Reprinted with Permission

There was a time when, as someone recently said, everybody and his cat knew the difference between real gold and paper gold. But today's kool cats, if they own gold at all (which few do), are too smart to pay storage or insurance on allocated gold, too sophisticated to tie up funds in stodgy old coins or bullion bars with no yield, and too greedy to forswear the allure of maximum leverage. Gold investors, on the other hand, know gold first and foremost as a portfolio anchor to windward, a shelter in a monetary storm. Ashanti and Cambior are examples of apparently good hooks that dragged badly at the first stormy blasts. Why?

The nub of the problem is to recognize that while the line between real gold and paper gold is quite clear, the line between paper gold and fool's gold can be a moving target. Paper gold is all paper instruments credibly repayable in, or otherwise linked to, gold. Fool's gold is paper gold that lacks credibility. Typical examples include unallocated gold in unsound banks, options or futures on gold from parties that may not be able to deliver, and mining shares in companies whose ore deposits or finances are questionable.

To appreciate the potential force of the coming monetary storm, a basic understanding of gold, gold banking, inflation and deflation is essential. Forget the CPI and other such price indices. They are generally lagging indicators of prices in certain sectors of the economy. What is more, the CPI is now subject to so many "adjustments" that its usefulness except perhaps as a tool to reduce government expenses tied to it (e.g., Social Security payments) is suspect. Forget, too, most blather about whether gold does better in an inflation or a deflation. Gold is insurance against severe currency or credit destruction, whether its precipitating cause be inflation or deflation. Inflation and deflation are, respectively, expanding and contracting credit relative to some reliable measure of money. Historically, the monetary measure was gold, which does not do well in periods of controlled or hidden inflation precisely because more credit can be built on less gold without arousing widespread public alarm. Measuring inflation today is difficult because what passes for money -- unlimited paper currency -- is itself so intermingled with credit as to make the two virtually indistinguishable. A money market fund is nothing really but short-term credit obligations aggregated to look like what was once a bank account backed (in a sound bank) by a 40% reserve in gold coin or bullion resting in the vault.

Measuring the amount of real money in the world is no more difficult today than a century ago. It is the total above-ground physical gold stock, now somewhere around 120,000 metric tons (excluding the double-counting of gold leased by central banks but still on their balance sheets). Going off the classical gold standard and the quasi-gold standards that followed has not change gold's inherent nature as real, permanent, natural money. What it has done, besides changing for a time at least general public perceptions about gold, is to reduce to a small but elite group (international financial institutions like the BIS and IMF, national central banks, bullion banks and their customers, and the gold markets themselves) that portion of the international currency/credit structure directly tied to gold.

The short gold position created by the bullion banks with leased gold mostly from the central banks is a fractional reserve position. This physical gold sold short must at some point be replaced, either by purchase in the market or new production. Be this short position 6000 metric tons, 10,000 tons or higher, it is a significant multiple of annual new production of around 2500 tons. Some portion of this short position represents forward sales by gold mining companies; the remainder is largely borrowed gold used in the so-called carry trade. Accordingly, counting forward sales by gold mining companies as existing gold (which they really aren't) and assuming these contracts cover approximately half of the total short position (as good a guess as any), the gold banks are operating with fractional reserves not far from the minimum safe level of 40% sanctioned by historic experience. Half the physical gold they owe to their lessors must be obtained on the market. What is more, the other half is not really in the vault. It is underground, but in an ore deposit, where it must be dug out, processed and refined before it can be delivered.

On top of this shaky reserve position, the bullion banks have created gold derivatives, principally options and futures. Cambior's hedge book shows how the gold banks have created options for gold in amounts that far exceed the amounts already sold forward by producers. What is more, they have done so primarily in the over-the-counter market out of public view. The gold banks' exposures particularly as they relate to the gold mining industry are detailed in an excellent article by John Hathaway of the Tocqueville Gold Fund entitled Simple Math & Common Sense: A $66 Billion Problem (www.tocqueville.com/brainstorms/brainstorm0041.shtml).

All that is reported about the activities of the London Bullion Market Association is its monthly average daily clearing volume, a figure that will be quite interesting to watch in the months to come. The LBMA dwarfs the two best-known public markets, the COMEX and the TOCOM, which though smaller are more transparent. They offer gold futures contracts where open interest now exceeds warehouse stocks by multiples of 20 or more. On the COMEX open interest is north of 600 tons (200,000 contracts x 100 / 31250 = 622) against warehouse stocks of some 30 tons. On the TOCOM, where the percentage of coverage appears even lower, open interest has very recently shrunk from over 500 tons to 400 tons on October 7. Fear, perhaps, is hitting the TOCOM a bit before it hits New York.

As I have discussed before, TOCOM futures, which are priced in yen, are in backwardation. The degree of backwardation, however, is more than accounted for by interest rate differentials between the dollar (in which gold is almost universally priced internationally) and the yen. In other words, the implied yen forward rate is not what the difference between gold lease rates and yen interest rates would suggest, but less (i.e., a smaller negative percent or discount) than on dollar/yen futures. However, as a result of the backwardation, open interest on the TOCOM is mostly in the further out months, although this too may be beginning to shift.

The COMEX also offers options on futures contracts, where the call open interest at strike prices between $310/oz. and $335/oz. running from November to February exceeds 500,000 contracts, representing futures on another 1500+ tons. Including options, the two public futures markets could be asked to deliver about one full year's production within a year, mostly in December and next spring. This potential obligation has been assumed on the erroneous assumption that because gold is just another commodity, there is no possibility of ever having to make actual delivery of the total outstanding open interest. Another quick $60 on the gold price, all the options will be well in the money, and futures on gold will almost certainly be fool's gold.

But what is most alarming about the strained condition of the gold banks is the larger world financial picture of which they are a small but very important part. At the macroeconomic level, not only are there eye-popping figures on credit creation, derivative exposures and stock market valuations, but the potential collapse last year of a single hedge fund, Long Term Capital Management, threatened sufficiently dire consequences for the entire international financial system to warrant a bailout orchestrated by the Fed and backed by three discount rate cuts. Determining what paper gold is credible and what isn't is difficult enough under ordinary circumstances. Far harder, and in extraordinary times much more crucial, is gauging external factors -- macroeconomic, geopolitical, cultural, whatever -- that paper gold and even real gold may have to survive.

The bullion banks and their customers were not caught wrong-footed by a free gold market. They were caught out of position by the first attack in a monetary war they they didn't expect and on terrain that they thought they controlled. The full story of how Anglo-American manipulation of the gold market led to a counterattack by the European central banks is yet to be told, but Ashanti, Cambior, and their shareholders are among the first victims. Before the gathering monetary storm is over, there will be many more casualties, caught in the cross-fire as nations fight a currency war the likes of which the world has never seen. Governments who try to wage this war with the weapons of old -- forex interventions, interest rate changes, currency controls, gold restrictions, competitive devaluations, etc. -- are likely to be overwhelmed by the very free market principles which they have recently preached if not always followed. For in a truly free market for money, one with no legal tender laws, gold wins.

In the United States, the legal and cultural settings are vastly different from the 1930's or 1970's. As a matter of law at least, gold is in a free market, hugely complicating the legal basis for any effort at confiscation. Trust in government officials, starting with the President, has never been lower. So turned off to their government are Americans that nearly half the eligible voters no longer participate. So offended are they by the shenanigans of the two major parties that third party or otherwise apparently independent candidates arouse astonishing levels of interest and support. And then there is the internet, giving freedom of speech and debate rein to affect public policy as never before while at the same time braking the power of the mass media. What is more, the internet is now as international as gold, giving gold bugs worldwide their own web in which to catch miscreant officials and expose official scams.

So-called "gold clauses" were a standard feature of many private contracts from the "greenback era" of the Civil War to the midst of the Great Depression, when the monetary measures of the New Deal made them invalid by government fiat. Thus fell at a blow supposedly certain protection against the gold devaluation of the dollar, catching off-base the most prudent and best-advised lenders of their era. For ordinary American citizens in that particular financial cataclysm, mining shares proved a much better refuge than physical gold or gold dollars, ownership of which was made illegal on the ridiculous theory that government gave gold its value by making it money. So too, in 1971 not even an international treaty, the Bretton Woods Agreements, could protect those nations who had placed their reserves in U.S. dollars from a second unilateral gold devaluation by the United States. Only the French, by redeeming dollars in gold "avant le déluge," gained a partial measure of protection. The monetary history of the twentieth century, for both individual nations and the world at large, is a story of swift and devastating discontinuities, not a linear progression of events.

Today the evidence points to an impending conjunction of macroeconomic and geopolitical events that will almost certainly sweep from the scene the entire monetary and credit structure erected on floating exchange rates with the U.S. dollar as the key reserve currency. This lopsided international structure -- imposed by and so favorable to the United States that it has for years run balance of payments deficits of truly gargantuan proportions -- is hopelessly dysfunctional, often placing smaller economies at the mercy of forex market speculators. As this structure disintegrates, gold will retake its accustomed place at the heart of the world monetary order not so much by official choice as by international necessity enforced by free market principles that will be virtually impossible for free governments at least to resist.

To ask at what price gold is to misunderstand both the problem and gold. No one could foresee in 1929 that gold, then $20.67/oz., would be $35/oz. in 1934? Similarly, no one could could tell in 1971 that gold, then $35/oz., would rise as high as $800/oz. within a decade? What a few could and did predict in the months and years immediately preceding these devaluations was that the world would soon be forced to confront the effects of then unprecedented credit inflation built with far too little regard for the underlying amount of gold available to support it. What they also could and did predict was that the existing dollar/gold exchange rate (or price) was too low and would have to rise substantially to offset what would otherwise be devastating credit deflations. As they say, history repeats though never in quite the same way.

Eight years ago in The Golden Sextant I discussed the problem of setting a new official gold price in the context of an orderly return to an international gold standard. Today 40% gold cover for U.S. currency in circulation would require a gold price over $800/oz., almost twice the number of eight years ago. Yet we are constantly told that this is the decade when inflation was vanquished. When gold was at $800/oz., in January 1980, one ounce would buy the Dow Jones Industrial Average, as it would have in 1932 if it had been fixed at $35/oz. two years sooner. If you must guess a future gold price, ask yourself what will be the price when next one ounce, two or even three will buy the Dow.

Eight years ago I also held little hope of an orderly return to a gold-linked dollar. By then American officials of both political parties and all three branches of government had decreed by their actions over many years that any formal return to gold would come, if at all, only under almost unimaginable crisis conditions, when the golden lifeboat is the only lifeboat. What historians may call "The Great Gold Scandal" and Americans may call "Moneygate" did not begin just a few years ago only to surface with the Bank of England's gold sales. It began in 1971 when President Nixon closed the gold window and for the first time in U.S. history cut the dollar free from any meaningful link to gold. Compared to what is coming, Watergate was a bagatelle.

It is no accident that Moneygate began with the first President to be driven from office and will likely end with the first in this century to be impeached. Scandal -- indeed, the most egregious breaches of public and private trusts -- are part of the pathology of all great inflations, a pathology not unlike that of the drunk or the addict. Nowhere is this pathology better described than in today's addition to my Reading List: Fiat Money Inflation in France by Andrew Dexter White, founder and first president of Cornell University. This essay, written in 1876 and read by its author to members of the House and Senate in connection with the debate over returning to the gold standard after the Civil War, tells the story of the French assignats of the 1790's. This great paper money inflation, originating in the French Revolution, ended "in the complete financial, moral and political prostration of France -- a prostration from which only a Napoleon could raise it."

The tragedy for today's America is not just that the looming monetary shipwreck could have been avoided by more honest policy decisions, but that it would have been if mostly well-intentioned but misguided officials had stuck to the letter and spirit of the monetary provisions of the Constitution. Its framers knew when they met in Philadelphia in the hot summer of 1787 what the French were about to prove to themselves the hard way despite their inflationary experience seventy years before in John Law's Mississippi Bubble.

Nobody can predict with certainty or in detail the consequences of a 100-year storm, be it financial and monetary or meteorological. Gold will more than survive; it will prevail as it always has. Gold mines will prosper though certain mine owners may fail. With clear thinking, preparation, nerve and luck, gold investors will survive; some may even prosper. As for the nation, let's hope that aided by their ability to speak directly with each other on the internet, exercising their good judgment and common sense, the American people will demand for themselves, their children and their Constitution -- as is their right in accordance with its exact terms -- early passage on the golden lifeboat.

Reg Howe
row@ix.netcom.com
http://www.goldensextant.com

16 October 1999