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 To some degree this loss from the market has been
replaced by newly mined gold and scrap, but the size of the market is such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.
Alasdair McLeod
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