Alasdair Macleod – 18 August 2010
Central banks have routinely manipulated the gold market since the beginning of fractional reserve banking, but they have always eventually failed in their quest. This time there is circumstantial evidence that we could be on the verge of the most spectacular failure so far.
Physical bullion differs from other investment media because today there is no secondary market. Buyers of bullion are not speculators, or even investors: they take delivery, hoarding it from the market, and are not tempted to resupply it at any price. To some degree this loss from the market has been replaced by newly mined gold and scrap, but the size of the market is such that gold from these sources is now insufficient for hoarding demand. So when the bullion banks try to shake out the bulls, as they have recently, they may manage to reduce their short position in the paper markets; but the lower prices for bullion simply generates extra physical demand. The result is that the size of the paper market has become increasingly dangerous relative to the physical gold actually available.
A fascinating insight into this process is recorded in an interview of one of the leading American coin dealers, who described how the fall in the gold price in 2008 from $1,000 to $700 was the opportunity for hoarders to clean out the market. I quote:
…all product worldwide disappeared. Within weeks the U.S. Mint was shut down. The Canadian, Austrian, and Australian Mints were all eight to 12 weeks back-ordered or shut down. The Australian Mint stopped taking any new orders in July or August for the rest of the year. The Rand Mint, for the first time ever, sold out of all its product. One wealthy Swiss businessman flew his own 747 there and cleaned them out.
The interview, which is well worth reading in its entirety, can be found here. It is particularly apposite given the recent shake-out in the futures market, raising the question, how much physical disappeared in the process? Not surprisingly, the interviewee is also worried that rising prices will merely generate yet more demand; so the absence of a secondary market is crucial to understanding the problem facing central and bullion banks today.
For the last fifteen years the European central banks have led attempts to keep the price down. In the last ten years alone, this cartel has officially sold about 3,800 tonnes, all of which is now effectively hoarded. On top of this, they have leased unrecorded amounts of their gold, all sold into the market and now irrecoverable – and still the hoarding continues.
Leasing has had one over-riding purpose, to swamp demand. Thirty years of leasing has fed the hoarders, and provided the feedstock for the futures market, where the bullion banks are also short on their trading books a net 718 tonnes today. This has been going on so long, everyone has become complacent. The result must be the accumulations of the largest short position ever on the bullion banks’ unallocated accounts and on Comex, where logic suggests they should hedge, rather than compound their short positions.
Some interesting research by Adrian Douglas suggests that the operational gearing on unallocated accounts is as much as forty five times: in other words the bullion banks only have one ounce of gold for 45 ounces of customer liabilities. If this is even half correct, the implications are frightening. In the absence of a secondary market for physical, just a small rise in prices leaves the bullion banks dangerously exposed.
These conditions are obviously explosive; but why does it matter, other than for reasons of hoarders’ self-protection? Well, central banks are going to have to rescue bullion banks or let them go to the wall. So far, they have always managed to conjure up a rescue, but now that their ammunition has almost run out a covert rescue is very difficult. The task is made more acute by growing instability in both general banking and the global economy. Worse still, the increasing possibility of unrelated systemic failure is fuelling the incentive to hoard.
So here is a major banking crisis in the making, mainly as a result of the central banks’ continual attempts to rig the market finally coming to a head. It is a time when the whole idea of a world monopolised by fiat currencies is losing credibility. Fears of deflation currently dominate central bankers thinking. They dare not address the risk of inflation and nothing would suit central bankers more than the ability to print money without inflationary consequences.
But talk of deflation is intellectually sloppy. It is based on the Irving Fisher theory that falling asset prices lead to a price collapse. This is certainly true of collateralised assets, but that is as far as it goes. The argument does not extend to the means of production, being raw materials and labour. It is true that an asset implosion will affect demand for raw materials and labour but this is a secondary effect and not an even one at that.
The risk of an asset implosion is tied to economic performance. If the recent global trend of failing demand and credit contraction persists, government finances everywhere will rapidly deteriorate. A renewed slump also brings systemic risks. This cannot be permitted, so the monetary imperative is to print, print, print. The effect is simply to undermine the value of fiat currencies, which will be dumped by foreign creditors; and with no reasonable amounts of bullion available, they have no alternative but to stockpile commodities and raw materials instead.
To illustrate the point, China is reducing her exposure to dollars by selling them to buy commodities. The common assumption is that this is only because she is stockpiling to satisfy her own future demand. There is some truth in this, but any asset allocation has to take account of the alternatives: in this case the unattractiveness of holding dollars. Furthermore, selling dollars and buying other paper currencies generates little enthusiasm. Through currency intervention, China is able to acquire depreciating dollars and turn them into metal and oil. She does this because no one will sell her enough gold to replace her dollars. Looked at this way it becomes apparent that a rise in the dollar price of gold becomes a threat to the dollar itself, since gold is the leading proxy for a general basket of commodities.
The threat extends to all fiat currencies. It becomes only a short step for creditor nations such as the Chinese to look upon all their forex dealings in commodity terms. It is thinking like this that the Western central banks are desperate to play down, since it completely undermines their position.
But what can they do? We can rule out a deliberate sharp rise in interest rates. Other than cover up the problem, there is now virtually no solution. Quite simply, there is so little ammunition left that further expenditure of what bullion is still available merely exposes the underlying weakness of the central banks’ position. The central banks’ banker, the Bank for International Settlements, recently made available 346 tonnes to the market, all of which smartly disappeared into the hoarders’ hands. It stank of a last-ditch attempt, and achieved little more than the temporary concealment of yet more hoarding.
The bullion banks can only have become so uncovered on their unallocated accounts with the encouragement of the central banks, since their exposure appears to exceed the maximum fractional reserve basis of ordinary lending by a factor of four. So from a regulatory point of view, no one is looking. The result of a combination of excessive gold-related credit and lack of regulatory oversight has much in common with the events that led to the credit crunch in 2007. The result can be expected to be similarly violent.
What we don’t know today is whether a broader systemic crisis will tip the gold price towards infinity, or whether a gold bullion crisis comes first, triggering a wider systemic collapse. It is too close to call. Either way, it should be spectacular.