hard money fallacy.

Finally, once that fiat is reasonably purchasing power stable, and it doesn’t matter whether this means 2% or 0% consumer price inflation, there is a second function of gold besides its international one: If fiat denominated credit gives you a high real interest rate in the future, it makes sense to hold a bit less gold (its velocity will increase) whereas when fiat credit gives you only little real interest, people will tend to hold more reserve (=gold). This is exactly the effect that caused Gibson’s paradox.

What’s nice AG is that in periods of low future real interest rates, when people tend to hold gold rather than let it circulate, this does not drain any reserves from the credit system and does not threaten any bank failures. Gibson’s paradox (the price level during the gold standard is high when actual future real interest rates are high and vice versa) will be replaced by gold’s second function: the real price of gold is low when future real interest rates are high.

Why do I want to talk about Gibson’s paradox? Well, we could have a single world currency, no? At least theoretically. No, no, this is no New World Order talk, I am just trying to understand monetary policy.

Alternatively, you can ask how the Euro zone will function internally. I still think it is a major strength of the Euro that there is no federal government of Europe with a single government and a single treasury department. This makes sure that the Euro is “merely” a currency rather than a political instrument – the Euro has severed the link to the nation state. So it is only natural that different economies in the Euro zone are in different phases of the business and in different phases of the fiat credit cycle. If you think about a potential one-world-currency, you would expect this even more so.

How can gold balance trade inside the Euro zone if there is no spur and brake function in the foreign exchange market that would accomplish this for you? It is easy to guess that “gold must flow” from the consumer to the producer – and it might depend on the business and credit cycles which one is which. Why would it? Because of the effect that caused Gibson’s paradox. If future real interest rates are high in some region, but not in another, then gold starts to flow. This way, gold will flow from the consumer (high interest rate because of consumption of capital) to the producer (low interest rate because of a surplus of investment capital), exerting restructuring pressure on the consumer in a way similar to the situation in which trade is cross-border and cross-currency area.

I have to repeat that I feel conceptually a lot better AB (=after Blondie), and given the different expectations about the time AG, it may even be worth some real bucks or quid or, expecting that these two will get in trouble, how do you call Euros?

1. Ambiguous Title ?

Does the leasing of gold (by central banks or whomever else) create ambiguous title of ownership to individual gold bars? The gold investment industry keeps suggesting this although it is easy to see that this claim is false.

Here is how leasing gold works.

Option 1. The London Gold Market (LBMA)

Both parties transact in unallocated bullion accounts. For example, one is an LBMA member and the other one a commercial bank, a hedge fund, or a central bank.

In order to lease gold for 3 months, I sell spot unallocated gold and at the same time purchase a 3-months gold forward contract. The combination of both transactions is a swap. For 3 months, I lease gold to my counterparty and at the same time borrow US$. The amount by which the 3-months forward is more expensive than the spot price, is the 3-months Gold Forward Offered Rate (GOFO). This is the rate I have to pay for the swap. Since I receive US$ from selling spot unallocated gold which I can invest in the meantime for x% annually, I can pocket a rate of x% minus GOFO for leasing my gold. This is the Gold Lease Rate (GLR). (Note that the LBMA publishes their GLR under the assumption that my x% is given by LIBOR which may or may not be the case.)

This way of leasing gold is a financial transaction. The ownership title to individual gold bars is not affected.

Depending on the small print of the contract, my counterparty is allowed to request allocation of their long unallocated position. In this case, the other party receives title to specific gold bars while I no longer have title to these bars. Title is unambiguous. When my forward contract finally matures and my account is credited with unallocated gold, I can similarly ask for allocation and receive title to specific gold bars. These will typically be bars different from those that I originally owned. What was leased was a financial claim on a number of ounces of gold rather than specific gold bars.

The leasing of gold is not a source of ambiguous title to individual gold bars. The only way multiple parties can receive title to the same bar is through outright fraud by the custodian.

Option 2. The New York Commodity Exchange (COMEX)

In order to lease physical gold for 3 months, I can sell physical gold in the spot market (this is outside of COMEX) and at the same time purchase a COMEX futures contract that matures in 3 months. In order to recover physical gold, I can then hold the futures contract into the delivery period. The role of GOFO is now played by the gold base rate, i.e. the amount by which the futures contract is more expensive than the spot price. When I sell my physical gold in the spot market, the title to these bars is passed on to the buyer. Only once I receive delivery on my futures contract, I will regain title to (other) gold bars. Again, title is unambiguous unless the custodian commits outright fraud.

2. Did Greenspan Spill the Beans?

On 24 July 1998, Alan Greenspan testified before the Committee on Banking and Financial Services of the House of Representatives on the matter of regulating Over The Counter (OTC) derivatives. His testimony contains the following lines:

The vast majority of privately negotiated OTC contracts are settled in cash rather than through delivery. [...] To be sure, there are a limited number of OTC derivative contracts that apply to nonfinancial underlying assets. There is a significant business in oil-based derivatives, for example. But unlike farm crops, especially near the end of a crop season, private counterparties in oil contracts have virtually no ability to restrict the worldwide supply of this commodity. (Even OPEC has been less than successful over the years.) Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise.

This last sentence is often taken as an indication that all central banks, including the Federal Reserve generally lease gold in order to suppress its price. This immediately raises the question of why he would be so unprofessional as to include this comment about gold leasing in a testimony that he had sufficient time to prepare ahead of the meeting, if gold price suppression was such a crucial secret operation. Whom is he really speaking to (certainly not the committee he is addressing), and what is the purpose of this remark?

But first let us dissect this statement step by step. Is the Federal Reserve leasing any gold?

The answer is ‘no’, simply because the Federal Reserve System has not owned any gold since 1934. The balance sheet of the Federal Reserve System contains only gold certificates valued at about $11 billion (Section 10 of H4.1 Release – Factors Affecting Reserve Balances), but no actual gold. With the Gold Reserve Act of 1934, all gold still held by the banking system became the property of the Treasury Department. It is the Treasury Department which owns the foreign exchange reserves of the United States and which is responsible for reserve and exchange rate management. In fact, the Exchange Stabilization Fund (ESF) was created for this purpose. Wikipedia writes

A change in the law, in 1970, allows the Secretary of the Treasury, with the approval of the President, to use money in the ESF to “deal in gold, foreign exchange, and other instruments of credit and securities.”

We can therefore not rule out the fact that the Treasury Department via the ESF intervenes in the foreign exchange market, involving both unallocated and allocated gold on the account of the ESF as opposed to that of the Federal Reserve. Note that the ESF would nevertheless trade through the Federal Reserve Bank of New York albeit on their own account rather than using the official U.S. gold reserve.

Remark:

This is an important difference between the Federal Reserve, the Bank of England and the Bank of Japan on the one hand and the central banks of the Eurosystem on the other hand. The former three do not have sovereignty over their exchange reserves. This is the responsibility of the governments of the U.S., the UK and Japan, respectively. The governments of the Eurosystem, in contrast, cannot use their gold reserves without approval by the ECB. From the introductory statement to the press conference by Willem F. Duisenberg, President of the European Central Bank, on 8 July 1998:

Before the end of the current year the Governing Council will also have to adopt an ECB Guideline pursuant to Article 31.3 of the Statute of the ESCB, which will subject all operations in foreign reserve assets remaining with the national central banks -including gold – to approval by the ECB.

One consequence of this assignment of responsibilities is the fact that neither the Federal Reserve nor the Bank of England nor the Bank of Japan are independent in the case of a currency crisis. They have to follow the orders of their respective treasury departments. The central banks of the Eurosystem, in contrast, are independent. Duisenberg phrased it as follows:

The euro, probably more than any other currency, represents the mutual confidence at the heart of our community. It is the first currency that has not only severed its link to gold, but also its link to the nation-state. It is not backed by the durability of the metal or by the authority of the state. Indeed, what Sir Thomas More said of gold five hundred years ago – that it was made for men and that it had its value by them – applies very well to the euro.

Alan Greenspan later explained what the term ‘central banks’ in his testimony referred to. From the documents of Reginald H. Howe vs. Bank for International Settlements (2001):

In a letter to Senator Joseph I. Lieberman dated January 19, 2000, Mr. Greenspan elaborated on his 1998 congressional testimony (C. 39; DOJ Ex. E): “This observation simply describes the limited capacity of private parties to influence the gold market by restricting the supply of gold, given the observed willingness of some foreign central banks — not the Federal Reserve — to lease gold in response to price increases [emphasis supplied].”

If it was not the Federal Reserve, then who else leased gold, how long for, and for what purpose? Finally, why did Greenspan mention these facts in public? Obviously, this was not meant to remain a secret. Whom was he addressing here? – Most likely not the Committee on Banking and Financial Services.

3. Estimates of the Amount of Gold on Lease

Around the year 2000, several attempts were made in order to estimate the total volume of central bank gold on loan. The consensus estimate at that time was that the amount of gold loans was between 3000 and 5000 tonnes. Frank Veneroso (for example here and here) kept track of the supply and demand statistics and estimated an amount of gold loans outstanding (not necessarily all lent by central banks) of between 10000 and 16000 tonnes. Dimitri Speck came up with an estimate of about 7000 to 8000 tonnes for 2001 (Figure 1 – this is Fig. 37 from his book Geheime Goldpolitik).

Figure 1: Estimate of Worldwide Leased Central Bank Gold, Figure 37 in Geheime Goldpolitik by Dimitri Speck

Figure 2: Foreign Official Gold held at the Federal Reserve Bank of New York (source: Federal Reserve Bulletin)

Furthermore, if a foreign central bank sells or leases gold, they will most likely use the gold held in New York first (and perhaps gold located in London) before they touch any gold held at other locations. This is because they acquired most of this gold as a consequence of a balance of payments surplus against the U.S. under the Bretton Woods System, and so this gold was initially located in New York when they received it. It is therefore more likely that they will eventually want to repatriate this gold rather than move any additional of their gold from other locations to New York.

From Figure 2, we see a decline of the inventory by about 4400 tonnes between 1982 and 2002. Since 2002, the inventory has been stable except for a drop by 405 tonnes between 2007 and 2008. Note that the International Monetary Fund (IMF) sold 403.3 tonnes in 2009 and 2010. What a coincidence! Recall from Section 1 that the leasing of unallocated gold and the change of title to the gold need not coincide in time. In a similar way, gold that is sold can initially be sold as unallocated, i.e. as a financial claim, and be allocated only later. Or it can be leased, allowing the counterparty allocation and be officially sold only later. Since we cannot confirm that the gold sold by the IMF in effect came from this vault, this possibility remains a speculation. Furthermore, more than half of the IMF sales went to official entities (India, Mauritius, Sri Lanka, Bangladesh), and it is not obvious whether they would have removed it from the New York vault or not.

In summary, we observe a steady decline of the FRBNY vault inventory by about 4400 tonnes between 1981 and 2002, and little change since then (if the outflow in 2007 and 2008 was indeed explained by the IMF gold, the inventory has been unchanged since 2003 up to a discrepancy of less than 5 tonnes!). Figure 3 shows the annual change of the amount of foreign gold held at the Federal Reserve.

Figure 3: Annual change of the amount of foreign gold held at the Federal Reserve (source: Federal Reserve Bulletin)

Figure 4: Annual Change of the Amount of Foreign Gold Held at the Federal Reserve (adjusted)

• Why did non-U.S. governments and central banks give up ownership title to at least 4400 tonnes before 2002?
• What changed around 2002, and why have they not given up title to any further gold since then?

Before we proceed to the question of what changed in 2002, we remark that Another gave an estimate of the total volume of LBMA unallocated gold outstanding in spring 1998: 10000 tonnes. This is well in line with Frank Veneroso’s estimates cited above.

Another’s figure, however, refers to the financial claims on gold rather than to the gold on lease. There is a crucial difference between these two figures. If an investor holds unallocated gold with a bullion bank (BB), i.e. a part of the 10000 tonnes alluded to by Another, the BB needs to hedge this exposure. They can hedge it in many ways, for example, by holding a physical reserve, by borrowing gold (allocated or unallocated) from a central bank, or by matching it with a forward sale from a mining company or by a short sale by a mining company that was intended as a price hedge. Only one of these possibilities refers to central bank gold on loan.

4. The Tide Turns in 1999

As Greenspan said, before 1999, it was foreign central banks who leased gold, mainly the Europeans. This is the story of supporting the dollar which was the only significant currency for international trade, and the story of lowering the dollar oil price by lowering the dollar gold price. The falling dollar gold price made gold less attractive to private investors, and the weak hands sold, providing the gold that the oil exporters wanted to purchase without running up the price. FOFOA summarized this story beautifully in his It’s The Flow, Stupid! and Flow Addendum. Let us just quote Another for an outline.

Date: Sun Oct 05 1997 21:29
ANOTHER ( THOUGHTS! ) ID#60253:

[...] This line of thinking is very real in the world today but it is never discussed openly. You see oil flow is the key to gold flow. It is the movement of gold in the hidden background that has kept oil at these low prices. Not military might, not a strong US dollar, not political pressure, no it was real gold. In very large amounts. Oil is the only commodity in the world that was large enough for gold to hide in. Noone could make the South African / Asian connection when the question was asked, “how could LBMA do so many gold deals and not impact the price”. That’s because oil is being partially used to pay for gold! We are going to find out that the price of gold, in terms of real money ( oil ) has gone thru the roof over these last few years. People wondered how the physical gold market could be “cornered” when it’s currency price wasn’t rising and no shortages were showing up? The CBs were becoming the primary suppliers by replacing openly held gold with CB certificates. This action has helped keep gold flowing during a time that trading would have locked up.

(Gold has always been funny in that way. So many people worldwide think of it as money, it tends to dry up as the price rises.) Westerners should not be too upset with the CBs actions, they are buying you time!

So why has this played out this way? In the real world some people know that gold is real wealth no matter what currency price is put on it. Around the world it is traded in huge volumes that never show up on bank statements, govt. stats., or trading graph paper.

The Western governments needed to keep the price of gold down so it could flow where they needed it to flow. The key to free up gold was simple. The Western public will not hold an asset that going nowhere, at least in currency terms. ( if one can only see value in paper currency terms then one cannot see value at all ) The problem for the CBs was that the third world has kept the gold market “bought up” by working thru South Africa! To avoid a spiking oil price the CBs first freed up the publics gold thru the issuance of various types of “paper future gold”. As that selling dried up they did the only thing they could, become primary suppliers! And here we are today. In the early 1990s oil went to $30++ for reasons we all know. What isn’t known is that it’s price didn’t drop that much. You see the trading medium changed. Oil went from $30++ to $19 + X amount of gold! Today it costs $19 + XXX amount of gold! Yes, gold has gone up and oil has stayed the same in most eyes.

Now all govts. don’t get gold for oil, just a few. That’s all it takes. For now! When everyone that has exchanged gold for paper finds out it’s real price, in oil terms they will try to get it back.[...]

Date: Sun Oct 12 1997 10:42
ANOTHER (THOUGHTS!) ID#60253:

How DO they do it?

It’s more complicated than this but here is a close explanation. In the beginning the CBs didn’t sell their own gold. They ( thru third party ) found someone else who had bullion. That “party” sold to a broker who sold forward for a mine or speculator or government ) . In the end the 3rd party had the backing from the broker that he had backing from the CB to supply physical if needed to put out a fire. The CB held a very private note from the broker as insurance and was paid a small fee. This process mobilized free standing bullion outside the government stockpiles. The world currency gold price was kept down as large existing physical stockpiles were replaced by notes of future delivery from the merchant banks ( and anyone else who wanted to play ) .

This whole game was not lost on some very large buyers WHO WANTED GOLD BUT DIDN’T WANT IT’S MOVEMENT TO BE SEEN! Why not move a little closer to the action by offering cash directly to the broker/bank ( to be lent out ) in return for a future gold note that was indirectly backed by the CBs. That “paper gold” was just like gold in the bank. The CBs liked it because no one had to move gold and it took BIG buying power off the market that would have gunned the price! It also worked well as a vehicle to cycle oil wealth for gold as a complete paper deal.
[...]

Date: Thu Nov 13 1997 09:34
ANOTHER (THOUGHTS!) ID#60253:

It was never the intent of the CBs to sell their countries gold in massive amounts. The “understanding” that was worked out years ago was good for the economies and the world. In return for the US$ remaining the “oil reserve” currency, ( oil would be not just supplied but supplied in dollars ) large amounts of gold would be supplied far into the future. The gold, while indirectly backed by the CBs would actually come from the mines of the future. With the oil money making a ready market for gold priced at a premium ( contangoed out many years ) , the mines could make a fair profit even with spot gold priced below production. All would win! And for some time, we did! I am able to know some CBs, they are not evil, their minds are for the best that can occur. But, I THINK the world ran away from them. The paper world of gold is now a mess with no resolve! They will not sell all gold. Some that have actually have paper for future return. [...]

The following is FOA on the politics involved.

5/27/98 Friend of ANOTHER

This article (see below) puts a different light on the Euro. I think a major effort was underway for many years to unseat the dollar. It was only after the gulf war politics that the EURO group saw a way to use gold to draw in the oil producer currency backing. It was clear that the dollar was going to someday fall from reserve currency status because of it’s compounding debt load. With nothing to replace it, gold would become the world oil currency, as Another says.

Initially, they built the Euro with little talk of gold, all the while building a paper gold market that is dollar settlement based. By increasing the Gold Trading Market with paper gold, it not only drove the gold price down, but gave these contracts credibility as they could be settled in a strong dollar via gold. The hook came when they suddenly wanted gold as part of the reserves for the Euro! Now the BIS just stops supporting the London market with Central Bank gold loans and sales. By the time for the Euro to debut , gold starts to rise through the $360 area, there by breaking the entire dollar based paper gold market! Every oil state, and anyone else that is holding paper gold, will try to first exchange it for physical. After that guess who will be waiting with a brand new hard world reserve currency, ready made for converting dollar gold loans into Euro gold loans!

The dollar will not necessarily be destroyed by inflation at first, but you can be sure it will collapse in terms of gold. In this process, if everyone try’s to spend their overseas dollars (presently Eurodollars), the US will no doubt invoke foreign exchange controls and most likely create a new currency. I think, that’s where ANOTHER gets the $30,000+ business for existing (replaced) dollars and I don’t doubt it one bit. This is why everybody keeps getting lost in the falling gold price. They keep working it like it’s the old physical market years ago. It’s not the same. Anyone that try’s to leverage it in any way will just keep getting pounded as London prints gold for all their worth until the Euro takes effect.
[...]

6/2/98 Friend of ANOTHER

[...]
The Middle Eastern bullion holdings are well hidden from official records. They control the gold market through the London/European gold paper markets. It was the BIS that handed them the market when it created the Central Bank lending deals. They were the prime buyers right off the bat! I didn’t understand until about a year ago, how they were gaining control without cash. The answer is they don’t buy the paper gold with cash! The Bullion Banks take oil reserves as collateral for it. The money that ends up in the account for a typical mining company forward deal is really a loan against oil in the ground. That’s why the CBs lend the gold so cheap, it’s not for the mines, it’s for the producers! Now you know how we buy cheap oil prices. The world thinks the CBs are doing this for a 1% return. Truth is, the mining industry is going to pay full interest in the end. It’s one hell of a complicated affair, with the politics and all. Needless to say, as the events open up and expose some of this, the public is going to be very interested. As for the SNB selling half of their gold. If they do, it will be for Euros, you can bet on it!
[...]

FOA (5/8/1999; 20:16:12MDT – Msg ID:5772)
BOE!

[...]
Many different factions are maneuvering gold these days, and each has their own agenda. The IMF / dollar faction, many years ago, went along with Europe in lowering the gold price in dollar terms. It made the dollar look stable and enforced it’s continued use as the “currency of settlement” for strategic commodities. Any country running a balance of trade surplus of dollars, was free to buy gold at a stable to lower price, and partially replace the paper dollar reserves. Because the dollar is the “world reserve currency” many countries ran dollar surpluses with trading partners outside of the US. In this light we can see how the integrity of the dollar was expanded, even in countries of nonnative dollar origin!

Not only was physical gold purchased, but paper gold with distant CB backing was also accepted. Ever wonder how all of this gold was placed? You see, over the last many years, there has been a quiet boom going on in gold ownership. The sheer number of world gold buyers has more than doubled, along with the amount of gold owned! The problem is that the amount of physical gold in existence has not doubled, only the warehouse receipts.

Most of it never, ever left the vaults, as the true placement was done in receipt form. Yes, slowly, over the years, even major private bullion holders offered up their physical for “convoluted, future delivered, leased and released gold”. Much of what is now held is little more than a form of gold options for “future deposit”. Not unlike the “cash dollar that is supposed to be in your bank”, but really isn’t? As the bank only holds your deposit as a “credit” to your account, so is much of the world traded gold “only a credit of account”!

When Central Banks (mostly the European, at first) began to lease / lend gold, they were beginning what was to become “the master plan”. The creation of a broad, liquid paper gold market that would ulltementally undermine the dollar, in time. As I said above, initially it was offered as an “appeasement” for continued dollar use. However, even the IMF / dollar faction never expected the successful creation of another competing reserve currency, the Euro! Right up to it’s offering, the political money was on the side of a complete failure, 100% with ten to one odds.

Not only did they lose, the Euro even accepted a percentage of gold as Euro reserves. If that wasn’t enough, the ECB also instituted a policy of “marking to the market” it’s gold reserves and effectively blocking any new sales or leases. These actions, as subtle and misunderstood as they were have had the effect of officially making gold money again. Yes, this new broadly traded paper gold market, standing side by side with the physical market has become a world currency.

The problem this creates for the IMF / dollar is that most, if not all of this new gold market is settled in dollars! Dollars that broke a contract with the world in 1971 and went off the “gold exchange standard” at $41 to the ounce. The same dollar reserve currency that is not supported when the gold price rises. If the ECB does nothing but stand firm by not allowing physical out of it’s vaults, the dollar will be trapped by gold. The US treasury cannot use gold as a backing reserve as the ECB does, because the BIS would claim it at $41 to settle trade imbalances. They have that authority and as such it leaves the US the only option of outright gold sales. However, with the dollar as “the” reserve currency, we can expect many nations to bid “aggressively” for any US gold. China, among others comes to mind! That is what America found when they tried to auction it’s gold in 1978. The Euro carries no such baggage.

This all leaves us in the present political situation, where the IMF entity, that was formed to replace the gold standard, is now trying to back the present paper gold with physical to prevent a run on the dollar. It is a futile effort as the ECB / BIS have grown the gold market into massive proportions by encouraging the many year expansion of holders through paper securities. All denominated, ultimately, in dollars. We will see $10,000 gold, count on it! It’s the only way this can be resolved. That same figure will create massive backing for the Euro and hasten it’s journey into world reserve currency status. Expect most of the ECB liability for gold to be easily converted into Euros at the dollars expense.
[...]
The US now has no choice but to encourage gold to rise and use that action as a political ploy. They will no doubt try to gain much mileage out of the fact that the treasury has 8,000 tonnes of gold for dollar backing or outright sales. It will be a political discussion, only. As the gold market becomes more dynamic and gains media attention, many congressional investigations will target the short funds. After all, with gold killing the dollar, something must be done.

FOA (5/11/1999; 08:34:18MDT – Msg ID:5911)
Reply

“Is it possible the the Middle East oil states have been mislead as to the bigger picture from the very beginning?”
[...]
I, personally, think they were for a while. After all, the Euro group will, just as the US group, take all the power they can get!
[...]
If they did suspect that the BIS was playing them into a “new World Order” then that explains their use of the “gold card”. It was allowed to be known that the failure of the Euro to replace the dollar would bring on the reprice of oil using partial payment of a tiny fractional gold amounts per barrel in the settlement mix. Real gold, not paper! It would have forced every oil producer in the world to follow as the gold price would have blew past $30,000 as the new oil currency. Quickly, at the last minute, the ECB and the BIS announced that Euro system Central Banks would stop all selling and wind down leasing. Then gold was brought into the reserve mix for the Euro. Perhaps a counter play? You bet!

FOA (5/11/1999; 18:47:49MDT – Msg ID:5952)
PH in LA (5/11/99; 9:59:21MDT – Msg ID:5920)

[...]
During the last number of years, possibly most of the 90s, the gold market was expanded tremendously. The result was that the holders of “paper gold” and “physical gold”, as a group, now own more gold than exists! Is no wonder that the “technical analysis” and “supply / demand” “investment managers” are in a shambles to explain the workings of this new market. Truly, as said before, they are commodity analysis, not political currency analysis. For them, a cornered market must be soaring to reflect the imbalance of longs and shorts. Now can one understand that gold, the political money, is managed on a world scale for the purpose of control of currencies.
From the beginning, the BIS knew that if gold ownership was spread far and wide by leasing from a few European banks, one day, gold would control the value of the dollar.[...]

FOA (5/21/1999; 11:27:15MDT – Msg ID:6570)
Reply

[...]
Just because the US said, in 71 that it would not ship gold any more does not mean the dollar isn’t still a contract to represent it’s old international obligations. Every analysts makes comments like, “let them sent their army if they want it”, but that is simply not the way the world works. It’s cheating, fair and simple! Why didn’t the US send out all of it’s gold at $41 to the ounce, then go off the system? As Another say’s, “think long and hard on that one”!

The entire international financial structure is based on procedure protocols that are not binding, repeat, not binding, but without them, the system will not work. If the BIS did not coordinate inter bank (CBs) transfers the whole system would stop. Using the same “line of reasoning”, the US cannot just back it’s currency with gold at say, $10,000 and start all over again. What manner of “rules of engagement” would prevent them from halting gold shipments again? “Come on”, people of the world are not that stupid!

No, the dollar would have to be totally destroyed, and a new currency, sanctioned by the BIS, and most likely controlled by them, would have to be created. The US will go down to the wire before that happens, therefore, the Euro was created!

[...] The IMF is a function of the dollar reserve dynamic. If the IMF did not the guarantee dollar debt of countries that could not pay, it would start a chain reaction of dollar reserve destruction. When dollar assets (debt) is no longer serviced (interest paid and debt rolled over) it no longer can be carried on the books as the backing for local currencies. Hence forth, all currencies that are based on this system are “imploded”. Now you see why the IMF does such “perceived dumb” maneuvers, it’s to maintain the dollar, not rebuild the foreign economies.

When the BIS, ECB and the other major world economies are ready to drop the dollar, they will stop supporting the IMF and pull out. The IMF “needs” their support, they do not need the IMF. Likewise, if the US ever disassociated itself with the BIS, they would simply stop all transfers of dollars and most likely buy gold in the open market with them! At that point the Euro would become the only tradable currency. Simple political blackmail, or should I say “international protocols”. It’s nothing new, but some call it a new “world order conspiracy”. They just haven’t liven through enough years, as Another has.[...]

Finally, here is Another on this topic:

5/3/98 ANOTHER (THOUGHTS!)

Mr. Kosares, Your friend thinks much of this gold owned by the USA. It could be used to back the dollar up to 25%, no? Many come to this thinking and hold a secure thought, that as last resort, this gold will save the day! I think, many persons never gained the understanding that the American gold is kept by the “Treasury”, not the maker of your money, “The Federal Reserve”. It is there for good reason, as the present world currency system is not a function of American law! If the US were to place gold in the hands of the US/CB as reserves for the dollar, the BIS could claim it! It is, as a point of contention and of no real use. I think not a war would come of this claim, if it should happen! As the world currencies are now, a “new dollar” would be needed if gold were used as reserves! The present dollar would then, truly be as “paper for the wall”!

The urgent drive to create a new “reserve currency” began in the early 80s, after the last small “gold war”. The road to making this new Euro did never include gold in large amounts, until the last few years! Even one year ago, the news would say, 5% or less. Today, we speak of a much greater amount! This is interesting, yes? The BIS did “hatch” this deal in a very late fashion! The future of the Euro was found to be “weak”, as the Middle East oil imports onto the continent would continue in dollars! This was so from the dollar being made strong in gold. Gold priced in dollars at near production cost, offered a “no switch currency” position, for oil. This position has been unstable for the last year, and the alternative of a switch to gold was in progress! You have read my “Thoughts” before. Now the BIS does offer to “change the rules of engagement”, a real reserve currency is offered!

Few do grasp what is happening and why! They think the holding of gold reserves by the Euro is of a little point, as to what good are gold reserves? One cannot use gold as Marks or Yen to intervene in currency market to support the Euro. My friend, the BIS has played the, as you say, “big poker hand”! The holding of large reserves by the ECB and the withholding of sales from the market will not only bring the end of the London paper gold market, it will, thru a high USD gold price, “make the dollar weak in gold”! From this position, the dollar will lose the “oil backing” from the Middle East! At first, all oil for Europe will be in Euro’s, then all producers want “strong currency”!

There is more: Many say, how to defend Euro without much currency reserves? If gold go to many thousands US, what will be used to bid for Euro as defense? I say, these persons will find a problem on their computer screens! You see, the Euro will start as “nothing”, no holdings of size, anywhere! The dollar is held as reserves as “the stars in heaven”! It is to say, “the dollar will bid for the Euro”, not “the Euro will bid for the dollar”! All currencies will “flow into the Euro for trade”. But, if the Euro becomes so strong, how to compete in world trade? It will be the price of oil that will make the “trading field” level! The soaring US$ price of gold will make even a 10% Euro reserve be as 100% today, in USD! Oil will become, very, very cheap in Euros and allow that economy to do well! Many other countries will see this and also want to join the new “world reserve currency” that has become”the new world oil currency”!

We have seen that the central banks of the Eurosystem stopped all leasing and further selling of gold with the introduction of the Euro. The following message was probably the first piece of information on this new policy.

Date: Wed Nov 12 1997 14:08
ANOTHER (THOUGHTS!) ID#60253:

[...] A person thinking of purchasing physical gold should see the Bundesbank statement as fact. They openly admit to lending in the past and no chance of selling real gold in the future. This is a clear indication that a solid decision was made at the BIS meeting ( see my post ) ! All CBs will now slowly stop all leasing operations and allow the market to size itself. The important players, the oil states, will have their paper covered without question! But, for all others, the great scramble is about to begin!

Oil now must rise if the US$ and the currency system is to survive. [...]

Date: Wed Nov 12 1997 20:41
ANOTHER (THOUGHTS!) ID#60253:

[...] A BIS meeting was held and from those doors the world did change. The Bundesbank has now made clear to all what will now be policy for CBs. A crisis is at hand! All physical gold sales will stop. All gold lending will wind down. We will see the results of this as a massive scramble to cover open positions slowly unfolds. [...]

Had the Bundesbank lent out any of their gold? Dimitri Speck has studied their annual reports in which the interest income from gold leasing is listed and uses this revenue and the average Gold Lease Rates in order to estimate the amount of Bundesbank gold on loan. He finds that gold leasing started in 1996 or 1997, that a maximum of 350 tonnes of their 3396 tonnes were on loan, and that the leasing had ended by 2006, up to a remaining balance of at most 50 tonnes. This is consistent with their published statements that they never leased more than 10% of their total gold holdings. The following is the reply by Bundesbank officials to an enquiry by Dimitri Speck, Appendix 2 of Geheime Goldpolitik (translation by Martin S.):

Deutsche Bundesbank
Wilhelm-Epstein-Straße 14
60431 Frankfurt am Main
 
28 September 2007

 
 
 
 
 
 

Your enquiry about the gold holdings of the Bundesbank

Dear Mr. Speck,

as part of their management of their gold reserve, the Bundesbank lends a proportion of their gold holdings, albeit very small, to selected banks. The amount of the leased gold varies depending on the market situation, but always remains within a one digit percentage range. The gold lending transactions are mainly short term and exclusively with international banks of the highest credit rating. This procedure has not changed, and so we cannot confirm any rumours to the contrary. This implies that the vast majority of the gold holdings would be available physically on short notice.

Yours sincerely,

Deutsche Bundesbank
(Market Operations Division)

signed: Griep, Breves

Upon reading the first draft of the present article, Dimitri Speck emailed me

The Bundesbank stopped lending in the year 2008 (I got confirmation for that).

Best wishes, Dimitri Speck

The policy of winding down all gold lending operations alluded to by Another already in November 1997 was finally officially announced on 26 September 1999. At the IMF meeting in Washington, the central banks of Europe published the following statement that is now known as the Washington Agreement on Gold:

26 September 1999 – Joint statement on gold
European Central Bank
Oesterreichische Nationalbank
Banque Nationale de Belgique
Suomen Pankki
Banque de France
Deutsche Bundesbank
Central Bank of Ireland
Banca d´Italia
Banque centrale du Luxembourg
De Nederlandsche Bank
Banco de Portugal
Banco de España
Sveriges Riksbank
Schweizerische Nationalbank
Bank of England

In the interest of clarifying their intentions with respect to their gold holdings, the undersigned institutions make the following statement:

• 1. Gold will remain an important element of global monetary reserves.
• 2. The undersigned institutions will not enter the market as sellers, with the exception of already decided sales.
• 3. The gold sales already decided will be achieved through a concerted programme of sales over the next five years. Annual sales will not exceed approximately 400 tons and total sales over this period will not exceed 2,000 tons.
• 4. The signatories to this agreement have agreed not to expand their gold leasings and their use of gold futures and options over this period.

This agreement will be reviewed after five years.

What is the meaning of the phrase `with the exception of already decided sales‘? Have you ever read this phase, an `already decided sale‘, in any financial statement? Now compare this with the amount of gold held in by the FRBNY on behalf on foreign central banks with our adjustments (Figure 4).

Looking at the figures, one might think that an `already decided sale‘ refers to gold that was leased and had been allocated to a third party and therefore no longer appears in the inventory of the foreign official gold. Title to this gold will not be demanded back, and the gold will later be sold in a financial transaction that involves only unallocated gold. We arrive at the following.

Conjecture 1.

The central banks of the Eurosystem had sold and leased a substantial amount of gold as of 1999. Some of this gold had been allocated to new owners before 1999. But these central banks have not given up title to any of their gold ever since. All official gold sales by these central banks after 1999 were only on paper, closing an open lease and not demanding the gold back.

If this is what is meant by an `already decided sale‘, this might be the blue print for the IMF gold sales in 2009 and 2010. Recall that the FRBNY gold inventory decreased not in 2009 and 2010, but rather two years earlier when the gold market was at the brink of failure in 2008 (for more details on why the London gold market is at risk from falling prices more so than from rising prices, please see FOFOA’s Today’s (quote-unquote) “Gold”).

Conjecture 2.

The IMF leased gold during the financial crisis in 2007 and 2008 and allowed allocation of this gold to the borrower. Only later, in 2009 and 2010, this gold was officially sold and the lease closed in a paper transaction.

If true, the 212 tonnes of IMF gold that were eventually sold to the central banks of India, Mauritius, Sri Lanka and Bangladesh must have been physically sourced elsewhere. But at least the remaining 192 tonnes had been on lease all the time, and therefore their sale was merely a paper sale, i.e. unallocated. Was this the reason why Eric Sprott could not buy the gold that the IMF wanted to sell? Finally, this incident would indicate that about 400 tonnes of allocated gold was sufficient in order to rescue the London gold market in 2007/2008.

The following remark by Another on the gold sales by the Bank of England is consistent with our interpretation of the term `already decided sale‘:

Date: Sat Apr 25 1998 23:35
ANOTHER (THOUGHTS!) ID#60253:

[...] Many think the only way gold can rise in dollar terms is if USA prints to many! Truly, they have printed to many already. Gold will rise in dollar terms, many thousands even if treasury inflates currency no more. This rise in price will cost London much! You have seen the Bank of England report of gold that does not come home? [...]

The big picture that emerges, is the following. Since perhaps November 1997, but definitely since September 1999, the central banks of the Eurosystem have stopped all further leasing operations and have not given up ownership title to any of their physical gold. They have been sitting tight ever since.

Only the core supporters of the US dollar, among them the IMF, have continued to occasionally intervene in the gold market in order to avert a market collapse. This view is supported by the following anecdote on the days following the publication of the Washington Agreement, reported in the complaint by Regnald H. Howe vs BIS (2000):

According to reliable reports received by the plaintiff, this effort was later described by Edward A. J. George, Governor of the Bank of England and a director of the BIS, to Nicholas J. Morrell, Chief Executive of Lonmin Plc:

“We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake. Therefore at any price, at any cost, the central banks had to quell the gold price, manage it. It was very difficult to get the gold price under control but we have now succeeded. The U.S. Fed was very active in getting the gold price down. So was the U.K.”

Notice that Edward George allegedly said that the Fed and the UK were very active. He did not mention the central banks of the Eurosystem. The signatories of the Washington Agreement on Gold were the central banks of the Eurosystem plus the central banks of Sweden, Switzerland, and the Bank of England. The alleged remark by Edward George might indicate some duplicity by the Bank of England: they signed the Washington Agreement and then immediately intervened in order to limit the damage to their London gold market. Also note that the Bank of England did not sign the renewal of the Central Bank Gold Agreement in 2004.

Figure 5: The Gold Forward Offered Rate (GOFO) between September 1999 and November 1999
(source: London Bullion Market Association (LBMA))

For the record, we mention that the Washington Agreement has since been renewed twice: on 8 March 2004 (with annual sales of up to 500 tonnes rather than 400 tonnes, and without the Bank of England as a signatory) and on 2 August 2009 (with annual sales down to 400 tonnes, again without the Bank of England as a signatory, and this time without mentioning gold leasing). Figure 6 shows the gold sales recorded under these agreements:

Figure 6: Gold sales under the Central Bank Gold Agreements (source: World Gold Council)

Our conjecture also implies that the published supply and demand statistics that view gold as a commodity, were wrong because they record the official gold sales on the dates on which the unallocated transactions were booked rather than on the dates on which the physical gold was made available. Figure 7 shows the annual change of the reported official sector gold holdings:

Figure 7: Annual change of official gold holdings (source: World Gold Council)

Figure 8: Annual Change of Official Gold Holdings (adjusted)

Figure 9: London (pm) Gold Fixing in U.S. Dollars from 1 January 1997 to 28 September 2012. The black line is the best fit of an exponential function to the gold price since 1 January 2002 (regression line in the logarithmic diagram). Its annual rate of increase is 19.4%. On 28 September 2012, the dark blue channel extends from $1612 to $2015 per ounce and the light blue channel from $1442 to $2253.

5. The U.S. Gold

Between August and September 2000, the U.S. Treasury Department changed the terminology for the part of the U.S. gold reserve stored at West Point from Gold Bullion Reserve to Custodial Gold Bullion. In gold bug circles, this lead to rampant speculation that this gold had been sold, leased, or swapped. The issue was eventually clarified by changing the terminology to Deep Storage, in contrast to the Working Stock of the U.S. Mint. One can even interpret the term Deep Storage to mean that this gold is not intended to be used (as long as the U.S. dollar is around in its present form).

The following is FOA on the Gold Trail on the term Custodial Gold:

FOA (04/23/01; 20:30:04MT – usagold.com msg#67)
Replies and Custodial Gold

[...]
I suspect the gold in West Point was reclassified in a show of good faith to those that own some international gold paper. I’m talking about people who’s reasonably priced product you cannot live without. I doubt the gold has outright swaps written against it or was swapped into the enemy’s camp (so to speak). While the ESF has the right to trade currency swaps against other’s gold (and they do do this). Our gold has yet to be possessed by others. Just as in 1971, when many dollar holders thought US gold was “in custody” for them, so to does the current world dollar gold markets. However, this open certification shows just how tight the system has become.

We have said for some time that the dollar faction has inflated paper gold and done so with very limited actual bullion of their own. We maintain that most of the leverage created in this arena has been done with the gold of private Western owners. Modern GoldBug owners that once held physical gold but now seek gold leverage and gold industry investment instead of gold wealth. That gold has now been leveraged for all it’s worth as it filled the use void. Today, we are reaching the mathematical end that that game can be played. Others know this and the West Point business is an attempt to counter this perception. Even if it was only a political move. We are getting close though (smile).

There is no logic in that the Bundesbank would risk it’s gold. They were major supports of the Washington Agreement. Counter to perception, the entire EuroZone CB system awaits the day when they can convert failed paper gold borrowers into Euro borrows. As our paper gold market fails to function, shuts down and physical gold soars, there will be no bookkeeping market to offload these paper positions into. The conversion ratio into Euros will then be something to behold. Along with the demand for currency Euros and physical gold! The BIS /ECB is delighted that the dollar faction is lending all the “gold on paper” the dollar market can stand. Eventually, the US will walk right up to the gold window with the intentions of selling, only to fall away as they stair at a mountain of foreign CB dollars.
[...]

Trail Guide (04/24/2001; 20:23:14MDT – Msg ID:52494)
Replies that help articulate

[...]
Sir, We need to remember that most of this “showing off of gold stores, from this point forward will employ a lot of political gamesmanship. Not unlike the BOE auctions. In that case they aren’t really selling that much gold into the market. The BIS could have taken it all real easy, but England wanted to drag it out for effect. That way they got the most exposure and time. Allowing some of their favorite BBs to escape before the Pound goes EMU.

In the same light, most of the real gold that has left the CBs ended up in other CBs as statistics show. Political gamesmanship! Same thing is in process with our West Point business. Political jockeying for more mileage. As an example; watch a newcomer ride into town pulling an open trailer of cash. Every real estate broker from miles around will be at his feet. Now. that cash isn’t in their possession, is it? Yet, it sure looks like it’s been put on a trailer format for easy spending (grin). Custodial gold has the same effect in international gold paper players. Like these real estate agents, gold players now think they have USA bullion in the bank just because it’s been placed in a trailer! (big smile)
[...]

We just said that the term Deep Storage might indicate that this gold will not be used as long as the U.S. dollar is around in its present form, i.e. in particular not in order to back the currency with a gold reserve at a floating price in the same fashion as the Eurosystem does:

FOA (5/8/1999; 20:16:12MDT – Msg ID:5772)
BOE!

[...]
The US treasury cannot use gold as a backing reserve as the ECB does, because the BIS would claim it at $41 to settle trade imbalances. They have that authority and as such it leaves the US the only option of outright gold sales. However, with the dollar as “the” reserve currency, we can expect many nations to bid “aggressively” for any US gold. China, among others comes to mind! That is what America found when they tried to auction it’s gold in 1978. The Euro carries no such baggage.
[...]

FOA (5/21/1999; 11:27:15MDT – Msg ID:6570)
Reply

[...]
Just because the US said, in 71 that it would not ship gold any more does not mean the dollar isn’t still a contract to represent it’s old international obligations. Every analysts makes comments like, “let them sent their army if they want it”, but that is simply not the way the world works. It’s cheating, fair and simple! Why didn’t the US send out all of it’s gold at $41 to the ounce, then go off the system? As Another say’s, “think long and hard on that one”!

The entire international financial structure is based on procedure protocols that are not binding, repeat, not binding, but without them, the system will not work. If the BIS did not coordinate inter bank (CBs) transfers the whole system would stop. Using the same “line of reasoning”, the US cannot just back it’s currency with gold at say, $10,000 and start all over again. What manner of “rules of engagement” would prevent them from halting gold shipments again? “Come on”, people of the world are not that stupid!

No, the dollar would have to be totally destroyed, and a new currency, sanctioned by the BIS, and most likely controlled by them, would have to be created. The US will go down to the wire before that happens, therefore, the Euro was created!
[...]

In fact, at the beginning of that month of May 1999, the Bank of England had just announced their gold sales (Brown’s Bottom). On 19 May 1999, the governor of the Bank of France, Mr. Jean-Claude Trichet, said:

I will simply say that as far as I am aware–and this is not just the position of the Bank of France and our country, but also the position of the Bundesbank, the Bank of Italy and of the United States, and these are the four main gold stocks in the world–the position is not to sell gold.

The next day, on 20 May 1999, Alan Greenspan confirmed this in front of the House Banking Committee:

We should hold our gold. Gold still represents the ultimate form of payment in the world. Germany in 1944 could buy materials during the war only with gold. Fiat money in extremis is accepted by nobody. Gold is always accepted.

The position of the U.S. not to sell any of their gold was clearly communicated at that time.

Finally, here is FOA on why there has been no audit of the U.S. gold reserve.

FOA (12/19/1999 18:59:35MDT – Msg ID:21368)
Reply

[...]
I think just about every other major country (outside the IMF / dollar faction) has private audits of their gold. Too date, it’s mainly been the US gold stocks that have worried people because the dollar is so leveraged over this holding. I understand that the gold is intact, but they don’t want to draw attention to it. Any audit only highlights how little gold is backing the trillions of dollar assets. That’s the reason for the stonewall.

Too a lesser extent, any audit carries overtones of eventual dollar backing. Something the BIS would have a major say in as they could attach it at the old $42 rate. Let’s be serious here, if current international law demands the compensation of German slave labour and Swiss Gold value reparations, all hell would break lose for the payment of dollar backed gold confiscated in 71. Both the official and private levels would be after any gold backing our present dollar. The only way the US gold could come into play would be with a new currency. And any whiff of that process (an audit is the beginning) would literally tank the dollar big! Well before the fact. So, good luck to GATA and MR. Turk!

6. Whom Did Greenspan Address?

It remains to be understood why Greenspan was so eager to mention that foreign central banks would lease increasing amounts of gold should the price rise. Let us repeat the passage from his testimony, but this time with a different emphasis:

The vast majority of privately negotiated OTC contracts are settled in cash rather than through delivery. [...] To be sure, there are a limited number of OTC derivative contracts that apply to nonfinancial underlying assets. There is a significant business in oil-based derivatives, for example. But unlike farm crops, especially near the end of a crop season, private counterparties in oil contracts have virtually no ability to restrict the worldwide supply of this commodity. (Even OPEC has been less than successful over the years.) Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise.

So was there perhaps any private counterparty who had cornered the gold market around 1998? Somebody to whom Greenspan wanted to signal that there would be enough gold available thanks to the leasing by his European colleagues? (Unfortunately, he had this only partly right because, as we have learnt from Another above, at that time, the Bundesbank had already enforced the end of the gold leasing by the central banks of Europe).

The first hints on the cornering of physical gold are contained in the messages on the old Kitco forum, some of which are preserved in Before the Thoughts! and Before the Trail. Later, Another has summarized it as follows.

Date: Thu Oct 09 1997 19:00
ANOTHER ( THOUGHTS! ) ID#60253:

[...]
What of the LBMA mess?

Gold is cornered. Plain and simple. No complicated theories, no options problems. The commodity value of gold was forced so low in paper currency terms that all of the new mined gold, going out some 10 years is spoken for. Between the third world buying physical gold and the jewelry industry ( same people buying ) there is none left for the oil states! They do value oil in terms of gold, but not IN the paper currency price of gold! How much is gold worth in terms of oil value? Just stop supplying gold to them in ultra cheep US$ terms and you will find out by watching the currency price of oil! In any event, LBMA has traded so much paper/oil/gold that any rise in the currency price of gold will implode them. The CBs must become the full primary suppliers of gold or the system as we know it is done.

One last note: No form of paper wealth will survive the financial crush once the CBs stop selling!

NOTHING!

Date: Fri Oct 10 1997 17:26
ANOTHER (THOUGHTS!) ID#60253:

Yes, we could go into details about the LBMA mess. But why? They are in way over their heads and the final outcome is on it’s way.

A big change in the gold market actually started last spring. You couldn’t tell by the charts or news stories but it had the CB trading rooms going nuts. Up untill then they were using 3rd party transactions to sell, then the boomshell hit that the Merchant Banks were doing deals for 10 to 20 times what was offered! Well “boys will be boys” and someone is now stuck, big time! That’s why “Big Trader” and his bunch closed out all paper and pulled in bullion. Don’t worry about the CBs selling everything, the market is huge compared TO WHAT THEY HAVE! And Comex is nothing, if “only a silly game”. Worldwide trading in gold could be cut in half and still equal all the metal in existance!

The CBs will have to sell outright now even as the currency price of gold starts to run away from them!

The market is changing now,,, it will go up but you will not be happy with the outcome.

Date: Sun Oct 12 1997 10:42
ANOTHER (THOUGHTS!) ID#60253:

[...]
Well a funny thing happened right after the Gulf war ended. What looked like big money before turned out to be little money as some HK people, I’ll call them “Big Trader” for short, moved in and started buying all the notes and physical the market offered. The rub was that they only bought low, and lower and cheaper. They never ran the price and they never ran out of money. Seeing this, some people ( middle east ) started to exchange their existing paper gold for the real stuff. From that time, early 1997 LBMA was running full speed just to stay in one spot! In other words paper volume had to increase to the physical volume on a worldwide scale, and that was going to be one hell of a jump. It could not be hidden from the news any longer.

This was not far from the time that “Big Trader” said that “if gold drops below $370 the world would see trading volume like never before seen”. The rest is history. Now the CBs will have to sell 1/3 to 1/2 of their gold just to cover whats out there. To use the Queens English “it ain’t gona happen dude”! [...]

Date: Sun Oct 19 1997 17:26
ANOTHER (THOUGHTS!) ID#60253:

[...]
The Asians are the problem, by buying up bullion worldwide and thru South Africa they created a default situation on all the paper for the oil / gold trade! Now the CBs are selling in the open to calm nerves but it’s known that they will never sell enough. It was never their intent to provide the gold, only the backing until new mining technology could increase production. Over time the forward sales, such as ABX’s should have worked. But LBMA went nuts with the game and the whole mess has now accelerated.

Obviously, Greenspan had a very good reason to reassure the holders of unallocated gold that the central banks would lease enough for their allocation requests to be honoured.

In his article More Proof (21 April 2003), James Turk summarized the import/export statistics of gold for the United Kingdom. For example, in the statistics for the 1960s and 1970s, one can even see a glimpse of the operation of the London Gold Pool (Figure 10). Indeed, the gold pool grew during the early 1960s, but it suffered from a huge outflow in 1967 and 1968 (Note that this is the import/export statistics, and so it captures only the flow of gold into and out of the United Kingdom, but not the reallocation of gold to new owners inside the United Kingdom).

Figure 10: Net Import of Gold into the United Kingdom 1962-1976 (source: James Turk)

Figure 11: Net Import of Gold into the United Kingdom 1992-2002 (source: James Turk)

7. Further Pieces of Information

Germany

Germany’s Bundesbank just announced the location of their gold reserve of 3396 tonnes (1036 tonnes in Frankfurt, 1536 tonnes in New York, 450 tonnes in London, 374 tonnes in Paris). From their report, it can also be seen that they relocated 930 tonnes from London to Frankfurt ‘at the beginning of the last decade’, yet, they only reported this fact on 25 October 2012. They also said that none of their gold is on loan as of today.

The salespeople of the gold investment industry often claim that the Bundesbank could not access their gold in New York, that the U.S. had already leased it all, or that the U.S. would view this gold as a collateral in order to impose political conditions on Germany.

Having read Another’s and FOA’s quotes above, we know that nothing would be further from the truth. Germany could just threaten to sell their U.S. dollar reserve in order to purchase 1536 tonnes in the open market which would immediately break the dollar gold market and collapse the U.S. dollar.

The real threat here is not the U.S. threatening to confiscate the German gold (and so Germany would not be able to sell this gold in order to defend the Euro). The real threat is rather Germany threatening the U.S. to purchase additional gold outright in the market, either using their U.S. dollar foreign exchange reserves or even with freshly printed Euros (and thereby collapsing the U.S. dollar as a reserve currency).

Update: As of 30 January 2013, the Bundesbank have released the locations of their allocated gold, the amount on lease or swapped as well as the amount of unallocated gold (sight accounts) they have held and a list of all their gold transactions.

This move by a central bank to publish a full history of their gold transactions and storage locations which makes fully transparent which part of the gold was allocated, unallocated, swapped and leased out, is totally unprecedented. We see about 200 tonnes of unallocated gold until 1997, about 740 tonnes swapped between 1979 and 1997, and up to 250 tonnes leased out between 1997 and 2008. Most of this is entirely in line with Dimitri Speck’s and our analysis above. A new piece of information is the large amount of swaps closed in 1997. In 1997, the Bundesbank converted a net amount of about 790 tonnes from `paper gold´ to `physical gold´ by allocating the 200 tonnes of unallocated, closing 740 tonnes of swaps, and only leaving 150 tonnes leased out. This must have tremendously increased the pressure on the London gold market in 1997. This information is a nice corroberation of Another’s remark

Date: Wed Nov 12 1997 20:41
ANOTHER (THOUGHTS!) ID#60253:

[...] A BIS meeting was held and from those doors the world did change. The Bundesbank has now made clear to all what will now be policy for CBs. A crisis is at hand! All physical gold sales will stop. All gold lending will wind down. We will see the results of this as a massive scramble to cover open positions slowly unfolds. [...]

It suggests the interpretation that the Bundesbank is the major gold power besides the U.S. and that they took quite a hard line approach, both risking a collapse of the dollar before the Euro was introduced and perhaps even forcing the Bank of England to sell some of their gold in order to rescue the London bullion banks. These Bundesbank publications also confirm that they relocated about 930 tonnes from London to Frankfurt between 1999 and 2001. They did not report this fact for another ten years.

In light of these events, it is even more remarkable that the Bundesbank publishes all these data now, in the beginning of 2013. Given their position as the major gold power besides the U.S., this must be interpreted as a signal to the rest of the world. I summarized my idea by tweeting

The Bundesbank is telling the rest of the world: We are all physical now. How about you?

At the same time, the Bundesbank announced that they would repatriate some 350 tonnes from New York to Frankfurt over the next seven years for about 50 tonnes per year. Gold bugs immediately claimed that the U.S. either did not have the gold or that they denied Germany the shipment in order to use the gold as a dead pledge and blackmail Germany. I do not think the U.S. can afford to do this and wrote at FOFOA’s blog

Here is a related remark. These days, the goldbugs on all channels hyperventilate about the Bundesbank being unable to recover their gold from New York.

This talk completely misses the point. The threat is not that the Bundesbank would retrieve the gold and then sell it in order to defend the Euro. This is IMF-think.

The real threat to the position of the U.S. is that the Bundesbank might purchase gold in the market: “Hey, Timmy, ship us the gold. If you don’t we buy twice that amount in the market.” Timmy will call FedEx before you can say “GLD Puke”.

Finally, the Bundesbank have demonstrated that they were willing to relocate 930 tonnes from London to Frankfurt. They just carried out this business and remained silent about it for more than a decade. So why are they now asking openly for the repatriation of gold from New York to be shipped to Frankfurt, but only for 350 tonnes, and even this spread out over several years? MF explained it in a discussion at Zero-Hedge. Here is my summary at FOFOA’s blog:

At ZeroHedge, I repeated my argument that the US will not confiscate the European gold (nor will they illegally lease or swap it out). Then:

Börjesson: All well and good, but that doesn’t really answer the question. Why the seven years? Presumably, since the Germans have such leverage, they’re only letting it take so long because they want to. But why? If the gold is really there, then why not just ship it over and have done with it?

VtC: Cause it doesn’t matter. The US government cannot afford to cheat, and so why care?

Recall that the Bundesbank shipped some 930 tonnes from London to Frankfurt in 2000 and 2001, and they didn’t tell anyone for a decade (it came out last fall when they published where their gold is stored).

So if they now make a fuss about 50 tonnes, then the point is the fuss rather than the 50 tonnes, no?

MF: What possible action could the Bundesbank have taken that would invite more notice and speculation? The only other is asking for everything immediately…but that would crash the gold market immediately and they would be blamed. This is a nice strategic move.

Germany : We only asked for a little gold, you can’t blame us.

ROW : Wth..hyperventilating.

Germany #winning

Börjesson: Why would asking for immediate delivery of all the gold crash the gold market, assuming that it’s actually there in the NY vaults and not leased to anyone? The Germans already own the gold, so nothing changes ownership, it’s just a matter of transport logistics. Right?

Now if the gold WASN’T there anymore, if asking for it all back would force the US to go buy some in the open market, or else mine it pdq, THEN I can see why it might have an effect on the markets. Is that your position?

MF: Because of the panic it would create. It would show an extreme lack of trust at international level between some of the most powerful entities that exist.

To others it would imply that the Bundesbank knows something they don’t (true most of the time anyways) and perhaps expect imminent collapse. That will send others scrambling for gold, even if there was no reason for panic (and the huge paper gold versus real gold ratio is reason enough for panic NOW).

That would break the market. Even though the Bundesbank would get every ounce from the Fed, just this action of asking will break things.

Switzerland

According to this speech by Thomas J. Jordan, Chairman of the Governing Board of the Swiss National Bank (SNB), about 70% of the 1400 tonnes of gold reserve of the SNB is stored in Switzerland, 20% at the Bank of England and 10% at the Bank of Canada.

Austria

Axel Merk pointed me to two articles (here and here) in the Austrian newspaper Die Presse of 21 and 22 November 2012, according to which the central bank of Austria (Österreichische Nationalbank) has gold reserves of 280 tonnes (224.4 tonnes in London, 6.9 tonnes in Switzerland and 48.7 tonnes in Austria). In 2000, they had up to 80% of their gold reserve on loan. As of today, the amount of gold on lease has been reduced to 16%, i.e. to about 45 tonnes. The following diagram (Figure 4) from the second article nicely supports our claim: The central banks of the Eurosystem kept selling gold until 1999, but then they stopped the sales (and even have been gradually recalling the leased gold):

Figure 4: Gold Reserves of Austria, Die Presse, 22 November 2012

Netherlands

Jaco Schipper sent me this letter in which the Minister of Finance of the Netherlands confirms that the central bank of the Netherlands stopped lending gold in 2008.

He also translated some questions and answers with the Dutch minister of finance for me according to which 49% of their official gold reserve is in New York, 20% in Ottawa, 20% in London and 11% in Amsterdam.

Question 12. Can you explain why the relative DNB gold ownership was brought more in line with other gold-holding countries, as was noted in the previous questions?

Question 13. What amount in gold stock do you think should serve as ultimate reserve?

Question 14. Can you give an example of a situation where a claim to the Dutch gold reserves as ultimate reserve should be made​​?

Answer to question 12 through 14. Since the end of the Bretton Woods gold has no explicit function in terms of backing money. Nevertheless, it still contributes – [albeit] more indirectly – to the confidence in the financial system. The process of European monetary integration in the early nineties led to a reassessment of the size of the gold stock. Gold was at that time a very large share of total foreign exchange reserves of DNB. Also, the stock in relative terms was considerably higher than the European average. This prompted DNB to sell the gold stock in part to bring it more in line with those of other countries. Hereby, it still was considered prudent for a small country like the Netherlands to keep holding more than an average gold stock in comparison with other central banks. Also nowadays, DNB reviews the amount of gold reserves from a international perspective. A claim to the gold stock as ultimate reserve can be done for example in an extreme crisis in which liquidity is necessary to meet financial obligations. The gold would then be used as collateral.

Ireland

Aaron at FOFOA’s mentioned an article in The Independent (Republic of Ireland) according to which the Central Bank of Ireland whose gold reserve is tiny with only 6 tonnes, had not entered into any lease arrangements regarding any of its gold. Most of the official Irish gold was stored at the Bank of England.

FOFOA

Please see FOFOA’s Happy New Year and Legs for further remarks on the European central bank activities in the gold market and further quotes of Another and FOA.

Acknowledgements

Slow Loris Larry asked me to comment on some of the unsubstantiated claims by a well known salesperson of the gold investment industry. My email response was the basis for this summary. Thanks are due to Dimitri Speck for permission to use some of his diagrams and to Martin S. for help with some translations. I am also grateful to FOFOA, Mortymer, Jeff and other members of the discussion at FOFOA’s blog for help with locating references and official statistics.

Comments

If you have additional sources, further data, or a different interpretation, please feel free to comment (comments are moderated, and it may take a while until I have time to respond).

GLD Inventory Strategy from 1 January 2006 to 30 April 2012

In this article, we explain how the signals can be computed from the variations of the inventory of the SPDR Gold Shares exchange traded trust (NYSEArca:GLD). We explain why the inventory adjustments can hardly be caused by price arbitrage between the GLD share price and the loco London spot price alone. We rather claim that bullion banks finance their inventory by lending it or selling it to GLD investors and that bullion banks manage their physical reserves by accessing the physical gold inside GLD.

The fact that a certain type of inventory adjustments has predictive power, supports the idea that large inventory changes are the result of active reserve management. This provides us with a unique window into the flow of physical gold that is usually obscured by the dominance of paper gold trading. A similar, but somewhat less robust result is shown for the iShares Silver Trust (NYSEArca:SLV).

WARNING (April 2013): This article uses the term buy signal in a technical sense. It does not mean that you ought to buy anything without understanding what you are doing. Notably, the rapid price increases after the buy signals have been absent since the fourth quarter 2012. Now you might dismiss the trading algorithm as a statistical fluctuation. Alternatively, you can wonder whether something might have changed.

The idea of a trading strategy based on changes to the GLD inventory goes back to Lance Lewis’ GLD Puke Indicator. The term Central Bank Of the Bullion Banks was coined by FOFOA who wrote about the GLD Puke Indicator in Who Is Draining GLD. In that article, FOFOA expands on Randal Strauss’ idea that GLD redemptions indicate a preference for physical gold over paper gold (see his Gold Dips Towards $1360/oz … and Gold Nears 3-Months Low…).

Creation and Redemption of GLD Baskets

The method by which GLD grows or shrinks differs radically from the way in which conventional investment funds operate. If you want to invest in such a fund, you wire money to the manager. If you wish to withdraw money, you fax them a withdrawal notice. Depending on the contributions and withdrawals, the manager then either invests the contributed cash or sells investments in order to satisfy the requests for withdrawal.

GLD is managed differently. As of 29 May 2012, there exist about 421 million shares of the trust. Each share corresponds to roughly 0.097 ounces of gold. The trust therefore contains 40.84 million ounces of gold (1270 tonnes) that are worth $64.5bn at the London pm fixing price of $1579.50 per ounce.

The number of shares of the trust can be changed only in multiples of a basket (100000 shares) and only by the so-called Authorized Participants (APs). According to the prospectus of 26 April 2012, these are Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, J.P. Morgan, Merrill Lynch, Morgan Stanley, Newedge, RBC, Scotia, UBS and Virtu Financial. Each of these APs can

• Transfer the physical gold that corresponds to a basket of shares to the trustee. The trustee then creates a basket of new shares and transfers them to the AP in return (creation)
• Transfer a basket of shares to the trustee and receive the corresponding physical gold in return. The trustee then cancels the shares (redemption).

Note that all the gold held by the trust is allocated except for an adjustment term that is smaller than one 400oz London Good Delivery (LGD) bar.

Creation and Redemption Statistics

Before we consider why an AP might wish to create or redeem baskets, let us take a look at the statistics of these creations and redemptions. The following histogram shows the frequency of the daily inventory changes depending on their size in millions of ounces (creations are counted positive, redemptions negative). Days on which the inventory remained constant, are ignored. We have analyzed the period from 1 January 2006 to 30 April 2012. Recall that one basket consists of 100000 shares which presently represents 9700 ounces or 301.67kg of gold, worth about $15.3 million.

Distribution of daily GLD inventory changes in millions of ounces from 1 January 2006 to 30 April 2012

We see that the changes to the inventory are not exactly normally distributed. In addition to a skew towards small redemptions and larger creations, there are obvious fat tails on both sides. In the following, we are interested in these fat tails, i.e. in the excess number of large creations and large redemptions.

The Trading Strategy in Detail

For GLD, we are interested in creations and redemptions that exceed the threshold of 250000 ounces on a single day, i.e. about 25 baskets or 7.78 tonnes (presently worth $394 million). Note that this threshold essentially captures the fat tails of the distribution of inventory changes displayed above.

On the first day (1 January 2006), our strategy is not invested. At about 4.50pm New York time on every New York trading day, i.e. after the close, the current inventory of GLD is published. If the strategy is not invested and the inventory has decreased by 250000 ounces or more compared with the previous trading day, our strategy buys gold at the London pm fixing price on the following day. If the strategy is invested and on any New York trading day, the inventory has increased by 250000 ounces or more, our strategy sells the gold at the London pm fixing price on the following day. These buy and sell signals are indicated by the green and red dots in the chart at the beginning of this article. The blue curve (right scale) shows the total inventory of GLD in millions of ounces.

Recall that the original GLD Puke Indicator by Lance Lewis counts a decrease of the inventory by 1% or more as a buy signal. We prefer an absolute threshold (250000 ounces) rather than a relative one. This yields a more consistent performance of the strategy over the entire period from 2006 to 2012 and is also more plausible in view of our interpretation of the inventory changes as reserve management (details below). Note that GLD began trading on 18 November 2004, and we have omitted the first 13.5 months from the analysis.

Of course, nobody would actually trade according to this strategy, simply because even during the times at which the strategy is not invested, the gold price still increases at an annualized rate of 7.9%. The strategy merely serves to demonstrate that inventory changes do have some power of predicting the future gold price.

Price Arbitrage

Let us now consider why an Authorized Participant (AP) might wish to create or redeem baskets of GLD. We therefore need to understand how GLD is priced and which type of arbitrage might enforce this price.

Assume you know from the data sheet that one share of GLD corresponds to 0.097 ounces of gold and that the London spot price is $1579.50 per ounce. This yields a Net Asset Value (NAV) of $153.21 per share. Even if you do not know the price at which GLD is currently trading, you nevertheless know that one share of GLD is worth $153.21. So if you bid $153.21 per share (plus spread), you should be able to purchase your shares of GLD, simply because GLD contains physical gold loco London that you could equally well purchase directly for the spot price (plus spread).

If you bid less than $153.21, you cannot expect to receive any shares, simply because the seller would be foolish to sell at this price. If you bid more than $153.21, you would effectively hand a free lunch to the seller. In fact, if you did, your counterparty can indeed capture this free lunch by arbitrage.

Paper Gold Arbitrage

Suppose there is a buyer of GLD shares who acts foolishly and who drives up the price of GLD shares well beyond their NAV. Any arbitrageur can now go short GLD and long any other gold investment that follows the London spot price. This allows him to capture the arbitrage, i.e. to lock in a risk-free profit. This works because GLD will eventually trade at its NAV again, and the arbitrageur can unwind both positions at that point in time. We call this form of arbitrage paper gold arbitrage because the arbitrageur can go long unallocated gold in addition to short GLD while the physical gold inside GLD is not touched.

If for some reason, GLD trades at a discount to its NAV, the arbitrageur can go long GLD and short paper gold. Most likely, GLD will sometimes trade at a small premium to NAV and at other times at a small discount, and so the arbitrageur can easily unwind the paper gold arbitrage after a short period of time.

Let us stress that paper gold arbitrage should be largely unnecessary though, simply because every investor knows that the NAV is the price at which GLD ought to trade. Deviating from this price would be foolish, and so in most cases the threat of arbitrage ought to be sufficient in order to keep the market efficient while the actual arbitrage would not be necessary.

In the unlikely event that there is so much buying pressure that GLD consistently trades at a premium even though paper gold arbitrage is performed, the short GLD and long unallocated gold positions of the arbitrageur would keep growing. How can this be avoided?

Creation-Redemption Arbitrage

The answer is that if an AP performs such an arbitrage and his position of short GLD versus long unallocated gold has grown beyond the size of a basket, he can unwind the position at any time by having a basket created, i.e. he

• has a basket worth of his unallocated gold allocated,
• transfers the gold to the trustee,
• receives a basket of created shares,
• uses these shares in order to close his short position in GLD.

If GLD has traded at a discount for some time, and the AP has accumulated a position of long GLD versus short unallocated in order to lock in the arbitrage profit, he can unwind this position by redeeming a basket, i.e. he

• transfers a basket of shares to the trustee for redemption,
• receives a basket worth of allocated gold,
• uses this gold in order to close his short unallocated position.

Whereas paper gold arbitrage has very little transaction costs, the creation and redemption of baskets involves the reallocation of gold and possibly even physical movements of gold bars into another vault, and is therefore subject to higher transaction costs. Note that Warren James at Screwtape Files discovered a fax from HSBC, the custodian of GLD, that confirms the reallocation of about 760000 ounces (or 1907 LGD bars of about 400oz each) related to the redemption of 79 baskets by Merrill Lynch, Goldman Sachs, and J.P. Morgan on 16 August 2011.

Due to the transaction costs, the APs will avoid the creation-redemption arbitrage as far as possible and perform it only if their paper gold arbitrage position gets way out of balance. Let us finally recall that every market participant knows the NAV and the spot price and therefore the fair price of a GLD share, and so even paper arbitrage should normally be unnecessary.

Then why do we see so many inventory adjustments? Is there a second reason for adjusting the inventory beyond the obvious price arbitrage?

Two Different Views on Inventory Changes

How can we better understand the creation and redemption of baskets? The arbitrage point of view was the following:

Some investor decides to buy a certain number of GLD shares, but he is not interested in other gold investments. If he is willing to pay a premium for these GLD shares if necessary, he will definitely get the desired number of shares. The price to pay is that an AP who acts as the arbitrageur, can pocket that premium as a profit for the service of creating the desired number of shares.

There is, however, a second point of view on the creation and redemption that is not centred around the GLD investor, but rather around the AP. Let us assume the AP decides to put a certain amount of gold into GLD. He therefore transfers the gold to the trustee, receives GLD shares in turn and sells these shares into the market. If GLD shares trade at a discount as the consequence, the rest of the market can act as the arbitrageur and, for example, slightly favour GLD over other gold investments, and thereby absorb all the newly created GLD shares.

So which one is it? Do the investors in GLD request a certain number of shares, and the AP delivers by performing the arbitrage and creating the shares? Or does the AP decide to place a certain amount of gold into GLD, and then the market absorbs these additional shares?

We suspect that at least those inventory adjustments that constitute the fat tails of the distribution, i.e. beyond the threshold of 250000 ounces per day, are in effect initiated by the AP rather than by the GLD investors.

If it were just the arbitrage in response to the investors, why would the trading strategy work? The only explanation would be that GLD investors represent the ‘dumb money’ (or ‘weak hands’) whereas all other gold investments represent the ‘smart money’ (‘strong hands’). In this scenario, GLD would lose a significant amount of inventory when the dumb money sells while the smart money buys, triggering a buy signal. Conversely, when the smart money sells and the dumb money buys, GLD would gain inventory which constitutes a sell signal.

The problem with this view is, however, that there is no reason to assume that GLD is held primarily by the weak hands whereas the other gold investments that are all tied to the London spot price, represent the strong hands. Both GLD and unallocated gold OTC or COMEX futures are held by sophisticated investors, endowment funds or hedge funds. Although many retail investors, i.e. typically weak hands, are in GLD, the same is true for other gold investments such as coins and retail bars, COMEX futures, and bank sponsored gold-related products that, in aggregate, all appear on the other side of the arbitrage, i.e. in the spot market outside of GLD.

The only consistent interpretation would be the following: The fact that the suggested trading strategy works, confirms that in aggregate GLD is dominated by weak hands whereas in aggregate all other gold investments are dominated by strong hands. This point of view is not plausible at all.

We therefore suspect that those inventory adjustments that are relevant to our trading strategy, i.e. those beyond 250000 ounces per day that form the fat tails, are rather initiated by the APs.

Inventory Financing and Reserve Management

Why would an AP decide to increase or decrease the inventory of GLD other than in order to capture some arbitrage profit? There are two plausible scenarios. In order to understand them, let us first note that all market makers except two (Mitsui and Société Générale) and all clearing members of the London Bullion Market Association (LBMA) are presently APs of GLD.

Inventory Financing

Consider a company whose operation requires an expensive inventory. In order to stay in the realm of the gold market, this might be a large coin store, a refiner or mint, or even the market maker of a public exchange. The regular operation requires a considerable gold inventory, but this inventory ties up a lot of capital.

In order to reduce the capital requirement, our company has several options, for example,

• To take out an unsecured loan in order to finance the inventory. This is usually an expensive strategy.
• To Take out a loan for which the inventory serves as the collateral. Given that the inventory is gold bullion, the collateral is easy to liquidate, and so the interest expenses on such a loan should be a significantly lower than those on an unsecured loan.
• To swap the gold for dollars with a bullion bank, i.e. our company borrows dollars from the bank and at the same time lends gold to the bank, both for a fixed term. This is almost the same as taking out a loan that is secured by the gold. Since such swaps are typically limited to 400oz LGD bars, this method is suitable for the market maker, but not for the coin dealer or for the refiner.
• To give private investors an opportunity to own a part of the inventory. The pooled accounts offered by Kitco or by the Perth Mint are examples of this type of inventory financing. Our company can sell the title to gold that forms part of the inventory, to private investors and offer to buy it back from them. Such a pooled account is indeed backed by physical gold, but this is the physical gold that flows through our inventory anyway. Voila, somebody else owns our inventory, and our capital is no longer tied up in order to hold this very inventory.

The London bullion banks can use GLD in precisely the same fashion as the last one of the above examples. They typically have many flow positions that contribute to their inventory, for example, receiving gold that has been sold forward by a mining company and then selling this gold to a wealthy investor. As long as the bullion bank knows which part of their inventory corresponds to this flow and how long it is held for, they can just move this inventory into GLD where it is owned by private investors and no longer ties up any capital.

Even better, should the portion of the inventory corresponding to this flow decrease unexpectedly, they can even purchase a basket of GLD shares in the market, redeem them and recover the gold at any time. In this sense, GLD is even superior to the Kitco pooled account. Kitco can decrease their inventory only if some of the investors in their pooled account decide to sell. GLD offers the advantage that there is a liquid market for GLD shares from which the bullion bank can purchase additional shares at any time. The average daily trading volume of GLD is about 12 million shares which represents an inventory of 1.16 million ounces or 36.2 tonnes.

Reserve Management

A second use of GLD for the bullion bank besides the financing of a part of their inventory is reserve management. This plays a role for every institution that accepts bank deposits in ounces, that lends ounces and that holds only a fractional reserve of physical gold against this created credit. For example balance sheets, we refer to Bullion Banking with Alice and Bob.

The bullion bank can hold gold instruments in various forms, for example,

1. physical gold in the vault,
2. allocated balances with other institutions,
3. shares of GLD,
4. unallocated balances with other institutions,
5. outstanding loans denominated in ounces,
6. long OTC Forward or COMEX futures positions,
7. and many others.

Only the first three of these are free of credit and counterparty risk and can therefore be considered as reserves. This is analogous to the reserves of an ordinary commercial bank that is in the business of lending dollars. The reserves of the commercial bank consist of cash in the vault and of reserve balances with the respective central bank.

Besides the credit risk, i.e. the risk that a counterparty fails to honour its obligations, any bullion bank that holds only a fractional reserve against their customers’ deposits, is exposed to liquidity risk. For example, customers might request allocation of their unallocated account balances. In this case, both a liability of the bank (the customers’ unallocated account balance) and an asset (a reserve of physical gold) disappear from the balance sheet. This is analogous to a customer withdrawing dollars in cash from a commercial bank or to a customer transferring out credit money from her account.

Since such a withdrawal involves a reduction of our bullion bank’s reserves, our reserve ratio deteriorates. We now have less reserves relative to the size of our balance sheet. This is where GLD comes in handy. We can easily replenish our reserves by

• selling unallocated gold or other instruments that involve credit or counterparty risk, and
• purchasing shares of GLD, and optionally
• redeeming these shares for physical gold.

In effect, on our balance sheet, we have replaced credit assets (paper gold) by reserve assets (GLD shares or physical gold).

Shortage of Reserves and Reduction of GLD Inventory

Although inventory financing may be one of the motivations for establishing GLD and for the APs to place additional gold in GLD, it is not the activity that correlates with the inventory changes on which our trading strategy is based. The reason is that our strategy is based on the creation and redemption of GLD baskets, but inventory financing occurs when a bullion bank sells existing shares of GLD to an investor.

Let us try to disentangle these steps. The bullion banks presumably hold a part of their reserve in the form of physical gold in their own vault and another part in the form of GLD shares. Whenever they acquire a larger amount of additional physical reserves, they probably place some of it into GLD and create new baskets of shares, but they do not necessarily sell these GLD shares to investors and even if they do, this need not happen at the same point in time.

Conversely, if a bullion bank faces a large allocation request and needs to replenish the physical gold in their vault, they can redeem baskets of GLD that they already own. In a true emergency in which a bullion bank runs out of reserves, they can even

• sell some paper gold, and
• purchase GLD shares with the proceeds, and optionally
• redeem these GLD shares in order to receive physical gold,

thereby replacing a credit asset (paper gold) with a reserve asset (GLD shares or physical gold).

Since our trading strategy uses only the instances in which shares of GLD are redeemed for physical gold, it is sensitive to the following two situations:

• The bullion bank has purchased shares of GLD in order to boost its reserves. In order to achieve a balance between their two forms of reserves, i.e. GLD and physical gold in the vault, they redeem some of these GLD shares.
• There has been a request for allocation by some investor who requires individual bars in the vault, and so GLD shares need to be redeemed in order to get to the bars.

We therefore expect that some changes to the inventory of GLD are related to the reserve management of the bullion banks. Excess reserves lead to a growing inventory of GLD whereas a shortage of reserves results in a reduction of inventory. If this picture is correct, we should find independent evidence that reductions of GLD inventory correlate with a shortage of reserves. There is indeed anecdotal evidence for such a correlation.

One of the largest recent reductions in GLD inventory occurred on 22 May 2012 with a net redemption of 563024 ounces, i.e. 58 baskets or about 17.5 tonnes. This event coincides up to one week with a negative one-month GOFO quoted by J.P. Morgan on 16 May 2012 as reported by Izabella Kaminska. This indicates that J.P. Morgan was presumably willing to pay a premium in order to swap dollars for gold, i.e. they were willing to buy at spot and sell a one-month forward at a discount.

GOFO on 16 May 2012 (Reuters)

Robert LeRoy Parker spotted another example. Some of the largest reductions in GLD inventory occurred on 23 and 24 August 2011 with redemptions of 798417 ounces and 876288 ounces, together 172 baskets or about 52 tonnes of gold. This coincides with the following reported Gold Forward Offered Rates (GOFO) found on the LBMA website at that time. The numbers are GOFO for 1,2,3,6 and 12 months:

19-Aug-11 0.40000 0.41600 0.42600 0.48800 0.51000
22-Aug-11 0.48250 0.43000 0.35000 0.25000 0.08750
23-Aug-11 0.40800 0.41600 0.42250 0.50000 0.52600

The term structure beyond one month was inverted on 22 August 2011, indicating that some bullion bank(s) frantically tried to borrow gold in the OTC market, gold that was needed within one to two months. They were willing to buy one-month forward and sell a longer forward at a discount. Recall that the GOFO rates reported on the LBMA website are not individual quotes that can be associated with a specific bullion bank, but rather the averages from their daily telephone survey of the major market makers. Also note that a few days later, these numbers were ‘corrected’ on the LBMA website.

A third example was again reported by Izabella Kaminska. On 10 August 2011, Société Générale quoted an inverted term structure:

GOFO on 10 August 2011 (Reuters)

Again, this coincides with losses of GLD inventory of 418373 ounces on 9 August 2011, 759559 ounces on 11 August 2011 and 408988 ounces on 12 August 2011, together 1.59 million ounces, 164 baskets or 49.3 tonnes. Since Société Générale is not an AP, apparently someone else took the gold out of GLD and lent it to them.

We have to concede that the published GLD inventory only records the aggregate daily changes. The fax from HSBC that Warren James at Screwtape Files discovered, shows redemptions of 759618 ounces for 16 August 2011. This must have been some intra-day movement that was compensated by even larger creations on the same day because the reported aggregate change of inventory for that day is positive. Apparently the inventory changes are such a good indicator that the trading strategy is still effective even if we work with daily aggregates only.

Interpretation

We arrive at the interpretation that large allocation requests by customers of a bullion bank sometimes force the bullion bank to take physical gold out of GLD. This is a buy signal that indicates a higher price of paper gold in the near future. Conversely, once the bullion bank has replenished its reserve of physical gold and shifts a part of this back into GLD, this forms a sell signal that indicates a less rapidly increasing price of paper gold in the near future.

FOFOA must have had this picture in mind when he called GLD the Central Bank of the Bullion Banks, i.e. a depository of additional reserves shared by those bullion banks that are at the same time APs.

It remains to understand why the paper price of gold rises during the period immediately following strong demand for physical gold.

Conservative Interpretation

A simple explanation is the following. Many large redemptions of GLD occur towards the end of a sell-off in the price of paper gold. There might be some sophisticated buyer(s) of physical gold who buy the dips and whose timing is excellent.

Notice that the buyer(s) purchase only about 5 to 50 tonnes of physical gold on the relevant days whereas about 2700 tonnes of paper gold are sold every trading day (total transaction volume of all sales, assuming 62.5 trading days per quarter) according to the Loco London Liquidity Survey published in August 2011. Although the physical purchase is tiny compared to the trading volume of paper gold, after this purchase the price of paper gold increases.

We might attribute this to the excellent timing of the large physical buyer whose activity we can sometimes spot by watching the inventory of GLD.

Speculative Interpretation

If you find this interpretation unsatisfactory and ask why should the paper price increase after the purchase of an amount of allocated gold that is small compared to the volume of paper gold traded, the only way out is more speculative.

What if somebody manages the price of paper gold in such a way as to control the flow of physical gold? The following chart shows the remarkably uniform increase in the dollar price of gold over the previous decade from 2002 to 2011. The black line is the regression line in the logarithmic diagram. It starts on 2 January 2002 at $266.60 and ends on 29 December 2011 at $1589.95 for an annual rate of increase of 19.56%. The blue and light blue bands are a factor of 1.118 and 1.25 away from the black line.

The London pm gold fixing in US$ between 2 January 2002 and 29 December 2011

Does this chart look ‘managed’? Maybe…

How would one manage the price in such a way as to control the flow of physical gold? Let us make up some numbers in order to arrive at a toy model. There is a flow of new gold into the market from mining and recycling. This amounts to about 3000 tonnes per year. If a third of this amount goes through the London market, this amounts to about 4 tonnes per trading day (assuming 250 trading days per year).

In addition, there are some investors who sell allocated gold and some who purchase allocated gold. Let us be generous and assume that this trading volume of allocated gold is three times as big as the flow of new gold. This suggests a trading volume of 16 tonnes of physical gold per trading day in the London market which is tiny compared to the trading volume of paper gold (2700 tonnes per trading day). It is important to keep in mind that the inflow of new gold has an approximately constant weight per day.

It firstly seems plausible that allocation requests of about 5 to 50 tonnes are big enough in order to affect the reserve management of the bullion banks and thereby result in changes to the GLD inventory. It is also plausible that the management of the physical reserve that underlies the gold market is a rather delicate business because the paper trading volume is so huge compared to the physical volume.

Secondly, let us assume that the allocation requests by the buyers of physical gold involve an approximately constant sum of dollars per time. Investors or central banks who gradually switch from dollars into gold or who gradually diversify their foreign exchange reserves. We therefore have an inflow of physical gold that is steady in terms of weight per time, but an outflow that is steady in terms of dollars per time.

In order to manage the flow of physical gold, someone might therefore try to manage the dollar price of paper gold. Since the physical inflow is by weight, but the outflow by dollars, one might try to increase the paper price in response to an increased outflow of physical gold and try to lower the paper price whenever there are plenty of reserves. There you go. This is indeed consistent with what we see in our trading strategy: The price of paper gold increases in response to an outflow of physical gold.

Let us keep this speculation in mind as a second possible explanation of why the trading strategy works.

In light of this interpretation, it would be worthwhile watching the total inventory of GLD (the blue curve, right scale, in the very first diagram of this article). The inventory of GLD, the central bank of the bullion banks, should move in line with their total physical reserves. We see that the inventory peaked at 42.1 million ounces (1310 tonnes) in summer 2010, a level that has not been reached ever since. Even though the dollar price of gold rose further from $1200/ounce to $1900/ounce, the investors in GLD were not able to entice the APs to make additional inventory available.

Nevertheless, the present GLD inventory of still 40.84 million ounces (1270 tonnes) forms a considerable reserve of physical gold which the bullion banks can draw on in order to replenish their own reserves. Should the total inventory continue to decline, this would indicate increasing pressure on the physical reserves of the bullion banks. The financial media, however, would presumably tell you that investors are no longer interested in gold, that they sold their shares in GLD and that this was bearish for gold. Nothing would be further from the truth.

The SLV Inventory Strategy

The same trading strategy that we developed for gold, can also be applied to silver. We therefore watch the inventory of the iShares Silver Trust (SLV) whose inventory management is organized in the same way as that of GLD. Note that a share of SLV presently represents about 0.97 ounces of silver. One basket consists of 50000 shares, i.e. about 1.5 tonnes of silver presently worth $1.37 million (London silver fixing of $28.25/ounce on 29 May 2012).

The following histogram shows the distribution of the daily changes to the inventory of SLV.

Distribution of daily SLV inventory changes in millions of ounces from 1 January 2007 to 30 April 2012

The threshold for our trading strategy is an inventory change by at least 3.5 million ounces (about 108.9 tonnes worth $98.9 million). Apart from the choice of this threshold, the trading strategy is identical.

The following chart finally shows the performance of this strategy. The black curve (left scale) is the London Silver Fixing in U.S. Dollars. Again, buy and sell signals are indicated by green and red dots, respectively, and the light-blue shaded areas are the times during which the strategy is invested, i.e. about 25% of the time. During the invested periods, the silver price increases at an annualized rate of 28.7% whereas during the remaining times it increases only at an annualized rate of 11.6%. The blue curve (right scale) finally shows the total inventory of SLV.

SLV Inventory Strategy from 1 January 2007 to 30 April 2012

Whereas in the case of GLD, basically any threshold beyond our 250000 ounces works, as long as it gives a sufficient number of signals at all, it is substantially more difficult to find efficient parameters for the strategy involving SLV and silver. Nevertheless, we do have an effective trading strategy, and so everything said about reserve management and GLD seems to apply to silver and SLV, too.

Comments

If you have comments, suggestions or corrections concerning this article, please comment here (comments are moderated, and it may take a while until I have time to check for new comments). FOFOA just opened a new thread GLD Talk Continued, and so for the further discussion, please take a look there.

West Texas Intermediate (WTI) from June 2002 to April 2012

Obviously, there was a speculative bubble from early 2007 to mid 2008 which then collapsed during the second half of 2008. In a series of articles, Chris Cook claims that the crude oil price has been in another bubble since the end of 2009 and that this bubble is just beginning to pop. The present article is an attempt at understanding the mechanics underlying Chris Cook’s ideas.

The relevant articles by Chris Cook are: Naked Oil (10 January 2012), The Oil End Game (27 February 2012), The Ghost of Enron … (5 March 2012) and Spikes and Speculation … (16 March 2012).

The Mechanics of Oil Swaps

In order to understand the mechanics of the oil market, I translate all positions into the language of swaps of oil for US$. Such a swap involves borrowing US$ and at the same time lending oil, both for a fixed term and with the same counterparty. This can be realized, for example, by selling oil for US$ in the spot market (i.e. for immediate delivery) and at the same time purchasing an Over The Counter (OTC) oil forward contract for delivery at some point in the future. Alternatively, one can sell oil for US$ in the spot market and purchase a WTI futures contract at the New York Mercantile Exchange (NYMEX).

If the forward price of oil is higher than the spot price, the oil market is said to be in contango. The opposite condition is called backwardation. More precisely, the contango is the difference of the forward price of oil minus the spot price. The term structure of the oil market at any given time is the function that describes how the contango depends on the time until maturity of the swap.

The article Profiting from a contango, not so easy (8 December 2008) by Izabella Kaminska contains the following diagram of the term structure between spot and 60 months of the NYMEX WTI futures contract for 3 October 2008 (black curve, left scale) and for 28 November 2008 (red curve, right scale).

Example of the NYMEX WTI Term Structure

The contango, i.e. the forward price minus the spot price, is precisely the interest payable when swapping oil for US$. If the oil market is efficient and arbitrage is possible, the term structure is determined by the no-arbitrage condition:

contango =

+ nominal risk-free yield of US$

+ risk-premium because you might not return the borrowed US$

+ storage expenses for the oil

- risk-premium because your counterparty might not return the oil

The reasoning is precisely the same as described for gold and silver in Backwardation in the Case of a Monetary Metal.

Why would somebody swap his oil for US$ and pay the contango as the interest on this swap? One answer is that this is a way of obtaining a cheap US$ loan because the oil effectively serves as the collateral for that loan and the risk-premium on the oil loan offsets the risk premium on the US$ loan. So in an efficient market and in a situation in which both parties have comparable default risk, the contango basically equals the risk-free return on US$ plus the storage expenses for the oil.

Term Structure Arbitrage

In the case of gold and silver, it is plausible to assume that the market is efficient and that the term structure is always determined by the no-arbitrage condition. Firstly, for both metals, there is a large investment stock available and ready to trade. Secondly, there exists ample storage space and both storage expenses and transportation costs are small compared to the price of gold and silver.

In the oil market, however, the situation is more difficult. If, for example, the contango is higher than the risk-free rate plus storage expenses, the following arbitrage becomes profitable. The well-capitalized arbitrageur can purchase oil in the spot market and at the same time sell it forward, storing the oil for the duration of this swap. But this can be done only by those market participants who have access to the infrastructure for handling physical oil, and only if enough free storage capacity is available. In addition, the transactions costs are no longer negligible as soon as the oil has to be moved.

Towards the end of 2008, i.e. after the first oil bubble mentioned at the beginning of this article had popped and the spot price had collapsed, the market had a huge contango as can be seen in the above diagram (red curve). We refer to the article Is it a bird? No, it’s a super-contango (11 November 2008) by Izabella Kaminska. In fact, since the end of 2008 and during 2009, the contango was so high that the arbitrageurs had already used all the available storage capacity onshore, and in addition they chartered oil tankers in order to be able to store even more. These tankers just remained anchored close to the major ports. Already on 30 January 2009, the Houston Chronicle wrote:

Frontline LTD, which runs one of the largest crude supertanker fleets, estimates 80 million barrels of oil are drifting slowly on the high seas—roughly equal to a day’s oil consumption for the entire world.

On 23 December 2009, the website Oil-Price.Net wrote

We have recently had a large contango in the oil market. In January, we saw an all-time high contango in oil – an incredible $23.70 a barrel [VtC: for a 1-year term].

That was quite an incentive to just keep any oil you had and sell it at a later date, even after paying to have the oil stored in massive oil tankers. In April, there was a record amount of oil in floating storage – 100-120 million barrels! And a record number of supertankers being used for that purpose – 56.

Paul Tossetti, Dallas-based director of oil markets at consultant PFC Energy, estimated that it costs 50 cents to 60 cents each month – $6-$7.20 per year – to store each barrel on a supertanker. So as long as the contango stayed above $7 per barrel [VtC: for a 1-year term], it made economic sense to just let the oil sit.

Muppets Make the Market Inefficient

Before we discuss the role of the muppets, let us stress that the oil market is infamous for being extremely opaque. The price benchmarks such as WTI or Brent refer to specific contracts with rather narrow markets, but are used as a reference for a much larger volume of oil trade, and so it is comparably easy and profitable for large market participants to influence these benchmarks. In addition, the number of market participants with access to the actual physical oil infrastructure is small, and so even if term structure arbitrage is possible, it may not be executed for strategic reasons. Finally, during times of a liquidity shortage such as in 2008 and early 2009, arbitrage may not happen simply because the required liquidity is not available.

A significant additional market inefficiency is introduced by passive investors such as ETFs and other retail products as well as by pension funds and insurance companies who use the oil market in order to hedge against inflation. All these investors, let us call them muppets (again following Chris Cook), operate solely in the financial markets, but do not have and do not want access to the physical oil infrastructure.

In an efficient market, the following two positions are essentially equivalent:

1. Purchase a futures contract for delivery of oil in 3 months.
2. Purchase oil in the spot market and immediately swap this oil for US$ for a term of 3 months.

The muppets, however, have access only to method (1) because (2) involves the handling of physical oil. As a variation of (1), a pension fund can, for example, purchase an OTC oil forward contract that is settled in cash rather than oil.

During a period of strong muppet buying, we therefore expect the contango to increase beyond the value that would be enforced by term structure arbitrage, simply because the muppets bid up the futures price, but not the spot price. This apparently happened between November 2008 and the end of 2009 when investors were betting that the risk of deflation was exaggerated and when they purchased oil futures. The arbitrageurs responded by buying physical oil in the spot market, by selling it forward and in the meantime storing it. But the arbitrage was still incomplete, the contango remained high and the market inefficient for almost a year.

Since the muppets cannot take delivery of their oil, but rather have to keep rolling their futures position, i.e. to sell the near month and purchase a futures contract with a longer maturity, they keep bidding up and paying the contango as long as they hold their paper only position. The arbitrageurs, in turn, can pocket the excessive contango as long as they can store physical oil on behalf of the muppets.

Although some hedge funds got involved in the ‘oil tanker trade’, i.e. in storing physical oil and capturing the arbitrage, the prime candidates for this arbitrage are the oil producers.

During normal operation, they keep shipping a certain flow of oil to the consumers and keep selling it in the spot market or through similar contracts. A producer can thus perform the term structure arbitrage simply by selling less oil in the spot market and more oil in the futures or forward market. On the one hand, they give up the immediate cash flow, but on the other hand, they can earn the artificially high interest rate embedded in the contango.

In order to see whether this idea is consistent with the published data, let us take a look at the Commitment of Traders (COT) data for WTI at the NYMEX and at the ICE. In Where have all the oil hedgers gone? (30 April 2012), Izabella Kaminska shows the following diagram by John Kemp.

WTI Commitment of Traders June 2006 to March 2012 (by John Kemp)

The green area below the x-axis is the short position held by the commercial traders, i.e. oil producers and consumers. This class of investors is typically net short because the producers tend to hedge a greater share of their production in the futures market than the consumers hedge their purchases.

The yellow area above the x-axis shows the long position held by those classified as ‘managed money’. Indeed, both of these positions increase between fall 2008 and spring 2010, indicating that investors purchased the future and kept rolling their contracts while the producers entered the market as arbitrageurs and took the opposite position.

If the muppets purchase and keep rolling the future, thereby driving up the contango, and the producers respond by maximizing their profits, i.e. by arbitrage in order to earn the excess contango, this results in a shift of producer sales from immediate delivery to forward delivery. Supply is shifted from the present to the future which contributes to a rising oil price.

Dark Inventory

The previous considerations for the producer, i.e. selling less oil immediately and more oil forward, refers to the ownership of the oil. It is a different question of where the oil is located physically.

Since transportation of crude oil overseas is technically demanding, the producers might prefer to ship a continuous flow of physical oil to the consumers. Although the sales are shifted from immediate to future delivery, the physical oil is shipped at the usual rate, corresponding to the long term average demand, in order to optimally utilize the existing shipping capacity.

This is possible, however, only if the producer can indeed accumulate inventory in the country of the consumer. This inventory is still owned by the producer and will therefore not show up in the usual inventory statistics. It is so-called dark inventory.

In fact, people speculate that Saudi Arabia owns a substantial amount of inventory overseas. For example, in the Financial Times of 28 March 2012, the Saudi oil minister, Ali Naimi, writes

For the record, as things stand today, our inventories in Saudi Arabia and around the world are full. Our Rotterdam inventory is full, our Sidi Kerir facility is full, our Okinawa facility is full – 100 per cent full.

In More On Crude (30 March 2012), Marshall Auerback speculates that Saudi Arabia can even utilize unused capacity inside the Strategic Petroleum Reserve of the United States, and cites

The SPR DOES have legal authority to store foreign oil. According to the Petroleum Reserve Annual Report for Calendar Year 2010 (Page 34)

“The Strategic Petroleum Reserve promotes the concept of storing foreign oil in its unused storage space as a strategy to increase world oil stockpiling, generate revenues for the United States Treasury, and/or add oil to the Strategic Petroleum Reserve (in lieu of a fee). The Balanced Budget Act of 1997 (Pub L. 105‐33) provides specific authority to store petroleum products of another country, or its representatives, in the facilities of the Strategic Petroleum Reserve, provided that the United States is fully compensated for all related costs, and that the ability to draw down Strategic Petroleum Reserve oil is not impaired. To enhance the Strategic Petroleum Reserve’s offer to store oil for foreign governments or their representatives, the Big Hill storage site was activated as a special purpose Foreign Trade Zone subzone on September 28, 1998. This designation permits customers to store oil without paying customs fees and certain taxes. The Big Hill storage site is the only storage site to receive this designation.”

Inventory Financing

What are the costs for a producer to enter the arbitrage and play the counterpart of the muppet? We recall that effectively the muppet swaps oil for US$ with the producer. The producer effectively sells less oil immediately and more forward, i.e. he loses cash flow. The arbitrage is profitable only as long as the (excessive) interest embedded in the contango that the producer earns through the arbitrage, exceeds his average financing costs.

As soon as this is no longer the case, the producer will again prefer to sell immediately and leave the muppet-induced arbitrage opportunity on the table for somebody else to take.

Who other than the producer can take the position opposite to the muppets? Firstly, other companies that typically handle physical oil, can perform the same arbitrage as the producer. They will probably have similar financing costs though. Secondly, some speculator who seeks an explicit short price exposure can sell the futures contracts directly to the muppets.

But arbitrage, i.e. a risk-free position, at the short end of the term structure can be performed only by those with access to the physical oil infrastructure. As soon as their financing costs exceed the (excessive) interest rate embedded in the contango, they can no longer profitably perform the arbitrage.

Until they realize that they can borrow against their excess (dark) inventory. In fact, rather than stopping the arbitrage, the producer can try to find a financial intermediary and swap his oil for US$, in effect borrowing US$ and using the oil as the collateral. Any financial intermediary who is willing to receive title to the oil for the period of the swap, can take the other side of this swap. This is profitable as soon as the financing costs of the financial intermediary are lower than those of the producer. This is where the large U.S. banks come in.

Let us summarize the position of the producers.

• When they enter the arbitrage with the muppets, they buy spot and sell the future. (Well, they sold less immediately and more forward).
• When they borrow US$ against their inventory, they sell spot and buy the future.

These two positions compensate each other. This means that effectively, the producers are now out of the arbitrage business.

But still, rather than selling to the consumer in the spot market, they now sell to the bank. The bank buys spot oil, owns the dark inventory, and sells the future to the muppet. So in effect, the aggregate muppet long position now corresponds to dark inventory held by the bank on behalf of the muppet.

If the producers indeed start to finance their inventory in this way, one should see the short position be transferred from the producers to the swap dealers (financial intermediaries). This is clearly shown in the chart of the COT data above. Since fall 2010, the commercial short position (green area below the x-axis) has been gradually replaced by the swap dealer short position (blue area below the x-axis).

Chris Cook writes in the comments to Izabella Kaminska’s Saudi Arabia Resorts to Jedi Mindtricks (29 March 2012):

Furthermore, my take is that the Saudis and J P Morgan Chase have for three years been using Enron-style Prepay contracts to maintain what was essentially an oil peg against the dollar using distinctly un-open market operations via oil repos.

The problem with this central oil bank strategy is that it requires a continuing flow of funds from muppets into the market as the producers take excess profits out.

There we go. In fact, as long as the aggregate muppet long position grows, this is in effect financial oil demand that drives the spot price up and that disappears into the dark inventory. If the aggregate muppet long position shrinks, this creates financial oil supply, additional oil on the market that seems to appear out of nowhere, being released from the dark inventory.

When the Muppets Start Selling

Finally, when the muppets start liquidating their longs, they will disproportionately affect the futures price, but not spot, reducing the contango or even causing backwardation. Inded, Zero-Hedge shows the following term structures for WTI (black: 7 October 2011; green: 2 November 2011; organe: 9 November 2011).

WTI Term Structure (source: Bloomberg)

The WTI term structure started inverting at the short end between 7 October and 2 November 2011. Note that the onset of backwardation at the short end (end of October 2011) coincides with the peak in the open interest in the COT data (end of February 2012) only up to a time lag of four months which may be due to the majority of muppets holding longer term futures or forwards. In any case, the muppets have started selling.

The last time the muppets started selling en masse, was in 2008 (please take a look at the chart at the very top of this article). Saudi Arabia’s oil minister Ali Naimi just wrote in the Financial Times Saudi Arabia will act to lower soaring oil prices (28 March 2012). Note that Saudi Arabia has a track record of taking on the speculators. Marshall Auerback writes in The Oil Conundrum (21 March 2012):

Well, let’s look at history to get a clue: in 1990-1991: the oil price went up from $20 to $40 when Saddam invaded Kuwait. The Kuwaiti fields went down and we embargoed the Iraqi oil.

But then Saudi went full throttle. The oil produced went into hidden stockpiles. For five months. Then when the air war began in Jan of 1991 the oil price fell from 40 to 20, most of it in one day. The Saudis and the allies dumped the oil and killed the specs.

Should Saudi Arabia stop both the term structure arbitrage and the inventory financing, they would no longer sell a part of their spot oil to J.P. Morgan, but rather to the consumers, causing the oil price to fall.

J.P. Morgan has no price exposure, and so it is a different question whether they want to unwind their remaining swaps whose counterparty are in effect the muppets. Since oil is now in backwardation, they can simply close these swaps at the same time as the muppets sell their futures. J.P. Morgan would therefore sell their dark inventory in the spot market and buy back the futures at a discount thanks to backwardation.

If there is not enough backwardation for a decent profit, they can just take their short futures positions into the delivery period, causing another headache for the muppets. Since the muppets cannot handle physical oil, they need to sell their futures well before the delivery month, if necessary at a loss, causing precisely the backwardation that is now profitable for J.P. Morgan.

There are finally independent indications that the producers expect the oil price to decline in the medium term. The Financial Times reports in Qatar joins Mexico with oil hedge (26 October 2011) that

Qatar, a member of the Opec oil cartel, has joined Mexico in taking out an insurance policy against falling oil prices next year, hedging some of its oil for 2012
[...]
bankers said that Qatar has taken out insurance only rarely over the last two decades.

(There was a rumour that Qatar purchased put options around $45/bbl for a part of their production whereas Mexico is known to hedge most of their production at $75/bbl.)

Where are all the Tankers Going?

There is finally one further observation that is perhaps not quite consistent with this picture. On 16 March 2012, Reuters reported:

Saudi Arabia is preparing to extend this year’s unexpected surge in oil sales to the United States, according to tanker industry sources and government data
[...]
Contrary to expectations that the modest recent rise in the kingdom’s output was bound for fast-growing Asian markets, preliminary data shows that shipments to the United States have quietly risen 25 percent to the highest level since mid-2008, when the OPEC kingpin was driving up production to knock oil prices off record highs near $150 a barrel.

The surge appears set to continue. Vela, Saudi Arabia’s state oil tanker company, has booked at least nine very large crude carriers (VLCCs) capable of carrying 2 million barrels of crude each from the Middle East Gulf to the U.S. Gulf since the start of March, the biggest such wave of fixtures in years, analysts say.

While the rise in Saudi output has been well charted, the fact that the lion’s share of it appears destined for U.S. refiners will come as a surprise to many. Overall U.S. demand for foreign crude has ebbed this year as a boom in domestic and Canadian production reduces the need for imports.
[...]
“We were all expecting to see U.S. imports fall for Vela, so it’s a jump at a time when we are preparing for a reversal given the Seaway pipeline,” one shipping source said. “It raises the question why would they need more imports?”

Omar Nokta, managing director with investment bank Dahlman Rose & Co, said in a note on Friday that it was the first time in “several years” for Vela to book so many tankers in such a short time.

Provisional weekly data from the U.S. Energy Information Administration shows that the rise in supplies began several months ago, and outpaced gains to other consumers such as China.

If we wanted to interpret this message in the light of the arbitrage and inventory financing described above, the following would be consistent.

• Saudi Arabia still held some short futures positions directly with the muppets that had not been transferred to the banks and that they now deliver on. (And the poor muppets who cannot deal with physical oil have to sell their futures contracts to some lucky consumer who will be happy to take delivery.)
• Saudi Arabia had not only financed their dark inventory located in the U.S. with the banks, but they had also financed some inventory that was still located in Saudi Arabia. Now that the arbitrage and thereby also the inventory financing is being wound down, they have to deliver this inventory to the consumers in the U.S.

It is not clear that these possibilities can explain the large volume though. From the COT chart shown above, the muppets have perhaps purchased 100 million barrels during the six months until March 2012, i.e. half a million barrels per day. This is indeed the same order of magnitude as the excess shipments from Saudi Arabia. But we also know that U.S. demand has been declining and Canadian and U.S. supply increasing. Already without the excess shipments by Saudi Arabia, Marshall Auerback estimates that

So the US is importing a million barrels a day that America apparently doesn’t need..
Why and where is that oil going? It is not showing up in our inventory data. And what will that import level be when the new increase in Saudi bookings to the US lands on our shores?

It is also possible that Saudi Arabia ships additional crude oil to the U.S. just in order to overwhelm the muppets and to hit the speculators. But we don’t think it is plausible that Saudi Arabia would finance such a presumably loss-making enterprise with their own money if the predictable unwinding of the muppets’ positions are perfectly sufficient in order to bring the oil price down.

Finally, there remains the possibility that they are acting on behalf of the U.S. government, trying to build up inventory inside the U.S. in anticipation of a crisis in the Middle East. We do not have any inside information, but like to relay the following opinion expressed by Chris Cook:

My take – I know for a fact that Marc Rich was in Tehran a few weeks ago, and it wasn’t to take the air or go clubbing – is that Obama and Khamenei (who is now firmly back in control) have come to an understanding. Marc Rich is one of the few people trusted by Khamenei: don’t forget that he was happily flogging Iranian oil to Israel for six years under the Shah, and another 14 years for his friend Khomenei.

That could be why Iran wrote within a couple of days of the election (which gave Khamenei political legitimacy over the Ahmadinejad oligarchic faction) to the 5 + 1 meeting to get the ball rolling again; why Obama suddenly became so clear that Iran were not going to have nukes; and why Khamenei was making comprehensive condemnations of nukes as a sin.

My scenario is that we will soon see Iran backing off – with as little loss of face as possible – to the very same concessions Cheney turned down in 2003 (when Khamenei called the shots) with the difference being that Obama will not insist upon regime change.

Apart from the possibility that Chris Cook is wrong and there will be a war in the Persian Gulf with a possible closure of the Strait of Hormuz, the additional crude oil shipments from Saudi Arabia to the United States are difficult to explain.

Summary

Imagine you favour a high oil price. How do you facilitate this? We have seen that one major component is the behaviour of the inflation hedgers, aka the muppets. As long as they are willing to hold an increasing aggregate futures and forward position, we only need a producer, perhaps together with a bank, who are willing to take the opposite position. This will create financial oil demand, and this oil disappears into the dark inventory, contributing to rising prices.

Both in the spot price chart at the top of this article, and also in the open interest in the COT chart, we see two recent peaks. April/May 2011 was the civil war in Libya. January/February 2012 was the anti-Iran rhetoric. It is not just the reduction in supply that affects the price, but also the predictable behaviour of the muppets.

Finally, the excessive oil shipments from Saudi Arabia to the U.S. fit into this picture qualitatively, but the quantity seems to be out of proportion by perhaps as much as one million barrels per day over several months. No explanation for this so far.

Update (27 June 2012):

Brent oil is back in contango throughout the 12 nearest months (FT Alphaville).

If you do not know what I am talking about, please read Red Barron, Another (Thoughts!) and the Gold Trail.

The mailing list archive covers the period between June 1997 and January 1999 (with most of July 1997 missing, apparently due to some oversight). On 4 June 1997, the writer Notnick posted his collection of some older messages by Big Trader, GFD and The Writer going back to December 1996. I include these messages in the following and highlight them as [via Notnick].

Judging from the archived messages, there have been many hoax messages under the alias Big Trader as well, and GFD was often in direct email contact with Big Trader in order to confirm which ones were authentic. A candidate for a hoax is the message of “Fri Jun 13 1997 00:19″ which I nevertheless include.

The selection of messages in mine. If you would like further messages included, please feel free to comment. If you possess a copy of further historic messages from the Kitco forum, please don’t be too shy to come forward.

Here is the material, for now without comment. Editing for formatting yes, but no editing of the text.

Date: Sat Dec 7 11:50 [1996, via Notnick]
Big Trader ( again@no lower! ):

TO ALL:

I want to thank my friend who post here on Kitco for leting me use his mail. He wanted meto add something to the group because I am, just that, a big trader ( name is not my idea ) . Hope to add a something each saturday. Last Tue. Dec/3 I made a “no@lower” post.

Myself and a group are indeed placing open orders for Feb/97 gold on any breaks below $370.00 and will continue to buy each day under that price ( for weeks if allowed ). We can and will call most or all of these contracts if the market doesn’t rise enough for a rollover. Our cost and fees is such that it’s easier to buy paper here than physicals in asia because of the markup and comex is the only area I would trade here .The only problem for the comex will be geting the shorts to deliver enough warehouse approved deposit receipts.Correct me if I’m wrong but they only have a few hundred thousand ozs for ready delivery. I will keep you posted. A note to the Old Man, you may find it hard to “roll off a log”. Thank you all and Kitco for this area. ( end of quoted post )

Date: Thu Feb 27 1997 23:10 [via Notnick]
Big Trader ( the writer! ):

Let me clear up a few things. I am not the “Big Trader”! He cannot speak or write english and does not/would not post here. He has a need to get “thoughts” to other people. I do not do well with english either. My relations with him are private and restrict me from posting my own thoughts. If I seem to reply to someones post it is to clarify further for other eyes. As we are guests here I should pay my way so let me toss out a fact that is stranger than fiction. Do some research first. Search your books and papers, ask your advisers and letter writers, look at all of the charts. Those of you who are rich and “on the inside” of gold companies and gold traders, ask if anyone alive had ever seen gold trade in the present volumes that have not been seen in history. The shocking truth is that more gold has just been traded than is held in most of the central banks. So much so that even the 100+ year old london gold pool was forced to admit to trading it’s share! I should think that the big investors on comex would have known this was going to happen! No? It could only have been the people who were about to do this buying that would know ahead of time. Yes, only they would know that a “once in a lifetime” buying spree was about to take hold.

Will gold go back down in price? They don’t realy care! Only on kitco can a trader find such good info. I advise every gold trader in the world to access this site every day! There is only one person who knows me at this site. That person is the soul of discretion and integrity. Someday I will contact him again and he will learn my real name. May the force be with you, and keep your eye on london! thank you

Big Trader ( ( the greedy paid ) ) :
They thought noone had enough to stop the game. Soon a brief pause then the game continues. We will be ready.

Date: Fri Feb 28 1997 00:22 [via Notnick]
Big Trader ( the writer ):

last, To all who use me, the 23:10 is not the trader. Will use uplink, not kitco again. Know me now, “I AM THE WESTISLAND”. DONE

Date: Tue Apr 01 1997 14:48 [via Notnick]
Big Trader ( @far east ):

Have taken much gold these days. CB games over now. Mr. Clinton and associates doing same.

Date: Tue Apr 01 1997 15:08 [via Notnick]
GFD ( Big Trader Post Confirmation ):

Eldorado: Agreed. We need to wait for confirmation within 24 hours if it is a BT post – unless something happens in Asia tonight… The post is a bit short and it is hard to say if it is indeed authentic but if it is I would guess a close above 355 tomorrow….

Date: Tue Apr 01 1997 15:32 [via Notnick]
The Writer ( one-westisland@worldnet.att.net ):

GFD: I will keep this address open as long as possible. If you have questions I will answer on Kitco #2 under WESTLAND. It may take time for me to get the answers. All questions must come from you.

Date: Wed Apr 02 1997 11:49 [via Notnick]
The Writer ( thoughts! ):

GFD: I have two email from you, no more. We are at the end of a long travel. The road now forks, what way to go? Many will chuse the bad path and the american family will hurt as the world changes. Another writes, do you think as this?

Understand, that over the past few years physical gold has been locked to the currencies more so than when it was used to back them. Western traders have done just what the money printers wanted, they accepted paper forms as gold. The lure was greed and it worked very well for the printers. The future was always the key “someday the metal would rise and a great payoff would be at hand”. The years have come and gone and no payoff, no 500/600/700/ gold. The truth, there will be no payoff for paper traders. One thing has happened that will “change everything”. The PHYSICAL GOLD MARKET HAS BEEN CORNERED! Any amount of large physical sales that come to market can be taken. To a traders eyes this cannot be, why is the price not going straight up? Why should it, westerners are still trying to rid themselves of metal and hold forward gold ( that is not cornered ) and any other form of leveraged gold. There is no shortage of paper, but there is now a real shortage of gold! Anyone who thinks that the central banks and their billion ozs of gold are a threat to this market have no idea how big real on/off market trading is. So, how do we see when gold will rise in all currencies? A slow fall in the price of paper gold and a opposite spike in real gold price will make westerners leave all paper and try to buy real metal. The rush to make good on forward sales will cause the market to lock, overnight. No bank failures, no depression, no stock market crash, no war, no inflation, just a worldwide shutdown of all “on market gold trading”. That includes all forms. The western traders will still own all of their mining stocks and gold and futures, they just won’t be allowed to use them. But don’t you see, they didn’t want real gold anyway! It was always the others that needed it,,,,,,right?

Date: Wed Apr 02 1997 12:38 [via Notnick]
GFD ( The Writer ):

The last post by “The Writer” ( 11:49 ) is authentic ( as far as my communication with him ). His post is interesting. I have involvement with a small mining play and there has been some discussion by investors whether to keep it private and collect gold dividends or go public and collect paper. Some are very sypathetic with The Writer’s view of the world.

Date: Thu Apr 03 1997 12:50 [via Notnick]
The Writer ( thoughts! ):

GFD: I have two more mail and some answers. We speak more freely now, draw close and think. Who will stand first, who will be last? The writer will say my thoughts.

If a person has more than enough for life others will receive it in time. But time is the enemy of all things created by humans. All who live now will see change, as those before us. In your history one can hear the voices of many others who lost all things as time marched on. If you are of a present day mind your thoughts are only of the here and now. If this be true then draw your sword and make ready to battle. Time and change are about to attack your wealth. There are some who have eyes that see a thousand years past, they know of gold! Know me now, time has tested it, and lost! Gold is not money, not currency, not an investment,it is wealth. The second american family is here, and time and change are ready for battle, are you?

Answers:
You own a house and one day you are given a clear deed and told to move out. Another now lives there for free. The deed may be used as currency if another will accept it. All know you are wealthy, the deed says so! The deed is clear, but is it free? Are you wealthy or is your wealth only in the mind of others? Much of american wealth is truly the thoughts of a nation, drifting on the wind!

Why would rent out a house for less than the going rate? If there are so many for sale just like yours, why not sell and put the money in the bank at a higher return? All know you can buy it back at a much cheaper price! Or is the lease rate low because you know you MAY NOT GET IT BACK AT ALL if you sold? Some realtors only trade cheap property, know also one who has traded with the sun!

When? You ask. Look in a mirror, be that person from the west, he will lead first! And that same person did supply the shortfall for he holds paper as proof!

Date: Thu Apr 03 1997 20:37[via Notnick]
GFD ( More On Thoughts ):

So far I have asked The Writer four questions, three of which he seems to have answered:

1) What did he mean by an earlier quote about our “currency being in jail”. I believe his ( partial ) answer the paragraph about having the deed to a house ( gold ) but not physical posession. However, I feel that this is a superficial interpretation. The real answer is the last ( beautiful ) sentence. Manias are nothing more than than “thoughts blowing in the wind”.

“You own a house and one day you are given a clear deed and told to move out. Another now lives there for free. The deed may be used as currency if another will accept it. All know you are wealthy, the deed says so! The deed is clear, but is it free? Are you wealthy or is your wealth only in the mind of others? Much of american wealth is truly the thoughts of a nation, drifting on the wind!”

The thing that suffers most upon the collapse of a mania is credibility – or credit, financially speaking. Historically, the Bank of England just about folded several times in it’s history and was only saved by boat loads of gold, literally – excluding one that sank!! So if the paper goes poof what is your credit rating. To put it another way – what are you worth?? James Grant’s book about Banking and Bonds is called “Money of the Mind”. So where WILL america’s thoughts drift when a storm comes?

2) Where is the gold coming from to meet physical ( jewelery, etc ) demand? I believe his answer is bullion dealers and banks: “Why would rent out a house for less than the going rate? If there are so many for sale just like yours, why not sell and put the money in the bank at a higher return? All know you can buy it back at a much cheaper price! Or is the lease rate low because you know you MAY NOT GET IT BACK AT ALL if you sold? Some realtors only trade cheap property, know also one who has traded with the sun!”

Intitially, when I read BT’s references to “westerners” foolishly exchanging gold for paper ( forward sales, etc. ) I superficially interpreted this to mean ma and pa dumping their eagles for Microsoft or something. However, Vieserre’s excellent posts over the last day have got me thinking that the real price setting and control of physical gold is the bullion dealers and their associated banks. And what has everyone been doing lately? Gold Loans, forward selling, etc. This implies that the swissies and the brits have ( had ) a lot more of the good stuff than any statistics indicate. These are probably private stocks that were off the books – such as hoards from European nobility, etc….

3) The third question was when would the bubble pop. I believe his answer is in the third paragraph:

“When? You ask. Look in a mirror, be that person from the west, he will lead first! And that same person did supply the shortfall for he holds paper as proof!”

This is a bit more straight forward, particularly if “the west” is really the bullion dealers, CB’s, banks, etc. So what happens if someone’s friendly banker calls a gold loan in this superheated and obviously distorted environment??

Have to get going. Will check in later tonight or tomorrow!!

Date: Sun Apr 06 1997 20:25[via Notnick]
The Writer ( Thoughts! ):

GFD: Yes, you are very close. I receive one mail. CMAX: Yes, you are thinking also. I hear the western countries have 300/400 million people. You know they are real. All other countries have several billion. The Big Trader knows they are real and is close to some of them. He is small and slow, but many hands can hold a large load!

Can you think this can happen? Another hand writes.

Gold is so old. Such a rich history. An educated western mind cannot begin to understand it! We live in a time of closed thought and controlled perception. How could we have known that two thirds of humanity would still think of gold as wealth. It’s not that they are right or wrong to think this way, it’s that we want them to work for us! That is the problem! And when they worked for us we paid them!

And who in the hell would have thought that they would have used so much of that pay to buy gold! Some bought in tiny amounts and some bought in large amounts. This started with the new world trading order that came into being about six years ago. By now that gold is so spread out it would take 20 years and 5 small armies to get it back, I think.

An interesting look, yes. Now the writer gives a view for tomorrow.

A western cowboy phrase, “cut and run” ! You have heard it before? Many had thought that the physical market would always have a great supply. The future selling during the last few months should have pushed the real price thru 300 by now. At that level most of the contracts could have been closed out. Now the buying is done and the vol is drying up! I hear that some do not want to play this game any more. This week I expect to see a cowboy!

Date: Sun Apr 06 1997 21:50 [via Notnick]
GFD ( Another Hand ):

It is interesting to note that BT has a western friend who included some of his own thoughts in the middle paragraph starting with “Gold is so old. Such a rich history. An educated western mind cannot begin to understand it! We live in a time of closed thought and controlled perception.”

In my reading and surfing I have noted that VERY informed persons with apparently close connections with the intelligence community have been concerned about the manipulation and control of the public’s perception of current ( and past ) events. This is true also of sophisticated observers of the spooks. “Another Hand”s comment about “controlled perception” makes me wonder if BT has an advisor with a ( western ) intelligence background.

Hows THAT for reading between the lines! And going waaay out on a limb!! ;- )

Date: Sun Apr 06 1997 21:34 [via Notnick]
GFD ( The Writer ):

I would like to confirm that this is a BT/The Writer post as I only sent one email to him after his last post. I primarily enquired as to whether I was close or not in my ( Thurs Apr 03 20:37 ) interpretation of his last post. It would appear that I was. It would also appear that CMAX is *close* with his Sat 23:11 post.

I also enquired he had also sent a post by “SimpleMan ( faraway ) Thurs Apr 03 16:27″ which implied that we had 6 to 8 weeks to get our affairs in order. I am not sure I have an answer to that but his most recent post just about says the same thing.

The key thing here implied by his posts is that this will be a bullion dealer/banker problem first or that the crises implied by BT will be triggered by the bankers wanting their gold back due to loss of “confidence”. This is the historical mechanism by which mainias collapse and cause economic trauma. Confidence in credit is shattered by some speculative bubble popping and everyone starts calling in loans. As I said in my last BT post, several of these manias just about finished the Bank Of England – the primary CB’s these days.

Some have rightly questioned here why someone like a BT would want to post to us bugs here at kitco – other than a shared philosophy. I have wondered this too. However, if we are talking about a banking problem this may be an excellent forum if you know for a fact that brother Al ( Greeenspan ) is lurking hereabouts ( and even reputed to have made posts here under the handle of “Oracle” ).

If I were Bt I would want to make a killing without killing the system. What is the point otherwise?? He has implied that he has taken his position and is just waiting to cash in. If he is impatient he can try – every so discretely – to rattle the cage a bit. If Al is indeed lurking and sees what BT is getting at he will now realise he may have a “system” problem with respect to the bullion dealers and their associated banks.

In any case the primary body that will be dealing with this is the BIS ( Bank for International Settlements – CB country club ). The BIS is VERY secretive. I would be shocked if there was any news leaked. If there was it would come from Europe, most likely London.

However, when you have a credit crises interest rates spike. Keep an eye on the kitco lease rates page for any twitches. If BT is correct you will see open interest dry up and lease rates spiking to historic highs ( 6% ?? ).

Date: Wed Apr 09 1997 11:11 [via Notnick]
The Writer ( More Thoughts! ):

The Writer ( Thoughts! ) :
GFD: I have other mail.
Anyone not allowed to read this? Stranger talk, Perhaps?

London unspins, but the World does not notice. Tiger wiskers, are ground fine and prepared for the feast. Eat carefully, West.

Questions:
1. Who would be a goldfish?
2. Do the Others know?

Date: Wed Apr 09 1997 11:06 [via Notnick]
The Writer ( Thoughts! ):

GFD: I have one mail.
As a group, paper makers are very strong. But one has “cut and run”! He has come to town and wants to join us! What is this? I see other cowboys “coming down the trail”! For many years they had fun. Now a tiger chases them into town for help.

Can anyone allowed to read this? Strange talk, Yes?

people told them not to take it under 365. Well they did and look at it! Now the fools want to unbolt the tables and chairs and sell them to save their skins. 15 bucks down and how many billions under the table. It’s gona look like a giveaway or a sellout. Heads are going to roll in the alley when london unspins this.

Answers:
1. We should not speak of this.
2. This is only in the minds of traders and thinkers. It has not.

Date: Wed Apr 09 1997 11:43 [via Notnick]
GFD ( Truth and Consequences ):

The post from The Writer at 11:06 is legitimate. The second post at 11:06 is a stinker – along with Ivor Bigbody. It would be nice if Bart would take imposters and make them take a long walk on a short pier…

However I DO find it interesting that the fake BT and Mr Bigbody are saying more about themselves than I suspect they want to – Monty Python indeed! Well it will be interesting to see what movie Mr Python will make out of the mess over in London!! So Ivor, how’s the weather in London these days??

Date: Wed Apr 09 1997 11:59 [via Notnick]
GFD ( Who has questions? I have answers!! ):

I don’t have time to properly comment on the legitimate ( 11:06 ) post from The Writer, however he did give two answers to questions that I did post to him:

1) This was a question about parties that were rumoured to be big players once upon a time. I will respect BT’s privacy here and “not talk of this”.

2) The second question was whether the US was writing calls. “It has not”. When I thought about it I realised they could not because it would be illegal to have the calls excercised…

“people told them not to take it under 365. Well they did and look at it!”

My thoughts exactly! :- )

Date: Wed Apr 09 1997 19:14 [via Notnick]
GFD ( Thoughts ):

For those who are interested here are my comments on BT/The Writer…

Firstly, I made sure that Bart had both our real email addresses so that imposter issues could be adjudicated by him if things got out of hand. Having a password for handles would be the way to go for the longer term.

It appears that The Writer is restricted as to what he can say publicly and so the delphic quality of his posts… What he is saying seems to be relevant to the very private London market and not to the open markets per se. There may be lurkers out there that he is targeting besides the usual suspects on this site.

Most of The Writers posts have preceeded big developments in the markets within 24 hours. As far as I can see, this is not true for his last post ( Sunday 20:25 ). However, what I AM seeing is the markets trading within an EXTREMELY tight range this week, particularly in New York. I wonder if this is deliberate ( but covert ) damage control while some mess is being straightened out in London…

In an earlier post I had said that one of the signs of problems in London would be open interest drying up and lease rates spiking up. Glenn posted today ( 09:45 ) that open interest for the COMEX gold is at the lowest level since 1995 so one possible symptom is in place. The Writer never seems to post unless there is something ( not necessarily obvious ) happening to back up his posts and so this might be it for his last post.

“people told them not to take it under 365. Well they did and look at it! Now the fools want to unbolt the tables and chairs and sell them to save their skins.”

This may imply a selloff of US and European stocks and/or bonds in the next day or so other assets to cover delivery requirements in London.

“15 bucks down and how many billions under the table. It’s gona look like a giveaway or a sellout. Heads are going to roll in the alley when london unspins this”

This whole post seems to be about the problems the bullion dealers and banks are going to face when people discover that their gold was sold for peanuts. However, this may be a little too superficial. BT made a post a day before Bre-X was first halted that had a line about governments confiscating mines. Which could be what happens to Bre-X over the next few months.

So I wonder about “billions under the table. It’s gona look like a giveaway or a sellout”.

Date: Sun Apr 13 1997 21:49 [via Notnick]
The Writer ( Thoughts! ):

GFD: I have four mail, one good, two dum and one different!

Ted B. : “a light vault holds much paper” !

Answers:
1. No settle, it spread far and wide. The price must slowly fall to stop a problem.
2. Table? A Euro size trouble, all will read of it.
3. No. A plain thought from a another.
4. You are seeing it now.

I will rest now

Date: Sun Apr 13 1997 22:55 [via Notnick]
GFD ( Thoughts ):

will provide a decode of the writer’s latest in a couple of hours as I don’t have the time right now. The cryptice answeres are to questions I emailed him.

Date: Mon Apr 14 1997 00:55 [via Notnick]
GFD ( Thoughts ):

I sent four questions to BT/The Writer and a couple of dummy emails ( just to keep imposters hopping! ).

1) I asked him if there would be a cash settlement or would there be something like a short squeeze. His answer: “No settle, it spread far and wide. The price must slowly fall to stop a problem.” This implies that there is not one person or group but rather a large number of parties who want their gold in a sock, but that the paper ( “open” ) markets are being manipulated to “stop a problem” – gold loans and forward selling out of control?? Mooney in his very interesting 23:15 post may be close to the truth.

2) I asked him to elaborate on what he meant by “billions under the table” in his last quote. I wondered if there would be a big scandal coming because dealers have loaned ( effectively sold ) gold that they did not own. His answer: “Table? A Euro size trouble, all will read of it.”

3) I asked him if I was off the mark in stating that “another hand” in his last post had an intelligence backgroud. I was. “No. A plain thought from a another”

4) Later I asked him whether it was possible that some of the selloff in the stock markets was in part attributable to people scrambling to sell other assets to meet their obligations in the gold scene: “You are seeing it now.”

Date: Mon Apr 14 1997 01:08 [via Notnick]
GFD ( Thoughts on Thoughts ):

The Writer responds to my questions as well as well as posting his own thoughts. So if you see a post from him with numbered answers they are in response to my questions. All this is to deal with the impostor situation.

I think that Ted Butler and Mooney are on to something which elaborates what BT/The Writer has been talking about for some time.

The one thing that is a fly in the ointment for me is that he implies that the price of gold is being held down as part of some crises management excercise. Most likely the European gold houses and their CB’s are in the throes of an “unpleasantness” that eventually will be publicised. Loans and forward sales may be constrained and gold will start a very solid bull market.

I suspect that gold may be flat to down for a few more weeks but not months.

TTFN

Date: Mon Jun 02 1997 18:59
SimpleMan (faraway.com):

Gold will reach $872.00 BY first week of July, 1998. Remmember this.

Date: Mon Jun 02 1997 21:24
GFD (Simplicity):

BT fans should note the comments made by “SimpleMan ( faraway.com ) ” at 18:59. He is somehow linked with BT making a few comments in the past. His most recent one on Thurs 20:58 preceeded a major spike on the comex the next day.

Date: Wed Jun 04 1997 16:21
GFD (Thoughts):

In the spirit of Tort, I have decided to contribute something to cheer things up – for our very dear friends the shorts!

BT’s comment about the South Africans made me wonder about something. Nelson Mandela has made a point of continuing ties with countries and organizations that supported the ANC during their time in exile. Just suppose a few chinese central bankers dropped by one day to very helpfully point out that Nelson could do himself and his loyal friends a big favour by saving the poor gold shorts from their compulsive, self destructive behavior. Particularly in light of new China Russia friendliness. ( Surely not extending to palladium markets!! )

I don’t have any information to confirm this kindly thought but it does warm my heart and so I thought I would pass it on! :- )

Date: Wed Jun 04 1997 16:35
GFD (Bouncy Thoughts):

George S. Cole: Given BT’s timing ( posting just before big spikes ) it will be particularly interesting to watch gold market behavior over the next couple of days. The last spike ( after a post by SimpleMan ) fizzled out quickly. I suspect that there will now be a move of sufficient magnitude to test the intestinal fortitude of the shorts to the utmost. I am thinking it is positioned to take advantage of your observation that gold is due for a rally having gone 4-5 consecutive down days.

How well it holds up will give a good indication of where the hedge funds are at, assuming BT is correct in his implication that CB’s are now standing down. This could be the “crossroads” that BT may be finding himself at. “Interesting times” indeed!

Date: Wed Jun 04 1997 15:23
BIG TRADER (THOUGHTS!):

They will not sell platinum and they will not sell palladium and now they will not sell gold! That is why the “writer” ( along with more than a few others ) has gone to Europe.

For many months open metal was purchased only as it set free by falling prices. But the paper contracts are never made good . People were asked to “stand down” as the market came to them. It no longer happens now as your own banks have said no more. The future will now be as the past! When is a “fact” accepted as real? Only when it comes from a factual source? Or when it is experienced as a real life event! For a time in past “all new supply was spoken for”, now it is “spoken for times two”.

Germany will not back the writers again. They will revalue and hold at all costs! The Swiss will sell a very small amount in the future at a much different price.

The Dutch will “swap” no more. These cowboys have cut and run. South Africa now will compete with “the Trader” as a buyer! London has told them!

Then I should think we are done, as people will “stand down” NO LONGER”.

The Trader is at his cross road, one path and more time will pass. The other path and the gold market, “as all now know it” will exist no more.

Uplink off, find me here.

Date: Thu Jun 05 1997 17:23
BIG TRADER (THOUGHTS!):

Hong Kong is as a great flowing river that has reached the ocean of her birth. They fear her no more. But a great “Noble House” has come out of these waters and it will not fail. Bring London’s problems to us, one by one and they shall be dealt with. If they have no fear then let them look behind as South Africa has drawn her sword. Many will soon loose their heads in a mad rush to find “real gold”!

Date: Thu Jun 05 1997 19:28
GFD (The 8th Thread):

Earl: Suppose that “7 Threads” is basically sound ( although I too squirm a bit ). How do you suppose the Chinese would react to it?

The “reunification” of Hong Kong does have considerable patriotic meaning to China as it redresses an ancient humiliation. What is not so widely known is the fact that China was also forced to accept foreign currency rather than gold for it’s exports at that time – another humiliation.

Now suppose we have the one world currency shaping up and whatever else the Chinese may think of it they know that it will not be a Chinese currency. They will most likely look at this as an attempt to pre-empt or mitigate the emergence of a dominant Chinese economy in the 21st century by western interests.

One response would be to ignore or “opt out” of the “plans” afoot. But a more “satisfying” approach perhaps would be to hijaack those plans. Suppose that what triggers the hypothetical financial apocolapse required for a one world currency is an explosion in the price of gold. And suppose the one world currency is a gold backed Yuan.

This is one scenario that would explain exactly what “Big Trader” may “really” be up to with his allegedly massive accumuation of physical gold.

Date: Thu Jun 05 1997 22:57
SimpleMan (faraway.com):

The slaughter of fools has begun!

Date: Sun Jun 08 1997 21:07
BIG TRADER (Thoughts):

Is this news? Can this be true? “ “ Now that the “discount bid at spot” is running 3 or 4 to one you can be real sure retail isn’t going to reach for it! They would start a free for all! But they have to bid, it isn’t going to come from the sky. No wonder the big holders are “standing down”! How are they going to handle the paper that the Asians are trying to sell? That’s a good one, because they hold physical to paper at 20 to 1 and spot will go thru the roof if they dump it! Well, with a roll-over of most existing deals being the only option, a good deal of “old forward gold paper” will be put on the street at whatever price. Nobody is going to pay par for this stuff when it was written at a premium to spot during a much higher price. And now that new supply can’t be pulled from retail to cover the paper the writers are the only bidders for their own stuff. But if any of it trades at a big discount, it’s going to hammer what‘s left to the point that the banks will call the loans! If one big boy grabs the physical during the next month or so it’ll take the whole thing down.“ “

Date: Sun Jun 08 1997 22:53
BIG TRADER (thoughts):

This could not be true? More? So many off market forward gold deals were done without any gold changing hands! Big buyers got on the paper side of these things and thought that the CB’s were backing the dealer banks by written contract. If the mines couldn’t perform the banks would …….! But what if in some deals the mines were not involved at all ? Just off market option trades as backing? And some of the paper buyers shorted the futures in a big way to cover. And now whatever gold that was to back these deals is found to be “not there”? And everybody was looking at all this paper being sold and thought there must be one hell of a lot of gold being sold! Now during the last six months the price has fallen, but I have to ask, “who has got who”?

Date: Sun Jun 08 1997 23:06
GFD (Who Indeed):

Big Trader: Who got who? It may be “retail” ( jewelers, etc ) anxiously contemplating their efficient “just in time” inventory systems that may just have ran out of time. I agree with Ted Butler that all this paper has sent markets the wrong ( but convieniently politically correct ) signals leading some down the garden path.

As for the deals that you are talking about I suspect that they will be quietly wound down – with the “helpful” assistance of the central banks. That is, the deals will be essentialy “canceled out”.

The real question is what will be seen in the market once this obscuring cloud of paper dissappears??

Yellow palladium anyone??

Date: Sun Jun 08 1997 23:32
BIG TRADER (thoughts):

GFD & Steve: Good write.

When we “wound down” and “cancel out” smallest part of this paper market it take out comex and otc paper completely! Then you must settle several hundred million ozs with london. The ability of the entire worldwide gold mining and trading community to sell a product will be destroyed in short time. The metal market as we know it from 1968 will end!

Date: Wed Jun 11 1997 00:35
BIG TRADER (@Delivery Day):

Watch London. Uplink terminated.

Date: Wed Jun 11 1997 11:36
SimpleMan (faraway.com):

Big Trader is right again. Chaos in London on delivery day!

Date: Fri Jun 13 1997 00:19
Big Big Trader (Big@trader.com):

Many of the June XAU Call writers are going to get blown out next week. This will start with a big gap up in the XAU tomorrow. Gold stocks wont be cheap much longer.

Date: Sat Jun 14 1997 22:39
BIG TRADER (THOUGHTS?):

Can the Trader know? Can people wait?

Are the CBs serious about selling all of the gold ? You bet they are! Except for Germany and the Dutch. You see, some did not accept that the physical market is “cornered”. Many only read official statistics but others have eyes and ears that receive thru walls! All new supply is covered times 4 . And it is the small existing stocks held by a few , who have written contracts , that are a “problem”! If the governments sell many will wait to be filled. If they do not the trouble in London will expand to the currencies! Time has been purchased.

Date: Sun Jun 15 1997 19:30
BIG TRADER (LAST THOUGHTS!):

People say gold not rise in us$, big trader say it rise “now”! Keep best eye on hk at london open, all week. Comex to late. Offer to sell is no take, time gone. No more talk, no more thoughts for West! “Stand down” for 4th time, no. It time now, Trader make “times interesting” for gold. Now we see what real. Now we see who real.

Date: Sun Jun 15 1997 19:57
SimpleMan (faraway):

George S. Cole You think that BT may be for real. But you are not sure. Others have ignored his comments. Two months ago I posted a warning to all who trust in paper, all paper. Last week I warned all about the slaughter of fools. There was a real concern and fear in London. US media reports nothing. London kept the lid tight. Next two weeks will show all that BT is for real. Re: future price fo gold, the increase and the speed of increase will shock 99.999% of investors and 98% of gold bulls. Summer 1997 will go down in history as the begining of geopolitical changes.

Date: Mon Jun 16 1997 10:27
Big Trader (closer.than@youthink):

WARNING!!!! Beware, Gold like dagger now!

Date: Fri Jun 20 1997 02:48
BIG TRADER (Thoughts):

Get ready. I know you have doubting me. In SIX days you will know if I speak true.

Date: Mon Jun 23 1997 09:10
SimpleMan (faraway):

Worry not about the price of gold. I have learned from a well conected source that western CBs and govs are scared! All the press releases, studies and posturing are not for us small gold traders, but for China!

For the last 12 months China has been buying up gold and demanding delivery. Western govs don’t care about you and I they can manipulate us. But not China. Time is VERY short indeed. Gold is about to hit the moon.

Date: Mon Jun 23 1997 16:19
SimpleMan (faraway):

Hashimoto’s statement is an indication of a riff between US and Japan. He realizes what is about to happen to global financial system.

All for themselves in times of crisis.

For him to make that statement in public is of HUGE significance! Prior to today all CBs and govs presented a united front when it came to gold. NO MORE. All countries will try to save themselves.

PUETZ is right. Today was a day of great importance.

Date: Fri Jun 27 1997 07:33
SimpleMan (faraway):

Is gold just another investment vehicle or is it a store of value?

Just another investment you say, then run like a rabbit. Store of value you say, then you have another great buying ( accumulating ) opportunity. Gold is cheap by any measure. Get it now and you will own the worldwithin 2 years.

Date: Fri Jun 27 1997 13:56
GFD (Thoughts on BT):

“Heard on Kitco Street” was great!! Definitely a Kitco classic.

Something I have been meaning to write for the last few days is how exactly a BT “apocolapse” would actually play out. If the recent BT posts are to be believed ( and the torrent of negative news about gold after his last posts kind of lend credence that it is the same BT as in the past ) then today he is dressed in his sunday finest standing at the wicket and asking politely for his gold.

I suspect the real question will be what happens after his polite request. First they will tell him to hold off for another month. He said he will decline to hold off – no more mr. nice guy. Then what happens?? I suspect this type of situation has never happened before and no one really knows…

Best guess would be that the market will declare force majeur ( “Yeah we sold you gold that we don’t own and now we can’t deliver” ). What happens after that will be very interesting… Does BT get his money back? Who will have to refund it?

And most importantly: What will they have to SELL in order to give BT his money back.

As far as gold goes, I really do not have a clue how this will play out. It may just mean that the open interest collapses and there are now fewer buyers out there for paper plays – which could be price neutral.

I don’t know what else BT could do to force the situation short of sending the Chinese navy ( such as it is ) down the Thames….

Date: Tue Jul 22 1997 11:29
BIG TRADER (last warning):

russia is the key japan is a sideshow the bull is charging in the form of a bear ..uplink severed..

Date: Tue Jul 22 1997 15:45
GFD (24 Hr Warning):

Someone alleging to be Big Trader made a post ( 11:29 ) and it sort of sounds like him. If it IS the BT of legend there is a high probability of a price spike within the next 24 hrs.

The alleged post is as follows: “russia is the key japan is a sideshow the bull is charging in the form of a bear ..uplink severed..”

Just out of curiosity does anyone have an even vague idea why russia should be a strong force in gold – or anything else for that matter ( except, of course, bankruptcy ) .

It is very hard to say if any of the BT posts over the last few months are actually from the BT of the beginning of the year. It will be interesting to see what happens.

Date: Sat Aug 23 1997 18:09
ANOTHER (thoughts not written anymore):

Hello to all!

I had the opportunity to read a private reports/discussion over the last week and thought this one would have some meaning to this group. The thoughts come from a different culture and land mass so they required conversion to Western style communication. Here is from one you don’t get here anymore.

Why do they view their debt in terms of yield when it only returnees more of the same paper? The only way to convert the return on this American debt is by buying something real with it. Only then do we have a “yield”. So let us continue to view it as always before, using it’s pricing gage to determine value, the US dollar. The marketplace is never wrong to give a high price to a low value debt as long as it uses an “unreal “ currency as a value gage. The Westerners use “paper to price paper” and “more paper to price more paper” in an endless quest to add value where value only exists in the minds of men. To this end they say we have lost holding gold, but our families and children cannot go broke? No one owes us and we owe no one, and we do not “convert paper to something real” to create “yield”. We already own our “yield”, no conversion needed! Now they have created the illusion of gold in great supply to lower it’s value in currency terms, and the Americans accept this. They do not question that this illusion was done using paper contracts ,that do not hold gold but are priced in currencies that offer a yield valued only in human emotion terms. It is in this fashion that the greatest folly of Western thinking will bring an end to an era of unvalued money. It will come about as the entire world evolves into those that have military might using paper currency maneuver little people countries with gold. But all gold is owned by someone, somewhere and is not free for the taking. In the near future a real value will be exchanged for gold and those that hold paper gold will bid much higher to obtain what they thought they already had!

Remember now, “a broke superpower ever destroys a simple country that has gold, they will do business with them ”! Big Trader

Now that most have converted paper gold contracts to real gold we have but to view the “great scramble” from far away. To the advantage of many, the Americans continue to position themselves in opposite fashion from the third world. They sell all real gold to hold gold contracts and gold stocks.

At some point all of the gold will be off the market. Then the CBs will be forced to become the full primary suppliers. This continued drift to CB sales will no doubt destroy most bullish gold traders until London is forced to sell real gold. Then the true volume will drive the price of gold in all currencies to such heights that it will force a reevaluation of “what was primary supply” in the first place. During this “lock up” time all Asians will be happy with the conversion price during the summer of the last few years.

Know this to be true, the millions of ounces out on hidden contracts will not be made up for by the CBs once the problem begins. During this time the new “currency price” of the entire gold stock will equal all the paper money in existence and the CBs will suddenly claim they have very little gold in an effort to hide all they can. Big Trader

This rewrite is very close. It comes from the real one, not the fakes. good luck!

Date: Sun Aug 24 1997 20:40
ANOTHER (REPLY TO ELDORADO.):

ELDORADO: These communiqué were done at different times appxomentally two weeks ago. I received them via an indirect/secure source. I can tell by this system that others have tried to interpret and post some of this gentleman’s thoughts. The content is thought provoking to myself and I hope to others. Here is a repost of the earlier work and appx. dates.

Hello to all!

I had the opportunity to read a private reports/discussion over the last week and thought this one would have some meaning to this group. The thoughts come from a different culture and land mass so they required conversion to Western style communication. Here is from one you don’t get here anymore.

Aug 01
Why do they view their debt in terms of yield when it only returnees more of the same paper? The only way to convert the return on this American debt is by buying something real with it. Only then do we have a “yield”. So let us continue to view it as always before, using it’s pricing gage to determine value, the US dollar.

The marketplace is never wrong to give a high price to a low value debt as long as it uses an “unreal “ currency as a value gage. The Westerners use “paper to price paper” and “more paper to price more paper” in an endless quest to add value where value only exists in the minds of men. To this end they say we have lost holding gold, but our families and children cannot go broke? No one owes us and we owe no one, and we do not “convert paper to something real” to create “yield”. We already own our “yield”, no conversion needed!

Now they have created the illusion of gold in great supply to lower it’s value in currency terms, and the Americans accept this. They do not question that this illusion was done using paper contracts ,that do not hold gold but are priced in currencies that offer a yield valued only in human emotion terms. It is in this fashion that the greatest folly of Western thinking will bring an end to an era of unvalued money. It will come about as the entire world evolves into those that have military might using paper currency maneuver little people countries with gold. But all gold is owned by someone, somewhere and is not free for the taking. In the near future a real value will be exchanged for gold and those that hold paper gold will bid much higher to obtain what they thought they already had!

Remember now, “a broke superpower ever destroys a simple country that has gold, they will do business with them ”! Big Trader

Aug 04
Now that most have converted paper gold contracts to real gold we have but to view the “great scramble” from far away. To the advantage of many, the Americans continue to position themselves in opposite fashion from the third world. They sell all real gold to hold gold contracts and gold stocks.

At some point all of the gold will be off the market. Then the CBs will be forced to become the full primary suppliers. This continued drift to CB sales will no doubt destroy most bullish gold traders until London is forced to sell real gold. Then the true volume will drive the price of gold in all currencies to such heights that it will force a reevaluation of “what was primary supply” in the first place. During this “lock up” time all Asians will be happy with the conversion price during the summer of the last few years.

Know this to be true, the millions of ounces out on hidden contracts will not be made up for by the CBs once the problem begins. During this time the new “currency price” of the entire gold stock will equal all the paper money in existence and the CBs will suddenly claim they have very little gold in an effort to hide all they can. Big Trader

This rewrite is very close. It comes from the real one, not the fakes. good luck!

Date: Mon Aug 25 1997 13:55
GFD (Thoughts On A Short BT):

George S. Cole, GVC, Bob: Is BT a short? Even a short short?? :- ) Certainly the last BT posts from around the time that Hongkong reverted back to China were definitely from some short. Was that person the same as the “original” BT?

In some of my earliest posts I had speculated that it would be in a BT’s interest to short COMEX while going long OTC or London. In my books it goes without saying that the interests of a large accumulator are not necessarily aligned with the traders. However, I can’t see the kitcoites being worth his time to spoof.

The last purported BT post from ‘Another’ have raised some interesting questions. Firstly, if prices keep trending downward and mines keep closing the CB’s will certainly become the primary supplier of the markets. Will the CB’s conciously adopt that position? In the cold light of morning I agree with Bob that the gold mining industry probably does not figure that much in the political equations of the CB’s – other than contributing to deflationary action they really cannot afford.

The other question is whether BT and other *large* asian money have now ceased buying and are now sitting in the hills with their gold watching the fun – martinis in hand. This might actually mean less shorting action. The shorts need willing buyers in places like the OTC markets.

Maybe that is how his operation worked. The shorts would sell to him, driving down the price while he accumulated the physical position that he desired. Maybe the markets will change trend if he has ceased to buy from the OTC shorts…

Date: Sun Sep 14 1997 21:12
ANOTHER (an answer?):

This could be an answer directed to the “Red Baron”?

The CBs are becoming “primary suppliers” to the gold market. Understand that they are not doing this because they want to, they have to. The words are spoken to show a need to raise capital but we knew that was a screen from long ago. You will find the answer to the LBMA problem if you follow a route that connects South Africa, The middle east, India and then into Asia! Remember this; the western world uses paper as a real value, but oil and gold will never flow in the same direction. Big Trader

The following message by ANOTHER is the first message included in the Thoughts!. I have not yet systematically searched for messages in the partial copy of the Kitco archive that might have been omitted from the Thoughts!.

Comments

Comments are moderated.

Our small closed economy has five main protagonists, Alice the Automobile Saleswoman, Bob the Banker, Charlie the Capitalist, Dave the Debtor, and Steve the Saver. This small economy is on a gold coin standard, i.e. gold coins circulate as cash. In order to see how the real price of gold (measured in Ferrari sports cars) depends on the creation of credit, we consider the following scenarios.

• A cash based economy without any lending and without any banks.
• An economy with banks, but without lending.
• An economy with banks and with fractional reserve lending.
• An economy without banks, but with private-to-private lending.
• An economy without banks, but with commercial Real Bills.

 
The reason for presenting the toy model is our claim in Sections 5 to 7 of The Many Values Of Gold that the fatal flaw that renders the gold standard unsustainable in the long run, is the fact that there exists credit denominated in a weight of gold and that this credit circulates as currency, i.e. that it is accepted as a form of payment for goods and services.

If you are just interested in how credit creates inflation, please ignore all the mentionings of the gold standard, imagine our economy would just use any paper currency such as the US$ or the Euro and continue reading.

Defenders of the gold standard often claim that the gold standard failed for one of the following reasons and can therefore be made viable if some specific problems are solved:

• Mismatch of maturities of bank deposits and loans. If the banking system were organized in such a way that maturities always matched, there would be no problem with the gold standard.
• Fractional reserve lending. If the banks were required to be fully reserved, there would be no problem with the gold standard.
• The fact that loans are extended for unproductive purposes. If loans were made only for productive enterprises, for example, in the form of Real Bills, there would be no problem with the gold standard.

Our toy model allows us to discover which ones of these additional measures succeed in fixing the problems of the gold standard and which ones do not.

1. The Protagonists

Our toy model economy is on a Gold Coin Standard. Its currency unit is the dollar ($). One dollar is worth precisely once ounce of fine gold, and for simplicity, all the cash in circulation is in the form of identical gold coins whose fine weight is precisely one ounce. There are no bank notes, and initially there is no credit and no debt either.

• Alice the Automobile Saleswoman plans to sell a Ferrari 458 Italia.
  
  

  Ferrari 458 Italia

  
  The car is to be auctioned in an open auction. The minimum bid is $10. The bid can be raised in increments of $2. Alice will sell the car to the highest bidder. Initially, she has no cash, but only the Ferrari.
• Bob the Banker runs the bank in our toy model economy if the scenario allows banks. Otherwise he is unemployed. He has $1 in cash which can form the shareholders’ equity of his bank. Bob is a prudent banker and never levers up his bank by more than a factor of three (by this, we mean the inverse of the cash reserve ratio). But he is always available for some good business if a favourable deal presents itself. In the scenarios in which Bob is unemployed, he cannot afford a car. In the scenarios in which he is a banker, he is content with the company car he can use, and so he does not care about the Ferrari that is for sale.
• Charlie the Capitalist has long retired from active work. He owns a number of companies and receives plenty of dividends. Right now he has $100 in cash. He, too, is always available for some good business. Since he loves his vintage Aston Martin,
  
  

  Aston Martin (1937)

  
  he does not care about the Ferrari either.
• Dave the Debtor has a well-paid position at a law firm. Unfortunately, right now, he is out of cash as he just spent everything on new furniture. He has only $1 left. But he would love to buy the Ferrari.
• Steve the Saver works as a carpenter. He earns substantially less than Dave, but he has always loved Ferraris, and he has managed to save $10 in cash.

Whenever we say “Back to square one”, this means that these initial conditions are restored: Alice has got the Ferrari, Bob has $1 and a banking licence, Charlie has $100, Dave has $1, and Steve has $10. Let us now study the various scenarios in order to see what happens to the price level in our toy model gold standard economy.

2. The Basic Scenarios

2.1. Cash Based Economy

Back to square one! Alice opens the auction of the Ferrari. In this case, the auction is rather simple and proceeds as follows. The only protagonist who is interested in the Ferrari and who can afford the minimum bid of $10, is Steve. So Steve bids $10 for the Ferrari. As there is no further bid, Alice sells him the Ferrari for $10.

Our toy model has discovered the general price level. Well, it has discovered the price for one Ferrari 458 Italia, namely $10. In fact, what the model has discovered is the Free Gold Price in terms of goods and services: one ounce of unencumbered physical gold is worth 1/10 of a Ferrari. For the notion of the Free Gold Price, we refer to Section 7 of The Many Values Of Gold or to FOFOA’s Once Upon A Time.

2.2. Economy with Banks, but without Lending

Back to square one! Whereas in the previous Scenario 2.1, banks were not allowed, this time Bob is in business. But since lending is not allowed, he merely offers depository services. The opening balance sheet of Bob’s Brothers’ bank reads as follows.

Bob’s Brothers – Balance Sheet No. 1

Assets		Liabilities and Equity
Cash	$1	Shareholders’ Equity	$1

Now Bob’s clients walk in and start depositing cash. Dave deposits his $1, Steve his $10, and Alice also opens an account so she can receive the payment for her Ferrari in a direct account-to-account wire transfer.

Bob’s Brothers – Balance Sheet No. 2

Assets		Liabilities and Equity
Cash	$12	Alice’s Account	$0
		Dave’s Account	$1
		Steve’s Account	$10
		Shareholders’ Equity	$1

As soon as everyone is set, Alice opens the auction of the Ferrari. Since lending is still not possible in this scenario, the auction proceeds precisely as in the previous Scenario 2.1. Steve purchases the Ferrari for $10. As we now have a bank and Steve is lazy and does not want to carry around that much cash, he just orders a wire transfer to pay for the Ferrari:

Bob’s Brothers – Balance Sheet No. 3

Assets		Liabilities and Equity
Cash	$12	Alice’s Account	$10
		Dave’s Account	$1
		Steve’s Account	$0
		Shareholders’ Equity	$1

In particular, the price of the Ferrari (our model for the general price level) and thereby also the real price of an ounce of gold are precisely as in Scenario 2.1.

2.3. Economy with Banks and Fractional Reserve Banking

Back to square one! Also, please everyone deposit their cash, and so the balance sheet of Bob’s Brothers is precisely as Balance Sheet No. 2 above.

Whereas in Scenario 2.2, Bob’s Brothers merely offered depository services, in this scenario Bob is allowed to make use of his banking licence, and he is able to apply fractional reserve banking and to create credit.

When Alice opens the auction, Steve immediately bids his $10 for the Ferrari. But Dave is also keen on the Ferrari, and thanks to the additional banking services that have become available, he can also join the bidding. Dave rushes to see Bob and negotiates a line of credit. Bob is a prudent banker, and so he verifies Dave’s employment record at the law firm, and once he is satisfied, he extends Dave the requested loan of $12:

Bob’s Brothers – Balance Sheet No. 4

Assets		Liabilities and Equity
Cash	$12	Alice’s Account	$0
Loan to Dave	$12	Dave’s Account	$13
		Steve’s Account	$10
		Shareholders’ Equity	$1

Notice that Bob’s Brothers’ balance sheet has expanded to $24 with only $12 of cash in the vault for an overall leverage of 2. This is still within Bob’s Brothers’ regulatory requirement not to lever up beyond a factor of 3.

Now Dave rushes back to the auction and bids $12 for the Ferrari. Since Steve has saved only $10 and since he is called Steve the Saver for a good reason, he decides not to bid for the Ferrari on credit, but he rather decides to quit the auction. Dave’s $12 is the highest bid. Therefore, Alice sells the Ferrari to Dave for $12. Again, payment is by wire transfer:

Bob’s Brothers – Balance Sheet No. 5

Assets		Liabilities and Equity
Cash	$12	Alice’s Account	$12
Loan to Dave	$12	Dave’s Account	$1
		Steve’s Account	$10
		Shareholders’ Equity	$1

Again, our toy model has discovered the general price level, symbolized by the price of the Ferrari 458 Italia. This time, the sports car went for $12. Consumer price inflation!

At the same time, our model has discovered the price of Paper Gold. Whereas in Scenarios 2.1 and 2.2, one ounce of unencumbered physical gold was worth 1/10 of a Ferrari, our model has now discovered a price of gold of only 1/12 of a Ferrari. We use the term paper gold in this case because what determines the price of gold relative to goods and services in this example is no longer unencumbered physical gold, but rather a mixture of physical gold and a loan contract.

Even if Alice had insisted on payment in physical gold rather accepting the wire transfer, the auction price would have been the same. For example, starting from Balance Sheet No. 4 above, Dave could simply withdraw cash from his bank account and pay Alice in cash. Regardless of the precise form of payment, in this Scenario, the price of the Ferrari is $12 rather than $10. What matters is only

1. That somebody (here: Bob the Banker) trusts Dave and extends him a loan denominated in ounces of gold, and
2. That this borrowed gold is accepted as payment for goods and services, i.e. that it circulates as currency. In the example, this became possible because either (Balance Sheet No. 5) Alice accepted credit money as payment (the wire transfer), or alternatively because Bob’s Brothers let Dave take out the cash in order to pay Alice in cash.

This Scenario illustrates the effect described in Sections 5 to 7 of The Many Values Of Gold that what matters for the price of gold relative of goods and services is the currency supply, i.e. the total amount of currency in circulation.

In Scenarios 2.1 and 2.2, the currency supply was $112 ($1 Bob; $100 Charlie; $1 Dave; $10 Steve), but in the present Scenario, the currency supply has been extended to $124 ($1 Bob; $100 Charlie; $13 Dave $12 of which is borrowed; $10 Steve). This was enough to cause consumer price inflation or, conversely, it suppressed the currency price of gold (paper price) below the Free Gold Price. It should come as no surprise that the availability of loans does influence the demand for Ferraris. Without the loan, Dave cannot bid for the Ferrari. With the loan, he can.

Conclusion: Extending loans denominated in ounces of gold suppresses the gold price.

Remark 1. This toy model is simplified and exaggerated (for example, the increment of the bids in the auction is a full 20%), but it is honest, i.e. the availability of loans does affect demand and thereby the market clearing price. Have you ever wondered what drives real estate prices? Demographics? Wage increases? Scarcity of space? How about the availability of credit? For empirical studies of the effect of currency supply on the price level in the case of Japan, we refer to:

Richard A. Werner, New paradigm in macroeconomics: solving the riddle of Japanese macroeconomic performance, Palgrave Macmillan, 2005.

Remark 2. In this scenario, Steve the Saver loses the auction to Dave the Debtor. The way in which this happens, contains a bitter irony: The loan to Dave is possible only because Steve deposited his cash in Bob’s Brothers’ bank where it can serve as the reserve that makes the loan to Dave possible. Had Steve kept his savings in a safe place at home or even in a safe deposit box at the bank, the loan to Dave would not have been possible, and Steve would have won the auction for $10. Morale: It is the saver who calls the shots.

Remark 3. One of the key features of the London (OTC) gold market is the availability of bank credit denominated in ounces of gold (Section 8 of The Many Values Of Gold).

Remark 4. What renders the gold standard unsustainable in the long run is the fact that under a gold standard, loans are of course denominated in a fixed weight of gold. This suppresses the currency price of gold as soon as the currency supply (physical gold plus credit created) grows. The sophisticated investors will realize that the market price of one ounce of paper gold of 1/12 of a Ferrari undervalues gold in this scenario. Therefore, by a variant of Gresham’s Law, they will tend to hoard physical gold and spend credit money, draining reserves from the system. In a crisis of confidence, a run on the banking system (in effect a run on the physical gold that forms part of the currency) is the rational response, leaving behind all the collapsing credit. We discuss this in the next Section 3.

Remark 5. Advocates of a gold standard who try to defend the gold standard, often point out that the problem is specific mistakes in the organization of the banking system. We will come back to this in Section 4.1.

3. Gresham’s Law and the End of the Gold Standard

Alice has always been an avid reader of FOFOA’s blog. As soon as she suspects that Dave did not pay her with his savings, but rather with borrowed money, she knows that there is paper gold somewhere in the system, suppressing the price of gold below its Free Gold Price. So Alice knows that by paying only $12 for 12 ounces of gold, she made a good bargain. By thinking through Scenario 2.1, she estimates that 12 ounces of gold should rather be worth 1.2 Ferraris (recall that Scenario 2.1 discovered that the Ferrari is worth only 10 ounces of gold) although she paid only one Ferrari in order to acquire the gold.

In currency terms and with the loans present, the Ferrari is worth $12, and so her 12 ounces of gold are truly worth $14.4. Therefore, Alice decides to take the gold out of Bob’s Brothers bank and to hide it at home until the market values this gold at its true value again at some point in the future. Her action is an example of Gresham’s Law.

Starting with Balance Sheet No. 5 above, Alice therefore withdraws the proceeds of the Ferrari sale in cash (i.e. gold coins):

Bob’s Brothers – Balance Sheet No. 6

Assets		Liabilities and Equity
Cash	$0	Alice’s Account	$0
Loan to Dave	$12	Dave’s Account	$1
		Steve’s Account	$10
		Shareholders’ Equity	$1

Grudgingly and with shaky hands, Bob hands her the cash. He knows that Bob’s Brothers has just run out of reserves, but trust is trust, and a business commitment has to be honoured. Before close of business today, he needs to phone the Federal Reserve and ask for an emergency liquidity injection and a courier shipment of additional cash. He will also call Dave and try to pressure him to pay back the loan earlier.

Unfortunately, today is not Bob’s day at all. Steve sees Alice walk out of the bank with all the cash and, just for a moment, he is worried that she might have a good reason for taking out the cash. Steve knows from the history books how devastating a run on the banking system can be (1929-1933). Just to be on the safe side, he therefore decides to ask Bob for half of his money in cash ($5), just in order to test whether withdrawals are still possible and in particular in order to see the expression on Bob’s face when he asks.

The story of our gold standard therefore ends here. In tears. It happened because the presence of gold denominated credit suppressed the real price of one ounce of gold from 1/10 of a Ferrari down to 1/12 of a Ferrari. Two rather different components of the currency traded at the same price:

• The physical gold coin, a tangible asset free of counterparty risk and an ideal long term store of value.
• The unit ($1) of credit money in Bob’s Brothers’ bank accounts (and at the same time the unit of all outstanding loans). These are contracts with counterparty risk.

The problem of the gold standard is that by construction, these two rather different assets trade at the same price. Theoretical considerations, in our case comparing Scenario 2.3 with Scenario 2.1, show that physical gold is undervalued in this system. It is therefore rational to speculate against the system. Initially, this is done only by sophisticated players (Alice), but in a crisis of confidence, it is obvious to all (Steve) that a run on the bank is the rational response.

Remark: If our toy model economy were not on a gold standard, but rather used fiat money such as the actual US$ or the Euro, the consumer price inflation from $10 to $12 for the Ferrari would have occurred in precisely the same fashion. But in this case, when Alice withdraws all her cash and Steve runs on the bank, the Federal Reserve would just buy the loan asset (Loan to Dave) from Bob’s Brothers with newly created base money (Quantitative Easing I) and thereby provide sufficient liquidity to Bob’s Brothers. By exchanging her credit money for cash, Alice would not gain anything.

Let us now see whether the problem of the gold standard can be fixed.

4. Trying to Better Regulate the Banking System

After the disastrous experience in Section 3, Bob’s regulators call in several experts on the gold standard in order to discuss how to fix the banking system. They propose various measures in order to make sure the Federal Reserve does not set the interest rates too low, that the leverage in the banking system is monitored much more carefully, and that mismatch of maturities is avoided.

4.1. Economy without Banks, but with Loans

Let us see whether this helps. Just to make a point, let us abandon the banks altogether. Poor Bob is unemployed again. Dave will not be able to just walk into a bank and get his loan. But what we cannot prevent from happening is that Dave finds somebody else who trusts him and who is willing to extend him a loan – not credit created in the banking system using fractional reserve banking, but rather lending Dave some of his savings. This is where Charlie comes in.

But first, back to square one! Alice opens the auction. Steve bids his $10 for the Ferrari. Dave is also keen on the Ferrari and now that the regulators have closed all banks, he has to consider other options. Fortunately, he remembers his dad’s old friend Charlie. Charlie knows that Dave has the job at the law firm, he knows Dave’s annual salary and estimates that Dave will have no trouble servicing the loan. He trusts Dave, and so he lends Dave $12 from his $100 of cash savings. They both sign a formal contract and determine that the term of this loan is 24 months. Dave rushes back to the auction, bids $12 for the Ferrari and, since this is the highest bid, he manages to purchase the sports car for $12.

Where do we stand? Alice has $12. Bob has $1 (and on top of that, he is unemployed). Charlie has $88 in cash and a $12 claim against Dave. Dave has $1 and the Ferrari. Steve as $10. The total currency supply is therefore $124 of which only $112 is physical gold.

Precisely as in Scenario 2.3, our model has discovered the price of paper gold which is 1/12 Ferraris per ounce. This happened although there was no fractional reserve banking (Bob is out of business). There was no mismatch of maturities either. Both Charlie and Dave agree about the term of the loan. What matters is only that

• There is debt denominated in ounces of gold (the $12 that Charlie has lent to Dave).
• That Dave can use this borrowed money in order to bid for goods and services.

Again, the weakness of this financial system in which lending of gold is possible, is Gresham’s Law. Alice will hoard the cash, Steve will be reluctant to lend his gold to somebody else, and they will wait until there are some loans that go bad. In this case, the Charlies of this world would get fleeced, and once the run on the credit has taken place, the market might one day discover the true value of the gold hoarded by Alice and Steve. (In the real world, the Ferrari would probably be crude oil, Alice be a sheikh, Steve a FOFOA reader, and Charlie a pension fund).

Remark 1: Charlie has a lot of cash at hand, and he is willing to invest some of it in the loan to Dave in order to earn some interest. Notice that, precisely by doing this, he creates consumer price inflation and thus lowers the real value of his savings. Again, it is the saver who calls the shots.

Remark 2: We said above that the currency supply in this example was $124. This is incorrect because Charlie has only $88 in cash plus a $12 claim against Dave. These $12 are not fungible, and Charlie cannot use them to buy groceries. One might therefore object and claim that while the loan enables Dave to consume the $12, it prevents Charlie from consuming the very same $12. The inflationary effect of the loan caused by Dave would therefore be compensated by a deflationary effect caused by Charlie’s lack of consumption.
The problem is that Charlie never intended to spend his $100. He is rather saving the sum for his retirement and, as he is very wealthy, he will probably pass most of it on to his children. Since Charlie intends to hold on to his savings for longer than the term of the loan to Dave (24 months), there is no deflationary effect that would compensate Dave’s spending.
In fact, basically all of the country’s retirement savings fall in this category: They are not intended to be spent any time soon, and so as soon as the savers lend this money (either directly to Dave or by depositing it in their bank accounts), they contribute to the consumer price inflation that devalues these very savings and that renders Alice’s speculation rational.

4.2. Vendor Financing

Before we finally mention Real Bills, let us sketch yet another variant of gold lending. This time, we not only outlaw banks, but we also regulate Charlie so heavily that he cannot lend his savings to other people. But the seller of the goods, Alice, might still be willing to accept deferred payment.

First, back to square one. Alice opens the auction. Steve bids his $10. In absence of Bob’s Brothers’ bank and in absence of Charlie, Dave can nevertheless approach Alice for a what is in effect a supplier loan. As long as Alice trusts Dave, Dave can simply bid for the Ferrari by offering deferred payment of $12 (plus interest, of course). Dave and Alice formalize this arrangement and sign a credit note, stating that Dave will pay $12 (plus interest) to the holder of the note as soon as 24 months have passed. Alice accepts this note as the highest bid and awards the Ferrari to Dave.

Where do we stand? Alice has a credit note for $12. Bob has $1 and is unemployed and without banking licence. Charlie has $100 which he is not allowed to lend. Dave has $1 and the Ferrari. Steve has $10. Again, the total currency supply is $124 of which only $112 is physical gold.

Our model has again discovered the price of paper gold which is 1/12 Ferrari per ounce, simply because Alice has extended a loan to Dave that is denominated in ounces of gold. Notice that there is no fractional reserve banking and no mismatch of maturities in this scenario either.

4.3. Real Bills

Some defenders of the gold standard propose that the problem is not lending per se, but rather lending for unproductive purposes. The Ferrari might a good case in point.

It is quite obvious though that the Scenario 4.2 of vendor financing also applies to the trading of industrial goods and services. So in order to address potential objections that involve real bills, let us adapt our selection of protagonists.

• Alice Inc. is a steel mill who sell raw steel. They have already sold almost all of their production. The last remaining ton of raw steel is to be sold in an open auction. The starting bid is $10 with bid increments of $2.
• Bob has $1 and is unemployed as there are no banks in this scenario.
• Charlie has $100, but he is not allowed to act in this scenario.
• Dave & Co. is a manufacturer of tools. They have only $1 in cash, but they need one ton of raw steel for their ongoing production. They are willing to take on a loan in order to finance this purchase of steel.
• Steve Plc is a car manufacturer. They have $10 in cash and should they be able to acquire a ton of steel for this price, they plan to do so. Should the steel be more expensive though, they will not expand their production any further and not purchase any steel.

After going through the Scenarios 2.1 and 4.2, it is clear that in a world without loans, Steve Plc will be able to purchase the ton of raw steel for $10. This is the Free Gold Price: 1/10 ton of steel per ounce.

Let us now assume that we live in a world with real bills. We assume that Alice Inc. have a very efficient cash management due to their high turnover of steel. For the last ton that is on auction, it does not matter to them whether they receive $x in cash or a real bill for $x from which they would receive interest. So they will accept either one of the two forms of payment as long as the $x is the highest bid.

In this case, Steve Plc will bid $10 in cash for the ton of steel. But Dave & Co. will offer a real bill for $12 (plus interest) which Alice Inc. promptly accept as the highest bid. So in this case, our model discovers the price of paper gold: 1/12 ton of steel per ounce.

Note that when we write that Dave & Co. offer a real bill for $12 (plus interest), we mean that the bill they present has a present discounted value of $12 and will mature at some face value above $12 at some point in the future. The difference is equivalent to the interest on the loan that Alice Inc. provide to Dave & Co.

In a world with real bills, however, this simplified example is no longer honest. Although credit is created and causes price inflation of unfinished goods (the raw steel), the credit allows Dave & Co. to expand their production. This will eventually lead to an increase in the available amount of goods and services which has a deflationary impact on consumer prices. The two effects, inflation in the price level of unfinished goods and an increased amount of finished goods available, counteract each other:

Here is the currency supply, its velocity, the price level and the real Gross Domestic Product (GDP). Assuming constant velocity, the currency supply is allowed to increase without affecting the price level as long as GDP increases accordingly.

And so, indeed, as long as the total volume of outstanding Real Bills remains at a constant proportion to GDP, the credit created in the form of Real Bills would not cause price inflation in the same fashion as in the previous examples. In order to guarantee this, Real Bills would have to be allowed only in order to finance additional production of existing businesses.

In practice, if one were to suggests to reintroduce a gold standard with Real Bills, it remains to resolve the problems of Scenarios 4.2 and 4.3. In particular, one would have to prevent Charlie in Scenario 4.2 from lending his savings and the vendor, Alice, in Scenario 4.3 from accepting deferred payment from the consumer, Dave.

5. Summary

We have seen that the problem of the gold standard was not fractional reserve banking, nor mismatch of maturities, but rather the presence of credit denominated in a weight of gold. This leads to an undervaluation of physical gold in terms of the currency and renders the speculation against the system trough Gresham’s law profitable. Furthermore, in a crisis of confidence, the run on the bank (better: run on the physical gold) is the optimum strategy.

The solution is therefore to embrace Gresham’s law and to separate the store of value from the currency: Freegold. See, for exmaple, FOFOA’s The Return to Honest Money.

The idea that the flaws of the gold standard cannot be fixed by better regulating the banking system, was also discussed in FOFOA’s Reply To Bron and in the discussion section at FOFOA’s blog starting here.

Aquilus at FOFOA’s blog pointed us to the following comment by FOA on this topic:

Trail Guide (05/11/01; 14:32:34MT – usagold.com msg#: 53425)
[...]
The ongoing over taxation, deficit spending, fiat inflation, deficit trade balances and mismanagement of private economies has always been with us. Yes, under different names and different degrees, that’s true, but no recent period in money history, gold or not, was without an ongoing effort to cheat the system. It was always in a process of decay, no matter what the books tell you. To think otherwise is to disclaim humans as they are.

How often have we heard that some special “hard school of thought” has all this terrible process documented and neatly explains where it all went wrong? Then, goes on to show us how to set it all up again so as to start over on the right foot.

So, trying to present the society as a whole, as “the awful, all controlling big government” on one side and the “good private economy on the other side” argues the lesser side of the larger issue;

—–hard money policy cannot work for long in a credit based system—-!

It makes absolutely no difference if we are even on a 100% gold use money system, if we as a society engage in credit commerce, we will break links with gold.

Consider:

I borrow 100oz of money gold from ten people so as to spend that gold doing commerce business. The hard money theory has us thinking that if I fail and cannot pay back the gold, this little portion of the money supply contracts. Thereby the gold system is perfect, as it slows the economic excess.
This is a minor example of gold banking. On a tiny scale. It works, as long as we don’t act out our motions in a political way.

Conversely, if gold was not part of a banking,,,,, credit,,,,, lending system,,,, rather it is just a tradable, non-lendable non-official money asset,,,,, then those ten people would have given me their gold and became part owners in my (ours now) enterprise. When it fails, our gold money is gone and no credit contract is lost in the process. Society at large will not come to our collective defense, no matter the scale of the loss. You see, we lost our assets, not society’s official money!

The difference:

When gold is lent,,,,, when it’s part of the banking system,,,,, when it becomes the object of a credit contract,,,,,, this whole hard money system falls into political RISK! No matter how perfect the “schools” have show this to work, in real life, political risk degrades our perfect credit money. This is the gray area that’s not ironed out because we cannot iron out society’s emotions. Let’s see:

In the above, the ten people I borrowed gold from would be holding my IOUs for that 100 ounces. Be they private citizens, banks or corporations they have effectively lost their gold money. The very money of the nation state!

Rather than see their losses made final, and cause harm, they partition the government to intervene by recognizing those money (gold) loans as good on the books. Further, the government is asked to lend some of it’s gold (collected through taxes) to me to extend my business life. I continue to function in a small way as I pay on those gold (money) loans. Further, those loans (held by ten lenders) become marketable as they become seasoned. Then, at a discount to their face value, they can be sold or kept as collateral assets. Over time, this is the political risk that seeps into any hard money system. Over time, even a gold credit system is expanded,,,,,, inflated,,,,,, until outright fiat must come into play.

It never starts out as “big corrupt government and their awful bankers” controlling the “good honest people”,,,,,, rather,,,,, it’s when a large enough segment of the “good honest people” are threatened with losing enough (gold) money that it could take down the economy,,,,,, they demand (elect into office) that their government and therefore bankers, expand the (gold) credit enough so as to slow the fall.

Acknowledgements

Many thanks to Aristotle at FOFOA’s blog for suggesting improvements to this article and to Motley Fool and costata for pushing me to give Real Bills a fair treatment.

Comments

If you have comments, suggestions or corrections concerning this article, please comment here (comments are moderated, and it may take a while until I have time to check for new comments). For the general discussion on the role of gold in the monetary system, please go to the comments section at FOFOA’s and so we do not fragment the discussion.

Have you ever wondered whether this would be possible? The answer is No. But why not? The reason we give might strike you as rather unexpected, but it leads you right into the question of what will be the future international monetary system. The answer is that it is the existence of the Euro that prevents the United States from returning to a gold standard.

The Euro zone is set up in such a way that it values gold at its free market price. Since the Euro zone is a major global trade hub, they are in fact in a strong position to block any attempt by the United States at returning to a gold standard. They can rather force the US to value gold at its free market price, too. Any attempt at linking the US dollar to a fixed weight of gold is futile in the long run because this would eventually lead to an under-valuation of gold in US$ and thereby irreversibly drain gold reserves from the United States. In the present article, we explain these ideas in greater detail.

1. Gold Standard

In order to understand the question of returning to a gold standard, we first need to understand how gold can be valued in terms of a currency. Let us therefore summarize the main results of Sections 5 to 9 of our article The Many Values of Gold.

In the following, it does not matter much whether the proposed gold standard is modelled after the Gold Coin Standard that existed in the United States until 1922, after the Gold Exchange Standard that lasted until 1933 or after the system that used to be in place between 1933 and 1971, including the Bretton Woods period, in which only foreigners or only foreign central banks and governments were allowed to redeem US dollars for gold while domestically in the United States, private gold ownership was illegal.

In each of these flavours of what is commonly called a Gold Standard, there existed credit money with deposits, loans, account balances and bank notes. This credit money circulated as currency and was generally accepted as a form of payment, for example, in the form of cash, i.e. tangible bank notes, or in the form of cheques. Today, it would be accepted as payment in the form of electronic account-to-account balance transfers, too.

In addition to the use of such credit money as currency, some institution, either the local banks, the central bank, or a government department, kept a gold reserve in stock and promised to exchange one unit of currency for a certain fixed weight of gold. In other words, all of the circulating currency, including the credit money created by the banking system, was denominated in a weight of gold. Before 1933, gold coins freely circulated along with various forms of credit money. Between 1933 and 1968, although private gold ownership was illegal in the United States, foreigners could still redeem US dollars for gold bullion. Between 1968 and 1971, redemption was possible only for foreign central banks and governments, but not for foreign private entities.

During each of these periods, the banking system was able to create credit, i.e. the total volume of currency units in circulation was variable, but the amount of gold held in reserve, was almost fixed or even declined substantially. As long as one currency unit could still be exchanged for a fixed weight of gold, both credit money and physical gold traded at the same price. Both are very different things though:

• Physical gold is a tangible asset, free of counterparty risk if in your possession, and it forms an excellent long-term store of value. The globally available quantity changes very little.
• Credit money, in contrast, is a contract and does involve counterparty risk. Its volume keeps changing, depending on the credit creation in the banking system, for example, depending on GDP, on the variations in economic activity, and on the prevalent debt level.

Let us assume that at some point in time, the value of the currency unit agrees precisely with the intrinsic value of the corresponding weight of gold. The parameters of the new gold standard that we are designing, are therefore fine-tuned in the optimum way. Rickards proposes to determine this value and then to return to the gold standard at this fixed exchange rate between credit money and gold. He mentions backing one US$ by 1/7000 of an ounce of gold as a good guess for this initial value.

Once this new gold standard has been established, GDP, economic conditions and debt levels change. The banking system creates new credit, some existing credit is paid back, defaulted on or is bailed out. The total volume of currency units in circulation which includes both the circulating gold coins (if there are any) and the circulating credit money, therefore keeps changing. This means that over time, the currency unit might be worth either less or more than the intrinsic value of the weight of gold to which it is linked.

In the former case, it would be profitable to redeem credit money for gold and hoard the gold because as part of the currency, it can be acquired at a discount to its intrinsic value. This can be seen as a variant of Gresham’s Law. In the latter case, it would be profitable to purchase gold bullion in the free market and to deposit it with the central bank in exchange for credit money because its value as currency is higher than its intrinsic value.

Firstly, let us recall which one was the prevalent situation in the history of the gold standard. How often have you seen people purchase gold bullion in the free market, take it to the central bank and deposit it there for newly issued bank notes? Never? At least not in a century? This is no surprise because the banking system typically creates additional credit over time – this is their job after all. When the total volume of credit expands, the real value of the currency unit is devalued, and so the currency unit will eventually be worth less than the intrinsic value of the weight of gold to which it is linked. Periods of shrinking credit volume, in contrast, have been the exception and have typically been brief. So we have to accept the fact that, historically, the currency unit was often cheaper than the corresponding weight of gold would have been, had it not been linked to the currency.

Secondly, one can nevertheless still argue that just the option of redeeming credit money for gold inspires confidence in the credit money, enough confidence in order to avert a run on the physical gold. In other words, one might acknowledge that the banking system creates credit over time while the amount of gold is fixed or changes little, and that the redemption of all credit for gold would eventually be impossible to guarantee. But one may still argue that just by allowing redemption at the margin, i.e. in not too large quantities at any time, one might be able to protect the currency from a loss of confidence.

The question we wish to answer is whether this is possible for the United States as of 2012, i.e. whether they can succeed in backing the US dollar with a fixed weight of gold per unit of credit money, even if this would undervalue gold in terms of the currency unit during some periods in the future. The answer will be a clear ‘No‘ as long as there exists a major competing currency which values gold at its free market price: the Euro (€). The existence of the Euro will eventually force the United States to value gold at its free market price, too, and to let the price of gold in US dollars float freely. The mechanism by which this is enforced is a kind of arbitrage using international trade. But let us first consider the question of whether a new gold standard is necessary in order to inspire confidence in the US dollar and what the United States can possibly gain from this step.

2. Confidence from ‘Gold Backing’

One primary argument for the gold backing proposed by Rickards is confidence. As long as the banks, the Federal Reserve or the United States Government guarantee that one US$ can be redeemed for a fixed weight of gold, say 1/7000 of an ounce as suggested by Rickards, no market participant should need to fear holding US dollars for the long run.

This backing of the US dollar with gold ought to be reflected in the Balance Sheet of the Federal Reserve System. As of 8 February 2012, this balance sheet looks roughly as follows.

Simplified Balance Sheet of the Federal Reserve System (billions of US$):

Assets		Liabilities
Gold Certificates	11	Cash in Circulation	1037
Foreign Exchange Reserves	5	Reserve Balances	1634
Financial Assets	2915	Other Liabilities	205
		Contributed Capital	55

We see that the official gold reserve of the United States is owned by the government which gave the Federal Reserve gold certificates that value gold at US$ 42.22 per ounce. The official gold reserve of the United States of 8130 tonnes whose current market value is about US$ 450bn (as of 17 February 2012, using the London pm fixing of US$ 1723 per ounce) appears on the balance sheet for a paltry US$ 11bn.

Now we assume that the United States Government hands the actual gold to the Federal Reserve in exchange for the gold certificates. Then the Federal Reserve revalues the gold to US$ 7000.00 per ounce which produces a huge revaluation windfall that they keep on their own balance sheet as an additional Capital Reserve. The hypothetical new balance sheet of the Federal Reserve System then reads as follows:

Hypothetical Balance Sheet of the Federal Reserve System (billions of US$):

Assets		Liabilities
Gold Bullion	1830	Cash in Circulation	1037
Foreign Exchange Reserves	5	Reserve Balances	1634
Financial Assets	2915	Other Liabilities	205
		Capital Reserve	1819
		Contributed Capital	55

We see that the gold reserve is now valued at US$ 1830bn. This would be more than sufficient in order to redeem the entire cash in circulation, presently US$ 1037bn, and it would in fact cover about two thirds of the entire monetary base of US$ 2671bn (cash in circulation plus reserve balances). Certainly this balance sheet inspires more confidence in the US dollar than the first one above.

Rickards advertises the return to the gold standard in particular with the claim that the first country that makes this step, would gain a considerable international advantage through the gain in confidence in its currency.

The problem with this statement is that the advantage of the first adopter is no longer available. The first step was made as early as 1999, and it was done by somebody else: by the Euro (€). It was just accomplished in a fashion slightly more sophisticated than just a plain old-fashioned backing of the currency with gold at a fixed exchange rate: The Eurosystem of Central Banks, i.e. the European Central Bank (ECB) together with the National Central Banks of the member countries of the Euro zone, account for their gold reserve at the current market price of gold in €.

As of 10 February 2012, the Consolidated Balance Sheet of the Eurosystem looks roughly as follows:

Simplified Balance Sheet of the Eurosystem (billions of €):

Assets		Liabilities
Gold	423	Cash in Circulation	870
Foreign Exchange Reserves	245	Reserve Balances	812
Financial Assets	1987	Other Liabilities	498
		Capital Reserve	394
		Contributed Capital	82

We see that it is the actual gold and not some gold certificates that appear on the balance sheet. Furthermore, the gold is valued not at some artificial historical value such as US$ 42.22 per ounce, but rather at the current market price. In fact, the gold held by the Eurosystem has always been marked to market since the introduction of the Euro in 1999. On the above balance sheet, the 10826 tonnes held by the Eurosystem are valued at € 1217 per ounce for a total of € 423bn. They are marked to market at the end of each quarter, and these figures correspond to the price of gold as of 30 December 2011. Finally, the increase in the price of gold since 1999 has already produced a healthy Capital Reserve (which can be found in the Revaluation Accounts on the liabilities side, item 11, of the consolidated balance sheet of the Eurosystem).

If we assume the United States revalue their gold to US$ 7000 per ounce as sketched above and that these US$ 7000 indeed agree with the free market price of gold, we arrive at a price of € 5310 per ounce using the exchange rate of US$ 1.3173 for € 1.00 (as of 14 February 2012). The hypothetical new balance sheet of the Eurosystem then reads as follows:

Hypothetical Balance Sheet of the Eurosystem (billions of €):

Assets		Liabilities
Gold	1848	Currency in Circulation	870
Foreign Exchange Reserves	245	Reserve Balances	812
Financial Assets	1987	Other Liabilities	498
		Capital Reserve	1819
		Contributed Capital	82

The gold reserve of the Eurosystem would now be worth € 1848bn, more than covering the € 870bn of cash in circulation and even the monetary base of € 1682bn.

From these balance sheets, we can see that there is no advantage of early adoption that could be captured by the United States. The Euro zone has already anticipated this step, and the Euro enjoys an even more robust gold backing. In fact, all else being equal, the comparative advantage of the € over the US$ increases with an increasing price of gold.

Let us finally clarify who would back what in this scenario:

• In the United States, according to Rickards’ proposal, the government or the Federal Reserve guarantees that one US$ can always be redeemed for 1/7000 of an ounce of gold. The key to this guarantee is that the government pays out the gold even if there is no private participant in the market who is willing to sell her or his gold for this price. Even if the free market values gold higher than US$ 7000 per ounce at some point in the future, the United States Government is still required to redeem one US$ for 1/7000 ounces of gold (this is the point of having a gold standard after all). How clever is that?
• In the Euro zone, in contrast, the Eurosystem values gold at its market price. When someone is uncomfortable holding Euros for the long run, she or he can therefore simply purchase gold in the private market. From the point of view of the individual saver or investor, this achieves precisely the same result, namely exchanging Euros for gold at the stated price, but it does so without running down the official gold reserve. How smart is this?

Once more in different words:

• If there is trouble with the confidence in the US dollar, the official gold price of US$ 7000 per ounce remains unchanged, but the United States start losing their gold reserve.
• If there is trouble with the confidence in the Euro, the price of gold in Euros rises while the gold reserve of the Eurosystem is unchanged.

Let us contrast the two philosophies as follows:

• In Rickards’ proposal, the United States claim that one US$ is as good as 1/7000 ounces of gold. Even if others in the market do not agree and value gold higher than that, the United States Government must still continue to allow redemptions at the fixed exchange rate of 1/7000 ounces per US$, drawing down the gold reserve in the process if necessary.
• The ECB simply lets the market discover how good the Euro is in terms of gold. Since the ECB has no intention of interfering with this market judgement, any gold that is purchased, can be purchased from the private market equally well, leaving the gold reserve of the Eurosystem intact in the long run.

And finally, yet another aspect:

• In Rickards proposal, the US dollar claims to be as good as gold and is advertised as a long term store of value. The United States Government or the Federal Reserve commit to draw down their gold reserve in order to deliver on this promise.
• Since the ECB has never claimed that the Euro were as good as gold, they need not redeem any Euros for gold. If somebody purchases gold with their Euros, these Euros continue to circulate. The Euro is explicitly advertised as a transactional currency, but not as a store of value. Gold is the store of value. This is Free Gold, the separation of the store of value from the medium of exchange, i.e. from the credit money that forms the transactional currency (also see Section 7 of The Many Values of Gold and FOFOA’s The Long Road to Freegold).

We could also ponder the political implications of these opposing choices: long-term sustainability; big government versus small government; regulated market versus free market; and so on. But in the present article, let us focus on the viability of Rickards’ proposal in the near term.

The only requirement for the ECB policy to work is the existence of a liquid private market for gold in Euros. As of February 2012, such a market does not exist. Gold is rather traded in US$ in the London market where it is linked to bank credit denominated in ounces (unallocated accounts), and its US$ price is almost certainly substantially below the intrinsic value of physical gold (also see Section 8 of The Many Values of Gold; FOFOA’s The View: A Classic Bank Run; and our joint Via Email). So the present mark-to-market valuation of the gold reserve of the Eurosystem can be viewed as a temporary placeholder: for now, they insert the current London price of gold in US$, converted to € using the current exchange rate; but once a liquid market for physical gold in € becomes available, this is the value that belongs on their balance sheet. We will come back to this point in Section 4 blow when we discuss possible Gold Open Market Operations by the ECB.

Let us finally remark that the price of US$ 7000 per ounce as proposed by Rickards merely serves as an example and that none of our arguments depends on this precise figure.

The material presented in this section was inspired by Rickards’ book and by contrasting it with FOFOA’s point of view. See, for example, Euro Gold, Party Like It’s MTM Time, Reference Point Gold Update 1 and Reference Point Revolution. Finally, we have seen that the Federal Reserve does not hold any gold, but that the U.S. gold reserve rather belongs to the Treasury Department. Please refer to this remark in Central Bank Gold Leasing for the political implications.

3. Currency War and Trade War

Let us now think about what happens if the United States take their new Gold Standard seriously and actually keep the official gold price fixed come hell or high water. Since returning to the gold standard includes the commitment to settle international trade balances in gold, the key question is whether a fixed official gold price (for example the US$ 7000 per ounce as suggested by Rickards) is compatible with international markets in which trade balances are settled in physical gold.

The problem is that as soon as the free market price of gold diverges from the official US price of gold, the new gold standard as proposed by Rickards becomes unsustainable in the long run. If the system does not break because of internal tensions (perhaps he would again make gold ownership illegal in the United States), it will certainly break because of external trade imbalances.

In order to illustrate this effect, let us assume that the official US gold price and the free market price in Euros diverge considerably. We estimate that the US$ and the € presently have purchasing power parity at an exchange rate of US$ 1.20 per € 1.00. As a very rough simplification, let us say that one hour of labour costs € 30.00 in the Euro zone and, at parity, it costs the same amount in the United States: US$ 36.00. Also at parity, the official US gold price of US$ 7000 per ounce corresponds to € 5833 per ounce. Let us further assume the free market price of gold in the Euro zone differs substantially: € 8750 per ounce.

Firstly, there is the obvious arbitrage: The smart money in the Euro zone can simply take € 5833, exchange them for US$ 7000 in the foreign exchange market, go straight to the Federal Reserve and redeem this sum for one ounce of gold which is immediately shipped back to Europe. There is therefore a continuous flow of gold from the United States to Europe unless the currency exchange rate adjusts to $US 0.80 per € 1.00. This is the exchange rate at which the official US price of gold of US$ 7000 per ounce agrees with the European free market price of € 8750 per ounce.

Although this adjustment of the exchange rate indeed eliminates the arbitrage opportunity, it does not stop the outflow of gold from the United States to Europe. The problem is that the currency exchange rate now deviates from the purchasing power parity of US$ 1.20 per € 1.00. At the no-gold-arbitrage exchange rate of US$ 0.80 per € 1.00, one hour of European labour can be offered in the United States for US$ 24.00 whereas American labour still costs US$ 36.00 per hour. The United States therefore run an increasing trade deficit compared with the Euro zone. Under the proposed gold standard, the Europeans who initially receive US$ for their exports, can immediately cash in and redeem their US$ for gold.

The flow of gold from the United States to Europe therefore persists regardless of the currency exchange rate. If it is not a consequence of direct price arbitrage, then it follows from an imbalance of the trade accounts. In either case, physical gold reserves are drained from the United States, and the United States would have to make a choice between accepting the increased instability of their banking system or starting to liquidate credit in order to adapt to the shrinking reserve base.

If you remember the 1960s, then all this might sound familiar. This is no surprise. During that time, the official US gold price at which the United States redeemed US dollars for gold internationally, was lower than the free market price of gold abroad (private gold ownership inside the United States was illegal). Since at that time, basically all currency exchange rates with respect to the US dollar were fixed, what happened was a combination of the two effects described above: (1) gold price arbitrage between the official and the free market price; and (2) US dollar redemptions for gold by foreign governments and central banks who cashed in their trade surpluses with the United States.

The United States and their Western European allies had tried to suppress the arbitrage with the London Gold Pool starting on 1 November 1961. This operation was, however, not sustainable in the long run. On 14 March 1968, the London Gold Pool collapsed, and the London gold market remained closed for two weeks at the request of the United States. On 18 March 1968, Congress officially revoked the gold backing of the US dollar. From this date on, the US dollar was redeemable for gold only by foreign governments and central banks, but not by foreign private entities. Finally, on 15 August 1971, US dollar gold convertibility was suspended even for foreign governments and central banks.

We see that the arrangement that is now proposed by Rickards, basically used to exist during the Bretton Woods period. In the late 1950s, the credit volume in US dollars was already growing so quickly that the official US gold price and the free market price of gold outside the United States started to diverge. Although the Western European allies helped to stabilize the gold standard, it inevitably failed because of the arbitrage and the trade imbalances sketched above. If a gold standard of this type is established again while a major trade block openly advertises a free market price of gold, it would probably collapse even sooner than it did in the 1960s.

In 1971, the United States chose to terminate the gold convertibility of the US dollar rather than to revalue gold in US dollars. We refer to FOFOA’s It’s the Flow, Stupid for the reasoning that lead to this decision. Finally, please see his Once Upon A Time for more details on the London Gold Pool.

4. Gold Open Market Operations

In the new gold standard proposed by Rickards, the gold operations by the local banks, the Federal Reserve or by the United States Government are essentially automatic. As soon as someone presents them with a US$, be it a coin, a tangible bank note or some electronic account-to-account transfer, they are required to redeem it for a fixed weight of gold, for example, 1/7000 of an ounce. Conversely, if someone presents them with one ounce of gold bullion, she or he would be entitled to a credit of US$ 7000 – perhaps up to some transaction fee.

The ECB, however, which does not guarantee a redemption of the Euro for a fixed weight of gold, can engage in various types of Gold Open Market Operations.

Firstly, in absence of a liquid market for physical gold in Euros, the ECB can act as a market maker and, say, bid for a fixed weight of gold at € 8745 per ounce and offer to sell a fixed weight at € 8755. If they bid for and offer more than 10 tonnes each at any time, they are able to make a liquid market for physical gold in Euros, a market in which other central banks can trade the quantities that typically arise in the settlement of international trade balances. As soon as it turns out that there is more weight of gold sold than it is bought (or vice versa), the ECB adjusts the bid and offer prices accordingly. This amounts to assisting the price discovery for large quantities of physical gold while the reserve of the Eurosystem remains essentially unchanged.

Let us stress that as of February 2012, there exists no liquid private market for physical gold in € in which bid and offer would be quoted for tranches of 10 tonnes or more at any time. In fact, this is apparently not even possible in the London market in which gold is traded in US$:

James G. Rickards, Currency Wars, page 26:
In ordinary gold trading, a large bloc trade of as little as ten tons would have to be arranged in utmost secrecy in order not to send the market price through the roof [...]

Secondly, the ECB can manage a dirty float of the gold price in order to smooth fluctuations in the currency exchange rates, in order to influence the domestic price level, or even in order to affect the competitiveness of goods and services from the Euro zone in the international market. If they expand the monetary base and purchase gold in the private market, they lower the exchange rate of the Euro relative to gold, creating domestic consumer price inflation and rendering exports more competitive and imports more expensive. Conversely, if they sell a part of their gold reserve and cancel the base money they receive, they raise the exchange rate of the Euro relative to gold, reducing consumer price inflation and rendering exports less competitive and imports cheaper.

In particular, if things ever turned hostile, for example because not only a book author but also some government officials started talking about ‘confiscating’ the gold owned by foreign countries, the dirty float could be used in order to terminate Rickards’ experiment with the new gold standard in the United States at any time, simply by expanding the monetary base in € and purchasing physical gold in the open market. This operation is always possible because it relies only on the ability to expand the € money supply, but does not require any existing official gold reserve. In fact, any major currency area or trade block who exports enough goods and services for which there exists a global demand, can make this move. So far, none of them has.

FOA also commented on the possibility of the U.S. returning to a fix exchange rate gold standard, just as Rickards suggests in his book. Please see the four comments by FOA starting with this one in our article Central Bank Gold Leasing.

5. How is this different from what we have today?

In the previous sections, we have illustrated that returning to a gold standard does not achieve anything that cannot already be obtained by the policies that the Euro zone has already adopted. On the other hand, most people agree that the global financial system is seriously under-capitalized and that many governments of the Western World are over-indebted and therefore in serious difficulties. So which step is missing that actually does solve some of the problems?

This step is the other part of Rickards’ proposal, namely to revalue gold upwards by a substantial factor. This would do little damage to the real economy (as opposed to, for example, increasing the price of oil by such a factor), but it would work magic in terms of recapitalising the financial system and restoring the confidence in the major currencies. It should be clear from Sections 2 and 3 above that it is the high price of gold in terms of US$ or € that inspires confidence in these currencies rather than the question of whether the currency unit is redeemable for a fixed weight of gold. (There is one caveat though: as long as the US gold reserve is owned by the highly indebted government rather than by the Federal Reserve, it will never inspire the full possible confidence.) The appropriate question to ask is therefore not why is the US$ not backed by gold, but rather why is the current price of gold in US$ so low?

We do have a free private market for gold in US$, the London market, don’t we? So why does this private market not value gold substantially higher if this is a key part of the solution? Why would it need Rickards in a US government position in order to do so?

The answer to this question has a technical and a political component. The technical answer, we think, is the observation that in the London market, the price of physical gold (allocated gold) and the price of bank credit in ounces (unallocated gold) agree as long as allocation is still possible at the margin. Only a run on the physical gold in the banks would allow the revaluation of gold to Rickards’ price target or beyond. For more details, we refer to Sections 5 to 8 of The Many Values of Gold; to our How Credit Suppresses The Gold Price; to FOFOA’s The View: A Classic Bank Run; and to our joint Via Email.

Apart from the fact that the London gold market commingles physical gold and bank credit denominated in ounces, there are further indications that the London gold market is not the liquid market for physical gold that would be required. Let us repeat:

James G. Rickards, Currency Wars, page 26:
In ordinary gold trading, a large bloc trade of as little as ten tons would have to be arranged in utmost secrecy in order not to send the market price through the roof [...]

Although some central banks have recently been buyers of gold (we do not even know whether they bought it through the private London market, by the way), this is a clear indication that the market is too small in order to settle international trade balances in physical gold. That would require multiple transactions of the order of 10 tonnes of physical gold every week at today’s price or smaller amounts at a substantially higher price.

The political component of the answer is that the United States, at least from the early 1980s until 1999, have generally preferred a strong US dollar relative to gold. Some quotations in Section 6 below come back to this question.

Let us summarize what is the key point of Rickards’ proposal to return to a gold standard at a substantially higher price of gold in US dollars. It is not the idea of the gold standard that the currency unit would be backed by a fixed weight of gold. This would not be sustainable in the long run, and it would eventually fail for the same reasons for which the London Gold Pool failed. It is rather the revaluation of gold in US dollar terms that inspires confidence and that addresses many of the present issues such as recapitalizing the banking system.

We finally refer to FOFOA’s How is that Different From Freegold for another response to a very similar question.

6. Another and Friend Of Another (FOA) on the US dollar, oil, gold and the Euro

Now that we have understood the question of whether a return to a gold backed US dollar is possible and that we have seen the special position occupied by the Euro, we are ready for a first glimpse of the actual historical developments: why the United States went off the gold backing in the first place and why the Europeans have countered the American control of the gold price with the introduction of their own currency.

The following are excerpts of the postings by Another and FOA in the discussion forums of Kitco and Centennial Precious Metals between 1997 and 2001.

Firstly, in 1971, the United States terminated the gold convertibility of the US dollar (rather than devaluing it with respect to gold) in order to raise the US dollar price of oil and thereby to reduce their dependence on oil from the Middle East. For more details, we refer to FOFOA’s It’s the Flow, Stupid.

7/19/98 ANOTHER (THOUGHTS!)

[...]
The Middle East nations, in particular, have shown their reserves to be much greater than ever thought possible. These “new/ larger” reserves have come to be known about, only in the last eight years. It was the “possible existence” of this oil that created much fear in the American Capitol, prior to the 1970s. In that time, it was known that the Western economy was growing on low priced energy. This growth would soon consume all “local / domestic” reserves that, in turn, would bring much dependence on low cost Middle East oil. The reserves in this region were, and now even more so, are the lowest cost to produce in the world. As all oil was sold in dollars, and US$s were then, still somewhat attached to gold, the ME producers had “no need” to raise prices! The political forces in the West needed much higher oil prices to “stimulate exploration” to avoid the “strategic problem” of “all oil supply from one region”. Make no mistake, there is enough oil reserves in the ME to supply “all world” for “many grandchildren”! It was in this time that the events created by the “politics of dollar currency”, allowed the decision to remove the gold backing from the US$. This move, broke the “gold bond to oil”, and created a need for more dollars per barrel of ME oil. The oil producers, as expected, did create “Beirut Resolution titled XXI. 122″! [VtC: It was Beirut XXV.140 which followed Caracas XXI.122]

Partial reprint from report by others:

Shortly after the gold window was closed in August 1971, OPEC called an emergency meeting with U.S. and other nations’ finance ministers in Beirut. The result of the meeting was the Beirut Resolution titled XXI. 122. It called for adjustments to OPEC’s crude oil pricing whenever the dollar had been devalued. The resolution called for OPEC’s price adjustments to be triggered whether or not dollar devaluation was caused by government action or by market forces. If the dollar lost purchasing power, OPEC could raise its prices.

[...] this was the beginning of a move by dollar advocates to raise this commodity price by inflating the “world reserve currency”. As an “also”, the ME was shown to be and caused to be “unstable” for dependence for oil production.
[...]

Date: Sat Apr 04 1998 19:55
ANOTHER (THOUGHTS!) ID#60253:

[...]
But, in the same time frame, all central banks did sell gold to all persons, even the US. All treasuries held gold and dollars as reserves. To what end did the world financial system gain with the dollar off gold backing, and then allowed to “dirty float” against all currencies? Would the world not have been better off to find gold revalued to, say $300 and then begin a “dirty float”? Noone would have lost, and the inflation would have , at best, not have been worse!

Truly, I tell the reason for this action. The US oil companies knew that the cheap reserves were found. The governments knew this also. The only low cost oil reserves in the world at this time were in the Middle East, and their cost to find and produce was very low. It was known, that, in time, ALL oil would come from this land. As much higher US dollar prices were needed to allow exploration and production of other reserves, worldwide. But, how to get crude prices, up, when the Gulf States were OK to pump and produce in exchange for “gold backed dollars”? I will not name the gentlemen that brought this thinking to the surface in that era, but it was discussed. It was known that oil liked gold. It was known that “local oil” would be used up without higher prices. What if, the US dollar was taken off the gold standard, and gold was managed “upward” to say, $208 per ounce? The dynamics of the market would force oil to rise and allow for much needed capital to search for the higher priced oil that was known to exist! The producers would find shelter in gold even as the price of oil was increased in terms of a now “non gold dollar”! Price inflation would rise, but gold and oil would also increase. The dollar would continue to be used as the only payment for oil, and in doing so replace gold as the backing for this “reserve currency”. All would be fair.

The war in 1973 and the Iran problem did make markets “overshoot”, but all did work to the correct end. The result was “a needed higher price for a commodity that was, as reserves, in much over supply by the wrong countries”! It was known that the public would never have accepted this “proposition” as fair. To this end, we have come.

And it is from this end, that the gold markets are managed for today!
[...]

Then, in the early 1980s, the US dollar faced huge problems from price inflation and the high oil price. The London gold market was developed and expanded in order to manage the gold price in US$ down and thereby induce the oil producers to lower their price in US$.

Date: Sun Oct 05 1997 21:29
ANOTHER ( THOUGHTS! ) ID#60253:

[...]
It was once said that “gold and oil can never flow in the same direction”.
[...]
It is the movement of gold in the hidden background that has kept oil at these low prices. Not military might, not a strong US dollar, not political pressure, no it was real gold. In very large amounts. Oil is the only commodity in the world that was large enough for gold to hide in.
[...]
the question was asked, “how could LBMA do so many gold deals and not impact the price”. That’s because oil is being partially used to pay for gold!
[...]
People wondered how the physical gold market could be “cornered” when it’s currency price wasn’t rising and no shortages were showing up? The CBs were becoming the primary suppliers by replacing openly held gold with CB certificates. This action has helped keep gold flowing during a time that trading would have locked up.
[...]
The Western governments needed to keep the price of gold down so it could flow where they needed it to flow. The key to free up gold was simple. The Western public will not hold an asset that going nowhere, at least in currency terms. ( if one can only see value in paper currency terms then one cannot see value at all ) The problem for the CBs was that the third world has kept the gold market “bought up” by working thru South Africa! To avoid a spiking oil price the CBs first freed up the publics gold thru the issuance of various types of “paper future gold”. As that selling dried up they did the only thing they could, become primary suppliers! And here we are today. In the early 1990s oil went to $30++ for reasons we all know. What isn’t known is that it’s price didn’t drop that much. You see the trading medium changed. Oil went from $30++ to $19 + X amount of gold! Today it costs $19 + XXX amount of gold! Yes, gold has gone up and oil has stayed the same in most eyes.
[...]

6/4/98 ANOTHER (THOUGHTS!)

[...]
Because the Central Bank loans and sales offered “credibility” to any outstanding “short gold paper”, a large derivatives market was built around this “gold trading arena”. The CBs, along with the Bank For International Settlements (BIS), wanted gold to fall into the low to mid $300 range as this made the dollar (US$) strong in gold. It also made much of the “old” gold paper “good for delivery” as the Bullion Banks could supply the physical by purchasing on the “outside market” at lower prices! Had many of the early paper buyers (year or so ago) called for delivery, there be no supply as the physical market was spoken for. A falling dollar gold price made good on past paper deals as existing private supply was made free. In this light, I think few do truly understand how much trading in done in the world “gold trading arena” by LBMA! To understand this, is to know, “the CBs could never supply it! To think that gold is not wanted or not traded or “is a dead asset”, it does become the foolish thought, yes?
[...]

Date: Sat Jan 17 1998 20:45
ANOTHER (THOUGHTS!) ID#60253:

[...]
Enter the world of “paper gold”.

Yes, gold just like currencies has been “digitized”. If you brought gasoline, made from oil sold under $20/bl, you are part of this system! For just as the “digital currencies” are created for trading only, paper gold was created for the trade of oil. In a very broad sense, it was created as an “extra” or “kicker” to allow the purchase of small amounts of cheap gold in return for a full supply of oil. In reality, this gold paper represents the future production of gold ( from the ground ) to balance the reserves of oil ( also in the ground ) . The huge amount of “paper gold” traded and outstanding today is now in excess of all the gold in existence above ground! In essence, it is of the same value as the currencies, “the thoughts of nations, blowing in the wind”. The Central Banks gave value to this paper by selling and lending some of their gold stocks. But, as economies became hooked on cheap oil, and demanded more of the same, these same CBs had no choice but to use fractional reserve gold lending” to pump the gold market.
[...]

5/26/98 ANOTHER (THOUGHTS!)

[...]
I say, a travel to London will offer much education, as the “city” trades more gold than exists!
[...]

On the question of backing the Euro with gold or using a flexible gold reserve that is marked to market:

6/14/98 ANOTHER (THOUGHTS!)

[...]
Your question of Euro gold backing? The Euro will not be backed or fixed in gold. It will, as Michael Kosares (USAGOLD) notes, be the first “modern currency” to hold true “exchange reserves” in gold. It is important to understand that “exchange reserves” of gold are much more powerful a tool for currency defense than gold backing! In this system, gold must be traded in a “public physical market”, in that currency, Euros! As such, the Euro can “devalue gold” (Euro price of gold falls) thereby making it strong in gold! In today’s world, this will happen as a “strong Euro physical market” displaces and defaults ” the old dollar settlement paper gold market”! The dollar will become”weak in gold”!
[...]

8/10/98 Friend of ANOTHER

[...]
This group, made up of much of Europe and the Middle East, is not looking for a return to the old Gold Standard, but perhaps something far better. They do not see any advantage in holding the currency bonds of one country, as a reserve asset of future payment, over holding physical gold as a reserve asset in full payment. The fact that the debt reserve asset pays interest is little more than a joke in these banking circles. Any paper currency, the dollar included, can fall in exchange value against your local currency far more than the interest received! In today’s paper markets, the only true value in exchange reserves, held by a government as currency backing, is found in it’s effectiveness for defending the local currency from falling against other currencies. In other words, use the reserves to buy your countries money. But, this is a self defeating action as sooner or later the reserves are used up! This fact is not lost on many, many countries around the world, as they watch their currencies plunge, lacking reserves as defense. Ask them how important the factor of earning interest on reserves is under these conditions.

On the other hand, buying gold on the open market, using your local currency, works as a far different dynamic from selling foreign bond\reserves. This action takes physical gold off the market, and in doing so increases it’s value in dollar terms. Gold is and always has been the chief competitor with the dollar for exchange reserve status. The advantage here comes from the fact that governments do not run out of local currencies to use in buying gold, as opposed to selling foreign currency reserves to buy the local currency on the open market. Of course, the local price of gold goes sky high, however, in this action you are seen as taking in reserves, not selling them off.
[...]
Basically, this is the direction the Euro group is taking us. This concept was born with little regard for the economic health of Europe. In the future, any countries money or economy can totally fail and the world currency operation will continue. What is being built is a new currency system, built on a world market price for gold.
[...]
The Euro will not replace gold, it will evolve into a gold transactional currency. It will also price Euro gold very high, perhaps $6,000 in current dollar terms buying power.
[...]

On the question of whether the United States can return to a gold backed US dollar:

5/3/98 ANOTHER (THOUGHTS!)

[...]
Mr. Kosares, Your friend thinks much of this gold owned by the USA. It could be used to back the dollar up to 25%, no? Many come to this thinking and hold a secure thought, that as last resort, this gold will save the day! I think, many persons never gained the understanding that the American gold is kept by the “Treasury”, not the maker of your money, “The Federal Reserve”. It is there for good reason, as the present world currency system is not a function of American law! If the US were to place gold in the hands of the US/CB as reserves for the dollar, the BIS could claim it! It is, as a point of contention and of no real use. I think not a war would come of this claim, if it should happen! As the world currencies are now, a “new dollar” would be needed if gold were used as reserves! The present dollar would then, truly be as “paper for the wall”!

The urgent drive to create a new “reserve currency” began in the early 80s, after the last small “gold war”. The road to making this new Euro did never include gold in large amounts, until the last few years! Even one year ago, the news would say, 5% or less. Today, we speak of a much greater amount! This is interesting, yes? The BIS did “hatch” this deal in a very late fashion! The future of the Euro was found to be “weak”, as the Middle East oil imports onto the continent would continue in dollars! This was so from the dollar being made strong in gold. Gold priced in dollars at near production cost, offered a “no switch currency” position, for oil. This position has been unstable for the last year, and the alternative of a switch to gold was in progress! You have read my “Thoughts” before. Now the BIS does offer to “change the rules of engagement”, a real reserve currency is offered!

Few do grasp what is happening and why! They think the holding of gold reserves by the Euro is of a little point, as to what good are gold reserves? One cannot use gold as Marks or Yen to intervene in currency market to support the Euro. My friend, the BIS has played the, as you say, “big poker hand”! The holding of large reserves by the ECB and the withholding of sales from the market will not only bring the end of the London paper gold market, it will, thru a high USD gold price, “make the dollar weak in gold”!
[...]

On the question of who else can force gold back into the international monetary system:

Date: Sat Jan 17 1998 20:45
ANOTHER (THOUGHTS!) ID#60253:

[...]
There is one oil state that no one will play for a fool. The CBs will sell all of their gold or the nations will nationalize all mines and operate them at a loss. One way or another, most of the paper gold market will be honored. Why? Because oil will bid for gold if they do not! We are not talking about an oil embargo or rising oil prices. Indeed, oil will become very cheap for those that can supply physical gold. This deal will not require the agreement of all oil states. Only one can start this, the others will gladly follow.

A large oil producer, with plenty of reserves and unused capacity, can say: We now value gold at $10, $20 or $30,000/oz.. That is the rate we will use to sell oil. We will go to “full” production and offer at $10.00us/bl.. Pay us in physical gold and USD ( or EUROs ) as a 50% mix to the above rate to equal $10/bl..

It would be a deal like none other! Oil, worldwide, would drop to $10.00/bl and every economy would do very well, IF they had gold. All gold would immediately be arbitraged to the above prices thereby creating a “world oil currency” large enough to handle oil. This creating of a new “specialized currency” will be the result of the first “commodity corner” that ever succeeded!

On the introduction of the Euro and its role in breaking the price lock on gold in US$.

7/19/98 ANOTHER (THOUGHTS!)

[...]
[VtC: The following refers to the termination of the gold convertibility of the US dollar in 1971 in order to raise the US dollar price of oil] Not all nations agreed with this move. The French and Germans did not, and by 1980, Europe was working with the BIS to implement a new “reserve currency”. They did long for a “money” that would resolve “Beirut XXI” and allow for the purchase of low cost reserves, not the high US$ cost “world oil supply”, of perceived strategic importance to America alone.

The “new Euro” did take much longer to create, and the Gulf War did create a crisis of payment for oil. In this time, early 1990s, the currency of gold was brought “into use” as a “temporary” partial payment until the Euro could be presented. A paper gold market, of sufficient size, was created, that as such, it could hide discount payments to a few producers for oil. Today, if these claims on paper were converted into bids for physical, it would take all of the “tradable gold” in existence! It was this “leverage” that forced the Euro makers into gold. Gold backing for the Euro would not be enough! Only “exchange reserves of gold” would allow oil priced in Euros. We move to this end today. Tomorrow will see ME oil in good supply for a new trading block of nations.
[...]

6/4/98 ANOTHER (THOUGHTS!)

[...]
Today, a new currency is formed. It offers a way to break the dollar valuation of gold without the total destruction of worldwide currency markets and economies. In time, oil producers can offer their low cost reserves at true valuations, that support industry and commerce in exchange for a revaluing of real money, gold, in a real currency, Euros!

And finally on the revaluation of gold and its effects.

Date: Sat Apr 25 1998 22:55
ANOTHER (THOUGHTS!) ID#60253:

When the US government does not take in enough taxes to meet expenses, it sells treasury debt to make up the difference. When no one bids for this debt at an “acceptable” interest rate, the Federal Reserve bank buys the debt, outright! It gives printed cash to Washington and then, “holds the new treasury debt ( bond ) as backing for the issued cash!

Everyone understands the implications of this. Or do they? In reality, when the US government needs money, it doesn’t sell debt! It “TRANSFERS” the obligation of it’s citizens to pay future real production ( taxes ) as a “backing” for it’s newly printed currency! As this process has been going on for decades, it has built up a debt of “real production payments” that it’s citizens can never pay. Further, as the world reserve, this currency is held thru proxy “by every single person on this planet” that uses paper to trade anything!

It is true, that in times past when a currency is inflated ( over printed ) to a point of only 10% real gold backing, the government could revalue gold 90% [VtC: 900%] upward and the currency was 100% backed again! A terrible blow to the holders of this paper, but at least the money system survived! Today, the worlds currency, the US$, by default, would require a gold price of many, many thousands to back it without using it’s citizens as collateral! The only problem with this is the US gold stock is so small, that even at $10,000/oz, a large deflation would be necessary to decrease the outstanding US currency to this gold backing level!

Now, consider the Euro. It will have much real gold backing from the beginning. Even at 10% to 30%, the Euro will be the equivalent of a 100% gold backed dollar, when the world comes off the dollar standard! The selling of old dollar reserves, alone will reprice gold in US$ terms of at least $6,000/oz! It’s present interbank reserve value.
[...]

Date: Sat Apr 04 1998 20:42
ANOTHER (THOUGHTS!) ID#60253:

[...]
When the battle to keep gold from devaluing oil ( in direct gold for oil terms ) is lost, the dollar will find “no problem” with $30,000 gold, as it will be seen as a “benefit for all” and “why did noone see this sooner”?
[...]

Update (24 February 2012)

FOFOA reported that his reader Aquilus had asked Rickards whether he really wanted to peg the USD to gold or whether it would not be better to let it float. Aquilus reported to FOFOA:

Aquilus: The more interesting part is that I had been trying to get him to give me a straight answer on the notion (from his book) that once gold is revalued to “the right price” the Fed would then step in and defend that price (in a narrow range). He had been avoiding a straight answer for months, but I finally got one yesterday while he was signing the book – in a short one on one conversation.

When I asked him how he could seriously believe that a fixed price could be defended when dollars continue to be issued and credit created, and how that would be different from the old London Gold Pool, he smiled and said, “no, no, you see, the defended price would indeed have to change every year or else it would not work.”

So, basically, he’s still somewhere in the “we can semi-control” the price with this Fed-defense of an adjustable price, as far as I can tell.

Blondie commented on FOFOAs blog:

Back in September I had an email exchange with Jim Rickards about his “peg to gold” proposition, which I reproduce here in full as it seems pertinent to the above post:

Blondie (to Jim): I have listened with interest to your interviews on KWN, and have a query with regards to your comments from your most recent broadcast

[KWN transcript start]
Jim Rickards: This is what the currency wars are all about – not everybody can devalue against everybody else, you have these sequential or partial devaluations of one currency against the other, but somebody has to be the strong guy, somebody has to be the currency that’s going up so all the others can go down, and this kind of brings us back to gold, Eric, because gold is the one thing in the world that everybody can depreciate against.

Eric King: Then given everything you’ve said Jim, what are the implications for gold?

Jim Rickards: Well the implications for gold is, gold has the unique role, because since its not a liability, (I think its the ultimate form of money because its not issued by any government) when I say that all the currencies cannot depreciate against all the other currencies, that’s true, but they can all depreciate against gold.

You know as gold is the one thing that allows every currency in the world, every paper currency, to depreciate against it, and that’s how kinda everybody wins the currency war at once, and of course the big winner is gold.

But in order to do that, you need some kind of gold standard, you need an international monetary conference, you need an agreed peg to gold, and then we can reset all the currency values against each other in ways that reflect the relative terms of trade and existing surpluses and deficits in the global trading system, and yet not have the currency wars because basically gold would have won the currency wars because it’s the one thing that everybody can depreciate against at once. It’s exactly what happened in the 1930s, it’s exactly what happened in the 1970s, and my view is it will happen again – in fact it’s in the process of happening – but nobody really wants to talk about it.

[KWN transcript end]

You make perfect sense (I have been of the same opinion for a couple of years now too), but can you please explain the reasoning behind your statement that “…you need an agreed peg to gold…”? It seems to me that the process you are describing of essentially the need to devalue fiat and repeg gold much higher is just like the raising of the debt ceiling: kicking the can but not solving the problem.

Why the need for a peg?

Why not let the market decide the relative exchange rates of currencies and gold? Pressure is thus equalized by the system constantly, eliminating the problems which arise due to the undervaluation of gold which are culminating periodically (every 40 years) in systemic crisis?

The market is the arbiter with regard to currency values, relative terms of trade and existing surpluses and deficits in the global trading system, and if gold were not intentionally undervalued this function would be performed, naturally and automatically.

You have a rare talent (and platform) for explaining the situation and your reasoning as to how it will be resolved, but on this issue of the peg to gold you supply no reasoning… are we just to accept that central planners know best?

Jim Rickards: It’s easy to do a peg using market forces. The key is open market operations. If you (as a central bank) are a willing seller and buyer at the peg price, the market will quickly tell you if your price is too high (by selling) or too low (by buying) gold from you. You then adjust your monetary policy accordingly to equilibrate at the peg price. So, in this case, the peg is not anti-market, in fact it relies upon the market as a price signal to dictate monetary policy (versus arbitrary rule).

Blondie: So if, for example, the market tells you (as a central bank) that your peg is too low (by buying your gold stock), you would engage in a deflationary monetary policy to increase the value of your currency, until such time as the buying ceased?

Or vice versa if your peg was too high.

Jim Rickards: Right. The point is, market forces are always in use to send signals about monetary policy.

Blondie: Could you (as a central bank) not more easily engage in open market operations in which you let the price of your gold stock float, altering your bid or offer accordingly until the equilibrium level was found? No discussing monetary policy, implementing it, waiting for the market’s judgement as to whether or not you have gone far enough, too far etc.

Such a float provides an instant, dynamic establishment of the equilibrium price in accord with market forces, whereas the peg seems a slow and cumbersome method of arriving at the same destination, so slow in fact that I question what is to stop the run on underpriced gold form exhausting all stocks before appropriate monetary policy has been enacted? The market would need more than jawboning to be convinced that the Fed for example was seriously going to embark on deflationary policy to defend their peg. Deflationary monetary policy would have massive repercussions in the debt markets. The market has also seen before (twice) that the US is not above defaulting instead upon its gold obligations.

The peg does however create the impression that the CB’s currency is valuing gold, whereas the float clearly demonstrates gold valuing the currency.

Is there some other unmentioned advantage to a peg as opposed to a float that I am not aware of?

Jim Rickards: It’s difficult for companies to plan capital investment if they have no idea what the value of money will be in the future. A fixed rate helps there planning.

I left the discussion there, as there seemed no point in continuing further. Jim clearly had no counter-argument of merit with which to defend his “peg to gold” proposition, and no intention of conceding; I can only assume he has his own reasons for promoting it, as he is clearly capable of grasping the vast superiority of Freegold to his completely unworkable peg (as demonstrated by Victor’s example above).

I did think he had shown his colors more clearly in the same interview on KWN when he stated that any monetary remedy involving gold was for him a PlanB, and that PlanA was, as far as he was concerned, the continuing reign of King Dollar.

Also see the subsequent discussion on FOFOAs block starting with this comment.

Comments

If you have comments, suggestions or corrections concerning this article, please comment here (comments are moderated, and it may take a while until I have time to check for new comments). For the general discussion on the role of gold in the monetary system, please go to the comments section at FOFOA’s and so we do not fragment the discussion.

We know the price of an ounce of gold. Last week, on 3 February 2012, the price of gold was US$ 1734.00 per ounce (London pm fixing). So much about the price. But what is its value?

Overview

1. The Value of Gold versus the Bond Yield
2. Brief Overview of Other Valuation Ratios
3. Commodity Value
4. Warehouses, Term Structure, and the Future Value of Gold
5. Monetary Value And Seigniorage
6. The Undervaluation of Gold and the Self-Destruction of the Gold Standard
7. The Free Gold Value
8. The London Gold Market and the Value of Paper Gold
9. The International Reserve Value
10. Another on the Free Gold Price

1. The Value of Gold versus the Bond Yield

There is one correlation related to the price of gold that has been established rather well empirically. The story of its discovery is somewhat convoluted and reads roughly as follows.

We first need to think about the yield on long-term bonds. Naively, one would expect that the nominal yield on long-term bonds correlates with present inflation or, perhaps more accurately, with the presently expected future inflation, i.e. it correlates with the rate of change of the price level. Alfred H. Gibson discovered in 1923, however, that the real yield on long-term bonds correlated with the absolute price level. His study was based on interest rates and price levels in Britain over more than two centuries! Why would this be the case?

John M. Keynes termed this observation Gibson’s Paradox and called it one of the most completely established empirical facts in the whole field of quantitative economics. In 1988, Robert B. Barsky and Lawrence H. Summers (who later became US Secretary of the Treasury) solved the paradox:

R. B. Barsky, L. H. Summers: Gibson’s Paradox and the Gold Standard, Journal of Political Economy 96 (1988) 528.

The data that Gibson had studied, originated from the time of the gold standard. The effect occurs because at that time, gold had two functions:

• Currency (i.e. medium of exchange)
• Store of Value

In the former function, gold is responsible for the general price level while in the latter function, it competes with long-term bonds.

The market participants decide about the allocation. If future real interest rates are high, the opportunity cost of holding gold as a store of value is high, and most of the gold circulates as currency. As there is plenty of circulating gold, the price of gold in terms of real goods and services is low. Under the gold standard the gold is the currency, and so this means that the general price level is high.

If future real interest rates are low, however, gold is preferred as a store of value and is withdrawn from circulation as currency. As there is little circulating gold, the price of gold in real terms is high. Under the gold standard, this means that the general price level is low.

So the correlation that Gibson observed, namely a correlation of the future real yield on long-term bonds with the present absolute price level was actually an anti-correlation of the future real yield on long-term bonds with the present real price of gold. What is even more remarkable is the observation that the correlation involves the future real yield, i.e. the market is quite efficient and is indeed able to predict the future real yield rather than suffering from inaccurate predictions of price inflation.

In order to test their idea, Barsky and Summers also studied the period after 1971 in which the price of gold in US$ was determined by the market and floated freely. Indeed, the correlation persists as an anti-correlation between the present real price of gold and the future real yield on long-term bonds, confirming their model that resolved Gibson’s Paradox. In other words, even in the absence of a gold standard and in a monetary system in which gold is not currency, gold still serves as a store of value and as such competes with long-term bonds.

One can now take this result of Barsky and Summers and go even further and

• Design a numerical model that uses the known correlation and past prices in order to estimate the future price of gold.
• Observe during which periods of history was the correlation of Barsky and Summers absent, and investigate whether the price of gold was perhaps politically controlled during these periods.

A specific model was presented by Eddy Elfenbein. We also refer to this and this blog article.

Nick Laird and Reginald H. Howe have identified the period since 1995 (their study covers the period 1977-2001) as a period in which the correlation discovered by Barsky and Summers is particularly weak in the data. Coincidentally, Lawrence H. Summers was Deputy Secretary of the Treasury from 1995 and Secretary of the Treasury from 1999 until 2001. Go figure. This period is also known for the rapid expansion of the London gold market. We will come back to this in Section 8 below.

Let us keep in mind that the work of Barsky and Summers yields an empirically well-tested correlation, but that it does not give any information about the absolute price for an ounce of gold.

Before we proceed to more conceptual questions about the value of gold, let us briefly mention a couple of other ideas that one might wish to consider.

2. Brief Overview of Other Valuation Ratios

There are plenty of other ways of valuing gold by comparing it to other quantities, for example,

• Gold might protect against inflation and have a constant real value. This is somewhat supported by data from the gold standard period over long time frames, but in the short run, the price level fluctuated considerably. One can see this in particular in the data set in which Gibson’s Paradox was discovered.
• The ratio of the gold price to the monetary base might revert to the mean. If true, it works only on time scales longer than 50 years. One major problem is that on such long time scales, the monetary system has also evolved, and so we would be aiming at a moving target.
• The ratio of the gold price to the Dow Jones Industrial Average might revert to the mean. The idea has essentially the same status.

Rather than going into greater technical detail as far as such ratios are concerned, let us explore further ideas at the conceptual level.

3. Commodity Value

One might also try to view gold as a commodity similar to copper, iron ore or wheat.

The market for commodities, say, iron ore, works basically as follows. There is a certain supply from mines and recycling; there is demand from industrial consumers; and there are warehouses and trading centres that store a certain amount of the commodity. Note that it is hardly common that the warehouses store more than, say, one year worth of supply.

In order to understand the market for iron ore, you therefore need to estimate the supply and demand curves, i.e. how supply and demand depend on price, and you need some knowledge about the warehouse inventories and capacities. Finally, perhaps you need to study how present price affects future supply and future demand due to investment in mining capacity on one hand and due to substitution by other materials on the other hand. Then you can try to come up with a prediction of the price of iron ore.

The problem is that this model does not apply to gold. Whereas nobody stores more than one year worth of supply of iron ore or wheat, the above ground stock of gold is estimated to be over 130000 tonnes. This is more than 50 times the annual mine production of presently about 2600 tonnes. The price of gold is therefore not determined by the annual mine production and recycling on one hand and by industrial and jewellery demand on the other hand, but rather by the trading of the above ground stock.

This is the reason why studies that view the gold market as that of a commodity, for example the studies regularly published by GFMS and by CPM Group are of rather limited use in understanding the gold market. The situation becomes considerably worse if one takes into account the market for gold denominated bank credit (Section 8 below). In fact, one might claim that these studies are promoted deliberately in order to distract from the true issues at hand.

4. Warehouses, Term Structure, and the Future Value of Gold

Gold is not only traded for immediate delivery, i.e. in the spot market, but also for future delivery. For example, you can today purchase a gold forward contract which guarantees you a delivery of gold at some fixed date in the future for a US$ price agreed today.

The origin of the forward (and the futures) markets was the trading of agricultural commodities, and so let us first think about wheat. Almost all the supply of wheat is brought to the market during the harvest period whereas demand is spread out uniformly over the year. So why would not the price of wheat be extremely low immediately after the harvest and then extraordinarily high right before the next harvest?

The answer is that there exist storage facilities, the grain elevators. Let us say you operate a grain elevator, and your business is well capitalized. Assume that you have spare capacity. When exactly should you buy and for how long should you store the wheat? You ought to watch two prices: first the spot price and second the forward price. In order to stock your elevator, you would buy wheat in the spot market, pay with US$ and receive the wheat immediately. At the same time you would forward-sell the same wheat for delivery at a specified date in the future. On that day, you will deliver the wheat to someone else and receive US$. Since you enter both contracts, buying at spot and selling the forward, simultaneously and since the forward price is determined when you sign the contract, you have no price risk. It does not matter to you if the price of wheat changes while the wheat is in your elevator. You operate a storage facility, but you are not a speculator in the wheat market.

Effectively, you have lent a part of your business capital in US$ to the wheat market and received wheat as the collateral for this loan. Usually, the forward price of wheat is higher than the spot price, and this difference, the contango, is the interest that you receive for lending your US$ to the wheat market. This interest is your business revenue.

It is now easy to see that the term structure of the forward market, i.e. how the forward price of wheat depends on the date of delivery, regulates the inventory levels of the grain elevators. Just in order to maximise their revenue, they will choose to store wheat for those periods over which the contango is maximum. In an ideally efficient market, the contango would thus equal the interest rate on a US$ loan plus the operating expenses and the profit margin of the storage facilities. In other words, in an efficient market, the grain elevators perform term structure arbitrage in the forward market for wheat.

Now you can apply these ideas from agricultural commodities to physically settled forward (and futures) markets for gold, for example the New York Commodities Exchange (COMEX).

If we not only take into account interest rates and storage expenses, but also counterparty risk, we can see that a negative contango (which is called backwardation) in the gold market indicates the counterparty risk that the gold may not be delivered. We refer to a previous article for more details. Backwardation in the gold market would lead to gold being withdrawn from public trading venues because the market makers operate in a fashion similar to the grain elevators and would simply cease to earn any revenue from their operations and therefore shut down their business. As far as we know, this point of view was first advocated by Antal Fekete. See, for example, his articles The Last Contango in Washington and Red Alert. For a connection with our Backwardation … article, we refer to our Red Alert Update. Let us finally note that these ideas about the term structure do not exactly apply to the London gold market because what is traded there is not only physical gold, but also bank credit (Section 8).

5. Monetary Value And Seigniorage

Take a US$ 100 bill from your purse and think about it. What do you think is its value? You can buy US$ 100 worth of groceries with it, and this is already a good answer. This is its monetary value.

Its production cost, however, is probably closer to 50 cents. And should the US$ ever cease to be the accepted currency, all you have is a small piece of cotton blend fabric whose intrinsic value is probably even less than its production cost. During the hyperinflation in Germany 1922-23, when a dozen eggs cost a billion marks, people just carelessly dropped their smaller denomination notes, say of a million or less. When the market closed, the cleaning staff came and wiped up these notes in order to use them as fuel for their fireplaces and ovens. This was the intrinsic value of these bank notes.

So in the language of a value investor, the US$ 100 bill is clearly overvalued. It has a lot of monetary value, but close to no intrinsic value. It is merely a token. A token that expresses the fact that somebody owes you a certain amount of goods and services, according to the prevailing social contract. A contract that may be honoured or may be broken. A pure token that has almost no intrinsic value on its own.

When gold or silver coins are used as currency, one way of managing such a currency is completely analogous. The government purchases gold bullion from the market and mints it into coins whose denomination is such that their monetary value is higher than their intrinsic value. The difference is what was historically called seigniorage. Since this term is sometimes used with a certain technical meaning, we prefer to call it the monetary premium, i.e. the amount by which the monetary value exceeds the intrinsic value. The minted coins bought more goods and services than bullion of the same weight. In this sense, these coins were tokens very similar to our US$ 100 bill.

Well, the difference was that you still had the bullion in case the government messed with the monetary system at some point in the future. But as long as there was a monetary premium, melting down these coins would have been a waste, squandering precisely the monetary premium that had been created when the bullion was minted into currency tokens.

The gold coins that circulated as currency, however, did not retain their monetary premium forever. In the United States, the monetary premium must have been lost well before the 1920s. This is the story of how the gold standard failed, how in fact any gold standard will fail, and finally why the present London gold market still carries the burden of a gold-standard-about-to-fail.

6. The Undervaluation of Gold and the Self-Destruction of the Gold Standard

Before 1933, a part of the US dollar cash circulated in the form of one dollar gold coins, originally intended as tokens of a monetary value that exceeded their intrinsic value. The period immediately before 1933 was a particularly perverse period of the gold standard of the US dollar because the US dollar gold coins must have traded at a negative monetary premium, i.e. at a monetary discount.

In order to understand how this can happen, we need to recall how paper money enters the picture. There are basically two ways of introducing paper:

• The first way is in the form of warehouse receipts. People deposit their gold coins in a vault, and the custodian issues warehouse receipts. These warehouse receipts can then circulate as currency. It is important that the original coins are kept segregated and remain one-to-one associated to the warehouse receipts. These receipts have no credit risk and will trade at the same price as actual gold coins. Strictly speaking, since storage in the vault is not for free, the holder of these warehouse receipts would have to pay a storage fee to the custodian.
• A second way of introducing paper is that some owner of gold coins lends these coins to a bank and receives a credit note, i.e. a tangible bank note, or another form of credit money, for example, an account balance, in return. The bank is free to use the gold coins that have been deposited on their own account. In particular, the bank can lend the coins to somebody else or write further credit notes or account balances against these coins. Both the credit notes and the account balances can circulate as currency.
  Our bank will probably have to offer interest on its account balances and perhaps even on its credit notes. Otherwise, people would not assume the risk of lending their coins to the bank. The interest payable by the bank would equal the risk premium minus storage expenses.
  The credit notes and account balances have credit risk because in case the bank suffers business losses elsewhere, the customers may be unable to redeem their credit notes or account balances for gold coins. Or the bank may suffer from a mismatch of maturities and may be unable to recall an outstanding loan quickly enough in order to allow another customer to withdraw her or his coins.
  In particular in an economic crisis, these credit notes and account balances may trade at a discount, reflecting all these risks. Runs on individual banks will happen occasionally.

Things get really botched up when one tries to make these two sorts of papers equal, for example, by trying to ‘guarantee’ that the holder of a credit note will always receive a gold coin. Such a ‘guarantee’ might be motivated by the desire to avoid bank runs. Several banks might join forces and set up a Federal Reserve that keeps an emergency reserve of gold coins in stock in order to inspire more confidence in the ‘guarantee’. Whereas before, individual banks had issued their own credit notes and one could associate the credit risk of a specific note with a specific bank, the Federal Reserve could issue Federal Reserve Notes in order to remove the link to a specific bank and its creditworthiness.

There is still a problem though. Since the banks have created credit, there exist more credit notes and account balances than gold coins. The ‘guarantee’ therefore rests on a shaky foundation and will ultimately remain unenforceable (unless all credit can be liquidated instantly). In a very serious crisis in which everyone tries to cash in their notes and withdraws their account balances, it would be plainly impossible to deliver on the promised ‘guarantee’ and make enough gold coins available. Also such a run on the banking system would create a credit crunch with serious implications for the real economy.

Let us now come back to the initial remark that the US dollar pre-1933 traded at a monetary discount. In order to see this, we need to take into account another effect of the ‘guarantee’. As long as the system functions and the ‘guarantee’ has not been broken, credit notes and account balances can always be freely exchanged into gold coins and vice-versa. Both therefore trade at the same price. The price is set at the margin.

Obviously, as soon as the banking system creates credit and the credit money, i.e. account balances (for example in electronic transfers) and credit notes (tangible bank notes), circulates freely along with gold coins, all being equivalent at the margin, the total currency supply is a lot larger than the number of actual gold coins. The term currency supply here refers to the total amount of gold coins (currency base) plus the credit created by the banking system. If the currency supply increases faster than GDP, more currency bids for the same amount of goods and services, and so the real value of the currency unit declines. If it declines below the intrinsic value of the gold coin, we get a negative monetary premium, i.e. a monetary discount.

If you are still uncomfortable with the idea that it is the currency supply, i.e. the total volume of monetary base plus credit created in the banking system, that is the primary driver of consumer and asset price levels, we have some mandatory reading for you:

Richard A. Werner, New paradigm in macroeconomics: solving the riddle of Japanese macroeconomic performance, Palgrave Macmillan, 2005.

Richard A. Werner, Towards Stable and Competitive Banking in the UK … (his contribution to the Vickers Commission)

What is important here is

• Firstly that the credit money is generally accepted as payment, i.e. that it circulates as currency.
• Secondly that people trust the credit money and that therefore, at the margin, the credit money trades at the same price as the original gold coins.

Note that before the introduction of nation wide Federal Reserve Notes, each bank had issued their own credit notes, and so the counterparty of the credit risk could always be identified. Also, these specific notes traded as currency only regionally and so they had not fully lead to additional currency supply.

It is furthermore the confidence of the market participants that matters, even if it is obvious that the ‘guarantee’ will ultimately fail and even if there is no law that guarantees that credit notes will be redeemable for gold coins. As soon as there is confidence in the credit money, however misplaced it might be, the currency supply will be effectively larger, and the currency unit may trade at a value lower than the intrinsic value of the gold coin.

In this situation of a monetary discount, it is rational to withhold gold coins from circulation and to spend credit notes instead. This can be seen as a variant of Gresham’s Law. This eventually results in a run on the gold reserve of the banking system. Since all credit money is initially equal as per confidence, or perhaps as per ‘guarantee’, once this trust is lost, the run will not be on a specific bank that is perceived as unsound, but rather on the currency itself. Just as in the period after 1929. Although the Federal Reserve was at that time required to back 40% of its notes with gold, this was still not enough because it did not cover all account balances, i.e. all the credit money that had been created by the banking system.

The claim that the US dollar had traded at a monetary discount before 1933 was finally acknowledged officially by the Gold Reserve Act (1934) which lowered the amount of bullion that corresponded to one pre-1993 one-dollar coin from 1/20.67 of an ounce to 1/35 of an ounce, thus bringing the monetary and the intrinsic value of the US dollar back in line. Well, not quite, because nobody inside the United States had been allowed to keep their gold after 1933. Only in international trade was the US dollar still related to gold. Foreign governments were still able to exchange credit notes for US dollars.

The US dollar actually developed a long track record of trading at a monetary discount compared to its claimed gold value. Gold convertibility was finally terminated even internationally. With the Smithsonian Agreement, although the US dollar was no longer convertible into gold, its value was further adjusted to 1/38.02 ounces and then one further time down to 1/42.22 of an ounce. (This last official price of US$ 42.22 per ounce was never changed – internationally, the United States are still in default of payments at that price of gold). As we have learnt so far, all this was no surprise at all, simply because the banking system kept creating credit, lowering the monetary premium further and further.

Another aspect of gold coins trading at a monetary discount is that it allows interested parties to accumulate bullion at a discount. Rather than purchasing bullion in the free market for which they would have to pay the intrinsic value (which we will call the free gold value below), they can take coins out of circulation and pay only the lower value of the currency unit. Market participants who know that this system will eventually fail and who are aware of the intrinsic value of bullion (let us call them smart money), can accumulate gold at a discount at the expense of the general public and the stability of the system.

Who played the role of the smart money in the past? In 1933, it was the United States Government. They were not very sophisticated, but rather took the gold by force of law. Between 1944 and 1971, it was the trade partners of the United States. Whenever they exported goods into the United States, they received US dollars which were then converted into gold. Settling international balances in gold was the standard procedure at that time, but due to the monetary discount at which the US gold traded, the foreign trade partners of the US received a disproportionate weight of gold. Finally, between about 1982 and 1999, it was Saudi Arabia and China. For this latter remark, we refer to Section 8 on the modern London gold market and to FOFOA’s It’s The Flow, Stupid and Flow Addendum.

The mechanism by which the presence of credit denominated in a weight of gold suppresses the price of gold, is illustrated with a toy model in How Credit Suppresses the Gold Price (with Alice and Bob). In this article, we also discuss proposals to make the gold standard viable such as eliminating fractional reserve banking, ensuring that maturities match, or limiting credit to real bills.

7. The Free Gold Value

In the previous section, we have seen that paper gold, i.e. bank credit that can be exchanged for a fixed weight of gold, regularly leads to a monetary discount, i.e. making physical gold available at a currency price that is below its intrinsic value.

This allows the smart money to take physical gold out of the system at a discount and, in a situation of crisis, renders a run on the currency the rational response. We will come back to this when we discuss the modern London gold market below in Section 8.

Let us summarize

1. If the value of credit that trades as currency, is tied to a weight of physical gold (we call this paper gold), the creation of credit in the banking system leads to physical gold trading at a monetary discount. This will happen as soon as
   • Credit circulates as currency, for example, in the form of electronic transfer of account balances or as tangible bank notes, i.e. credit money is accepted as payment in transactions,
   • At the margin, credit can be exchanged for gold, rendering the prices of both equal.
2. If gold trades at a monetary discount, the rational response to a loss of confidence is a run on the gold that is part of the currency, leaving behind the collapsing credit part of the currency.
3. Furthermore, even before such a loss of confidence, the system allows the smart money to accumulate physical gold at a discount and at the expense of the stability of the entire system because this accumulation drains reserves from the system.

Following the work of Another, FOA and FOFOA who developed the ideas presented in this section, we use the term free gold value for the price of gold that you would get if gold were not tied to credit in such a fashion.

Nobody knows exactly what the free gold value is since the world has not seen gold trade free from credit for more than a century. Even in the absence of a gold standard, the price of gold is presently tied to the US dollar through the London market (Section 8). The International Reserve Value of gold, however, gives us a strong hint (Section 9).

For further thoughts, we refer to FOFOA’s The Return To Honest Money, and for more details on the history of the gold standard, to his Once Upon A Time.

From the discussion in the preceding section, it is quite clear what went wrong during the gold standard: it was the fact that physical gold and the unit of credit traded at the same price. It is quite natural to expect that the free market rather wants to discover two different prices:

• That of a gold coin as a store of value, depending on savings rates, risk tolerances and future real interest rates on competing bonds, etc.
• That of credit notes and account balances, depending on economic prospects, the solvency and liquidity of the issuer, interest rates, currency supply, etc.

If both prices are equal because credit is denominated in a weight of gold and, at the margin, can be exchanged for gold, it is quite obvious that one gets some arbitrage flow, basically a form of Gresham’s Law. If it is possible to accumulate physical gold at a discount, the smart money will attempt to do precisely this, rendering the system unstable by draining its reserves. Eventually, in some crisis of confidence for whatever economic or external reason, the system collapses because the run on the gold in the currency is the rational response for all market participants. Think of 1929-1933 or 1999-2001.

The solution is now also quite obvious:

Never denominate credit in a weight of gold.

More precisely, one has to avoid that any of the credit that circulates as currency, i.e. that is accepted as payment, is denominated in a weight of gold.

8. The London Gold Market and the Value of Paper Gold

Before January 1997, outside a small circle of insiders in the London bullion trading houses, basically nobody had any idea of how the London gold market worked. They traded gold, sure, and they fixed the price of gold, but how big was the market and how did things work at the technical level?

On 29 January 1997, the London Bullion Market Association (LBMA) for the first time published statistics of their clearing volumes. Red Baron has preserved the following article from the Financial Times of London the next morning:

The London Financial Times
Gold global market revealed, THURSDAY JANUARY 30 1997
By Kenneth Gooding, Mining Correspondent

Deals involving about 30 million troy ounces, or 930 tonnes, of gold valued at more than $10 billion are cleared every working day in London, the international settlement centre for gold bullion. This is the first authoritative indication of the size of the global gold market, and was revealed yesterday by the London Bullion Market Association. With the blessing of the Bank of England, the association overturned years of tradition and secrecy to provide statistics illustrating the size and depth of the London market.

The volume of gold cleared every day in London represented nearly twice the production from South African mines in a year, Mr. Alan Baker, chairman of the association, pointed out. It was also equivalent to the amount of gold held in the reserves of European Union central banks. The size of the gold market will surprise many observers, but traders insisted the association’s statistics were only part of the picture because matched orders are cleared without appearing in the statistics. Mr. Jeffrey Rhodes, of Standard Bank, London, said the 30m ounces should be “multiplied by three, and possibly five, to give the full scope of the global market”.

Mr. Baker said the association would produce average daily clearance figures every month. “They will provide a useful benchmark for comparison and analysis of trends in the volume of the global bullion business,” he predicted. He denied suggestions that the move might drive business away from London by upsetting clients who preferred secrecy. “These figures do not in any way affect the confidentiality of the market. While discretion and integrity will always be bywords in the London bullion market, the LBMA is nevertheless conscious of the general call for greater transparency in markets. “The statistics demonstrate the prominence of London in the world of bullion, something we have long been aware of but which until now has been difficult to demonstrate with statistics.”

LBMA members were divided over the move. One said he was puzzled. “What will people make of it?” Another said the exercise was “futile” because it did not give a complete picture of bullion market activity. But Standard Bank’s Mr. Rhodes suggested the statistics would “become the key indicator in the world of gold, providing the numbers by which the market can be monitored”.

Mr. Martin Stokes, vice-chairman of the association, said: “This shows we have a serious market with a lot of depth and deserving of more attention.” The statistics showed, for example, that the 300 tonnes of gold sold recently by the Dutch central bank – a disposal that badly affected bullion market sentiment – was not a large amount by the market’s standards. The association was “making a bid to attract investors’ interest”.

The association also gave details yesterday about the silver market. Roughly 250 million ounces of silver valued at more than $1 billion are cleared daily in London. It also published the results of a Bank of England survey of turnover that the 14 market-making members of the LBMA in the London bullion market conducted in May last year. This showed about 7 million ounces of gold, worth nearly $3 billion, was traded daily by these market-makers.

This official revelation by the LBMA and their regulator, the Bank of England, was the starting point that lead to the contributions by the users Another and FOA first in the discussion forum of Kitco and later in that of Centennial Precious Metals. The press release showed that gold was traded in the same fashion as a foreign currency in the Over The Counter (OTC) market between the major banks and bullion trading houses, completely analogous to, say, eurodollars.

The gold in the vault plays the role of tangible cash, but there are also unallocated accounts which correspond to credit money, i.e. bank account balances. These unallocated accounts are denominated in ounces of gold. The banks can create credit and clients can borrow this sort of credit gold (I have illustrated in a previous article how this works in principle). When a customer has her or his gold account balance allocated, i.e. receives title to individual bars, this is finally analogous to withdrawing tangible cash from the bank account and putting it into a safe deposit box, thus eliminating the credit risk. The Bullion Bank needs to manage their reserve, i.e. the physical gold in their vaults, in such a way that they can honour these allocation requests. Depending on whom they lent credit gold, they may or may not be able to recall these loans quickly enough in order to replenish their reserves.

We have, of course, heard this story before in Sections 6 and 7. This is yet another flavour of paper gold. The unallocated accounts are a form of bank credit denominated in a weight of gold. At the margin and as long as there is confidence in the London gold market, both bank credit and physical gold trade at the same price. One is, however, the tangible asset free of counterparty risk that serves well as a store of value in the long run whereas the other one is merely another form of bank credit. The only difference to the historical gold standard is that the unit of the unallocated gold accounts is no longer the official currency of the United States. The other aspects are completely analogous though.

Before we delve into the matter in greater detail, let us contrast the situation with the eurodollar market which is just a government fiat currency traded by non-US banks as a foreign currency. If there is a loss of confidence and depositors withdraw their eurodollar balances, this run on the eurodollars has the potential to cause a serious credit crunch. Thanks to the fact that the US dollar is a fiat currency and no longer equal to a weight of gold, the Federal Reserve can always avert a bank run on the eurodollar market simply by providing the relevant non-US banks with ample liquidity in the form of currency swaps. So the fiat money does not have the same intrinsic instability as the gold standard. The price to pay for this advantage is the fact that the Federal Reserve may have to increase the monetary base in order to re-liquify the eurodollar market. The London gold market, however, suffers from the intrinsic instability of the gold standard simply because no government department can create additional gold in order to provide liquidity to the market.

In comparing the London gold market to the gold standard, we have already noted that unallocated gold is no longer the official currency of any country. How about the other features of the gold standard? Is the US$ price of gold in the London market lower than its intrinsic value? Does the market offer the smart money an opportunity to accumulate physical gold at a discount to its intrinsic value? In order to answer these questions, we need an estimate of the relevant currency supply, i.e. the aggregate balance of all unallocated gold accounts plus the physical reserve that underlies the London gold market.

The clearing statistics published by the London Bullion Market Association (LBMA) indicate that over 650 tonnes of gold are cleared by the LBMA member institutions each trading day (as of early 2012). According to the World Gold Council, the annual mine production is about 2600 tonnes per year. Even if the full global mine production went through LBMA institutions, that would amount only to 10.4 tonnes per trading day (assuming 250 trading days per year). Per year, the LBMA institutions clear more than 150000 tonnes – this is the order of magnitude of the total amount of gold ever mined. Admittedly, the LBMA is likely to trade not only new mine supply, but also a part of the investment stock, but assuming that the typical owner of physical gold is not a high-frequency trader, these data strongly suggest that unallocated balances dominate the London gold market.

A second piece of information on the ratio of the physical reserve of the London market relative to the aggregate balance of unallocated gold is courtesy to Jeffrey Christian of CPM Group in his debate with Bill Murphy of GATA:

Many banks use factor loadings of five to 10 for their gold and silver, meaning that they will loan or sell five to 10 times as much metal as they have either purchased or committed to buy. One dealer we know uses a leverage factor of 40. (Long-Term Capital Management had a leverage factor of 100 when it nearly collapsed in 1998.)

Finally, the user Another has given a rule of thumb from which we obtain a factor 18.9 as of 7 February 2012 (see Section 10 below).

Let us summarize this section. Although gold is no longer the official currency of the United States, it still exists as an independent currency in the OTC market between the banks and bullion trading houses, a currency that is managed in a fashion completely analogous to a foreign currency: with tangible cash, account balances, the creation of credit, lending, debt, swaps, forward and futures contracts, and so on. Since this currency uses bank credit denominated in a weight of physical gold, it shares the major deficiencies of the historic gold standard:

• If the banking system creates credit, this leads to physical gold trading at a discount to its intrinsic value.
• In a crisis of confidence, the run on the physical gold reserve of the banking system is the rational response.
• It allows the smart money to accumulate physical gold at a discount, draining reserves from the system and further contributing to its instability.

9. The International Reserve Value

We mentioned above (Section 7) that it is difficult to estimate how high is the free gold value, i.e. how high would be the price of gold in the absence of any bank credit denominated in ounces.

We suspect that a large part of the present global trade imbalances are a consequence of the practice that international trade accounts are not balanced by a flow of physical gold as it was the custom during the gold standard before World War I, but rather offset by an opposite balance in the capital account. The reasoning is as follows.

If country A had a trade surplus with country B, then A received B$ (Bs currency) in turn. Country A now has several options. The two extreme choice are

• (a) A spends the B$ in order to purchase physical gold in the market.
• (b) A spends the B$ in order to purchase debt denominated in B$ and issued by counterparties in B.

Choice (a) was the rule of the game before World War I. The consequence of the gold purchase was that gold flowed from B to A. Since the amount of gold in A increased and that in B decreased, the real price of gold, i.e. the price of gold relative to goods and services, therefore decreased in A and increased in B. Internationally, the price of goods and services in terms of gold decided about whether these goods and services were competitive or not. Due to the change in the real prices of gold in A and in B, goods and services from A became less competitive relative to goods and services from B. This was the major balancing mechanism that counteracted the trade imbalances and regulated the trade flows.

In his Once Upon A Time, FOFOA identifies the Genoa Conference of 1922 as the end of the classic rule of the game. With the accord of Genoa, country A was encouraged to keep B$ for the long run. If Bs currency contained credit money, this automatically implied choice (b) above. It is no surprise that this removed the primary mechanism that had balanced international trade flows before. Again, we notice that now debt and gold are commingled.

In order to get some idea of the order of magnitude of the free gold price, let us pretend that international trade balances would still be settled in physical gold. How much gold do the present trade imbalances correspond to? Let us first take a look at the most serious offenders in terms of trade deficits:

• The United States have a trade deficit of more than US$ 40bn per month. At the official US gold price of US$ 42.22 per ounce, this would be 29500 tonnes of gold per month. At last week’s London price of US$ 1734 per ounce, it would still correspond to 715 tonnes per month. The official gold reserve of the US government of 8100 tonnes would disappear in less than one year.
• The United Kingdom has a trade deficit of about £ 3bn or US$ 4.8bn per month. This would correspond to 3500 tonnes (at US$ 42.22) or 86 tonnes (at US$ 1734) per month. Even in the latter case, the official British gold reserve of 310 tonnes would last only for 3 months and 18 days.

These are aggregate figures, i.e. after netting exports and imports. Finally, an example of a major trade hub: Germany.

• Germany exports goods and services for about US$ 125bn per month and imports goods and services for about US$ 113bn per month (2010 figures). At US$ 1734 per ounce, this would correspond to a monthly inflow of 2240 tonnes of gold due to exports minus an outflow of 2025 tonnes due to imports for a monthly gain of 215 tonnes. The official German gold reserve of 3400 tonnes would double in just under 16 months.

With these figures it is rather obvious that, if international balances were still settled in gold (or if they will again be settled in gold in the future!), the price of gold would have to be an order of magnitude higher than today.

As a disclaimer, we should add that we have above focused on the official gold reserves only to illustrate the magnitude of the imbalances. What matters in a real world scenario in which trade balances are settled in gold, is also (and in the long run: primarily) the gold held by private entities, i.e. companies and individual savers.

10. Another on the Free Gold Price

The following information on the free gold price was contained in Another’s postings:

Date: Tue Nov 25 1997 10:06
ANOTHER (THOUGHTS!) ID#60253:

The US$ is today, backed by oil. As all other currencies are but “digital units” tied directly to the dollar, they are indirectly on the oil standard also. This world currency position is supported thru the BIS. In CB circles, it is well known that the world debt markets as we know them, can only be maintained with cheap and cheaper oil! Without cheap oil the entire system fails and reverts back to pay as you go economies. This is the central reason for “two price gold”.

With gold discounted to it’s production cost and below, those that have it can trade it for it’s monetary value. Make no mistake, the BIS knows gold in the many thousands. The future “reset value” of gold is the key. “support the dollar with oil and the currency system works” “fail the currencies and the dollar will come off the oil standard and the BIS will reset gold to $10,000+ with many conditions”

That is why they continue to accept the dollar as a reserve. If Japan or any other COUNTRY sells US treasury debt it’s all over!

Date: Sat Feb 14 1998 19:10
ANOTHER (THOUGHTS!) ID#60253:

[...] Look to LBMA, for currency looking for gold! Compare the Comex average open interest with it’s average daily trading volume. Now use average daily trading volume at LBMA and convert to open interest in London, using comex ratio. Here you will find “real currency” in “paid for” gold derivatives ( not futures ) ! This money is now looking to convert to physical! [...]

Date: Mon Feb 16 1998 14:40
ANOTHER (THOUGHTS!) ID#60253:

So where are we now? I’m’ not sure! How much gold paper is out there? If you look at the comex ratio of average daily volume to open interest, it’s sometimes around 8. Funny thing that ratio is close to the gold commitments traded in London. Multiply, say 40 million ozs by the ratio of 8 and we get 320,000,000 ozs. of gold. Now, the money is in this gold paper, paid up. Just no gold yet, I think? That’s about [VtC: 10000] tons, I’ll be dam! That’s a lot of IOU gold, don’t you think? Add to this, that between the IMF and what CBs could sell, only about 1/3 of it is available at a much higher price, if at all! Then again, I’m not in any position to know this, am I?

The ratio of COMEX average daily trading volume to open interest is the frequency by which the currency supply (open interest) is turned over, i.e. the velocity of the currency relative to the total currency supply. Another’s basic idea is that both COMEX and LBMA have comparable velocities, and so one can estimate the LBMA currency supply from its daily trading volume.

As of 7 February 2012, COMEX Open Interest was 437000 contracts (43.7 million ounces) and daily trading volume was 167000 contracts (16.7 million ounces) for a ratio of 2.6. According to Another’s rule of thumb in his posting of 16 February 1998 and using the daily LBMA clearing volume of 22 million ounces as in December 2011, we get a figure of 1780 tonnes of unallocated gold waiting for allocation.

We should remark that before the collapse of MF Global, COMEX volume was much higher, around 200000 contracts. This would give an estimate of 1500 tonnes waiting for allocation. Finally, if COMEX has changed over the years, for example through the introduction of high frequency trading, but the ratio of LBMA outstanding contracts to daily volume were still 8 as in February 1998, we would get an estimate of 5500 tonnes.

Date: Sat Apr 18 1998 19:18
ANOTHER (THOUGHTS!) ID#60253: [VtC: probably written by FOA]

[...] In this modern world, the current value of every asset is formed by a relationship of gold/currencies/oil. This cross relationship is the “very basis of our modern world banking system”!

Through this basis, all currencies are given value as the local government treasuries hold US$ as reserves. The US$ is given backing as it’s government is guaranteed, that all crude oil, worldwide, will be settled in dollars. An oil reserve backing, if you will. And, the “value” that the “future supply of “currency traded “oil” imparts to the world economy, is guaranteed by an “INTERBANK paper gold MARKET” that values “physical bullion” in the Thousands!

I’ll let Another explain:

But, how can this be, you ask? It is done, “right before your eyes” and we see it not! I ask you, if you have one ounce of gold, and sell it on the market for $300, it is worth $300, yes? Now, what if CB hold one ounce of gold, and sell it twenty times, that one ounce is now worth $6,000, no? The difference between you and CB? The persons that hold “interbank” IOU for gold, value it at the multiple of leases/sales made against reserves. This leverage, it is held for performance on bank part. The BIS, it force performance, on any economy! You ask Korea about gold, yes?

This is why oil can take a small amount of physical gold out of world supply, at current “freely traded”, “managed prices”, and hold it at a many times valuation. That is what gives this “new world gold market” much value in trade at high levels. Look even at your “Comex”, and divide the daily volume by the “eligible stocks for delivery”. That number ( perhaps three million ounces divided by 150,000 stocks, deliverable, times the spot close gives close, real world price of physical, $6,000. It follows close to paper trade on LBMA.

You see, “physical gold is of much greater value than public traders can move it for”! In your world, this cannot be, but it is, and will show for all to see in your time.

After some discussion at FOFOA’s blog, we think that Another here rather wants to divide the COMEX open interest (not daily volume) by the COMEX registered (not eligible) inventory. This would be an estimate of the inverse reserve ratio at the COMEX. The point is that the registered inventory is the part that can be immediately delivered on long contracts, but the eligible part is largely owned by others and just happens to be stored in COMEX warehouses.

Again, it is Another’s idea that the COMEX reserve ratio is comparable to the reserve ratio at the LBMA, and there the ‘open interest’ actually represents buyers that have fully paid for unallocated gold and are waiting for allocation. So one unit of physical reserves supports a multiple in currency and would therefore be worth the corresponding multiple in US$ terms if there were no credit gold.

As of 7 February 2012, the ratio of the COMEX open interest of 47.3 million ounces per COMEX registered inventory of 2.5 million ounces (6 February 2012) is 18.9. This gives an estimate of US$ 32700 per ounce for the free gold price. Of course, a run on the LBMA would have its own dynamics, and most international trade balances are still not yet settled in gold.

Finally, combining both estimates, we get a rather rough picture of the present physical bullion reserve of the LBMA instiutions: between 80 tonnes (with our low estimate of 1500 tonnes in open interest) and 290 tonnes (with 5500 tonnes).

Just for fun, we have calculated the analogous figures for silver.

Acknowledgements

Many thanks to Robert LeRoy Parker for his help in fixing some inaccuracies in the article. We are also grateful to FOFOA and Motley Fool for the somewhat heated debate at FOFOA’s which helped to sort out the correct way of reading Another’s estimates.

Comments

If you have comments, suggestions or corrections concerning this article, please comment here (comments are moderated, and it may take a while until I have time to check for new comments). For the general discussion on the role of gold in the monetary system, please go to the comments section at FOFOA’s and so we do not fragment the discussion.

For much of 2011, the COMEX silver futures market has been in backwardation. Similarly, the London OTC silver forward market is in backwardation as reported by the London Bullion Market Association (LBMA). Figure 1 shows the Silver Forward Offered Rate (SIFO) from November 22, 2010, to May 19, 2011.

Figure 1: The LBMA Silver Forward Offered Rate (SIFO) 2010-2011

 
We see from Figure 1 that the contango of the LBMA silver forward market collapsed on January 19, 2011, and silver has been in backwardation ever since – with the exception of about 4-5 weeks in March and April. For more background, please take a look at Backwardation in The Case of a Monetary Metal.

In this article, I briefly explain why it is perfectly natural if

• COMEX inventories are declining,
• Silver is being moved from the registered to the eligible category,
• Silver deliveries occur as late in the delivery period as possible,
• Silver deliveries suddenly appear out of nowhere and are checked into the registered category only at the last minute before delivery,

as long as silver is in backwardation. None of these indicates that there is a shortage of physical silver or that there is a short speculator about to default.

Managing Inventory

In order to understand COMEX inventory, it is helpful to take the point of view of a COMEX dealer or of a market maker. We have a fixed capital to operate with, we do not care about whether prices rise or fall, but we wish to book as many transactions as possible. What is expensive about our transactions is moving actual physical silver. We therefore prefer a large inventory which always stays in the same vault and on which we write warehouse receipts that change hands when our customers trade. The bigger the inventory the smaller is the amount of physical silver we have to move around and the more profitable we are.

Given our starting capital in US$, how do we initially get our silver to operate with? The answer is that we can borrow it from the market. We buy silver at spot and sell the futures contract maturing in, say, one year. This is a synthetic swap of US$ for silver: we lend our US$ for one year and accept silver as the collateral. This is the silver that goes into our vault as our initial inventory.

For the above argument, it does not matter whether this synthetic swap is the way we actually get our silver. It is sufficient that we could have done it this way and, by arbitrage, any other way of getting the silver would be equally expensive. Expensive? The swap is usually a good deal for us. As long as silver is in contango, i.e. the futures contract trades at a price higher than spot, we receive interest on our swap because we sell the futures contract and buy at spot. This interest is the market interest rate on a US$ loan that is collateralized with physical silver. Not only can we borrow physical silver from the market, we are even paid for it! We can use the interest we receive in order to fund our vault operations and to cover other operating expenses. With silver in contango, we can basically carry an inventory as large as we please.

The situation changes entirely when silver is in backwardation. With backwardation, we have to pay interest in order to carry our silver inventory. In the example of our synthetic swap in which we buy silver at spot and sell the future, we now pay a higher price for spot silver than the price we realize when we sell the future. With silver in backwardation, keeping inventory costs us money. We therefore have to compromise and reduce our inventory as far as possible without hampering our transactions.

We can summarize the situation and say that for a dealer or market maker, the opportunity cost of holding physical silver as opposed to US$ cash is the negative of the contango. If silver is in contango, it is therefore preferable to hold physical silver whereas if silver is in backwardation, it is preferable to hold a cash balance.

This consideration explains why COMEX inventory decreases when silver is in backwardation. It also explains why inventory is moved from the registered category (the dealers’ inventory on which warehouse receipts circulate) to the eligible category (inventory that is owned by somebody else and just left in the COMEX vault system for convenience).

When to Deliver on a Short Position

Let us now think about the delivery process. Every holder of a long contract who still has his position open on First Notice Day, must fund the contract in full and must be prepared to take delivery. Every holder of a short contract must either close it and buy it back or must deliver by Last Notice Day the latest. It is the holder of the short contract who decides about the precise date of the delivery.

Now imagine we are a speculator or a mining company, we own a large position of physical silver, and we are short the futures contract and prepared to deliver on our contract. When do we choose to deliver? We are free to select any day between First and Last Notice Day. Since we locked in the price when we sold the contract some time ago, at first it seems that this choice would not matter. But let us think about every single penny.

If silver is in contango, we would probably deliver as early as possible just because we can then save the storage fees if we get rid of the silver rather soon. But with silver in backwardation, this decision changes as well. We could postpone our delivery as long as possible and might still be able to lend the silver to someone else against a US$ collateral in the meantime. With silver in backwardation, we would receive additional interest on such a swap.

This consideration explains why in a contango situation, the holder of a short position has an incentive to deliver early whereas under backwardation, they have an incentive to deliver as late as possible.

Conclusion

Given that silver is in backwardation and assuming that every participant maximizes their profit, we have explained why inventories shrink and deliveries occur as late as possible. Indeed, both effects are observed. It would be wrong to interpret these observations as a shortage of physical silver or the impending default of a short speculator.

What these observations do not explain, however, is the reason why backwardation has occurred in the first place. For this, please take a look at Backwardation in the Case of a Monetary Metal.

In the following, I explain why I think the answer is no.

What exactly is meant by synthetic supply? Let us interpret this term in a broad sense as any measure which makes the market for gold look bigger than the market for physical gold actually is, or any measure which tempts people to trade a substitute for physical gold instead of the real thing, a substitute which can be supplied in larger quantities.

Let us assume we are a large financial institution, we have some physical gold, but we wish to create a much bigger such synthetic supply. Which choices do we have?

1. The brute force method. We sell short more gold than we own

If we wish to do this with physical gold, we can use the commodities exchanges and sell futures contracts, write call options or purchase put options. We would sell short more gold than we have actual physical. If we have gold in an unallocated account with a bullion bank, we can also use this strategy and sell more forward contracts than we have unallocated gold.

This strategy is profitable if the price of gold is in a downward trend such as the period from 1995 to 1999. In fact, it is very likely that this was indeed done as part of the so-called gold carry trade. The gold carry trade consists of borrowing gold, selling it for US$ in the spot market and investing the proceeds elsewhere. The position is closed by buying back the gold in the spot market. This strategy has a positive carry as long as the forward or futures market is in contango and borrowing gold is cheaper than borrowing US$, but it has the obvious exchange rate risk if the price of gold in US$ rises while the carry trader is short gold.

When the downward trend in the price of gold stops and reverses such as it did between 1999 and 2001, however, the carry trade starts losing money and we will have to unwind it. Depending on how crowded the trade was, this may become difficult because everyone will run for the same exit. In fact, it is very likely that some of these carry trades indeed ‘blew up’. The signature of such an event is a sudden drop in the Gold Forward Offered Rate (GOFO) a few of which can indeed be found in the historical data as we have seen in a previous article.

Since 2001, the price of gold in US$ has been in a strong and steady upward trend. Shorting gold against such a trend, except perhaps as a technical trade for a very short period, would be financial suicide. We would probably not even find any bullion bank who would enter such a forward contract with us, simply because they know we would blow up. Of course, we can still sell futures contracts at the COMEX, but we would keep getting margin calls and would burn more and more capital.

So is it plausible that any significant synthetic supply is being created by systematically shorting the forward or the futures market? If anyone has been doing this, they must have lost hundreds of billions over the previous ten years. Very unlikely.

2. The elegant method. Unallocated accounts

If we are a member of the LBMA and if we offer unallocated gold accounts to our customers, then creating synthetic supply is straightforward. We just need to find somebody who is willing to borrow gold, and we are in business. For example balances sheets of how this works, please refer to this previous article. Update (20 March 2012): For further examples on how synthetic supply is obtained by creating credit, we refer to How Credit Suppresses The Gold Price.

The only limitation is our reserve ratio, i.e. the ratio of gold we lend per physical bullion in our vaults. If this ratio is stretched too far, we risk a run on the bank.

The beauty of lending gold to unallocated account holders is its simplicity. It works just like conventional commercial banking in US$, except that we are not required to hold a banking license (because we do not create credit in a legal tender currency that is regulated by a government. In legal terns, unallocated gold accounts are just derivatives on a commodity). The downside is that there is no guarantee that one of the central banks helps us out when our customers run on the bank and try to withdraw physical gold.

3. Other ways of lending gold

In addition to lending gold to an unallocated account holder, we can also lend gold to the general market. With physical gold, we would sell physical gold for US$ and purchase a futures contract in order to buy it back at some point in the future. But we can lend physical gold only if we have some. With unallocated gold that we hold in our account, we can enter the analogous transaction. We sell it in the spot market and purchase a forward contract. Again, we can lend only what we own, but not create any new supply.

Summary

Apart from entering a high risk naked short position, the only way of creating synthetic supply is the lending of unallocated gold while we hold a physical gold reserve only for a fraction of the amount that we lend. This is completely analogous to the creation of US$ in the commercial banking system.