September 22, 2002 - I was recently given an interesting challenge. An Australian friend of mine named Laurie McGuirk, a hedge fund manager with an exceptional track record who happens to be an enthusiastic gold bull, had been in touch with a friend of his who is a gold analyst at one of the world's largest bullion banks. Let's call this analyst 'Mr. A'.
I've met Mr. A before, and I have read some of his work. His research is first-class.
After some discussion, Laurie was unable to convince him that the gold price is being suppressed. So Laurie put Mr. A in touch with me, hoping that I could put-my-shoulder-to this quest that Laurie has taken upon himself to convince Mr. A that the gold price is indeed being suppressed.
Mr. A is a numbers-oriented data-guy who, in his words, wants to see some "hard evidence". Fair enough I thought. Mr. A is skeptical about the suppression of the gold price because he believes "one can explain gold's behavior over the past 20 years perfectly well by looking at economics". To convince me of this last point, he shared with me some of his latest research.
Mr. A is bullish about gold in the near-term, and has established a $345 target for gold by Q1 2003. He based this forecast on an interesting model he had developed that looks at factors such as the dollar's exchange rate, money supply and stock market performance. His conclusion is: "Over the past 20 years gold prices have shown a direct correlation to the health of the US economy".
The model is very compelling. The correlation of the gold price to the component variables is exceptionally high. And I can see - given my own economics background and training - how a trained economist would find this model persuasive. So I thought to myself, convincing Mr. A that other factors are at work may prove to be a tough challenge, but here it goes. I'm using this issue of my newsletter to explain to Mr. A why the gold price is being suppressed. Let's see whether you agree with my analysis, which focuses more on money than on economics.
To begin with the big picture, governments manage money. Hundreds of years ago before paper began circulating, they managed the weight and fineness of gold and silver coins.
They rarely managed this responsibility well. Coins were regularly debased with copper and other base metals. In short, governments cheated, which remained a common practice when paper began circulating as a money-substitute circa 1700.
Under the gold standard, gold most of the time remained in a vault and paper notes promising to pay gold circulated instead, largely because it was easier and more efficient to use paper instead of coin. Inevitably, paper was issued (i.e., credit was extended) to excess, causing the promise to pay gold to periodically be broken.
Under the gold standard, governments were to manage the currency so that its value remained linked to the weight of gold for which it was redeemable (though governments frequently mismanaged this task). After the gold standard was abandoned (tacitly if not formally), governments grabbed the other end of the stick. They began managing gold in order to try making it fit the value of an ever-diminishing currency. For example, the US government dishoarded 10,000 tonnes of gold in the 1960's to maintain the illusion that the dollar was worthy of being the world's reserve currency. In the end this government suppression of the gold price didn't work, so the fixed price gold standard was as a consequence abandoned altogether.
There are here a couple of very important points worth emphasizing. The dollar and every other currency are still on a gold standard; only the mechanics of the standard have changed. Previously, the dollar-to-gold rate of exchange was fixed. Today their rate of exchange floats.
Also, it is just as important to note that the US government today has the same task that it had forty years ago when it dishoarded those 10,000 tonnes - it tries to make people believe that the dollar is worthy of being the world's reserve currency.
We of course know that it isn't. Its purchasing power is being inflated away. What's more, the dollar is being debased. But today's corrupt monarchs don't use copper or other base metals to debase the money like kings did hundreds of years ago. Instead the dollar is being debased by ever-more extensions of credit, the quality of which taken together is becoming increasingly inferior.
All one has to do to appreciate this point is to look at the quantity of substandard assets and over-leveraging of bank balance sheets today compared to forty years ago to know that the dollar is 'backed' by promises to pay that are becoming increasingly dubious and doubtful. The dollar is being insidiously debased by the reckless and ever-growing extension of credit.
So how does the US government make the dollar look better than it really is? By using the same techniques that it has used for decades.
(1) Jawboning - It is easier to believe the hollow promise of politicians than to spend the time and effort to analyze for oneself the poor quality of the dollar, so most people mindlessly choose to believe what they hear.
(2) Interventionism - More and more economic processes are being distorted by the involvement of big and ever-growing government. This intervention in the marketplace gives false signals about underlying economic activity and market prices, with the consequence that many people are unwittingly misled by these distortions.
Gold - like so many different things today - is subject to this jawboning and interventionism. The examples of anti-gold government propaganda are clear and obvious, so I'm not going to bother pointing those out. Nor am I going to delve into all of my previous work or the work of others. That research can be read on my website (www.fgmr.com), the website of Reg Howe, (www.goldensextant.com), and the website of www.GATA.org, where one can read in particular Frank Veneroso's analysis that establishes, among other things, the amount of gold loans outstanding and the incentive for governments to intervene in the gold market. But there are three pieces of 'hard evidence' for Mr. A that to my mind are perhaps the most telling.
1) In my article "The Smoking Gun" (which can be read at www.fgmr.com) I note how the Federal Reserve reported the gold activity of the Exchange Stabilization Fund. Unfortunately, after my article appeared, the Fed in February 2001 stopped reporting that data without explanation. Why doesn't the US government want anyone to know about the ESF's activity in the gold market?
2) Most central banks report gold in the vault and gold on loan as one asset. The Bundesbank's balance sheet is but one glaring example, as it reports "Gold & Gold Receivables" as one line item. This flagrant breach of generally accepted accounting principles again shows deception by governments. Why don't governments want anyone to know how much gold they have loaned into the market?
3) The Federal Reserve reports that since 1990 3,300 tonnes of central bank gold have been removed from the vault of the Federal Reserve Bank of New York, presumably shipped to Europe for lending and/or dishoarding. Given the added expense of shipping gold from the US instead of using gold already available in Europe, it is not unreasonable to assume that most of the central bank gold available in the Bank of England and other European vaults has been dishoarded and/or loaned. As a result, it is very easy to reach the conclusion that gold loans are in excess of 10,000 tonnes.
Given that this total of outstanding gold-credit is four times annual production, it is clear that there is a systemic risk from this short position. Every $100 rise in the gold price results in $32 billion of losses by those short this gold ($48 billion of losses if the gold loans are 15,000 tonnes as some people believe). This systemic risk explains in part why the gold price is being managed.
The world's reserve currency should not have systemic risk, but the dollar clearly does have this risk. Covert management of the gold price makes that systemic risk less visible. It thereby helps maintain the illusion that the dollar is worthy of being the world's reserve currency.
All of this deception and lack of disclosure by governments no doubt is going to end badly. There is no logical reason to conclude otherwise. How bad it will be is open to conjecture, but there is a way to make some useful measurements. My Fear Index shows what might happen. It also provides visual evidence that the gold price is being suppressed.
The calculation for the Fear Index as of August is as follows:
|(US Gold Reserve) * (Gold's Market Price)
||= Fear Index
|(261.5 million ounces) * ($312.00 per ounce)
The accompanying chart of these monthly calculations shows that the Fear Index recently reached record low levels. That these unprecedented levels have been achieved opens the possibility that something unusual is occurring within the gold market, and that 'something' - based upon all of the mounting evidence as well as some reasonable assumptions about motive - is suppression of the gold price.
In 1980 the Fear Index rose to nearly 10%. Its peak during the monetary distress of the Great Depression was 30%. Since the creation of the Federal Reserve in 1913 the Fear Index has averaged 7.8%. Even if the Fear Index just rises back to its historical average, we're talking about a near 8-fold increase in the purchasing power of gold.
Mr. A and I probably have more areas of agreement than those few areas where we may not agree. For example, in commenting about his gold model he says: "A remarkable feature is how little the supply side affects [gold] prices. Forget the bottom up - gold is a top-down story." In other words, gold is demand driven, and I agree completely with Mr. A in this regard. This conclusion explains why the Fear Index is so important.
Gold is demand-driven. Supply hardly matters because the aboveground stock of gold remains relatively unchanged in the short-term. Similarly, so does the aboveground stock of dollars. There are in effect these two massive pools of money - gold and dollars - vying for consumers' attention. The Fear Index shows how consumers vote. And trends in the Fear Index show where demand is flowing.
So have I provided enough fodder to convince Mr. A that the gold price is being suppressed? Are you convinced that gold is at an unnaturally low value because of government actions? If not, I hope that I have at least presented enough evidence for you to keep an open mind on this matter.
As I see it, the gold price is undervalued today for the very same reason that its rate of exchange to the dollar was unnaturally low in the 1960's - government suppression. In the 1960's the evidence of this government suppression was clear - the US government dishoarded some 10,000 tonnes of gold. In contrast today, the evidence of government suppression of the gold price is subtle and less clear. We are unable to measure the weight of gold leaving government vaults because central banks report "Gold & Gold Receivables" as one line item, a fanciful and dishonest accounting which speciously claims that gold on loan is no different than gold in the vault.
Governments have the motive to suppress the gold price. The historical record shows that they have suppressed the gold price in the past. And there is enough evidence to show that they have been suppressing the gold price today. And just like government action in the 1960's caused gold to be undervalued when measured in terms of dollars, so too today has government action caused the gold price to be unnaturally cheap, and exceptionally good value.
A List of Related Articles Follow ...
Newmont's 4th Quarter Report
Paper vs Metal, Chapter 2
The US Gold Reserve is Now in Play
More Evidence That Gold Is Cheap
Letters from D.C.