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I would like to congratulate Aristotle on his extraordinary Five Part series on the relationship between oil and gold, gold and humanity. I am especially thankful, not just for what he did for all of us interested in the subject, but for the young people coming up behind us, who might make their way to gold in future years and need intellectual grounding to make their intuitive understandings stick. They aren't going to get it at most of the universities (unless things change), so they'll have to find it here. In that regard a tribute is owed to all who post their contributions for the enhanced thought and understanding of each person following this path toward illumination.
Let us make it the first entry in a new wing of the USAGOLD Forum Archives, a permanent hall of record, established so that anyone searching for this sort of information can find it more easily among the wealth of archived contributions. Let us not take lightly that which we place in this Hall. Any knight or lady is free to nominate a post or series of posts for the Hall with a review of its merits. It must be seconded by at least three others who also cite its importance for inclusion in the Hall. The more members who speak in its behalf, the better its chances of entry. A final determination will be made under consultation with our team of trusted advisors as to whether or not a piece should be entered into the Hall. The original nominator is asked to monitor the arrival of any supporting seconds, and to alert the "TownCrier" (our sitemaster) via the forum or preferably at email@example.com of the nominated commentary ID when it qualifies for final consideration.
Fellow knights and ladies.......I want to thank all of you for making this such a fine place to gather. We keep this Table Round as our personal intellectual holding to advance our own knowledge and wisdom as well as the knowledge and wisdom of others. Each a member. Each a contributor. Each an important voice. Let this Forum Hall of Fame be our shrine.
As with all our endeavors, we will start this as an experiment and make sure that it does not present problems or create unnecessary tensions around the Table, evaluating it as a permanent institution. Don't forget that this Forum also started as an experiment -- an experiment that has gone very well. The credit belongs to you, the participant.
Let the discussion continue... Michael J. Kosares, USAGOLD.com
21:24:14MDT - Msg ID:19061)
..You may have seen the movie Matrix. The story is of humanity being used as production plant for something, the people live a life completely within their heads, controlled by computer simulations. The key to the hero's survival and success is realizing that the world around him, in which he grew up all his life, is completely false. Walking through a room full of people trying to free themselves from the images bombarding their brain, he crosses a kid bending a spoon. He asks the kid, how did he bend the spoon. The kid says, it's simple, there is no spoon.
What is played before us in the world is a hoax that you have been conditioned by daily experience to accept as reality. But there is a cost to the charade and a cost to you. But you can't bring yourself to come to the conclusion when you watch CNBC, read the Journal or Investor's Business Daily, see Moneyline, Ruckeyser, etc. that they are involved in a theatrical production; that they are like well trained actors in a drama about money that never was. Remember: There is no spoon.
Aristotle (6/30/99) The Five Part Series on Gold, Oil, and Money in the Free Market
Aragorn III (8/11/99) Coming to terms with the Dollar and with Money (a continuation from Aristotle...)
FOA (9/19/99) All Roads Point to...Gold has Been Set Free as "Money"
Holtzman (9/24/99) The Many Prices of Gold, and a Lesson from the American Civil War
DD (10/14/99) Prisoners in the Workplace
TownCrier (11/05/99) An Easy Lesson on the Fed's Repo Operations and Banking System Reserves
Special Discussion Thread -- A Forum Team Effort (Feb 2000) A Remarkable Conceptual Discussion on the "Proper" Role of Gold in the Monetary System with Many Participants
ORO (02/11/00) An Argument Against the Use of and Justification forFiat Currencies and Central Banks
FOA (1/10 -19/2000) An Overview Series
USAGOLD (2/2/2000) On Promulgating the Idea of Sound Money...the Purpose of this Forum
Usul (3/26/2000) On the Expanding Money Supply and the Perils of Easy Money
Fasolt (3/27/00) The Price of Gold: a Tale of Two Hats...Commodity and Currency
ORO (4/19/2000) The Hidden Gold Standard and the U.S. Debt Trap
Aristotle (4/19/2000) On the Distinction of Wealth --Where Gold Serves Better than Currency
John Doe (05/18/00) On Capitalism and the Monetary System
ORO (06/14/00) ORO's Impression and Overview of FOA's Presentation of ANOTHER's Concept for "Free-Market Gold"
ORO (7/19/2000) On Savings and Profits
auspec (09/04/2000) Gold Economics in Abbreviated Format
SteveH (10/15/2000) On the Who, Why, and When of the Gold Market and Expected Price Reset
Sierra Madre (10/31/2000) On Floating Currencies, Gold, and Reserves
ORO (11/10/2000) On the Electoral College and the Republic
Holtzman (01/04/01) On Eternity
Mr Gresham (1/6/2001) Alan Greenspan and Payments System: Squeeze is On
ORO (01/13/2001) Thoughts on Black Market Gold
ORO (01/30/2001) Triffin's Dilemma
ORO (02/08/2001) The Error of Supply-Sider Jude Wanniski...Failing to See the Big Picture
The Stranger (03/02/2001) On Bonds versus Gold
ORO (03/05/2001) On Oil and Gold
miner49er (02/16/2002) The New Alchemy -- "Financial Arbitrage Socialism" -- Wringing More Life Out of the Dollar
miner49er (05/30/02) Providing a perspective on gold through analogies
Aristotle (10/17/2002) "Let's step through the looking glass now, shall we?" (a model for gold suppression and acquisition)
miner49er (05/06/03) "The fate of overseas dollars -- will they or won't they 'come home to roost'?"
Black Blade (9/23/03) "World Gold Council sponsored ETF (Securitized gold shares?)"
Sierra Madre (02/24/2008) "Where we are at -- a thumbnail sketch of history
Farfel (09/28/2008) "Is America on the Cusp of a Military Coup?
Golden Nuggets: Proverbs - Odds and Ends, by ski (04/15/2003)
Forum Contest Metal Winners Americans Discard Old Rules, Invest and Spend With Abandon; Happy Birthday O' Mighty Oaken Table of Yore...; Top Five Events for the Gold Market in 1999; Who is the New Fifth Horseman?
The Lighter Side of Gold Paper Money Was Never This Much Fun
(6/30/99; 9:41:59MDT - Msg ID:8236) Part
5--- Life on Earth: Gold and the Free Market
...continued from Aristotle (6/25/99; 18:06:45MDT - Msg ID:8073) "Part 4"
which was continued from Aristotle (6/24/99; 6:17:53MDT - Msg ID:8007) "Part 3"
which was continued from Aristotle (6/23/99; 19:56:08MDT - Msg ID:7997) "Part 2"
which was continued from Aristotle (6/20/99; 15:31:21MDT - Msg ID:7839) "Part 1"
Thanks in advance to Aragorn III for his direct input and valuable insights for what I am embarking on here. Much of this I hope will help to illuminate many of the developments and ideas that have been valiantly offered by ANOTHER and FOA over many preceding months.
The estimable economist Milton Friedman stated his forgettable opinion in 1974 that OPEC would collapse and oil would never get up to $10 per barrel. In all fairness to Professor Friedman, we must recognize his position as coming from a staunch monetarist, emphasizing money supply as the "true religion" for the Federal Reserve to keep the US Dollar as good as Gold. At times, he half-seriously argued for the abolition of the Federal Reserve in light of the simple monetary policy guidelines that could serve in its stead, with the economy returning to a state of self-regulation. (In the past sound-money days, economic hardships were far from unnatural, and they were not necessarily attributable to acts of government. However, modern attempts to centrally manage the economy ensures that any blame for systemic difficulties today may be clearly laid at government's feet.)
Milton's mistake was two-fold. First was his knowledge that Arabian oil could be produced for one dime of real money, and that inevitable competition among OPEC members would surely keep the price close to cost of production. Second, and most importantly, Milton failed to account for the possibility that the government would abandon such reasonable monetary management to keep the dollar nearly as good as Gold. This fact was NOT lost, however, on the oil producing countries. Ask yourself, what would YOU do if your business or trading partners suddenly started offering you payment with Monopoly money instead of "real" money? Would you shun real money as though it were the plague, and embrace Monopoly money as the greatest thing since sliced bread? If you would, then I have got a job for you!! Bring your shovel and some work-clothes, you have been hired for life...
Upon the 1971 declaration by the United States that redemption of dollars for Gold would be terminated, the entities in receipt of dollars for balance of trade settlements had no difficulty recognizing this as an outright default on payment contracts. The scramble was on to make sense of this new payment system in which the dollar was no longer a THING of value (a small amount of Gold), but was now reduced to a CONCEPT of value; an undefined unit with which the world would denominate the amount of value in contracts for goods and services. The problem ever since has been in coming to terms with the meaning of value for this shifting and undefined unit, and its vulnerability for mismanagement and abuse.
Jelle Zijlstra, who became head of the Bank for International Settlements, said while with the Bank of the Netherlands in regard to the 1971 severing of Gold from the dollar, "When we left the pound, we could go to the dollar. But where could we go from the dollar? To the moon?"
As I continue this tale, I hope it becomes clear that not only have we gone to the moon, but that Gold is going there also.
Do you see the world as it is? Or, do you see the world as you are? A tough obstacle, to be sure, as our experiences weigh heavily on our perceptions, and many people have no practical earthly experience with real money. There is hope..."the Truth is out there!" as a popular show is quick to proclaim. Albert Einstein puts an interesting slant on this theme: "My religion consists of a humble admiration of the illimitable superior spirit who reveals himself in the slight details we are able to perceive with our frail and feeble mind."
So with a ready admission our minds are frail and feeble, let's prepare to tackle something so ponderous it must hopelessly remain an abstraction to us mere mortals. I refer to the U.S. national debt, expressed in dollars, that stands at 5.6 trillion. Wow! What does that really mean? To put it in some perspective, we will revisit the 1970's, and try to get our arms (and feeble minds) around some much smaller numbers, and yet numbers that themselves are large enough to be abstractions. Let's examine the incredible and overwhelming wealth and economics of oil.
Imagine having claim to a sandy and barren land that reaches 120 degrees Fahrenheit in Summer, making your living through the ages on goats, dates and Pilgrims to Mecca. Not a posh existence when compared to America in the Roaring 1920's, but the passage of time reveals the fortunate few that were in the right place at the right time. When the Standard Oil Company of California was granted an exploration concession for Saudi Arabia in 1928, the 35,000 Gold sovereigns paid by Socal were reportedly counted by Sheik Abdullah Sulaiman himself. Wispy shades of things to come! This can be thought of similarly to how you might view a collection of skinny stock investors who found themselves heavily invested in penny internet stocks when the technology market exploded in the 1990, making them all millionaires. Except this: Oil is much, much bigger! We will soon examine what it means to be in the right place at the right time.
I will talk about pricing and balance of trade in the next part...stay tuned for the biggest transfer of wealth the world has ever seen. The key-currency gets debased in 1971, and Gresham's Law rules the land.
Having purchased this Saudi Arabian concession, in subsequent drilling Socal's Damman Number 7 struck oil in 1937 (I believe old Number Seven is still flowing.) Socal partnered with Exxon, Mobil, and Texaco to form the Arabian-American Oil Company. Over a thirty year period, Aramco discovered petroleum reserves in Saudi Arabia in excess of 180 billion barrels...a quarter of the known reserves of the planet at that time. And as the world aged and changed, the amount of oil consumed daily in world trade climbed dramatically, from 3.7 million barrels per day in 1950, to 9.0 mbpd in 1960, to 25.6 mbpd in 1970, to 34.2 million barrels per day in 1973 during the first Oil Crisis.
Consider this for better perspective: the average yield per well at the end of the 70's in the United States was 17 barrels per day per well, in Venezuela (one of the co-founders of OPEC) it was 186 barrels per day per well, and in Saudi Arabia (the other OPEC co-founder) it was 12,405 barrels each day per well. Wow! Just imagine if the internet companies today issued new, additional shares each day at this same rate as oil consumption...the stock price would plummet! But unlike internet stocks, because this oil is consumed, it must be replaced (and paid for) every single day.
But before I can move into the fascinating region of this miniseries that sheds light on how and why the Gold market is as it is today, this background is vital, so please bear with me, and I shall thank you for your patience. Oftentimes, understanding is its own reward, but in this case it may well prove essential for wealth preservation at a minimum. To begin, we must look at life in these United States (and in the process we will see a compelling reason that import barriers must be fought tooth and nail)...
What does the Texas Railroad Commission have to do with this story? Plenty. So much oil was being produced in Texas in the 1930's that engineers were concerned about depletion and wastage, and the owners would fret over the effects of oversupply that would at times bring the price per barrel down to ten cents. Tiny independent producers were often drilling side by side with the majors, but when the price slumped their profitability suffered more because they didn't have income from the downstream processes like the majors did. Because some of the individuals operating these independent companies happened to be multimillionaires, their complaining voices were heard thanks to their political contributions.
The state government responded by giving the Texas Railroad commission the power to regulate drilling. And while they didn't have the authority to set prices, they could regulate production levels. By setting an appropriate rate of production, oil would be conserved and this restricted supply would achieve price levels high enough to keep the independents in gravy. This Texas price became the American price, and also the world price (in the 1950's the U.S. was producing half of the world's oil.) This meant pure profit for the major companies with overseas production that cost only ten cents per barrel. To keep the price of oil up, what started as a gentlemen's agreement among the American oil companies to limit the imports of cheaper oil later became enforced by the U.S. government--known as the "invisible dike" against the outside world of cheap oil. Throughout the 1960's, the Persian Gulf offered the world oil at $1.80, while inside the "invisible dike" oil was being sold to the nation at the Texas price of $3.45 per barrel by the end of the decade.
The great irony is that a Venezuelan lawyer (and oil minister) named Juan Pablo Perez Alfonso studied and used the Texas Railroad Commission as his model for OPEC, which he co-founded with the Saudi Arabian director of the Office of Petroleum Affairs, Abdullah Tariki, in 1960. OPEC from the beginning maintained that oil was a depleting asset, and it had to be replaced by other assets to balance national budgets and fund developments.
Now that we know a bit about the producers and the price and cost of oil during the era of "real money," let us take a look at the dollar itself. The dollar and the world was pegged to Gold via the post-WWII Bretton Woods agreement in which $35 was convertible to one ounce--but for foreigners only, not U.S. citizens. The rate for international currency exchange was coordinated through the International Monetary Fund (IMF), with each currency pegged to each other through the dollar and Gold. The U.S. economy steamed along nicely in the 1950's, producing half of the world's oil as I've already stated, and half of the cars that burned up this oil. By the arrival of the 1960's, American industry was buying foreign factories, equipment and raw materials. In addition, the government was spending for its foreign bases and troops, and Vietnam was funded largely in the red.
An overhang of dollars was developing overseas--and while at first the foreigners were reassured that the Gold guarantee of the dollar was solid, as ever more dollars piled up, ever more of them cashed in the dollars for Gold. General de Gaulle summed up the sentiment, saying that America had "an exorbitant privilege" in ownership of the key-currency. By that he meant that the dollars America was able to issue via simple printing carried the same value in trade as the dollars that had to be earned by other nations through meaningful productivity. It quickly became clear that too many claims had been issued on the limited Gold, and President Nixon was prompted to close the Gold exchange window in the face of a certain run on the Treasury.
In a quick repeat from Part 1: " Upon the 1971 declaration by the United States that redemption of dollars for Gold would be terminated, the entities in receipt of dollars for balance of trade settlements had no difficulty recognizing this as an outright default on payment contracts. The scramble was on to make sense of this new payment system in which the dollar was no longer a THING of value (a small amount of Gold), but was now reduced to a CONCEPT of value; an undefined unit with which the world would denominate the amount of value in contracts for goods and services. The problem ever since has been in coming to terms with the meaning of value for this shifting and undefined unit, and its vulnerability for mismanagement and abuse."
With OPEC in place, and the dollar now rendered meaningless by traditional standards, the stage is adequately set to describe what followed. With OPEC now united and able to conserve, and threaten to cut back in the grand tradition of the Texas Railroad Commission, they were able to name their terms of payment, and decide essentially what value the dollar would have in oil terms. That is important enough to repeat: They were able to name their terms of payment, and decide essentially what value the dollar would have in oil terms. The increased world demand for oil ensured that the price would be met (Texas was pumping around the clock and still coming up short), and the printing presses essentially ensured that there would be no lack of dollars, so to speak.
It is important here to realize the attitude of OPEC, and notably the Middle East. In the mid 1970's, the finance ministers of both Kuwait and Saudi Arabia stressed that their needs were only to provide for the welfare of their citizens, and that oil in the ground is better than paper money. Who from the West can argue with that? They called our money's bluff, fair and square. So in 1971, while the Texas price of oil was $3.45, OPEC re-priced their Middle Eastern oil up from $1.80 to $2.20 (such audacity, don't you think?) only to see the market price due to demand in 1973 overtake the official posted price, at which point OPEC saw the writing on the wall, and in October raised the price per barrel to $5.12 while curbing production. By December, the Shah of Iran called a press conference to announce the official price would now be $11.65. Well, why not? It's only paper to you if you are not in NEED of this currency through a debt to someone else. And so began the First Oil Crisis of the 1970's.
Just as America had been issuing claim checks on the national Gold throughout the 1960's, its spending habits didn't change with the advent of the all-paper dollar. As a consequence, the world's greatest transfer of wealth was underway. Watching the rising cost of real estate became a national pastime in the 1970's--an odd distraction from the gas lines and cost of fuel. By raising the price of oil $10, from $1.80 to $11.65, at those current production levels OPEC raised its annual revenues by approximately 100 billion dollars. Now recall from Part 2 where I promised you we would tackle some large numbers, though nowhere near as incomprehensible as the $5.6 trillion U.S. debt. Here we go...
How much IS 100 billion dollars per year? It can't be much, because we all know the Middle East is heavily in debt with struggling economies even now at the end of the 1990's. Right? Well, I invite you to follow along, and judge for yourself. Let's try to spend that $100 billion, and remember...it is 1974. And let's not waste time on small stuff, we'll go right for the big ticket toys.
How about some F-14's? Fully equipped (minus missiles because we are a peaceful bunch) they are ours for $9 million each. Grumman on Long Island assembles 80 each year. Hell, let's take 'em all for $720 million. How about some F-15's too? At $12 million each, we conclude our visit to McDonnell Douglas with 100 under our arm for a cool $1.2 billion. Let's take home the biggest brute the U.S. has to offer--a top of the line nuclear-powered aircraft carrier for $1.4 billion. Better yet, make that two carriers. Throw in some destroyers, some submarines...let's see... We've spent a total of $2 billion on a kicking air force and a little more than that on a fine little navy. How much money is left in round figures? About $100 billion. And this amount comes in not only this year, but the next, and the next, and the next... [a side thanks to Mr. Goodman for these historical prices.] $100 billion is a large annual paycheck, and we haven't even touched the $30 and $40 dollar prices brought about in the Second Oil Crisis. Now consider again that America has written future claims on $5.6 trillion dollars. Can you imagine how such a figure might be settled? Ouch.
Where did all of this money come from? It would seem that America found an efficient means to issue claims on the country in exchange for something that goes up in smoke. Would OPEC own America lock, stock, and barrel? What would OPEC do with all of that cash? And would there be any end to it? How are the poorer countries that must EARN their dollars, as General de Gaulle indicated, going to fund their own oil needs? Banks are the answer. Buy banks, fill banks, and recycle the petrodollars. Oh, and let's not forget Gold. Straight from two ministers of finance, "We would rather keep the oil than have the paper money." We thank you for that insight.
Now that I have properly set the stage, in the next part I shall relate the really good stuff of Aragorn's tale suggesting where this money went, and how the system survived 20 years after the end was nigh, bringing cheap Gold crumbs for anyone mindful enough to pick them up. To quote that good knight, "With a payday reaching that magnitude, the question of destiny begs no answer. You set your own, and hope for nice weather."
One Oil Crisis down, one to go. We looked at some pretty incredible figures in Part 3. Where did this money go, and maybe more importantly, where does it come from? For the sake of brevity I will assume the reader is well acquainted with the process of money creation via modern banking. If not, then you have some important questions to ask and research to do. For now, accept on faith that new money is created (as a simple ledger entry at a bank) through the process of borrowing. A loan creates new money, and banks collectively may create money far in excess of what they hold on deposit. As a contract, the loan is quite real, but the dollar is not. A dollar is an undefined concept--an undefined unit of measurement for value, so to speak. You can see how such an arrangement favors those in a position to name their price.
As you can well imagine, for a country such as Saudi Arabia that had been subsisting on simple agriculture and the business of Pilgrims, a sudden infusion of such a magnitude of money can be seen as pure profit, and a fine opportunity for capital improvements to national infrastructure. Much of this money flowed back to the rest of the world to pay for international contractors and materials. But clearly, much more money was coming in than could possibly be spent. Vast sums of it found its way into the world's largest international banks--the five largest American, three largest Swiss, three biggest German, two biggest British, and then on to the next tier... Suddenly there were over one hundred banks that set up shop in tiny Bahrain: Citicorp, Chase Manhattan, Barclays, and Bank of Tokyo among them; all competing for surplus oil profit deposits. Paris suddenly found itself host to over 30 new Arab banks.
So much money flowed in, and so much was lent in turn to the poor countries that could scarcely afford to buy oil with their meager exports, that the financial system became a large game of musical chairs, and the biggest risk was that the music might stop. There were no chairs to sit on! To protect themselves from the unthinkable--that the Arabs might pull their deposits out of an individual bank--the banks developed a system. This system provided for the relatively smooth inter-lending of funds. Because even though a bank can create new money "out of thin air," they have to have deposits in the bank as a starting point. If these funds were to be withdrawn, the bank must locate other deposits to cover their outstanding loans. If the money were pulled, say from a British bank, it had to go somewhere; the amount of money was too great to "hide" for long. This British bank could call around, and arrange to borrow the funds back from a Swiss bank, or German bank, by paying a nominal interest rate on this inter-bank loan. The important concept to grasp here is this: as long as the petrodollars stayed in the banking system, the banking system would survive.
In fact, that is how the world weathered the storm of the First Oil Crisis. Such a grand scheme of inter-reliance was formalized by several central banks in a meeting in Switzerland to handle any event should money come up short in one area or another--the Basel Concordat. Have you ever heard of the LIBOR in any of your financial reading? Some credit card issuers make use of the LIBOR instead of the US. prime rate in their contracts. It is the London Inter-bank Offered Rate, and functions as the international bank borrowing rate, and it is the tie that binds the group together into a nearly seamless global financial System.
When the First Oil Crisis caused a global tightening of belts, only America, as the issuer of the key-currency, could shamelessly create new money with ease to pay its bills. Other countries had to balance their own books with productive output, or else turn to the banks to borrow the needed funds. And borrow they did! Let there be no doubt that these petrodollars were recycled through the banking system. Throughout the Oil Crisis and the distractions of the Nixon Watergate scandal, the former Secretary of Defense under the Johnson administration, and then president of the World Bank, Robert McNamara, was focused on one thing only--maintaining the good graces of OPEC. McNamara had to ensure continued access to OPEC's funds. During 1974, the World Bank had drawn on OPEC for $2.2 billion, for a total at the time of $3 billion--one quarter of all World Bank debt. For Euroland banks, business was booming because lending was their business. And the IMF had its hands full trying to hold together the international currency exchange system.
Some of the countries that quickly found themselves behind the eight-ball: Brazil, Korea, Yugoslavia, the Philippines, Thailand, Kenya. (You can easily imagine that there aren't enough coffee drinkers in Saudi Arabia to achieve a meaningful balance of trade of coffee beans for oil for a country like Kenya.) So in a move driven more by politics than banking to ease the financial squeeze upon a nation's citizens and industry, the governments would turn to their central banks and to the international and multinational banks to secure the needed money. And the banks couldn't stop lending, because many countries relied on new loans to pay off the old loans in addition to their continued need for oil. Loans in default were simply rescheduled. There were no chairs, and the music could not be allowed to stop.
If a bank were to fail, what would the Arabs do with their remaining deposits, now clearly in jeopardy? Further, the inflationary impact of all of this borrowing was also a fact not lost on the OPEC nations. Many of the OPEC members' advisors and ministers held Ph.D.'s from prominent American colleges. They did not have their heads in the sand. The inflation would lead to a new price of oil just to recapture the value that was lost, and the cycle would intensify in the next round. OPEC knew the western currencies were depreciating faster they were compensating with price hikes. They were getting less "real" money as a result. Hopeless.
Remember Jelle Zijlstra with the "moon" comment earlier? As head of the BIS in 1980, he confidently predicted that the Second Oil Crisis could be worked through, slowly, but that the System (international financial system) could not survive a Third Oil Crisis--the inflation would make it impossible to recycle the petrodollars to the oil importing countries with any hope of repayment, trade would crumble, and the System would be brought to its knees. On that grim note, we need to take a quick look at how the world reacted to the Second Oil Crisis. It opens the door to everything that follows.
By now you are patiently awaiting mention of Gold. There it is. Now back to the story... No, seriously, pay attention here, and things will start to fall into place. I hope you have noticed the few references to oil prices throughout this series. In most cases, the oil was made available at a posted price. In the 1960's, OPEC's posted price was $1.80 (though sometimes the producers would undercut that to gain an advantage through additional volume), then it was $2.20, then $5.12, and within weeks it had been changed again to $11.65 (in late 1973). By May 14 of 1979 the posted OPEC price was $13.34 per barrel, but life was about to change. The key element to keep in mind is that oil was not priced directly by the market. It was mostly sold under long-term contracts at posted prices that were set by the producers after careful analysis of what the market could bear under self-determined production levels.
When the Ayatollah Khomeini's revolution deposed the Shah, Iran's 6 million barrel per day production fell off dramatically, and the resulting shortage sent the downstream processes scrambling for sources of oil anywhere to feed their refineries. Many turned to Rotterdam for oil, to fill their empty tanks. The deepwater port at Rotterdam was the principle harbor where huge tankers could be found to deliver oil on the spot, and hence the spot market for oil was often referred to as the Rotterdam market--but in truth, the spot market was available worldwide. This spot market was never meant to determine the price for oil, but was only supposed to supply day-to-day purchases.
Due to the stresses of low supply, the Rotterdam price sailed above the $13.34 posted OPEC price on Tuesday, May 15,1979 to $28, and two days later it reached $34. Iran immediately took what little production remained and sold on the Rotterdam market. OPEC then set a ceiling price for oil at $23.50 per barrel, but that was soon broken by Libya and Algeria. Obviously, Rotterdam was the place to sell oil at the best price, so many tankers with long-term contracts for oil stood empty waiting for delivery while ever more of OPEC-member production was diverted through Rotterdam. Countries and many companies looked at the low levels in their storage tanks, and soon they were rushing to support the Rotterdam market with their business. The "spot" price reached $40 per barrel as uncertainty about the future brought forth every empty tank or dilapidated tanker out of retirement to be filled.
Gresham's law can help explain this phenomenon-- bad money is spent and good money is saved. Oil was being bought and saved as a store of value, while paper money was spent. The flames of this Rotterdam inferno were eventually cooled as the last available storage tank was filled to capacity. This display of the spot value for oil reinforced OPEC's concept of value, and they had no qualms about raising the posted price to the spot value. Please recall, "We would rather keep the oil than have the paper money." Any student of history will also recall that the explosion in Gold prices also occurred in 1979 to early 1980, showing us Gold priced at $850 per ounce.
So what exactly has changed in the world since 1980? There haven't been any similar blowups in the pricing of important assets...so how was this wild tiger tamed? Is the money better than it once was? Or are the OPEC nations now suddenly and truly beggars upon the West's doorstep? What happened? Are the multinational banks (once scrambling to hold together the System) now calling the shots with nary a care in the world?
In Part 5, I put an end to this tale, and answer the biggest mysteries about Gold in the easiest of terms. The road will seem so straight and fair to travel, you will kick yourself for struggling through the brambles for so long, and wonder at your neighbors who STILL can't see the path, though it is truly a freeway.
Before I conclude this commentary, let me first express my gratitude to USAGOLD for hosting this illuminating site, and for the tolerance I've been extended by so many here for my four long posts that up until this moment probably didn't seem germane to the topic of Gold.
On any journey, the first few steps are the most important, and in this case they were also the most difficult--to include enough for context without drifting off-topic. This last part is easy. The task at hand is to provide an explanation of Gold's pre-eminence as a monetary asset. Gold is, in fact, Money, while the dollar and others are merely currencies--an importance difference!
I am not claiming to be offering new findings of my own. The inspiration for this tale originated from many sources, comments Aragorn III offered to a small group last month, a knowledge of history, and keen perception. I have been challenged to render this tale into the clearest of terms suitable even for those not acquainted with Gold and worldly economics. If I have succeeded in my challenge, at the conclusion of this final part you will fully grasp how the free market has managed to provide a sophisticated asset (Gold) at a laughably minute fraction of its relative value. You will know that Gold is Money, and will gain new respect for its "price." Although this information isn't new, it might be new to you, and hopefully this explanation of financial operations with Gold, together with the background information of the 1970's Oil Crises, will help you anticipate and conclude for yourself an outlook for events ahead, and will also help you to better understand and evaluate the important messages being presented by ANOTHER and FOA, in addition to the other worthy knights of this Table round. Knowledge is power, and with it your destiny shall be yours to decide.
To start, I'm going to paraphrase some specific remarks made by Aragorn III that some people need to hear and think about, though most of the Forum posters are already in tune with this.
'The falling price of Gold has had various effects on people. The common person says, "Of course it is falling, because Gold has been demonetized." The Goldheart knows better, so the falling price has a more remarkable effect, bringing out insecurities and irrationalities of some. Though these people don't question that Gold is money, their insecurities start to question whether the world really needs money at all...that somehow this greatest device of mankind has been antiquated. Simply preposterous. If they knew the truth they would confidently buy today at triple the price and call it a bargain of a lifetime. People ask, "Why waste effort to dig up Gold from the ground, only to rebury it in vaults?" I say, "For the same reason the central banks toil to print millions of fancy notes that nobody reads. If you've read one, you've read them all." The effort is needed to prevent cheating, though we easily see the fancy cash does not stem the abusive tide of money from nothing. People also say, "Gold is a dead asset. It does not earn interest." What is the point of such a comment, to demonstrate their naiveté? Did banks not pay interest when coins were stamped from Gold?
You see, it is not the nature of money itself to earn interest, but rather, it is the investment risk that maybe earns a reward. A modern dollar in a shoebox is as a Gold coin beside it. No interest for either. You should know the interest paid by a bank savings account is not a product of the money itself, but instead it is the rewards on the risk the bank takes with the money you have provided for their investment use. Sometimes these banks choose poorly, and in those cases even the modern dollar earns no interest, and does not come back at all--lost with the closing of the bank doors. Money must be risked (invested) to expect a yield, and in this regard, the big players in the world risk Gold money as they do paper money (though often not as aggressively), while the small players are content with the shoebox yield. You are forced to be more aggressive (more risky) with paper because its value dies quickly, unlike Gold that stands forever even in a shoebox of no risk.'
With that, I will now conclude this tale that shows Gold functioning in its role as Money. And because preconceived notions of words often cloud a person's ability to see the case before them, I shall try to deliver this message with the slightest use of such terms as Gold loans, leases, shorts, etc. In fact, I will be so bold as to simply refer to Gold as Money (I will write it as "Money (Gold)" to ensure you know my meaning, but as you read, simply pronounce it as money). As far as what you might think is money (dollars, yen, pesos, etc.), I shall from this point forward not call them money, but refer to them by their given name (dollars, yen, pesos, etc.) or else will call them "fiat currency," or just "currency" for short. Fiat means "by decree, and fiat currency is currency because the government tells us it is.
Enough of the preamble. Let's pick up where we left off from Part 4. In days past, the oil exporters had been poor to modest countries scraping by when two things occurred. They discovered that they owned lots and lots of oil, and they also found that the rest of the world had developed a voracious appetite for oil. Think how different the world situation would be today if this supply of oil had simply never existed. We are certainly lucky to have its availability, and it is a reasonable expectation to pay fairly for all that we take. As bald as that statement is, it is necessary because some people have suggested (as Kissinger did in the 1970's) that warfare is a possible alternative to obtain what isn't ours. Such a world!
We've already discussed much of the turmoil that resulted from consumption that outpaced ability to pay. Payment in Money (Gold) was terminated, and many payment scenarios were developed in addition to the ever rising prices in paper currency. While it can be suggested that currency is a reasonable means in which to track balance of trade accounts (equating oil exports with similar value of imports such as infrastructure improvements), it should be readily admitted that paper currency is an unacceptable means in which to pocket one's profits. Book the trade balances with paper currency, but pocket the profits (savings) with Money (Gold). That's what I do every month, too!
Paper currency was falling fast in value when it was no longer tied to Money (Gold), and this was causing international settlement difficulties on many fronts in addition to oil. It is instructive to investigate some of the tools of the international financial System, because what worked for Money (Gold) and currency back then, certainly works for Money (Gold) today. (Please reread the paraphrasing of Aragorn's money comments if you have forgotten them already.)
Back in the 1960's when dollars were still tied to Money (Gold) under the Bretton Woods agreement, the American penchant to spend for goods abroad led Kennedy's Undersecretary for Monetary Affairs, Robert Roosa, to fear a mass "cashing in" of these dollars in international hands for Money (Gold)--a run on the Treasury. Roosa created a new financial device, referred to as a "Roosa bond," which was a special issue of Treasury bonds that were denominated in Swiss francs. As the bonds were sold to the world, they would sop up excess U.S. dollars with the terms that repayment at a future date would be in a given quantity of Swiss francs. (Notice I said quantity, and not value.) While these Roosa bonds stemmed the tide of a possible run on the Treasury, they ended up costing America more because the Swiss currency appreciated versus the dollar during the life of the bond.
In 1978, the U.S. issued 10 billion dollars worth of bonds denominated in foreign currencies (marks or yen) to milk extra life out of a dying dollar system, and the fix lasted until the 1979 Oil Crisis made mincemeat of it. It was an acknowledgment that some foreign investors wouldn't hold U.S. government obligations that would be repaid in dollars worth less than originally spent on the bond. Further, it was at this time that the U.S. promised to sell Money (Gold) from the Fort Knox stockpile to foreign central banks unwilling to hold dollars. (On his last day of office, March 31, 1978, Federal Reserve chairman Arthur Burns suggested that the entire $50 billion of the nation's Gold stock be sold for foreign currency in defense of the dollar, at which time the foreign reserves could be used to buy up the collapsed dollar in international markets. While this plan was originally rejected, within three weeks the Treasury Department was forced to announce it would auction Money (Gold) on a regular basis.)
Treasury Secretary Michael Blumenthal pledged in a meeting two days later with top-level Arab businessmen that the integrity of the dollar would be defended vigorously, and asked them to do their part to stabilize the global economy by keeping a price freeze on oil in place at least through 1978. (You should have no questions now about where the dollar found its value after the 1971 delinking with Money (Gold). The asking price by oil--influenced by many factors--is what established the dollar's value.)
It is also important to realize that not all international arrangements are conducted on the open market. For example, to avoid the German mark from being bid up in strength with a result of ever more people bringing them dollars for an exchange, Germany's Bundesbank issued bonds directly to the Middle Eastern buyers, avoiding the marketplace impact altogether. This was at the time Saudi Arabia was swimming in cash and spreading the excess among the world's largest banks (as mentioned in Part 4). My point is this (which I shall expand on soon): don't be surprised that banks are far more creative in their operations than revealed in your common experience through savings and checking accounts and home loans.
Eliyahu Kanovsky, an oil economist, won renown by many for accurately forecasting long-term oil production and pricing trends by OPEC where all others had gotten it wrong. In the 1970's he maintained that economics, not politics, were the determining forces behind the decisions of OPEC. In 1986 he wrote in response to the prevailing notion that OPEC would eventually own the world as a result of its oil wealth: "It is, by now, abundantly clear that these forecasters committed gross errors not only in terms of magnitude of change, but, far more important, in terms of direction of change. Instead of increased dependence on OPEC and especially Middle East oil, there has been a very sharp diminution. ... Oil prices have been weakening almost steadily since 1981 and there has been a collapse since the end of 1985. Instead of rising 'petrodollar' surpluses, most OPEC countries, and Saudi Arabia in particular, are incurring large current account deficits in their balances of payments, and are rapidly drawing down their financial reserves."
In the 1990's, Kanovsky maintains that OPEC has lost its ability to raise income through raising prices, and that oil below $20 is virtually assured. (This should remind you of Milton Friedman's poor prognostication from Part 1.) Kanovsky claims competition among producers ensures an end to price fixing. They can only pump it and sell it for whatever the market will provide. He contends (rightfully so) that Iraq can be counted on to "pump like mad" upon lifting of UN sanctions. He also contends that with the current account deficits of many OPEC members, notably the Saudis, they have no option themselves but to add to the oil glut with overproduction to raise revenue.
Since it has been brought to our attention by Kanovsky, let's take a look at the Saudi budget, and the toll taken on it in the aftermath of the Gulf War. IMF data reveals that the Saudi deficit climbed from $4.3 billion in 1990 to $25.7 billion in 1991. Oil had been selling at around $14 per barrel until June 1990 when Saddam Hussein pressured OPEC to raise the price to about $20 to help repair Iraq's national budget (which had been wiped out and sent into the red by their 1980-88 war on Iran). Iraq's subsequent invasion of Kuwait in August 1990 temporarily spiked the price higher.
Here I must ask you to pause for a moment to reflect on those huge oil trade surplus figures we toyed with in Part 3, and recall that they were from early 1970's oil demand at a price of $11.65 which caused the First Oil Crisis. What happened to the vast amounts of petrodollar revenue that was being pumped into international banks, and recycled as fast as the loans could be written to borrowers throughout the 1970's? Further, what happened to the earnings that were surely being generated on these deposits through the activities of the lending institutions? As I noted at the end of Part 4, the System miraculously survived the Second Oil Crisis of 1979, and concurrently the skyrocketing price of Gold promptly abated in 1980. Further, Kanovsky points out that oil prices started weakening in 1981, and then plunged in 1985. Force yourself to make the connections. You will be one step ahead of Kanovsky, who has identified the effect, but no doubt has missed the cause entirely. Let us now tie together everything we know, and fill in the remaining pieces.
Historically, the price of oil had been simply posted by the producers for contracted delivery until it was unleashed to respond to daily supply/demand forces on the "spot" Rotterdam market, at which time the price exploded in 1979-80. Although the dollar had been historically fixed to Money (Gold), after it was unpegged in 1971, the currency price of Money (Gold) was determined by the daily supply and demand, similar to Rotterdam. Gold auctions began in May of 1978 because the U.S. had trouble getting international entities to accept its dollar currency. After "booking" their trade balances with dollars, the House of Saud, among others, wanted to "pocket" their profits with Money (Gold), and therefore competed with everyone in the world for Gold on the spot market. As the price shot right through $700 it was clear that every ounce purchased made it that much more difficult to purchase the next ounce. There was little trouble raising the price of oil as needed, except the financial structure of the world was coming apart at the seams. Each dollar withdrawn from international banks to buy Money (Gold) made life ever more difficult for the banks to square their books against outstanding loans or to write new loans. There had to be a better way...the return of Money!
The high price of Gold brought mining companies out of the woodwork. The Earth was suddenly crawling with geologists looking for the next jackpot Gold deposit. The mining companies needed capital to finance the construction of these numerous new mines. It's not strange to you to accept that banks can lend currency. It should not be difficult for you to accept that banks can lend Money (Gold) also. Struggling with that thought? Don't. They lent Money (Gold) in the days prior to Roosevelt's 1933 confiscation of Money (Gold) in exchange for currency, and they can lend Money (Gold) today. In fact, they can even create Money (Gold) out of thin air, in a manner of speaking, and I'll walk you through it.
Sometimes a parallel familiarity assists comprehension. Consider the existence of Government-Sponsored Enterprises (G-SE's) such as the Federal National Mortgage Association (commonly known as Fannie Mae). Fannie Mae is in the business of creating financing for people to acquire a house. The government's involvement in this affair is that they underwrite the risk of a default on the repayment of the loan. Dollars are borrowed, dollars are lent, and dollars are repaid. It doesn't matter what happens to the exchange rate of the dollars versus other currencies. A certain amount of dollars are owed, plain and simple, under the terms of the loan contract. If a home mortgage loan is sold on the secondary market, the purchaser of the loan is effectively buying not the house that was financed by this loan, but rather the rights to receive the borrower's scheduled repayments over a span of time.
Think of a loan to a mining company in a similar fashion. Interest rates on Money (Gold) loans are often much less than on currency loans because the Money (Gold) holds its inherent value over time (despite its "price,) whereas the paper currency fails so fast you must return more for the lender to at least break even, not to mention show a profit for the risk. Because miners will be pulling Money (Gold) out of the ground, it makes the most sense to them to seek a loan of Money (Gold) rather than currency in order to finance their new mine construction. But because Caterpillar has its head in the sand, it requests dollar currency for the purchase of its mining equipment, so an exchange must be made for paper currency as an integral part of this Money (Gold) loan. These arrangements can take place in every conceivable fashion, but this following example will be representative.
As 1980 arrived, the Saudis naturally still wanted Money (Gold) for their oil, and the rest of the world was struggling with liquidity. Much currency "wealth had already been transferred to OPEC, leaving many countries toiling to service their own debts--much of their credit existing as recycled petrodollars. Let the lending continue! Bullion banks would facilitate these deals, and central banks (CB's) would act in the same capacity as with the G-SE Fannie Mae, guaranteeing ultimate repayment in the event of a borrower's default. In this simple example, the House of Saud could be looked at as the principle lender (although the borrower doesn't see this)...providing the currency equivalent of the Money (Gold) borrowed by the mining company to pay for Caterpillar's equipment to build the mine. Because this is contracted as a Money (Gold) loan, Money (Gold) must be repaid over time. In a sense, from the Saudis' viewpoint it is similar to the Roosa bonds where U.S. dollars are paid for the bond, with a fixed amount of another currency (in this case, Money (Gold)) expected to be returned upon maturity.
With the simple but vital central bank guarantee against the default of these Money (Gold) loans, the House of Saud, for example, would have no qualms about supplying the cash side, effectively buying not the Gold metal immediately, but rather the rights to receive the borrower's Gold repayments over a span of time. Just like buying a home loan on the secondary market. And the Money (Gold) of the central bank need not ever move or change ownership unless the borrower defaults on the loan, and the CB is obligated to deliver on its guarantee for the full repayment in Money(Gold).
There is nothing sinister in all of this. The price of Gold has fallen simply because anti-gold sentiment has been fostered throughout the common investment markets while the principle buyer at the Golden "Rotterdam market" had found another avenue in which to obtain the Money (Gold) desired in exchange for oil profits. This is very much like the off-market Bundesbank offerings that I mentioned about earlier. Please appreciate the patience in this approach, and the commitment it shows to Money (Gold), knowing full well that for many years it might be getting ever cheaper, while they would appear the fool for buying it from the top prices all the way down to the lowest. But the big payoff is in the end--which is near--and I'll get to that.
Now that you grasp the basics, let's take things up one level. So many Money (Gold) loans were written, that the House of Saud in our example spent down their past petrodollar surpluses. What now? It is time for banks to do what banks do best...create new money. This is the typical example I promised you earlier:
The miner approaches a bullion bank for a Money (Gold) loan. Let's assume the current dollar price of Money (Gold) is $400 per ounce, and the miner needs $20 million to pay Caterpillar for equipment. The bullion bank (such as can be found operating in the network of the London Bullion Market Association--LBMA) writes the Money (Gold) loan contract specifying the term of repayment of 50,000 ounces of Money (Gold) plus interest at 1% - 2%. The borrowing miner collateralizes this Money (Gold) loan with company stock, the deed to the mine, etc., and is sent down the road with $20 million in currency for Cat. Where did this cash come from? The bullion bank turned to the House of Saud, which is currently out of currency. However, using their oil in the ground as collateral, the bullion bank is able to write them a currency loan out of thin air (just like banks can do) with which the Saudis purchase the repayment rights on the Money (Gold) loan. They will be receiving future Gold for their future oil! As they sell oil, they will use their dollar revenue to repay their currency loans, and in the meanwhile, the miner's Gold loan repayments will be directed to the Saudis' account.
What does the bullion bank get for all this trouble? First, the central bank gets 1% - 2% for underwriting or guaranteeing the loan. (Just like the underwriting done with Fannie Mae.) The bullion bank had added on top of this low interest rate an applicable margin for its cost of funds to establish the final interest rate for the miner that borrowed the Money (Gold). This rate might run 3% - 5% (while currency loans would demand much more.) Each year the miner produces Gold, and after paying the required installment of Money (Gold) for the Loan, the remainder of his annual production can be sold on the spot market for currency used to meet business expenses.
There's one hitch. Because the biggest Gold buyer is no longer shopping on the spot market, the pricing pressure has come off, and prices could very well be expected to fall. To protect against this leading to the possible bankruptcy of the miner, and hence his default on the repayment of Gold, the terms of the Loan might also require that the miner lock-in a certain amount of future production at the current Gold prices at the hedging counter. (Economists first scrutinize the mining plan to ensure that it will in fact be viable at current prices before granting the Loan.)
As described so far, it should come as no surprise that the House of Saud would also step right up to purchase the delivery side of this hedged production. Enough must be hedged to ensure the mine will remain viable (even at lower prices) at least long enough to repay the Loan. Lets assume this mine is operating today with Money (Gold) at $260 per ounce, while their cost of production is actually $320. The current price of Money (Gold) is not a factor on the Loan repayment...they owe 50,000 (plus interest) ounces, regardless. Any additional production would be sold under the terms of their hedge, at $400 per ounce, and they can pay their bills comfortably and stay in business. Is the House of Saud a fool for paying $400 long ago for the Loaned ounces, and for paying $400 today to honor such hedged ounce agreements? You or I could pay $260 today for that same ounce on the spot market. Have you started to develop a new opinion of your currency, or at least a new opinion of Money(Gold)?
OK, so what else does the bullion bank get out of this, other than the applicable margin on the Money(Gold) loan mentioned above? It also collects the interest on the currency loan that was written to the Saudis using their oil as collateral. You can see how the mechanism that has brought us temporarily cheap Money (Gold) over the years has also given us cheap oil not subject to the same shocks witnessed in the Seventies. You can also see why the economists can look at the Saudi balance books and see tremendous currency debts and budget deficits where once there were surpluses that threatened to buy up the world. They have in fact bought up a significant portion of the Gold mined well into the future...through Loans and Hedges bought all the way down from the top. So who are we to question whether to exchange our currency for Gold now or tomorrow, and to gripe over a missed opportunity of $10? The equation is simple. If you have cash, buy Gold immediately, because the downward trend has become terribly unstable. Here's why...
The various financial Hedge Funds saw how easy it was for miners to raise low interest capital, and further appreciated the fact that even if they were not themselves a producer of Gold, the Gold itself needed for repayment could be purchased on the spot market at ever lower prices. The Hedge Funds could meanwhile invest the capital received through taking out this Loan and expect to have a double profit potential in the end. (The infamous Gold Carry Trade would invest the currency received through the 1-2% Gold Loan into U.S. bonds that yield over 5%.) And of course, with the proper central bank guarantees, the House of Saud would be there to buy up the repayment contracts expected on these Money (Gold) loans also.
The problem is that these speculating Hedge Funds have cumulatively driven the price so low (well beyond where mines would have long ago stopped seeking this type of Loan) that some unhedged mines are shutting down or going bankrupt. This aggravates the spot market with thin supplies of real metal reaching it (due to so much production already having delivery obligations) such that it becomes hypersensitive to any real effort to make substantial purchases there.
As a result, the Hedge Funds will be in for a rude awakening in their efforts to purchase the Gold needed to repay their Loans. And the bullion banks are sweating, because they stand next in line having facilitated the Money(Gold) loans and pledged to the CB's that they were credit worthy of the CB Gold guarantees. And the important Oil Producer sees that the big bucks paid long ago for future Gold delivery has actually purchased only uncertain arrival. And further, some miners, despite their hedges, have played fast and loose liquidating them for cash, and through general mismanagement have not been able to stay so viable as to ensure future operation and delivery of the repayment terms.
The CB's are fretting because their guarantees were used over and over again, and they are on the hook for a lot of Money (Gold) when the speculating Hedge Funds and bullion banks find it impossible to cover their Loan repayment obligations on the spot market as the price races away from them due to the hypersensitivity that low supply has caused. Shades of Rotterdam. Currently aggravating this spot market problem is the massive demand by individuals brought about by the low prices and concerns for Y2K. I hope this give you new perspective on the push lately by some CB's to free up some Money (Gold) from the vaults, whether it is Bank of England, IMF, or maybe even Swiss. It should also give you perspective on the anti-gold propaganda delivered regularly by the media. Consider that a skyrocketing price of Gold would not only be viewed by the masses as a viable investment avenue, it would also tend to shake the confidence in paper currencies, and threaten the banking system and Wall Street in general.
It is this same currency, borrowed against oil collateral for the purchase of Gold, that has added the massive liquidity to the world over the past decade and a half that many people have used in turn to fan the flames of the stock markets here and overseas. That's a lot of cash born unto Gold, and were it not for the prospects of receiving the real wealth of Gold metal, this supply of currency would have been stillborn, and oil would likely only come forth by way of brute force rather than by civil, economic means. I realize that I have left a lot out, but this should get you started along the clear road traveled by smart currency. Now, knowing what you know, what would you do with your dimes? Because this is really his tale, not mine, I'll leave you once again with perhaps my favorite statement made by Aragorn one evening last month among his old friends. "If I were given a dime for every time I cursed the market for providing easier gold, I'd have a dime...and that one was found on my way over here.
Everyone, your comments are welcome. And thanks again to MK for the USAGOLD forum and for the opportunity to obtain a world-class Money education and shiny yellow metal diplomas all at the same place!
(8/11/99; 2:39:01MDT - Msg ID:10880)
Coming to terms with the dollar and with money (a continuation from earlier)
My good friend Aristotle has relayed to you much of the modern story. (Where has he been these days?) I am pleased it met with acknowledgements regarding its assistance, and would like to continue with perhaps some additional background for assistance to some in the understanding of money. Please forgive me the many oversights for which haste may have to play the fall guy. As later time allows, I shall attempt to repair what is necessary, but meanwhile this should help continue our dialog on these matters.
Aragorn III (08/09/99; 03:06:13MDT - Msg ID:10714)--Looks good, Peter
Yes, indeed, this is a good way to view our currency, such as it is...
Peter Asher (08/08/99; 22:51:59MDT - Msg ID:10701)--Fractionalization limits are just a regulation.
<<"Lets try this possibility.--- The extra $50 Billion of Y2K Greenbacks can get into circulation by withdrawal of deposits, or my writing loans. If they write loans, up goes the Money Supply. If people withdraw their demand deposits, all that has happened is a ledger entry has been replaced by a receipt. That's really what a banknote is. Not an IOU as some have said, but a UOI. 'You the people of this country owe me this numerical value of goods or services.' So in a sense, when you take that currency out of the bank you are saying, "Hey tear me out that piece of the page where you have my deposit written down. I'd rather hold on to it myself."">>
Very nice! As the only "value" which is to be found in our currency exists entirely within an elaborate accounting system of "who owes how many numbers to whom", the physical dollar we may carry in our wallets is truly nothing more than a portable and transferable piece of the official ledgers; one that has been duly certified to stand alone as one of those ledger numbers with the proper pedigree to pass as currency. Numbers that remain in ledger form may only be added or removed through official banking channels, such as we see in the example of the check clearing house of the Federal Reserve. This has been Aristotle's attempt recently to explore with others why his simple act of typing "$17" does not create 17 spendable dollars; because it does not have the proper pedigree of origination within the banking system. Specifically, it was not borrowed into existence by the Treasury from the Federal Reserve, or even perhaps borrowed by you or me from our own Main Street bank.
Fancy designs with presidents on paper is an assurance that these "ledgers to go" so to speak do bear the proper pedigree as numbers acceptable for legal tender. When they exist in ledger form, they demonstrate this proper pedigree by the integrity of the database that tracks their movement. Nothing more, nothing less.
This gets us back to the thread I began a few hours ago in an examination of the dollar and money, and I shall now try to return to that...
This is where we left off from
before, more or less... Aragorn III (08/08/99;
17:19:07MDT - Msg ID:10664)
"...It should be obvious by the nature of our topic (money) that our conversation is focused on tomorrow, in addition to today. Were we to be truly concerned about today only, we would instead discuss whether our needs of food, clothing, and shelter had been adequately met, we would not speak of money. To speak of money is to speak of today's confidence in our ability of meeting tomorrow's needs."
A currency with an unknown expiration date is arguably of limited use for the role we expect our money to play...to hold its value within acceptable limits of fluctuation based on normal market pressures and thereby successfully fulfill its ultimate destiny to be spent as a medium of exchange for our future needs (food, clothing, shelter, hardware, medicine, etc.). No one wants to be the one left holding the bag when the purchasing value drops out the bottom.
Prior to 1971 the dollar was truly money (gold standard defined the dollar as gold) in the international economy, freely convertible with gold, with an equivalency of 1 oz. @ $35 -- FIXED, no questions asked! (Though it is fair to say there was squawking from time to time when overseas paper came home for redemption). Unfortunately, the U.S. had painted itself into a corner and was trapped. Here is how it happened.
Prior to 1933 the U.S. was on a gold standard domestically, also, at which time the equivalency was 1 oz. @ $20.67 -- fixed, no questions asked. A bank would readily exchange paper currency for the equivalent gold currency on demand. There was a general confidence in the banking institutions, and people were content to use their paper dollar equivalents, and further, were content to let their deposits remain in the bank. Fractional reserve lending privileges allowed banks to expand the money supply--YES...even while on a fixed gold standard! As long as not everyone together would choose to withdraw their money and convert the paper proxies for the gold dollars, this fractional reserve lending privilege did not cause any apparent problems. Did prices stay reasonable as the dollar still appeared "good as gold"? I give you... The Roaring Twenties! When the attendant stock market bubble popped in 1929, the financial system, and much necessary confidence began to unravel, and the bank run became a probationary event for the Olympics. In 1929, 659 banks failed. In 1930, 1352 banks failed. In 1931, 2294 banks failed. Late 1932 and early 1933 witnessed this trend swell to envelop not small or isolated banks alone anymore, but entire communities and statewide banking institutions. (I will tell you that by 1933's end, nearly half of U.S. banks had disappeared...such is the "privilege" of issuing excessive claims on money that cannot be backed through this fractional reserve system!)
You can see why the Roosevelt Executive Order of a bank holiday effective March 6, 1933 was something other than a trip to the beach. In this year, 4004 banks failed, or else were found to be unfit to reopen at the end of the "holiday". In the following year, only 62 failed. Why? Because as you already know, it was at this point that President Roosevelt took the money (gold) out of the domestic dollar, and it should be obvious to us all that a crippling bank run is no longer a threat when a bank need not be held to deliver real money. It could easily deliver the ledger numbers endlessly in portable paper form. A bank run becomes meaningless because the people are not at risk of being cheated by arriving too late, they have all already been cheated 100% in full! The government knew international parties would not fall for such trickery, so the gold convertibility was maintained, but only after defaulting on the paper dollars they held by redefining their equivalency to 1 oz. @ $35 (as was maintained from this point until the Second World War, and reaffirmed at Bretton Woods until 1971).
With domestic U.S. companies and citizens now subject to the inflationary dollar supply through fractional reserve lending, and a new dollar that even with the best confidence was not as "good as gold" within the U.S. borders, the anticipated effect of higher wages and higher prices was soon to follow. Here is the trap we fashioned for ourselves. The U.S. dollar would easily buy overseas products, as simple math and occasional "confidence reassurances" (by testing the success of convertibility) proved that to be paid $35 was truly to be paid one ounce of gold. Foreign goods were then priced accordingly, and imports flowed to American shores in due course as we spent down our national gold savings. And what of our balance of trade...the exports?
Domestically, with higher wages and prices reflecting a paper dollar rather than a gold dollar, American goods were not a bargain to foreign shoppers. The dollar itself (gold) was the best deal they could get from America in exchange for their own goods, and this money would then be used to shop where a gold dollar was properly held in value...anywhere but America! U.S. imports rose and exports fell against each other until the risk of gold exhaustion caused President Nixon to end international convertibility in 1971. This was essentially a world-scale replay of the 1933 Roosevelt action for the same reason...too many claims had been created on the gold money, and when the confidence for convertibility eroded to bring about a "bank run", the paper system failed to continue in its former manifestation. In the 1930's, gold was made available only outside the U.S. and the paper "price" rose from $20.67 to $35...a 70% increase. In 1971, the paper currencies lost their attachment to real money everywhere else in the world, and gold found a paper "price" in the many hundreds. So ended a time period of a fixed notion of a dollar's value.
Today, the international need for long-term reliable money still exists. Only gold can play that role to satisfaction. Speculators aside, the paper gold trade (as largely explained in Aristotle's work--which can be found at the Hall of Fame link atop this page--in the event you are newly arrived to our Round Table) has functioned as a much needed currency of gold in a fashion very similar to that just described for the dollar during the Roaring Twenties...albeit with a floating dollar attachment rather than a fixed one. The paper gold is received and held as a contract that specifies a right to gold delivery, perhaps some as a lump sum, perhaps as installments. (Contracts can be written so many ways!) The key parallel, and purpose of this post is to show you that this works only as long as confidence is retained, and that excessive issues of claims has not jeopardized the real ability to get gold without being the one left holding the bag of paper gold when the bottom drops out.
These various gold contracts have been a temporary patch in the monetary system, filling a niche in the economic environment of the world. You see why the dollar failed in 1933...too many claims issued on the available gold. You see why the "new dollar" failed in 1971...too many claims issued on the available gold. You see why the "new patchwork currency" of paper gold contracts will fail in due course...too many claims issued on the available gold. The caution is that more is in jeopardy than only the viability of this paper gold system. The dollar stands to fall with it as the excess paper side is firmly attached to dollars. In the 1920's, you might run to the bank with your "paper side of the deal", and the bank would be expected to make the contract "whole" by honoring the gold side or else it would FAIL trying--with no where else to turn. The parallel in today's system is that you might run to your contract writer (bullion bank) with your "paper side of the deal", and when the bank cannot itself produce the gold to settle the claim, it will have no choice but to turn to the spot gold market (if central banks will not stand for the clearing of gold reserves--such as the U.S. would not in 1971!) to buy gold with dollars, or else FAIL the dollar and themselves in the attempt.
Look for signs of lost confidence in the paper gold system to read the road ahead. Abnormally high lease rates on borrowed gold. The Bank of England, in the backyard of the LBMA, is selling much of its preciously small gold reserves into the hands of this same LBMA. The BoE has been the primary agent to push for IMF sales of gold. LBMA average daily turnover has been slowing, (to be taken as a sign of failing support of this paper system perhaps?) The ECB has called for a halt to gold lending activity among the euro system of member banks. This aggravates the fractional reserve system that depends on new loans to out pace loan repayments to the extent not provided by dishoarding and new production. And on those accounts, Y2K and low prices have brought record bullion sales, and these same low prices have brought failing mine production through shutdowns and curbed exploration. The warning signs are plentiful. When this paper system collapses, the gold metal that always remains will inherit the value currently spread thin throughout the expansive paper system.
A few more parts to the puzzle may be falling into place. We might even say that the next act in the play is starting. It's a foregone conclusion that the IMF [International Monetary Fund] has been forced to revalue their gold. Most everyone gives the US congress credit for this action. True, they did make it clear how the voting would go if a "sell gold" proposal came before them. But, the selling of gold was only one part of a larger proposal to further fund the IMF. Given the terrible record of "good money down the hole", not only was the single debt relief provision for poor nations at the center of the funding debate, so too was the question of the existence and need for the IMF in the background.
The current problem facing the IMF is in justifying more member commitments that allow the continuation of their operations. It can be looked at two ways: 1. They either are in a squeeze for funds because the extraordinary failure of their policies now require much more money. OR 2. They have been put in a squeeze, more so because major member contributors will no longer support a policy of maintaining foreign dollar debt at the expense of nations outside the IMF/Dollar block.
Indeed, politically one must wonder; why support a system that is built upon a "strong dollar" policy for the benefit of only one country? This rift was opened wider during the last two years as the very "strong dollar policy" that flowed from the US, is the very catalyst that has helped destroy the assets in nations now absorbing most of the IMF flow.
A major item that has been part of this US support structure for the dollar was the G-10 policy on gold. The falling gold price, as seen in the world reserve currency has contributed immensely to the ongoing settlement of all trade in dollars. Indeed, the very continuation of the world trade system. Leading the dollar support component of trade was the use of crude oil settlement in dollars. That one item required practically every nation on earth to buy dollars (or at the least run a positive dollar trade balance with other dollar holding countries) to pay for oil. (NOTE: this post assumes the reader has retained the knowledge presented in the USAGOLD Hall of Fame posts [http://www.usagold.com/halloffame.html])
If a low gold price (indicating a strong dollar) could induce an overflow production of oil, then oil prices in dollars would fall. A steady, neutral or falling price of oil was always an indication that the settlement of oil in dollars would continue side-by-side with the purchase of BB [bullion bank] leveraged gold securities. In addition, the continued physical function of the established world gold markets was paramount in holding this oil support for the dollar. When the day comes that the paper contract gold markets are seen as "in question", the flow of oil will slow and its price in dollars will rise. From early this year, this process has begun.
The beginnings of this change was born in the success of the EMU [European Monetary Union]. With that Euro creation, the ECB/BIS [European Central Bank, Bank for International Settlements] has slowed, stopped and now reversed it's support to lower the price of gold in dollars. In effect, for them, the world's reserve currency position is now slowly changing towards the Euro.
Every day, new evidence emerges that shows Euro liquidity becoming as deep as the dollar with little threat of "dirty float" interventions in exchange rates. The fact that Euro interest rates have remained below the dollar rates indicate this currency's long term perception of strength.
The ECB can now slowly phase out dollar reserves as the Euro assumes more of the world trade settlement function. A function in and of itself, that will further lower the dollar's world need, use, and therefore, value. Because the US still runs a trade deficit, it still ships a surplus of dollars to most countries. In today's new Euro world, the dollar exchange rate will eventually be forced to fall enough to balance this flow. Further, a falling dollar will release ECB dollar reserves as fair game to buy physical gold from any and all entities. However, this buying will most likely be through the BIS and member CBs, not the over leveraged LBMA [London Bullion Market Association] or world gold paper.
In addition, because the Euroland external debt is very low compared to the US and they posses a positive trade balance, a rising price of gold reserves (in Euros or dollars) will support their currency with extra reserve value. Their policy of marking gold reserves to market (on a quarterly basis) and eventually establishing a "true physical" marketplace offers every enticement to get the dollar (and Euro) price of gold higher. Because this process creates a unique reserve benefit, not used in the old gold standard, they will never officially back the Euro with gold. Rather, allow a new "free market" in physical gold (not paper) to supplement their currency operations. The efficiency of modern trade requires a digital currency. That need alone will always support the use of a currency. If gold can trade beside paper money, neither will drive the other out of circulation (as old money gold coins did to paper gold money) as long as they can each seek their own values. ( a very interesting concept??)
During the last several years, the dollar-established gold exchanges created more paper gold than existing gold could ever cover. All done in an effort to create additional world support for a strong dollar. The middle of last year it became apparent that the successful Euro launch would, in time, remove most of the major physical (sales and lending and lending guarantees) support from this marketplace. The result was an IMF/dollar move to sell the physical gold of others into the paper gold arena. In as much as this supply would help, the continued further building of "fractional gold paper" has completely overwhelmed any ability for large physical stocks to cover it. I believe, the BOE sales have been part of a last ditch effort to salvage their London gold operations. Truly, the last round fired in this final battle.
Today, all roads point to a break-up of the world established gold pricing system, as settled in dollars. The IMF gold hoard is constrained to stay in place from lack of further world support for the debt of the dollar block community. The US has changed it's view of gold and views this IMF holding as the only asset that can still be used to support their floating dollar debt overseas. They did this because when a chain reaction of defaulting on foreign dollar reserve debt begins, the dollar would quickly crash!
In choice, the IMF must either release/sell their gold back to the original countries that committed said gold into the IMF, or revalue and use it as money. I think the USA congress knew they needed that gold to remain in the IMF system. They used the "gold fire sale hurting debtors" story as a political ploy to block the gold returns. Let's face it, IMF members would have been glad to return unusable dollar reserves into the IMF for gold. Especially with the ECB thinking of buying other CB gold through the BIS using Euros! In any event all now know, the IMF gold path has been chosen. This will become the trail of no return for the dollar.
Each new revaluation and money usage of gold will bring further reductions of member dollar support for IMF operations. Perceptions will slowly change, especially when oil is seen priced better in a gold "friendly" currency. In a reverse of policy, higher gold will bring cheaper oil. With each further IMF budget reduction, gold will be revalued again higher to create more reserves. One has but to grasp that this is no longer subject to SDR [Special Drawing Right] (also a dollar/IMF creation) paper calculations. This is the absolute revaluation of physical gold for official world debt settlement. The SDR articles will slowly die in this atmosphere. As will the Arabian currency link to SDRs. Perhaps a link to the Euro or complete EMU will occur?
Today, gold has just become set free as "money". In time, officials will review their need to "lend" gold for a return, where as they may "revalue" gold to create a increasing reserve source. As gold rises, there will be "no contest" in this conflict of thought.
With physical gold being quickly withdrawn from a position of support for the established world paper exchanges, the imbalance will become very visible in "lending rates". As these rates rise, the gold pricing market as we all know it will grind to a halt. I am sure it will be closed for "renovation"; use your best imagination. In 1968, on 15 of March, the US asked for the closure of the London gold markets. On 1 of April it reopened, fixing in dollars for the first time. This time I expect the official dollar gold markets will not reopen for a long time.
It was pointed out to me that our great world gold market is the most liquid it has ever been. The members have many reserves and even insurance companies to back them. I completely agree! They will not fail one investor with the lack of cash settlement for all remaining, unsettled claims. The dollar/IMF block of countries will print whatever money is needed to clear out this arena. Just as the US once before called in gold and settled up in "local gold backed cash" because the foreign dollar gold loans had failed, this time will they call in "real gold paper" and settle in "absolute fiat cash".
Some say gold will be confiscated! I reply as in the "Bear Joke" about two hikers confronting a bear. I don't have to out run the bear, says one to the other, I only have to out run you. My friend, in that day of gold turmoil, I will hold my gold and have but to only outrun you! For people with goods to sell will SEEK MY GOLD FOR ECONOMIC TRADE, not the government collection man.
Buy physical gold to hold. In the time to come, this money in the hand will outperform any investment you have ever known. Few today accept just how high physical gold will rise. Be a part of the "physical gold advocates" and tell a story your grandchildren will grow tired from hearing! (large smile)
Thank You for reading.
More than one POG
There are many different prices for gold. Or, more accurately, there are many different ways in which gold is formed and stored, and those differences cause prices to differ between the resulting products.
A one-ounce gold JM bar, a Krugerrand, a 1999 U.S. gold Eagle, a slabbed 1908 MS-65 St. Gaudens (ignoring for the moment that it's not precisely one ounce of fine gold), a one-ounce portion of a London Good Delivery bar, a one-ounce portion of a vault claim ticket for same, a one-ounce portion of a futures contract, a one-ounce portion of a derivative contract for same, and one ounce of fine gold formed into a piece of jewellery, all have prices which are somewhat independent of one another.
True, at their core, they all centre around what the market currently feels an ounce of gold is worth, but each has its own additional factors (premiums, risks and quantities) which cause its price to differ, often substantially, from the others.
The U.S. gold Eagle differs in price from both the JM bar and the Krugerrand because of a Patriotism premium. The St. Gaudens differs in price from similarly sized bullion coins because of a Numismatic Rarity premium.
The officially quoted Spot POG differs from the price of one JM bar bought at a coin shop because Spot POG is the price per-ounce at which very large quantities of physical gold trade. By large quantities I mean hundreds-to-thousands of ounces and upwards. Some of these sales are between mining companies and refiners or mints or jewellery manufacturers, where the buyer intends to reshape the metal into some new form, be it ingots, coins, or next month's necklace special at Marks & Spencer.
But in many cases, the purchaser has no plans to remanufacture the gold. Rather, he simply wants to own it. In such cases, the gold itself typically remains in a third-party repository in forms such as London Good Delivery bars (400 ounces), with only the Right to Claim those bars being transferred from buyer to seller.
Since these rights can be transferred electronically, this allows Spot market participants to make brief forays into the market, then retreat, with minimal overhead expense. Money centre banks are better known for their similar operations between paper currencies (buy Swiss Franc sell Yen this morning, then reverse that this afternoon, etc.), but no doubt a great deal of daily Spot POG setting is the result of trading rather than buying to own. Regrettably, I do not have detailed information on the various global Spot markets, so I have no way to discern the proportion of speculators to commercial traders.
In any event, this speculative access to Spot POG makes it susceptible to the same sorts of "professional" day trading which is usually associated with paper markets.
In addition, most of the gold sold at Spot POG has yet another factor influencing it, one which can easily place it more in alignment with the various paper forms of gold when market conditions become abnormal: the risk that the gold is not entirely under the supposed owner's control.
If you have a few gold coins buried in your back yard, and if you bought those coins anonymously with cash, you control that gold. If you have a claim ticket for a few hundred kilograms of gold held at the Federal Reserve Bank of New York, or a few hundred tonnes of proven reserves in a mine whose location is known to tax assessors, or even a few dozen U.S. gold Eagles in a unit trust, don't be so sure you're the one in control of that gold.
If or when a breakdown in the paper gold market occurs, it's quite possible we may see the officially quoted Spot POG remain in lockstep with paper prices, very possibly plummeting even in the face of blatant shortages of physical metal. But all this would mean is that a make-believe price is being impressed on market participants who are large enough to be easily identified and coerced.
If a private citizen holds the claim ticket to a London Good Delivery bar stored at the Fed, guess who has the power to insist on knowing details of any sale of said bar. Even if a private citizen takes possession of the bar and buries it in his back yard, Uncle Sam will be very keen to periodically bother him about its whereabouts. Although Spot POG is a measure of physical gold, it adheres to the paper world more so than to the physical world because of this one point: the risk of governmental intervention.
This ties in with points about gold mining shares made by Another and FOA: mining companies theoretically are at liberty to sell to the highest bidder, but governments have a way of convincing their subjects to accept less and be happy with it. If during an emergency the U.S. government were to declare Spot POG to be $50, and if Homestake Mining were to begin selling gold privately at a higher Street POG, the U.S. government could very easily make life unpleasant for Homestake.
By contrast, the government would have a much more difficult time coming after you and the handful of gold coins you've anonymously buried in your back yard. Most likely, they simply wouldn't attempt it. A wise politician never frightens his citizens too much, most particularly during emergencies. A government can achieve its goals by oppressing the majority owners (few in number) of a desired commodity while graciously allowing the minority owners (vast in number) to retain their property.
The confiscation in the U.S. in 1933 was along such lines: the government's intent was to take direct possession of the vast majority of gold within U.S. borders (common gold coins) by pulling them out of circulation, yet not overtly injure citizens who had sentimental or numismatic attachments to specific coins. There weren't any jack-booted thugs banging on Americans' doors after midnight in search of every last gold coin, and I can't imagine any present or future administration doing so either. It's far too expensive to be worthwhile... not to mention that it's far too likely to start a revolution (or in your case, re-start one) :-).
And yet, despite the very convincing scenario of complete meltdown painted by FOA and Another, I still find myself clinging to the hope that the supply/demand cycle will re-assert itself as has happened in other industries (the recent history of the airline industry being my beacon in the darkness).
I would never touch futures or their derivatives even under normal market conditions, but a small stock investment in the most efficient, best established global mining companies seems to me still to be worth the risk (note again my use of the word "small"). Whether those shares are ultimately sold for Euros instead of dollars, I still am optimistic enough to wager that they will indeed trade on some market for some price in some currency. In any event, though, I plan to keep an eye on potential warning signs that such optimism may be about to be dashed.
So where will we find a "real" price of gold amidst the make-believe? Clearly neither Spot POG nor futures POG will be realistic during a full-blown emergency, nor will the share prices of gold mining stocks. Of course, if I find myself still in possession of such papers during an emergency, their official resale value will be all too real to me.
Even under normal market conditions, the paper price of gold is not the perfect guide because it is determined by constant repetitions of FOA's analogy of the two neighbours betting over the fence. Perhaps one in a thousand participants in the daily setting of the official prices of gold plans to acquire or deliver physical gold. The other 999 participants are merely there to bet on it and claim their winnings in some other currency.
Put another way, how many people at a racetrack are attempting to buy a horse? If you want to know the going price of a physical horse, don't look to a racetrack for answers. And don't assume that being a partial owner in a horse farm (thanks FOA) in any way assures you of being able to own a physical horse at some future date.
Likewise, if you want to know the going price of physical gold, don't look to the paper chase, most especially during any sort of financial emergency when paper-related numbers will become very distorted. Frankly, even though the emergency has yet to be publicly declared, things in that arena are already becoming increasingly distorted.
Most of us here at the USAGOLD Forum do not buy and sell thousands of ounces at once, and most of us take immediate possession of our purchases. From that, it's clear where we should look to find the price of physical gold which is most appropriate for our activities: in fact, our very conversations here are being hosted by someone who spends most of his waking hours discovering that price.
The Cash or Street price of gold is the number of dollars (or pounds, or euros) you take out of your wallet and hand to your friendly, neighbourhood coin dealer in return for a one-ounce Krugerrand.
Why a Krugerrand? Because it's the least numismatic, most commonly encountered, least lovely form of gold. It has no numismatic premium and no jewellery premium and no patriotic premium. It's even less attractive than a one-ounce JM bar.
That makes the Krugerrand the perfect unit of measure for Street POG. Its only special quality is that it contains exactly one ounce of gold (mixed with much too much copper).
The only circumstance which would disqualify the Krugerrand would be if suddenly coin dealers were willing to sell Maple Leaves or Eagles for less than Krugerrands. But to deal with that case, let us define Street POG as the price of the cheapest one-ounce coin or wafer available for sale at that moment.
You will know that the governmentally influenced markets are becoming highly distorted when you see a Krugerrand selling on the street for significantly more dollars than the Spot POG quoted by the paper markets that day.
A Krugerrand will always have a little premium built into its price (hi, I just bought these coins and I'd like to sell them to you without making any profit at all on the sale... my, that would be daft).
At some point in August 1999 when Spot POG was quoted at $260, I bought a single Krugerrand for $268. That's within the range of normality. We're not in uncharted waters yet.
But let's say that Spot POG drops to $200 (sadly still not out of the question even with the September 1999 rise in POG towards $270). What will a Krugerrand cost on the street then? If Spot POG drops no more abruptly than has been its wont in recent months, there's a decent chance Michael and his fellow coin dealers might then be able to profitably sell Krugerrands for $205 each. In that case, the shorts and the financial ministers are still in control.
But if you see Spot POG drop below $200 while a Krugerrand selling on the street never falls below $230-$240 ... or if you see Spot POG remain at $256 yet Krugerrands leap to $300 and Eagles to $310 ... hello new gold market. That would be a clarion call that things are starting to become seriously distorted.
The American Civil War
I think maybe the hardest mental hurdle for people to clear in understanding Another and FOA is this notion of two gold markets occurring simultaneously. There's an historical example (and it's Western :-) in which very much the same thing transpired...
In 1864, the USA and the CSA were reaching something of a stalemate in their war. Contrary to what most Americans learn today in (the winner's) school system, had but a very few decisions been made differently, the Confederacy would have won.
This, by the way, is why we see so many Americans (descended from both sides) re-enact Civil War battles over and over. How often (except on Monty Python) have you seen re-enactments of Pearl Harbour? The only battles worth replaying are the ones that could have gone either way.
In any event, to the average person living in Either the USA or CSA in 1864, the near term future was incredibly unclear and terrifying.
In the pre-war USA, national government funding was handled by the levying of import/export duties. The IRS was not yet a glimmer in politicians' eyes. For a nation at peace, duties provided sufficient income to run a minimalist national government.
In time of war, however, expenses magnify dramatically. Both the remnant USA and the new CSA needed to acquire vast funding very rapidly to raise an effective military. The both of them did so in the time honoured way: they borrowed the money. Have a peek at Lincoln greenbacks and Confederate paper money sometime. They are promises to pay the bearer with gold and/or silver at some significant time following the cessation of hostilities.
These documents were by no means the equivalent of today's Federal Reserve Notes (try redeeming a $20 FRN for a St. Gaudens sometime). No, Civil War paper banknotes were the equivalent of today's Gold Futures Contracts.
Oh, Lincoln greenbacks and Confederate dollars passed from wallet to wallet during the Civil War years as if they were currency, and in the first year or so they were regarded as 1-for-1 equivalents of coin. But as 1864 drew nearer, something odd began to happen.
"Howdy, I'd like to hand you this crisp $1 greenback in return for ten silver dimes change."
"I'll give you 8 silver dimes for a paper dollar, not a penny more."
Realise that this happened in the North, in the remnant USA. It happened too in the Confederacy, but modern people remember it there only in association with the final default on paper which happened when the CSA government was extinguished.
But the sole difference between a Confederate dollar and a Lincoln greenback was that one paper issuer was still in existence in 1866 and one was not. In 1864, no one could confidently say that either government would still be there a mere two years hence.
Notice that, in this regard, not much has changed since then. In 1933 for US citizens, then in 1971 for the rest of us, the USA government voided its obligation to pay gold for paper dollars.
If you hand me silver or gold, I won't care whether the symbols impressed on it are from a reliable government, an unreliable one, or a defunct one. But if you hand me paper, I'd better be firmly assured the issuer will live long enough (and be inclined) to pay off this debt to me. Even if you hand me a paper claim ticket to silver or gold stored in a vault somewhere, I'd better be firmly assured the vault keeper is of a mind to let me take possession of that metal without the slightest hesitation.
Another and FOA, by saying wise people should avoid paper and only hold physical, are indicating that they expect the LBMA and Comex Gold Contract documents will go the way of the Confederate Dollar (or maybe more appropriately, the way of the pre-1933 paper dollar: "Yes, a dollar is still a dollar, we just won't live up to it in quite the way we used.").
At the very least, they're saying the risk of such a systemic change is so substantial that one should not be standing too near the fault line should the quake come sooner than predicted.
What the both of them are describing is an official Spot POG (and its kindred future months' POGs) which may well plummet to $200 or even, as Another allowed some time ago, perhaps $10. Realise, though, that Another is by no means predicting that Michael will be able to profitably sell Krugerrands at $10 each. Far from it.
What Another and FOA are anticipating is a situation much like the paper money situation in both the USA and the CSA in 1864: how likely is it that the paper contract you're handing me today will be redeemable for any amount of gold by this time next year?
Tell you what, I've got a spare ten bob I feel no desperate attachment to. I'll buy your one-ounce IOU just for kicks. If LBMA completely expires, I'm out only a small amount. If LBMA unaccountably fails to expire, I've struck it rich. Of course, I may still not receive a physical ounce of gold on settlement day. I may find I've become the proud owner of a 1/400th part of a London Good Delivery bar, which I'm then told may not be removed from the vault. If I'm lucky, I might be able to sell my claim ticket for some amount of whatever paper currency is still worth accepting.
Meanwhile, those of us with less of a gambling inclination will sleep more soundly holding physical. After all, a silver or gold coin firmly in your possession remains silver or gold even after its issuer expires.
In high-tech, most companies tend to be small, fast paced and driven by energy and initative. Most are driven by a vision of some sort as opposed to short term numbers. Many are fun places to work. However, as numbers become more important than visions and people, high-tech begins to suffer the same prison-like problems as other industries.
IBM is, in my opinion, one of the least creative, most bureaucratic organizations on the planet. Notice how they're continuing to cut costs at people's expense. Are they as bad as Aerospace? No, I don't think so. Why not? I have my own theory.
I believe that the closer one gets to government, the more the aliveness of the companies and their people dies. I also believe that, in general, the larger the organization becomes, the more oppressive too. The root cause: FEAR!!! People are meant to be energetic, creative, thoughtful and emotive. Fear steals this aliveness. Fear steals our humanity and replaces it with false security. It takes great courage to trade ones security for ones happiness. Still, it's a worthy exchange, I do believe
Like a foreign language, isn't it? As near as I can figure it out (*wink, wink, nudge, nudge*) repo operations are where you traded your wealth in on some sure-bet paper investment strategy as recommended by a slick broker or CNBC commentator. When the laws of nature in a closed system regain the upper hand, and the card houses built to the sky on a leveraged foundation come crashing earthward, these repo operations are what the Fed uses when you can't make the next payments on your two SUV's and bass boat all parked in your three stall garage.
To start with, you must understand that banks have the distinct privilege to create money from "thin air" as needed to give to a borrower rather than to be limited by the fact that what "real" money they have is often owed to someone else that might choose to claim it back at any given time. This is what fractional reserve lending is all about, and arguably is the biggest culprit to the boom and bust business cycle. (Many varied opinions on that claim, you can be sure.)
Banks are limited in their ability to expand the money supply, however, by legal reserve requirements...a minimum percentage of the bank's liabilities to its depositors (bankspeak for money deposited with the bank by its customers, particularly money held in checking accounts) that must be kept on hand to meet any anticipated immediate demand of withdrawals. If the reserve requirement were 10% and the bank had one customer who had placed $10,000 in a checking account, the bank would be required to keep 10% of this ($1,000) in readily obtainable form (cash in their own vault, for example). So while this one customer "owns" this full $10,000, and has the ability to spend it at will, the bank also has the green light from congress to lend out up to $9,000 to a borrower, who might use it to pay for a remodeled kitchen.
Let's say the contractor takes his $9,000 payment from this borrower, and he also places it on deposit in a checking account with this same bank. The bank may then set aside 10% ($900) of this additional deposit and be free to lend out $8,100 to someone else. At this point, from the original deposit of $10,000, you can see that the bank now miraculously has $19,000 (called "liabilities" because the bank owes this money to its depositors) on deposit in two checking accounts. On the other side of the balance sheet, the "asset" side, the bank has $1,000+$900=$1,900 in vault cash as mandated by the reserve requirements, it has an outstanding loan written to that borrower (for his new kitchen) for $9,000 (which the banks expects to be repaid with interest), and at the moment, the bank also has the remaining $8,100 in available funds from the second deposit (after setting aside $900 from the second deposit of $9,000). So in total assets, the bank has $1,900 (vault cash) + $8,100 (available funds) + $9,000 (loan) = $19,000. Assets are seen to be equal to liabilities on the balance sheet. (Recall, only $10,000 was originally introduced into the banking system as "seed" money to start this inflationary process.)
The bank looks to that $9,000 loan as a profit maker for their own pockets because it gets to keep the interest when the loan is paid back. (Because the bank (within the banking system as a whole) temporarily created 9,000 new dollars that didn't originally exist (inflation), the banking system has an obligation to destroy (strike from the collective ledger) this $9,000 as the principle of the loan is repaid...deflation.) Clearly, the bank would like to make similar profits on its remaining $8,100 in available funds. And if these funds get redeposited with this bank, it will be able to play its happy part to yet further expand the money supply from that original $10,000 checking account deposit.
Let's say that there is no one else in town that wants to borrow money. The bank still wants to earn "profits" on these available funds, so the bank does the natural, next best thing and purchases U.S. Treasury bills that pays interest at 5.5% with a maturity of three months. Now, let's say that first depositor is reading this, and is now keenly aware of the shortcomings of this financial system. He decides to pull out $6,000 in order to swap it with MK for an independent monetary asset, gold.
The bank has only $1,900 in vault cash with which to pay this smart customer. Obviously, the terms of that $9,000 outstanding loan are such that it isn't going to be of any help in this matter. The bank must use its Treasury bill as collateral to seek a loan from another bank for two piles of money. First, the bank needs $4,100 to meet their vault cash shortfall on the $6,000 withdrawal. Second, the bank still has a total checking account liability of $4,000 + $9,000 = $13,000, so it must also borrow another $1,300 cash in order to meet the 10% reserve requirement on this remaining level of checking deposits.
That is a simple example of a problematic turn of events for a bank. They don't net out much "profit" on their assets (outstanding loans and T-bills) when they are forced to be borrowers themselves from other banks, paying near the Fed Funds target rate (decided by the Fed at the FOMC meetings) which is currently 5.25%.
More often, the adjustments needed to maintain reserves are small and short term. The reserve requirements are calculated on a daily average basis over a two-week reserve-maintenance period, from Thursday to Wednesday. Yesterday, for example, marked the first day in a new two-week period. In a more typical situation, let's assume one of our depositors withdraws or writes a check on $1,000. As the bank pays the $1,000 out of the vault funds, it is left with only $900 in reserves. However, that amount is only half of the 10% required on the remaining checking deposits of $18,000. The bank must make arrangements to borrow 900 more dollars to meet its $1,800 reserve requirement until such time as new deposits arrive from customers, or else until their 3-month Treasury bill matures (or perhaps they sell it outright on the open market for cash.)
This is where the Fed repo operations come in handy... viewed simply, the Fed is writing a short term loan. Repo is jargon for repurchase agreements. The two parties, the Fed and the bank in need, both agree to an effective yield (price of doing business) that will be realized when the bank "sells" its collateral (in this case the T-bill) to the Fed for a set short period of time, and then "buys" it back at a slightly higher price that produces the agreed-upon yield. Time periods are short, from overnight, to the special 3 month period in use for Y2K liquidity needs. (Also by special concession for Y2K liquidity shortage is the Fed's willingness to accept "crap collateral," referred to in my news reports as "tri-party" operations because there is a potentially dubious third party in these operations that ultimately stands behind the credit-worthiness of the asset/collateral. The Fed isn't generally worried about the US Treasury as the third party behind T-bill repo operations, but when you start scraping the barrel on agency bonds and whatnot ( -- like a mortgage-backed security) because the bank has already sold or borrowed against all of its prime collateral, well, you can see the recipe for disaster with the Fed left holding the bag on defaulted bonds if the bank fails to buy it back as agreed followed by the third party failing to honor their own payment on the bond.)
Now you know more than 99.995% of all Americans about much of the banking system, and about overnight (three-day, weekend, 7-day, etc) system repos in particular, although in truth, we only scratched the surface on repo operations, and Fed Funds, and discount rates, and a whole host of ways to play musical chairs to find and create money as needs. Some people say that gold is manipulated. Well, it is certainly insofar as it serves as a financial asset that must endure these same banking practices, and further, that it must endure the indignity of bogus "price discovery" through futures markets. That whole game finds its limit, however, where the call is made for the "virtual metal" (paper gold) beyond the ability of the system to deliver. Notice how the European central banks have backed safely away from the coming implosion of that degree of artificial-supply manipulation (confer the September 1999 Central Bank Agreement on Gold). On the other hand, The Tower submits to you that the dollar is subject to unlimited manipulation...like Quasimodo at a chiropractic clinic. There's no practical ceiling at which the artificial supply of the artificial dollar may be held in check, and worse, no practical floor at which its value may be held at any meaningful point above worthless.