I n t r o d u c t i o n

Perhaps the greatest single influence on the gold price over the last 2 years has been Central Bank dishoarding of their gold stocks. This dishoarding has eliminated a supply/demand imbalance which would otherwise have resulted in a substantial increase in the price of gold. In fact, the 33,000 tonnes of gold which currently resides in the vaults of CBs would be sufficient to fill the gap between the supply of newly mined gold and the commercial demand for gold for several decades. As such, CB selling has had a negative psychological impact on the gold market, depressing sentiment to extremely low levels and creating a belief amongst many investors that the gold price will never be able to rise significantly whilst the prospect exists of further sales. Another popular belief, particularly amongst gold bugs, is that there has been a coordinated effort by the major CBs of the world to keep a lid on the gold price. Let us examine the credibility of these beliefs, in the opposite order to which they are mentioned above.

CB Gold Sales - The Conspiracy Theory

Once upon a time gold was money and it circulated as currency. Today gold is still money, but it does not circulate as an official currency. The fact that gold is money is completely independent of any government edicts or regulation. It is money simply because billions of people throughout the world consider it to be so, that is, it is considered to be a store of value which is widely accepted in exchange for goods and services.

Unlike the forms of money which circulate as national currencies, gold cannot be arbitrarily created and does not rely on a government promise for its value. As such, it tends to maintain its purchasing power. For this reason it is considered to be a hedge against inflation (to paraphrase Alan Greenspan, as the supply of a national currency increases relative to the supply of tangible assets (gold), then the price of those tangible assets (gold) will eventually rise).

The price of gold is highly conspicuous (it is reported daily on almost every news broadcast and in every newspaper), therefore an increase in the gold price is equivalent to an "inflation alarm" being simultaneously beamed into millions of homes. This is the reason why many people believe that the price of gold is being manipulated by CBs. In summary they believe that politicians, via their obedient CBs, are trying to mask the fact that their spendthrift policies have caused inflation.

I will not dispute the plausibility of the above argument, and I am certainly not naive enough to think that CBs act independently or would not contemplate such a gross deception. However, in spite of how appealing the conspiracy theory is, it is not supported by hard evidence. In fact, the only evidence I have seen supports the view that CBs are not acting in concert on this issue.

Firstly, take a look at which CBs have sold significant amounts of gold - Canada, Belgium and The Netherlands. These countries have had more pressing concerns than the public relations problem of a rising gold price. They have dishoarded gold in a short sighted attempt to mitigate financial problems brought on by an over-whelming debt burden. Basically, they just needed the cash. In the cases of Belgium and The Netherlands their actions were prompted by the need to meet Maastricht Treaty requirements relating to budget deficits in order to enable participation in EMU.

It is equally likely that the CBs of China and Japan will add to their gold stocks in the future (China has been reported to be a purchaser of gold in recent months and senior Japanese officials have expressed concern that Japan's gold reserves are too low).

Secondly, take a look at the countries which have not sold any gold, most notably the US and Germany. Politically, these are the countries which have the most to gain by maintaining the perception that inflation is low. However, they are yet to dishoard a single ounce of yellow metal. Germany has recently announced that it is going to re-value its gold reserves upwards to bring the book value of this asset closer to actual market value, but this is simply creative accounting as even this economic powerhouse now looks unlikely to meet the EMU entrance requirements. It also deserves a mention here that Switzerland has stated its intention to sell 400 tonnes of gold to benefit Holocaust victims whose gold had been confiscated by the Nazis and placed in Swiss banks. This is clearly a separate issue, although I will say that a publicly stated intention to do something and actually doing it are two very different things. Even if the Swiss people do vote in favour of this reduction in their country's gold reserves, there are enormous logistical problems to overcome to facilitate the correct distribution of this wealth.

The Future of Gold in the Face of Further CB Sales

As stated above, I have been unable to discover any hard evidence that CBs are conspiring to maintain a low gold price. However, the fact remains that CB dishoarding has severely impacted gold's price in recent years. Will their sales continue and, if so, can the gold price rally under the weight of this selling?

We can all speculate on what governments may or may not do in the future, but our investment decisions should not be based on anticipating the whims of politicians. It is very likely that some European governments will continue to sell gold as they desperately try anything to lower their budget deficits in order to gain entry into EMU. It is equally likely that the CBs of China and Japan will add to their gold stocks in the future (China has been reported to be a purchaser of gold in recent months and senior Japanese officials have expressed concern that Japan's gold reserves are too low).

...we also know that gold is currently at, or near, record low levels of valuation when measured against the quantity of US dollars in circulation and the value of the US stock market.

Although the day to day actions of politicians are impossible to predict with acceptable accuracy, the broader effects of their policies and the resultant actions of individuals trying to protect themselves from these effects can be understood. The ultimate self defense against the de-basement of paper currencies is the accumulation of tangible assets, primary among these being gold. Regardless of whether CBs are net buyers or net sellers of gold in the future, the desire amongst individuals throughout the world to accumulate gold for monetary purposes will determine gold's price. For example, the CB gold sales which have occurred over the last 2 years have led to a depressed gold price only because the monetary demand for gold, outside of the Middle East and Asia, has remained extremely low. Something will need to change to bring about a widespread recognition that gold should be accumulated for monetary (defensive) purposes. Any of the following situations, each of which I consider to have a greater than 50% probability of occurring, would likely spawn such recognition:

• A Japanese stock market collapse (the May 12 Steve Puetz Letter at the Gold Eagle Website provides an excellent dissertation on this subject)

• A collapse in the US bond and stock markets. Such a collapse could be precipitated, or at least extended, by a repatriation of Japanese money arising from a financial crisis in Japan, a reduction in the interest rate differential between the US and Japan (a massive amount of money has exited Japan in recent years in search of higher returns in the US), or Japanese concerns that the US dollar will drop in value against the Yen.

• Increasing exchange rate volatility in the absence of any objective restrictions to money supply growth.

• Continuing high levels of growth in the supply of major currencies leading to price inflation.

• An escalating oil price leading to fears of general price inflation.

• Problems with European Monetary Union. To meet the Maastricht requirements the major European economies will either need to drastically cut spending to reduce their budget deficits as a percentage of GDP, or increase their GDPs. They will almost certainly opt for the latter and will choose to stimulate their economies through low interest rates and high levels of money supply.

The following have been deliberately omitted from the above list:

• A potential war in the Middle East or Korea. The results of war are totally unpredictable and, in my opinion, should not be considered as part of any investment strategy.

• A collapse in the US dollar. Although the dollar has recently plunged 10% in value against the Yen I believe that the dollar's direction over the next 2 years will most likely be up. This will occur due to a lack of credible currency alternatives. The commencement of EMU in January 1999 will remove one existing alternative by taking the Deutschmark out of circulation and replacing it with the Euro. The Euro will be backed by the full faith and credit of a collection of politically and economically incompatible countries. Rather than cause a partial replacement of the US dollar as a reserve currency, I expect the introduction of the Euro to lead to an increase in the amount of US dollars held as currency reserves throughout the world, including Europe.

C o n c l u s i o n

In addition to the capacity of any of the above mentioned events to propel the price of gold to substantially higher levels, we also know that gold is currently at, or near, record low levels of valuation when measured against the quantity of US dollars in circulation and the value of the US stock market. As such, gold's risk/reward ratio at current prices is extremely favourable. However, a large up move in the gold price will not occur until there is a large increase in the monetary demand for gold, which in turn would require a 180 degree change in sentiment. In today's world such a change could occur very quickly.

Milhouse                                        

Also by Milhouse:

The Intrinsic Value of Gold
Gold & Disintegration of U.S. Economic Influence

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