An Open Letter to Congress on the Euro,
the Gold Market, and the DollarPart 1
Executive Statement
The US routinely purchases and manages items in dollars. The US dollar has enjoyed a long history as the world reserve currency. It is the author's opinion that the Euro is directly challenging the dollar in its role as the world's reserve currency and stands behind oil's recent rise. The net effect of the Euro replacing the dollar as reserve currency would be a return of foreign-held reserve dollars into circulation. Should that happen, the following could be a direct result of this:
- Dollar to devalue relative to Euro possibly by 200% or more.
- Foreign goods, especially oil, could change from a dollar-based exchange to a Euro-based exchange.
- US goods purchased overseas or with oversea components would see a significant price increase (100% or more).
- US fuel purchases would see a dramatic rise in price (100-1000%).
- US strategic commodities (precious metals) would see a dramatic rise in price (100-4000%).
- US existing inventory would see a dramatic rise in market value, if revalued to market.
- US petroleum-based goods surging in price in proportion to the rise in the price of oil.
The author's purpose is to point out the possibility of the Euro replacing the dollar as the world reserve currency. The author believes the wheel for this is already in motion and demonstrates numerous events and indicators that shows this might just be the case. This paper is not meant to convert, convince, or construct the Euro as the better currency or that the Euro is the replacement for the dollar; rather, it is to merely demonstrate a phenomena that can be observed once one is aware of certain facts, events, and principles. Being Euro-aware is the point. With this awareness, then, certain long-range business decisions can be made that would allow the US to position itself better for a possible significant dollar devaluation. This paper discusses the dollar's spar with the Euro. Finally, the author offers alternatives and possible postures the US could take if the Euro continues to replace the dollar as the world's reserve currency. Ultimately, the author merely wishes to point out a significant financial event that could take most people by storm unless they become Euro-aware.
Dollar Twice Defaulted
Internal Default
To understand the Euro and its potential as the future reserve currency, one must first understand the role that gold has played in monetary policy from the early 20th Century. From the late 1800's through 1933 gold traded at a fixed rate of $20.67 per ounce. During the stock boom of the late 1920's, not dissimilar to the present stock boom, many credit excesses came to pass. Margin requirements for individuals, unlike today, were not limited to 50%. Stock leveraging was high. When the well-known crash came, the dollar suffered a loss of confidence that resulted in many bank closures in the ensuing years. See chart 1.
Chart 1Note: Figures for 1932 were not available.
As Chart 1 indicates, bank failures increased through 1932. In 1933, President Roosevelt, in an unprecedented move, defaulted on the dollar gold backing for US citizens. He used an emergency power Executive Order to declare a bank holiday effective March 6, 1933. He ordered all American's to turn in all their gold at the official rate, except special numismatic coins. As this gold confiscation was internal to the US, it did not affect settlement of gold and dollars between countries. Following the gold confiscation, the dollar price of gold rose to $35 per ounce and remained there through the Bretton Woods agreement after World War II through 1971. The net effect of the confiscation was to make more gold available to the US for international settlements. De-linking gold from the dollar prevented bank runs due to exchange of dollars for gold as this was no longer permitted. It allowed what is called fractional reserve lending and the printing of sufficient dollars to provide the needed bank fund liquidity to curtail and prevent bank failures. One could say that the excesses of the 20's led away from the discipline that a gold standard set and forced a liquefaction of dollars to meet demand and prevent financial failures. In part, this was because there was a fixed international price of gold and not a floating price of gold. In that fixation of the price of gold, liquidity could not be maintained.
The author intends to prove that a recent myth, to wit: gold is no longer at the center of the financial universe, is a false myth and that it actually remains at the center world finance, albeit more opaque than in the past. It is seeing around the corner of that myth that allows one to see how the Euro may actually be well along the road to replace the dollar as the reserve currency. The impact on the US and its mission could be significant. It is this potential impact that warrants understanding the birth of the Euro and its potential impact on the dollar.
External Default
Post-World War II, the Bretton Woods agreement created the IMF (International Monetary Fund), whose role it became to manage the currency exchange markets with gold backing of the dollar at the rate of $35 per ounce. At that time, circa 1950, the US produced 50% or more of the world's oil production. Chart II depicts the production of Saudi Arabian (SA)oil over a period of decades up until 1973, when the US defaulted on its external gold debt. As can be seen by the chart, SA oil production, the cheapest in the world, soon ramped up to supercede the percentage of oil production in the United States. Because the Texas Railroad Commission had set a higher price for US oil, that also raised the price for SA oil. The SA oil always has netted a much greater profit percentage than US producers have been able to enjoy.
Chart 2As the US entered its Vietnam era, it was forced to spend greater and greater amounts of dollars that resulted ultimately in President Nixon's defaulting on its external gold debt in 1971. It just couldn't keep up with the demand for its gold as these dollars worked their way home to exchange gold for dollars. President Nixon made it again legal for Americans to own physical gold but no longer honored the exchange of foreign dollars for gold bullion. It was quickly draining the US gold reserve.
"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 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…. 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 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…. And so began the First Oil Crisis of the 1970's." Understanding the Mid-eastern strong affinity to gold and not dollars is critical. As long as they could get gold with dollars from their oil, they were content. Later, when the size of paper gold loans increased such that 14K metric tons were sold forward, serious thoughts of contract default changed the nature of the paper gold market.
The SA oil generated huge profits for the SA and Kuwait and other cheap oil producers. They used these profits to buy infrastructure, weapons, and aircraft. The magnitude of the profits also netted a continual and huge net profit above and beyond the systems capacity to absorb these petro-dollars. These profits were largely placed into gold. From 1973 until 1980, these dollars largely bid for gold on the open market and resulted in an increase in the price of gold from $174 to $852 per ounce. This open bid for gold by oil caused a near failure of the dollar, it caused gas shortages at pumps across America, it caused the highest interest rates, set by the Volker Fed, and the largest run on commodities and real estate in the later half of the 20th Century. Something had to be done to restore faith in the dollar and return the US to a stable currency.
Jamaica Accord
Little is know about a secretive meeting of the IMF in 1976. It met in Jamaica of that year. The Accords that came about ratified a year or two later resulted in the de-monitization of gold and an arrangement that would remove gold from the limelight. It was a way for the SA and other cheap oil producers to buy their gold with cheap dollars in a way that wouldn't bid the price of gold higher and higher. The result of the Accord was to ultimately start a 20-year bear market in gold prices and to allow the price of oil to actually get cheaper in real-dollars during this same period. To rephrase, the reason gold became cheaper and cheaper over the past twenty years wasn't because it didn't have significant monetary value, rather, a little bit of gold was set up to bid with each dollar for a little bit of oil. This is called "oil bidding for gold" and is the very reason why oil and gold have dropped together: more gold could be purchased for less dollars. At some point, however, the designers of this plan must have known or expected that gold would rise in value. It would seem, therefore, a stopgap measure to keep the dollar in place until an alternative could be created that would not be in a position of defaulting on its debt. Since the dollar had now defaulted twice on its obligations, many nations doubted that the dollar would last forever. That was 1976, it is now 2000.
Oil for Gold
Since 1980, the dollar price of gold fell from $852 to $252 per ounce. It is the complex paper-gold arrangement as depicted in chart 3 that shows how gold was removed off the radar screen but continued to provide the impetus for cheap oil for cheap gold. The majority of these contracts are cut on the LBMA, a secretive, non-public gold market based in London. Every day over 1,000 metric tons of paper gold are traded.
Chart 3 depicts a contract relationship commonly called 'paper gold' or 'gold leases.' Paper gold is the process of a Central Bank acting as a guarantor of a gold loan by a bullion bank to a mining company. The bullion bank sells the contract to a Foreign-oil interest (FOI). The FOI now receives payments in gold from the mining company. The paper gold contracts can be paid in gold borrowed from private holders of gold or bought from the open market too. Hedge funds including Long Term Capitol Management (LTCM) have recently allegedly become involved in paper gold contracts. Since Hedge Funds are not gold mines, they must obtain their gold from alternative sources as they can not produce it. It is hedge fund involvement and other gold players other than mining companies that have created the systemic risk to the dollar that may have accelerated a potential move to the Euro. Bullion Banks and hedge funds have now written paper gold contracts totaling upwards of 14,000 metric tons of gold or more. In some case, mining companies have sold forward their annual production up to 10-years. THE REASON GOLD HAS FALLEN IN PRICE SINCE 1980 IS NOT BECAUSE OF A LACK OF POPULARITY. IT WAS BECAUSE OF THE 10,000 to 14,000 metric ton FORWARD SALES OF PAPER GOLD CONTRACTS. In other words, what seemed to be a simple solution to extend the dollar payment system as a reserve currency in 1976 (without bidding up the price of gold through the use of paper gold contracts) has now become seriously close to a third default of the dollar on its gold obligations. From recent events and news reports, this does not appear to sit well with the FOI. In other words, SA and other FOI put more credence in physical gold. It seems they may consider the paper gold arena at risk from failure and this is what ultimately may cause the LBMA (the London Bullion Market Association) and COMEX (Commodity Exchange – the New York-based gold market) to default – a third default. Finally, one could construe it is this very same risk of a third default that is moving the FOI's to the Euro and permanently driving the price of oil higher in US dollars.
(Part 2 next week)
Steve Hickel
February 3, 2000
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