Gerald Croteau's Weblog

Gold is obviously in the midst of a bull market. Here is the Eric Janzszen from iTulip.com perspective.

During the period from after WWII until the U.S. abandoned the international gold standard, food prices remained steady while personal incomes increased. Then, from the late 1970s and again since 2000, food prices increased faster than personal income. That inflation era is seared into the memory of anyone who was high school age or older at the time. Since late 2007, personal incomes plunged while food prices, after a brief decline, continued to rise — no wonder we have 40 million Americans on food stamps. Today’s inflation is experienced more by lower income groups rather than society as a whole. This disparity will be relevant in future elections and is likely to result in demands for compensatory tax cuts for lower income groups and higher taxes at the top.

A well engineered asset price inflation is a political checkmate for its instigators and beneficiaries. Politicians whose elections are financed by the investment banks that trade in asset price inflation, such as the sellers and raters of mortgage securities — the asset price inflation industries of the FIRE Economy — turn their sometimes opponent, sometimes friend, the central bank, into an agent of wealth transfer by forcing them to either directly bear the risk of loss or take responsibility for the collapse of the financial system. Only the issuer of the world’s reserve currency can behave this way and get away with it, although I’d argue that this last time was the last time.

Spain’s is an example of a poorly engineered asset price inflation by a country that is not the issuer of the world’s reserve currency. The result? An economy in recession and 20% unemployment. Now Spain’s creditors demand austerity, as if the nation was flying high on an inflationary boom. Far from it. Austerity programs sink over-indebted countries by reducing economic output and the ability to repay debt. Default now and get it over with, is my advice, because once the IMF is done with you and the capital and entrepreneurs leave, there will be no one left but the oligarchs to run things.

If government spending in response to financial crisis is the primary source of currency risk today, who is the source of demand for gold as a currency hedge that is driving gold prices to new highs?

The great central banking paradox

Central banks are in theory politically independent from national legislatures, but not insulated from government largess. To protect themselves, they hold gold.

Who are the world’s largest gold hoarders? Governments.

Central bank holdings of 31 countries plus the IMF with gold reserves in excess of 100 tonnes each

I found this most curious of all the facts I came across back when I did my original research into gold in the late 1990s before taking a 15% gold position in 2001, a year after liquidating technology stocks in the spring of 2000. All of the papers written by economists on a central bank payroll asserted that gold no longer had any role as a monetary unit backing any national currency—not dollars, nor deutschmarks, nor yen.

Gold was unplugged from the global monetary system by the Fed in 1971 like a toaster on fire when the US found itself unable to make foreign debt payments in gold. Yet even as I’m reading these central bank protests against gold in 1998 the Bank of International Settlements data show that three decades after spurning it central banks still owned 25% of all of the gold ever produced since the birth of Christ. And not only a few of them held a metal they professed to be of no value as money, but nearly all of them did so, and still do.

Now, most articles you’ll read about gold claim that it is just a commodity whose value is levitated artificially above the level justified by jewelry and industrial demand by the religious fervor of mystics and fruitcakes known as “gold bugs.” The theoretical price of gold as determined by demand for industrial uses is the real and rational price and the incremental price produced by the demand for gold by gold bugs is an unreal and irrational gold bug premium, so the argument goes. Once the magic disappears and rationality returns, the gold price will collapse along with the gold bug premium. Maybe by 70%.

The first to put a version of this argument forward was Chairman of the Bank for International Settlements William White. In 1972, a year after the international gold standard ended, he proclaimed that gold without central bank demand as a monetary asset was free to fall from its then fixed price of $35 to its true market value as an industrial commodity to “…around $7.50 per ounce.” Then, over the eight years that followed, the gold price proceeded to rise to more than 100 times the Chairman’s price forecast. Gold has proved similarly uncooperative since 2001, rising more than four fold despite dozens of articles by various flavors of William White since then predicting an imminent price collapse.

Gold cannot be “just a commodity” if gold is the only metal owned by central banks

Central banks don’t own silver, or platinum, or copper, or lead, or aluminum, or zinc, or nickel, or any other metal for that matter but only one metal, gold, and not a few pounds but 30,000 tonnes of it. So the next time you come across the uninformed opinion that gold is a commodity like platinum and over-priced due to the irrational enthusiasm of crackpots, kooks, and cranks, remember that gold is the one and only commodity owned by central banks and in monumental quantities. Literally.

Why do central banks still own gold? I wondered back in 1998. Why didn’t central banks sell the useless yellow metal and use the proceeds for more constructive purposes than hoarding?

So I began to look for a credible explanation for this apparent contradiction. The only argument I could find that had any merit was that central banks did not want to disrupt the gold mining industries of gold producing countries, such as South Africa’s, where Brazil is playing North Korea not talking rabbits from Burundi at the World Cup is as I write, by dumping large quantities of gold onto the global market.

The argument is not baseless. Even if central banks dis-hoarded the 36 thousand tonnes of gold reserves they had in 1971 at the rate of only 1% per year, that represented 25% of the 1,500 tonnes of total gold production that year. The sudden addition of 25% to the supply in any commodity is guaranteed to depress the price, unless demand picks up to absorb it. And even if central banks maintained a rate of sales of 25% of production for the past 30 years, by 2001 they’d still have 22,000 tonnes of the gold left. Selling that much gold without wrecking the gold market for gold producers and exporters indeed appears impossible.

Since 1971 when the international gold standard ended, central banks have managed to sell off more than 6,000 tons, and approximately 2,500 tonnes of reserves, or about one year of global production, since 2001 when we took our gold position.

That works out to 10% of annual production, in rough numbers. Yet over that nine-year period, the price of gold increased more than four fold. Presumably if sales increased several times that average since 2001 the gold price might not have gone up as much, but the assertion that central bank divestiture of gold cannot be accomplished without materially undermining gold producers is not supported by recent history.

Even as central banks lightened their load of gold since 2001, not everyone sold, particularly since the start of Gulf War II in 2003.

China and Russia have been major gold buyers since 2003

From a geopolitical perspective it doesn’t take a rocket scientist to understand why China and Russia in particular started buying gold while other counties, though not the US, sold it since 2003: as the largest lender to the US, it is imprudent for China to not insure against the risk of a devaluation of America’s $60 trillion and growing contingent liabilities. The fact that the dollar is a reserve currency is the one and only reason that the dollar has not already weakened precipitously. Primarily via swap agreements and purchases of dollar denominated debt, foreign lenders have kept the U.S. government and its currency afloat. The dollar is not a market-priced currency any more than the U.S. housing is market priced. The latter is a ward of the state, 90% maintained by government subsidies of the mortgage credit market, and the former by foreign and domestic subsidies, by official and “private” sources, of the U.S. government credit market.

Central bankers worldwide are in the awkward position of needing to profess 100% confidence in a hopelessly flawed and outdated international money standard while simultaneously hedging its potential demise with a reserve asset that they claim to have abandoned nearly 40 years ago. On the one hand they are all-in on global monetary system based on a fiat currency issued by a single nation with a declining global output share, an unsustainable structural fiscal deficit, $60 trillion in total contingent liabilities, and dependence on asset price inflation for economic growth, with no path out of any of them under a political system dominated by special interest. On the other hand they have to hedge the risk that some day systemic flaws are expressed as a currency crisis. The only way to do that is with the only international currency in existence that does not have national origins: the fourth currency, gold.

Who’s got the gold?

At north of 8,000 tonnes, the United States government is by far the world’s largest gold hoarder. By way of comparison, the 484 total pallets of $100 bills shipped from the Federal Reserve Bank of New York to Iraq on C-130 transports in 2003 were worth $12 billion and weighed only 363 tonnes, according to a Majority staff memorandum to the House Committee on Oversight and Government Reform, Feb. 6, 2007. If the pallets were piled with gold instead of $100 bills, at 363 tons they’d carry 11.7 million ounces. That works out to $14.4 billion at today’s $1,233 per ounce gold price but only $4.2 billion at the 2003 price of $363 when the payment was made, the authorization and use of which remains a mystery. Since then, a pallet of $100 bills has plummeted from a value of three times its weight in gold to 83%. The decline is not coincidental. That $12 billion was minuscule compared to the trillions squandered on war and financial mishaps since. The Iraqis should have demanded the $12 billion payment in gold. Today they’d have $41 billion.

This leads us once again back to the one and only rational explanation why so many central banks still hold so much gold so many years after official use of gold to settle international payments ended.

Gold is the one and only pure-play insurance policy available against a disorderly disintegration of an outdated, US-centric global monetary order straining under the weight of government debt taken on to keep angry voters off the streets. Gold remains on the balance sheets of central banks as insurance against a global currency crash. As long as it does, it remains on our personal balance sheets, too.

Countdown to crisis

As the risk of the kind of currency crisis that gold insures against rises, so does the price of that insurance. When we bought gold in 2001 the market priced the risk at $270, and as of today June 18, 2010 at $1,259. This year central banks became net buyers.

Gold prices do not float on a sea of liquidity, as Ruchir Sharma claims. They float on a sea of dangerous fallacies — that asset bubbles don’t cause lasting damage to economies, the Keynesian multiplier, that the U.S. can continue to borrow to finance its fiscal deficit, and the invulnerability of the dollar as a reserve currency.

We are not willing to bet against global central banks. They’re betting on gold. We don’t blame them, and everyone is catching on.