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Forget Trading Gold - Buy Physical !

May 21, 2003

A Thinking Shift

Outdated habits of thinking are probably the worst enemies of mankind. For most people, once they are comfortable with a certain world view, they would rather die that give it up, even if reality shows itself no longer compatible with their hard fought "understanding."

This is especially true in the case of those who have encountered some measure of success with their formerly valid thinking.

Ideas of "Value"

We all have been brought up with the thinking that a thing's "value" is coterminous with its (paper) dollar price. As we grew up and became interested in investing, the same thinking has prevailed. We have applied it to all kinds of transactions, and - because of the dollar's reserve currency role - have had the luxury of teaching the rest of the world our perception of economic "value" as well.

That thinking, that perception of value, is about to break down - and we had better face this reality, or else ...

Especially in the case of valuing gold and oil, this "dollar perception" is by now a given in the world. But not only that, in the case of gold, we have built up a further abstraction on top of the notion of "dollar pricing", namely the concept of "derivative pricing."

How is the current price of gold determined? By trading physical gold, as most people believe?

Not so.

Gold "Valuation"

The dollar-gold price is determined largely on the London Gold Exchange and the US COMEX through a series of futures and option trading transactions on any given trading day. In that system, paper-claims to physical gold are traded just like physical gold, under the assumption that each claim can be "cashed in" for physical gold at any time. Truth is, though, that the paper claims to physical gold have so proliferated during the past two decades that it is impossible for the responsible parties (those owing physical gold on such paper claims) to deliver gold into all of these claims at current gold rates.

Financial derivatives instruments are ridiculously complex creatures, and need not be explained in detail here. Suffice it to say that they are usually paper claims to physical gold based on a lease transaction of some form or another.

An (oversimplified) example:

Bullion bank (BB) borrows physical gold from central bank (CB) at a stated "interest" rate, or lease rate (usually near or below 1 percent), for a stated amount of time, the "lease period." During the lease period (3 months to one year) BB gets to sell the gold at market price, invest the proceeds in higher-yielding paper securities, cash in the yield on the paper securities at the end of the period, buy gold at market price, and return the borrowed amount of gold to CB, plus the "interest."

This is done, as you probably know, mostly to "short" the market for gold, i.e., in a bet that the price of gold will stay the same or decline. The underlying "lease contract" is the CB's paper claim to have the borrowed amount of gold returned to it.

The CB can now enter the paper-gold market and sell this contract (i.e., the documented right to have the amount of gold returned to it) at a discount in order to recoup at least the cash value of the contract. In the gold markets as they are currently constituted, such a sale of such a gold "derivative" is considered a "sale of gold". The more sales of this nature occur, the more "gold" is considered to have been "sold" in the market, exerting a price-depressing effect on physical gold (in the minds of most participants in this market).

However, as the number of such "sales" proliferates, the same effect is noted as in a fiat currency inflation: In currency case, the value of the inflated currency declines relative to the goods and services it can buy - prices rise in the economy.

In the case of gold derivatives, paper gold is sold in the paper-gold markets, reducing the value of paper-gold. Since this paper-gold pricing mechanism is what is currently perceived as "the gold market", all participants are conditioned to perceive the paper-gold price as "the" gold price (i.e., the actual price of physical gold). Result: The physical gold price drops as well. But this will only go on for so long.

When the Paper-Shackles fall off ...

This all works just fine and dandy as long as there is not such a percentage of physical delivery demanded into these derivatives claims that the nasty truth comes down on all the participants: that there are not enough people in the world willing to sell physical gold at such artificially low prices so as to enable all of these paper claims to gold to be satisfied with physical gold (as is currently assumed by most participants).

The situation is very much the same as it was in 1933, when too many people lost faith in the paper dollar (because too many of them were in circulation) and went to their banks, demanding their gold. The banks of course knew all along they never had enough gold to satisfy everyone's demand to convert, but the "system" worked because the probability of that many people demanding gold was so small.

The paper-gold market is built upon the same illusion. Traders, bullion banks, gold producers, and central banks never expect that too many people will demand physical delivery, so the faulty pricing mechanism is allowed to continue - fulfilling its still useful function.

However, in the current environment of a rapidly falling dollar in the face of a rising alternative reserve currency (the euro), the paper-gold pricing mechanism (gold priced in fiat-dollars) can no longer keep up. To preserve this illusion of viability, too much gold must be loaned by central banks at ever-increasing quantities in order to supply the market with physical metal to prevent delivery problems that are just around the corner.

After about a decade of full-bore gold lending and other off-the-books transactions like swapping, etc, the world's central bank gold holdings have decreased by too much to sustain the effort.

Nail that Coffin!

But that alone is not so bad. The last nail in the coffin of both the dollar and paper-gold pricing mechanisms for gold lies in the fact that, collectively, the most gold-heavy central banks of the entire world (the euro-system CBs) have agreed to limit their lending activity (via the Washington Accord), which itself has raised the bar considerably.

Eventually, gradually, physical supply shortages will creep in and - at first quietly - make their presence known through a considerable upward swing in paper-gold prices (is that happening now?)

At some point it will become clear to all market participants that their paper-claim based pricing mechanism has never been able to account for the real value of the underlying asset - physical gold. Physical gold will become so hard to come by that a huge price increase will ensue - a price increase which the paper-gold market is not equipped to accommodate (largely because it is set up to achieve the opposite).

Here comes the cool part: in 1933, FDR had complete control over the banking laws, and though his extra-constitutional emergency decrees (called executive orders) made the private ownership of gold "illegal" thus enabling the banks to survive while forcing the people to give up their gold.

Now we are dealing with an entire region of individual foreign governments acting in concert to support the price of gold internationally with the express purpose of dooming the dollar, so it can be replaced by their own currency. This time no executive decree can change the outcome.

When the time of physical shortages comes, the gold derivatives markets (or rather the derivatives pricing mechanism for gold) will simply melt down. There will be forced cash settlements, probably imposed by judicial decree after lengthy litigation. There will be amicable cash-settlements - literally compromises - that will not even get close to approximating the true value of gold-settlement in this unfamiliar environment. What there will not be enough of is physical gold to satisfy these paper contracts, and the (dollar) "price" of gold will rise ... and rise ... and rise ...

... and the value of the euro system's gold reserves will rise along with it. That is the crucial point. The euro itself will float like a pleasure-cruiser on the surface of that rising tide of euro bank gold-reserve values, while the dollar will remain tethered to the silly quasi-official "gold price" of $42.222 per ounce (see, Title 31 United States Code, Section 5117) like a buoy with too short a tether during a tsunami. It will simply stay under water.

And gold?

Gold will take on a dynamic that centuries, even millennia of "monetary use" have not allowed it to assume. Gold will become the number one wealth asset of the very rich and powerful. (Wanna bet that all of the really rich and powerful are already stocked up on physical gold as you read this - all the while telling you and your compatriots through the approved media outlets that gold is "risky" and should not be relied upon too heavily as an investment?)

Free-gold will be the ultimate foundation of the value of the euro reserve currency without being tied to it by any legislative mechanism! This, as simple as it sounds, has never happened during gold's entire history of human use. For, commercial viability in our modern world requires the symbiosis of a mature fiat/computer-blip currency system with the oldest store of wealth known to man. This mature fiat component is an absolute prerequisite for such a system to function properly, and that is the reason why even a classical gold-standard cannot provide the same benefits. Gold convertibility has led us to where we are today - given human nature and the temptations that power provides.

The silver lining in this cloud of a bleak dollar future is the fact that, at current, distorted, ridiculously low prices, gold - physical gold - represent a bargain that is simply unfathomable to most (and that's why "most" will never buy enough gold to truly profit from this dynamic, I'm afraid).

To recognize this requires a total thinking-shift. It requires adopting a completely new and different perspective on financial life. It requires that people learn to think in terms of true value rather than "dollar-pricing" when it comes to physical goods (and "derivative pricing" when it comes to physical gold.)

Thinking shifts of that nature are hard to make. They require us to make mince-meat out of our former world view, the one that we have fought so hard to acquire during our lifetimes. Most people are more attached to their idea of themselves and the world around them than - to life itself.

When that idea is threatened or challenged, or even utterly destroyed by the sheer force of reality as it happens around us, most people go into denial, attempting to continue to navigate by a set of data that no longer has true relevance in the new reality. In doing so, they often actually risk their lives, or they start wasting away, incapable of dealing with a totally new set of variables. This will be a very sad thing to behold - but it is bound to happen.

Conclusion - or just a new beginning?

After millennia of gold use as money, gold will finally break its man-imposed shackles and fulfill its "best use" function. Gold will trade as a pure wealth-asset without government tampering or restrictions - not because the governments of the world suddenly "got religion" and saw the error of their ways, but because they see how they can benefit from a free gold price and "stick it" to their current number one foe - the United States of America.

Once the US is removed as a superpower, there is of course no telling what will follow. It may not be as pretty as some envision.

If US leaders won't recognize the danger and take the appropriate course of action, individual Americans can contribute to the survival of their country (and possibly even rid themselves of the bankster crowd to some extent?) by accumulating physical gold now. Prices are rising, and there is no telling at present how fast or how slow this scenario will progress in playing itself out - but play itself out it will. Rest assured of that!

You can already see it happening all around you.


May 8, 2003

Alex Wallenwein

Editor, Publisher


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