THE GOLD 'SOLUTION'
Shorts in an honest market do a service by providing a buying floor (at or near their short sell price when they cover, if they are lucky) during a time when bulls make an effort to buy into the market. In small amounts, shorts test the weakness of the market to probe and decide if further short selling is warranted. When their selling is absorbed readily they fade. When the price falls on their selling, they think they are encouraged to sell more.
All this is outlined in detail in Charles LeFevre's classic, Reminiscences of a Stock Operator.
Once paper gold was introduced the game changed. It became possible to create paper amounts of gold. These obligations need to be tied to real amounts of gold, or they become divorced from reality. See also the Red Baron series at Gold-Eagle, especially: http://www.gold-eagle.com/gold_digest/baron1020.html, and the following: http://www.gold-eagle.com/gold_digest/baron1020.html. Note the gold-oil connection, and the suggestion that all the central banks gold would be sold (by sometime in 2001?) if 1/3 of the price of oil were paid in gold. In the next Red Baron article we see that the price of oil in 1997, expressed in ounces of gold, is similar to the price in 1980: http://www.gold-eagle.com/gold_digest/baron1026.html. Note the commentary at the end of the article that explains how the banks lost control and how the mines were participating, and why.
Short selling paper gold permitted some to sell more paper gold than was being sold on the gold bullion markets. The paper gold market developed into a large market and it simply overwhelmed the real gold market. The real or bullion gold price began to be priced in paper gold terms. It became possible to force the price of both paper gold and real or bullion gold down.
We are seeing a gold market in which the tools that once were used judiciously to protect the market are now being used to make the market. The actual or real bullion price of gold does exist. For the time being it has been dissolved in the solvent, 'paper gold.' So it has become invisible. It has not been lost however. The real gold price is still available.
We simply need to remove the solvent from the 'solution' and we will see that the real gold price has been there all along.
To do this removal requires some modern financial chemistry. Whether this solvent is removed by an overt act of those who can make the change, or whether it is removed by some free market force is yet to be determined. To learn more of what might happen we could study the examples provided by history. One well-known example is that of John Law and paper money in France a few hundred years ago. Other paper currencies may also be studied because paper gold is simply another form of gold-backed currency. Paper gold being traded in ever increasing amounts would be, conversely, backed by less and less gold. Once the day arrives when confidence in paper gold erodes, the whole market could collapse. The currency value of paper gold could decline then, since non-confidence would lead to selling or its equivalent. Once selling overwhelms buying of the paper gold securities, their value would be expected to decline.
Those short sellers of paper gold would, in this example, find themselves holding paper gold contracts that they cannot resell. As the date of their expiration, closing, or fulfillment approaches, there would arise a need to acquire physical gold to cover the paper gold obligation. Insufficient real gold bullion available to cover the paper gold contracts could lead to a crisis. Such an event could create hardship for many others in the financial system, so it would be expected that some 'deus ex machina' resolution to the problem would be found.
Perhaps rules on the exchange could be changed to permit settlement, not in gold, but in some other form of security or cash. This would not please those who thought that owning paper gold was as safe as owning the real thing. But it might avert some forms of financial problems.
In our analogy, the gold bullion price is hidden in a solvent of paper gold. Paper gold as a solvent is likely to have a saturation point. This point would occur when the gold bullion price increases so much that the paper gold market cannot sufficiently (in volume) absorb the bullion gold price. Those who add to the paper gold market may think that the ability to create paper gold is like a guarantee of supremacy for paper gold. Paper gold can be created on paper. Real gold is in limited supply. What would change the paper gold 'solution' so that the price of gold bullion would rise enough to saturate the paper gold 'solution', thus allowing the gold bullion price to become visible and to exit the gold 'solution?' Volume is the answer.
Several possibilities come to mind. Gold is traded in US dollars. Paper gold contracts can be denominated in various currencies. Those paper gold contracts traded in US dollars could be at risk if another, larger gold market were to develop in another currency, one stronger than the US dollar. The same effect could be created if the US dollar volume at current value were to shrink. Let's look at an example.
Proxies for the US dollar have developed. The US equities markets have developed paper valuations of enormous size, which are valued in US dollar terms. The US dollar denominated bond market is very large as well. In a large decline in the value of these proxies for the US dollar, we would expect that the US dollar would decline vs. other world currencies. The total value of equities and bonds would decline, thus the total volume of dollars represented by these markets would be smaller. To increase the volume to offset the decline, we would expect a large injection of liquidity to replace the 'lost' dollars.
At some point we would expect that the US dollar value of gold would begin to rise in such a scenario. The gold price in other currencies could remain stable, but rise in US dollar terms as the US dollar declined in either a deflationary volume reduction, or an inflationary volume increase, and devalued the US dollar proxies. Further along in this scenario the US dollar price of gold bullion would achieve saturation in the paper gold 'solution.' The gold bullion price would emerge from its immersion in the paper gold price. Free market gold bullion would begin to be free of the paper gold price.
It is unfortunate that the savings and wealth of many are riding on the paper trail.
We can now try to understand the desire to increase US dollar liquidity over the past few years. By increasing the liquidity available to the US dollar system, it was possible to inflate the value of the equities markets. Speculators and investors could borrow cheaply to invest and then see the value of their equities rise. Overseas money could find a safe haven.
Unfortunately the use of borrowing created debt. Had much of this debt been retired after profitable use we would have seen the successful use of borrowed money. The problem facing policy makers is that liquidity can be injected into the system by borrowing from many sources, not just from the Fed. So the control of the use of the created liquidity has spun out of control into the hands of many lenders and their clients, the borrowers.
If it is the equities and bond markets which act as proxies for the US dollar, and if the protection of both is fundamental, then we could see the dollar drift lower for a time as the liquidity needed to reflate the markets is offered over the next few months. A decline in the dollar may occur during the attempt to reverse a fifty- percent decline in the Nasdaq and to avert such a decline in the DOW.
Due to the apparent misuse of so much debt, and the concurrent decline in the equities markets, it may be impossible for many to liquidate their debts, unless new liquidity enters the marketplace.
Gold bulls may test the markets during this time to see if the paper gold market has become saturated.
(With thanks to the pioneers who questioned and discovered and shared)
Robert Bird
(Copyright 2001)
February 24, 2001
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