by Gary North
It has long been a standard policy of central banks to sell gold and invest the money gained in interest-bearing securities, which are usually government bonds of their own national treasuries.
These sales are non-inflationary. They do not represent an increase in the monetary base. The increased holdings of Treasury bills are offset by the reduction in gold holdings, which also serve as monetary reserves, i.e., high-powered money. Nothing changes with respect to the money supply.
These sales are applauded by those politicians who believe academic monetary theory, whether Keynesian or monetarist — a small group, indeed. Nobody else in government pays any attention.
Gold is regarded as a dead asset or an unproductive asset because it doesn't generate interest. (I mean interest as money, not interest as public awareness.) It just sits there, gathering dust.
If a central bank leases gold, this also doesn't change its monetary base, since the central bank pretends that an IOU from a private "bullion bank" — a bank that sells off all of its borrowed bullion — is equal to gold bullion in the vault. Therefore, the lease is not treated as a sale. The IOU for gold is as good as gold, legally.
A problem arises when gold's price rises in the nation's currency. This calls into question the ability of the bullion bank to enter the gold market and buy gold, so that it can repay the gold it borrowed from the central bank, which the bullion bank has promised to do one of these days, Real Soon Now. If the bullion bank cannot repay the loan, then its IOU is publicly exposed as not being as good as gold. If the central bank were to press the bullion bank for repayment, rather than rolling over the loan, then the bullion bank could go bankrupt, which would reduce the value of its IOU's to something less than face value. This would create a legal crisis for the central bank, which would lose reserves on its books.
What would a central bank do then? Simple: buy more government bonds to offset the reduction in gold reserves.
The main problem would not be the lack of repayment but a lot of unwanted public interest. "What did the central bank do with our gold?" A default by bullion banks would be a public relations problem, not a monetary problem.
To forestall this PR problem, central banks are prepared to sell off more gold to keep its price down. This will enable the bullion banks to continue to draw interest from the investments they made with the money they generated by selling the leased gold.
Everyone is happy, except for people who think that government currencies should be backed by gold, something that has not been true ever since Roosevelt issued his executive order to confiscate Americans' gold. The number of people who feel this way are few and far between. I am surely not one of them. For almost three decades, I have called for exactly what is happening: the sale of stolen gold by central banks to the public, in order to get gold back into private hands. I even had an article published in The Wall Street Journal in the 1970's that recommended this. The gold should be in private hands. Gold is too important to be left to the discretion of central bankers.
Oddly, there are conservatives who don't believe this. They trust central bankers. They think central bankers are not agents of the national government. They think the government can be trusted to fulfill one (and only one) promise: "Bring in an IOU for gold at any time, and your government will give you gold." The more times governments default on this promise, the more strongly certain economists (few in number) assert, "Next time, it will be different."
Fools and their money are soon parted, but economists are always with us. They are there to encourage the next generation of fools. That's the way the world works.
ANOTHER THREAT TO SELL GOLD
An article by the Financial Times's Kevin Morrison appeared on July 23. In it, we read:
Europe's central banks are expected to extend their four-year-old gold sales agreement when it comes up for renewal next year.
The low returns to be made from lending gold to market participants hedging forward sales and the budgetary pressures on Germany and other leading economies will encourage the banks to continue sales of the precious metal.
This seems a bit odd. The low returns made by gold mining firms that have promised to deliver gold at a fixed price should be of no concern to central bankers. Why should central bankers care one way or the other?
Of course, they don't care about gold mining profits. They care about the bullion banks' inability to repay in gold. They care because defaults by bullion banks could create a PR problem for central bankers. Bureaucrats don't like PR problems. So, they don't want gold's price to rise.
The banks will also want to retain the stability of the gold price created by the restrictions imposed by the sales pact.
The current agreement, which expires in September 2004, allows for 400 tonnes of gold to be sold each year. One central banker told the Financial Times recently that he thought there was room for an increase in gold sales.
Anonymous central bankers tell the media the same story every time gold's price rises. I mean, it's not as though it would be a good idea for a central bank to own an asset whose price is rising. What kind of speculative nonsense is that? "Buy low, sell low" is their motto. Well, sort of. "Buy low, lease low, get stiffed" is closer to it.
Some analysts expect the new pact to allow the sale of 500 tonnes a year over a five-year period, or 2,500 tonnes in total. This would allow additional banks — from Greece and the European Union accession countries — to join.
The original arrangement was signed in September 1999 in response to increasing concerns that unco-ordinated central bank sales of gold were adding volatility to the market and pushing prices lower.
Are you following this? They worry about a repetition of 1999, when gold sales pushed prices lower. You may also recall Mr. Morrison's explanation, presented in paragraph two, for the need to sell gold next year because of "The low returns to be made from lending gold to market participants hedging forward sales. . . ." So, let's see now: the banks sold gold in 1999, lowering its price, thereby making a potful of money for the mines that had sold gold forward at a fixed price, which had been higher. But now they worry about a replay of that event, while, simultaneously, they worry about the absence of profits for forward-selling gold mines.
Mr. Morrison dutifully reports all this. No bells went off it his mind. Nothing said, "does not compute!"
The gold price fell to a 20-year low of $252 a troy ounce when the Bank of England announced its gold sales in the summer of 1999. The current pact has proved successful in adding order to the market.
Order? What exactly is order? A stable price? This is not what we have seen so far.
Gold rose to about $320 shortly after the agreement was reached. After a brief subsequent fall it has risen steadily for the past two years.
He then added more information.
Although the gold price has firmed, the rate central banks can charge borrowers such as gold miners — which use it to hedge forward sales of the metal — has fallen. The miners have needed less gold as they have unwound their long-term hedge positions.
He is saying that some gold mines have borrowed gold from the central banks at low interest rates, so that they could unwind — i.e., deliver — their forward sales obligations. Let me get this clear. The mines had debt positions — promises to deliver gold at a higher price — which became less profitable when gold's price rose, so they borrowed gold from central banks to pay off their gold debts. That is, they took on a debt in gold to pay off a debt in gold. This is called "unwinding."
You bet it is! The forward gold contracts were made in a free market, where those who are owed gold on a fixed date can bring gold mining officials into court for payment if the mines don't deliver physical gold. In contrast, gold leasing debts to central banks are assumed to be open-ended, never to be repaid, only rolled over.
One-month gold deposits rates are zero, against more than 3 per cent at the time of the agreement.
Now, that's a deal. Borrow gold at 0 percent, sell it, take the money received by the sale, lend it to someone at some rate of interest, and pocket the money. Nice work if you can get it. There is only once catch: the price of gold could go up. But bullion bankers don't seem to care. Why not? I suggest this reason: they know they will not have to repay. At worst, the loans will be rolled over at low, low rates. Nice work if you can get it.
Germany will play a key role in any future agreement. Gold accounts for an estimated two-fifths of its foreign exchange reserves.
It is the largest holder among the 15 signatories to the gold agreement, whose members, all European central banks, hold about 40 per cent of the world's official gold reserves.
The central banks hold 22 per cent of the 147,000 tonnes of the world's gold that is in circulation, in the form of jewelry, in industrial uses and in official or investment holdings.
Morrison quotes Matthew Turner.
"However, there are also ways that funds can transfer from the central banks to the treasury, such as dividend payments," said Matthew Turner, an analyst at Virtual Metals, a consultancy.
Germany would be motivated to sell gold because it could probably earn a better return from a switch to other investments, he noted.
Well, yes. And if Germany had sold gold at $800 an ounce in 1980, and had bought 30-year U.S. Treasury bonds at 13%, it would be sitting on a huge pile of money. But the central banks did not do this in 1980, when they could have gotten a huge return on their gold. Yet they are now talking anonymously about selling it at $350, when the available return on bonds — highly risky, as we have seen in recent weeks — is 4%, and short-term rates are 1%.
Gold earns no interest return. Quite true! It never has. So, Mr. Turner's observation would have been equally true in 1980, 1960, and 1800. "Gold held by the central bank earns no interest return." To invoke this fact as a guide to understanding central banking policy is the equivalent of arguing that a lot of people will go to bed because the sun will go down.
Mr Pringle said central bank sales were part of a long-term trend which will further reduce the banks' role in the international gold market.
"I think there will be a day when they will be able to conduct buying and selling activity without disrupting the market too much," he said.
How could that ever be? Only because the central banks will have sold their gold to the public.
Well, not quite: to the public and to China's central bank.
When you read explanations for anything central bankers have done or plan to do regarding gold, bear the following in mind:
The explanation makes no sense.
The explanation was never intended to make sense.
Central bankers want to avoid PR problems.
They have leased out gold that will not be repaid if gold goes over $800/oz.
If they try to get their gold back with gold at $800, their debtors will declare bankruptcy.
Loans on the books to defunct debtors will reveal the fact that leased gold is not the same as gold in a vault.
This has bad PR implications.
The central banks are trapped by their own gold-leasing programs.
They must now sell gold in order to create the illusion of bullion banks' solvency.
This will act as a depressant on the price of gold for as long as central banks continue to lease gold and sell it.
The public will slowly get back that portion of its gold that China's central bank doesn't buy at these subsidized prices.
Indian fathers will continue to receive their gold subsidies from Western central banks.
Indian daughters will have dowries in gold, just as they have had for 3,000 years.
In exchange, Americans will have Alan Greenspan, who seems to have been around almost as long as Indian dowries — and is beginning to look like it.
October 31, 2003
Copyright © 2003 LewRockwell.com