Arctic Goldfinger

There is a link on this site to a 47 minute animated film entitled “Money As Debt.” The film contains a cogent description of the origins of the current banking system and why the system is headed for eventual collapse.

I was watching it with the Amazing Kathryn, however, and I remarked to her, about 2/3 of the way through, that the film was about to go off the tracks in its recommendations for the future. She asked me whether I have said that on this blog and the answer at the time was no. The purpose of this entry, therefore, is to explain why I believe the film goes astray once it enters the home stretch.

The first 35 minutes or so of the film spell out the history of banking as practiced today with an analysis is factual and rock solid. In a nutshell, it describes how banks create money out of thin air and must create more and more of it to keep the financial system afloat. But then, after setting out that history, the film turns to the obvious question of what should happen next. At this point it badly founders by dredging up a mishmash of worn out socialist ideas.

It brought to mind part of an old union song that was sung in college by some of the school’s budding young socialists. The lyrics, in part, went:

Oh the banks are made of marble,
With a guard at every door,
And the vaults are stuffed with silver,
That the workers sweated for.

Ironically, one of the film’s major points is that the vaults are NOT stuffed with silver. And that, if they were, we wouldn’t be in our current mess. But a link on the movie’s site to “socialistworld.net” pretty much foreshadows the harebrained ideas that follow. (A gratuitous dose of environmentalism is also throw in to give the film a more contemporary flavor.)

For starters, the film broaches the idea of modernizing barter into something workable as a substitute for money. For example, it suggest using vouchers representing an hour of someone’s work as a sort of currency. The problem, of course, that an hour of a lazy bum’s time cannot be equated with an hour from someone who is industrious. The old socialist notion of “from each according to his ability and to each according to his need” never ever ever ever works.

As another option the film suggests that the government issue money that is used for the building of useful infrastructure, such as bridges, and that then stays in circulation. Needless to say, any government issuance of money invites the issuance of greater and greater amounts, but the filmmakers solve that problem by suggesting that the electorate would vote out of office any administration that created excess inflation.

To call this naive is an understatement. Since when has any government been truthful with the electorate about its economic policies? The film makers fall into the eternal socialist trap: an unwillingness to accept the fact that power corrupts. We have dealt with enough “Peoples’ Republics” to know that collectivism is generally an excuse for tyranny. If government is the answer, then the film makers were obviously asking the wrong question.

The film rejects gold as part of any solution and that hardly surprises me. Gold is to socialists as Kryptonite is to Superman. It simply has too much historic symbolism for them to even begin to think about it. Their understanding is backwards on that score, but that is the subject for another blog entry.

So what SHOULD happen after the current system collapses of its own weight? I don’t really have the answer to that. There are those who say that gold is the only solution and I’m not sure I agree with that. The future is too unpredictable to draw such a hard and fast conclusion.

What I do know is that gold is a good parking place for wealth while the mess is sorted out. I view it as more of a shelter from the storm than as a permanent edifice. The ultimate solution to the eternal problem of money will be known only in the fulness of time.

However I still strongly recommend watching “Money As Debt.” Its usefulness as a diagnosis of the current money problem is admirable even though its prescriptions for the future leave a lot to be desired.

I thought “Helicopter Ben” was a pretty good nickname for the Fed Chairman, but somebody dreamt up an even better one for him and the whole Federal Reserve Board: “Bennie and the Ink Jets.”

Printing vast quantities of money is what they do, but they also have to perform the magic trick of convincing people that this avalanche of paper money has nothing to do with inflation. Bernanke, of late, has tried to perform this bit of legerdemain by blaming inflation on “inflationary expectations.” In other words, if we could just keep inflationary expectations “well anchored,” then inflation would stay in the acceptable range. (Why there should even be an “acceptable” range for inflation is a really good question).

So what would take to rev up inflationary expectations? How about this: suppose you were earning five percent on your savings account while, at the same time, the inflation rate was ten percent. Naturally, you would save as little money as possible and spend it as fast as you could. In fact, since asset prices would be outstripping interest rates at a healthy clip, you would borrow like crazy and pour the money into real estate and the stock market and other things whose rising prices would let you make a profit and pay the money back with cheaper dollars. (Remember that prices going up and money being worth less are the same thing).

But wait a minute. Isn’t that EXACTLY what people are doing right now? The answer, of course, is yes. The Fed labors mightily to “anchor” inflationary expectations by relying on the government’s phony CPI numbers, but people aren’t stupid. The KNOW that saving money is the royal road to ending up poorer than when you started. Market “bubbles” are as much about self preservation as they are about greed.

It should hardly be surprising that the federal government is even less interested in saving money than the average Joe on the street. The Bush Administration seems to think that the best way to pay for a war is to put it on the national credit card. And the government borrows and borrows and borrows as if it will never have to pay the money back. And, in fact, since Bennie and the Ink Jets control the throttle on the dollar printing press, it is very likely that we will pay our creditors back with toilet paper.

So the Fed not only has to “anchor” inflationary expectations at home, but they have to also do it abroad. Otherwise our creditors will start dumping their dollars and/or stop recycling them back to the U.S. by purchasing Treasury debt. That would force interest rates much higher and create a major risk of either another Great Depression or a hyperinflation that destroys the value of the dollar completely.

If I make it sound like the American economy is precariously balanced on a knife’s edge then you have been paying attention. Congress and the Administration have created a worldwide financial morass, but they hope that Helicopter Ben to talk our way out of it. Good luck to him and to us.

Let’s assume for the sake of argument that Howe and Landis are on to something and that this clandestine gold leasing is a fact. What does it mean for the price of gold? You can find as many answers as you can gold aficionados. They range from the merely bullish to the very bullish to the unbelievably bullish.

Let’s start at the extreme and look at the unbelievably bullish case. These folks believe that Howe and Landis have uncovered only the tip of the iceberg. The superbulls believe that there is no gold in Fort Knox and that the Central Banks only have a fraction of the gold they claim to have. They also believe that the Central Banks will, at some point, demand their gold back from the investment banks who will, in turn, have to buy it on the open market. This will trigger the mother of all short squeezes and send the price of gold to — who knows? I have heard mention of five figure numbers per ounce.

The very bullish point of view simply doesn’t buy into the Fort-Knox-is-empty kind of thinking. These folks believe that there has been some leasing of gold by Central Banks, but they still have plenty left. They believe that gold is mispriced to the low side because of the missing gold, but not to the point of sending the price to the moon. They do believe that the investment banks will be squeezed, though, and that the price rise will be dramatic as the investment banks are forced to cover their short positions in the open market.

The bullish point of view agrees with the very bullish point of view regarding the mispricing of gold, but disagrees when it comes to the investment banks. The merely bullish believe that the Central Banks will let the investment banks off the hook by allowing them to settle their debt in cash rather than gold. And since cash is printed by you-know-who . . . you can figure out the rest.

I personally hold the merely bullish point of view. I believe the investment banks are too wired into the world financial establishment to be left on the hook. Keep in mind that the current Treasury Secretary, Hank Paulson, was Chairman of Goldman Sachs. I do believe there is a deficit in the Central Bank reported gold, but I do not believe that we will see a short squeeze for the ages. (It would be nice to be wrong about that.) I therefore expect the price of gold to rise substantially, but I don’t expect a moon shot.

So why wasn’t Gibson’s Paradox working any more? That is, with real interest rates declining, what was holding down the gold price? There were no announcements of new Central Bank selling, yet the market was acting as if gold was appearing out of thin air to meet the increased demand naturally resulting from the low real interest rates.

Howe and Landis deduced, after finding some clues in obscure Central Bank gold statistics and a few things said in the public record, that the source had to be the Central Banks, but this time covertly, out the back door, rather than openly out the front door. It was their theory that the source of the supply was a new gimmick: gold leasing.

Instead of selling gold outright, the Central Banks were leasing it, quietly and privately, to international investment Banks such as Goldman, Sachs. An investment bank would pay what is called the “lease rate” on the gold. (To call it an “interest rate” would be an admission that gold is money). The “lease rate” for gold was extremely low. The investment bank/lessee would then sell the gold on the open market and invest the sales proceeds in some instrument paying well in excess of the lease rate. They pocketed the difference between the lease rate and the rate of return on the sales proceeds.

But here’s the part that stinks: in the opaque accounting of Central Banks the leased gold was still accounted for as an asset and was carried on their books as if it were still in the vault. Therefore, the amount of gold they CLAIM they owned had stayed the same. The difference, however, is that some of it was now hanging around the necks of Indian brides.

The investment bank/lessees owed the Central Banks the borrowed gold, but the gold had long since disappeared into the physical market. So the investment banks now had a “short position” in gold. They had sold something that they didn’t own and which they were legally obligated at some point to lay their hands on and return to the Central Banks.

This scam had three results. First, the gold price was suppressed. Second, the Central Banks, through the gimmick of leasing, no longer had control of as much physical gold as they showed on their books. Third, a group of investment banks owed the Central Banks a lot of gold that they didn’t have. In the next post I will discuss the implications of all this.

I have talked about the open selling of gold by Central Banks. And whatever their motives might have been, they made no secret about what they were doing. They certainly had as much right as anyone to sell their gold.

But suspicions began to arise that something other than the open selling by Central Banks was suppressing the gold price. The intellectual heavy lifting was done by two very bright men named Reg Howe and Bob Landis. (There is a link on this blog to their website, goldensenxtant.com, that tells the story that I am about to tell, but in far greater and more sophisticated detail). Starting around 2001, something strange seemed to be happening because of the gold market’s non-response to an economic phenomenon known as “Gibson’s Paradox.”

I am not sure why it is considered a paradox, but this economic rule of thumb pertains to the relationship between the price of gold and our old friends real interest rates. Real interest rates, you may recall, are nominal interest rates (e.g. the rate on your bank CD) minus the rate of inflation (as best you can calculate in light of the government’s ongoing statistical lies).

Here’s an example of how you would figure a real interest rate: Suppose the nominal interest rate on your Bank CD is six percent. So far so good, but if you also have an inflation rate of six percent you are effectively earning zip-a-dee-doo-dah on your money.

Historically, there appears to be a rough inverse correlation between real interest rates and the gold price. In other words, the price of gold will tend to go up when real interest rates go down, and vice versa. That is Gibson’s Paradox.

This seems pretty easy to explain. When real interest rates are high you can actually earn money on your money. This tends to make people want to save rather than spend and that, in turn, will mean less spending and therefore less inflation. Less inflation usually means less desire to own gold. Conversely, when real interest rates are low, and the best use for money is spending it rather than saving it, then gold looks more attractive as protection against the resultant inflation.

Now for a side note. Like all economic principles, Gibson’s Paradox isn’t a scientific law like the law of gravity. In fact, anything you call a “law” that has its roots in human behavior is suspect. Thus, much of what is called social “science” is garbage.

A further problem stems from there being recurrences that resemble “laws,” but turn out to be sheer coincidences. An example: for a number of years the Superbowl was considered predictive of the following year’s stock market. If an NFC team (or a non-original AFC team, i.e., the Steelers) won, then the market would go up. Otherwise it would go down. That “Superbowl Predictor” worked year after year. That is, until the New England Patriots (an original AFC team) started winning Superbowls. The Superbowl Predictor turned out to be just a coincidence.

So, with that caveat, I return to Gibson’s Paradox. Starting in the 1990’s Gibson’s Paradox seemed to no longer “work” in the gold market. Real interest rates went down, which historically implied that the price of gold would go up, but it didn’t.

Messrs. Howe and Landis smelled a rat and I will next identify the rat and dissect it.

Central Bank selling of gold did not end with Britain’s seemingly odd decision to jettison half of its gold reserve. There next came an agreement among a group of European Central Banks to do more of the same. The bizarre part was that this strategy was described in terms of “supporting” the price of gold. Since the European Central Banks were then, and are now, among the largest holders of gold (the United States being the largest) they definitely had the power to influence the price by selling or not selling.

The idea that they were “supporting” the price of gold was based on the fact that they placed limits on the number of “tonnes” (metric tons, i.e. 1000 kilos) they would sell over the term of the agreement. The limit was 400 tonnes (later 500 tonnes) per year, which doesn’t make it seem like much of a limit, except, of course, one supposes that they could otherwise sell all the gold they owned at once.

This agreement was initially known as the “Washington Agreement on Gold” since that is where it was cooked up, but it has subsequently been renamed the “Central Bank Gold Agreement.” The signatories have lived up to its terms and year after year sold and sold and sold and sold.

While this was going on, however, the price of gold continued to rise and rise and rise and rise. The market seemed to find all these tonnes of gold quite appetizing and would gobble them up as soon as they came on the market. Of course, if you give the situation a moment’s thought, you realize that at the same time that the Central Banks were selling their gold they were printing tons of paper money for people to buy it with. There were weirdoes out there (like me) who think, for some perverse reason, that endless reproducible pieces of paper for virtually irreplaceable ounces of gold is not such a bad deal.

And, of course, there is the one question that they never seemed to answer very convincingly, namely, why were they selling their gold at all? From the tone of the discussion, you would think that the Central Banks had looked in the attic and came upon all this dusty gold lying around and decided to organize a garage sale. As if!

It is at least clear, however, that what I have described to you so far has taken place in the open. In fact, it occurred with the full intention of making sure that everyone knew what was going to be sold, how much and pretty much when. I promised you more than that, though. I said that I would tell you about price suppression by covert means. A genuine conspiracy. That discussion will begin next.

Between 1999 and 2002, Gordon Brown, who is now Britain’s Prime Minister but who was Chancellor of the Exchequer at the time, sold 400 tons of the Queen’s gold bullion. That is a LOT of gold and was about half of Britain’s gold reserve. Gold at the time traded in a range roughly between $250 and $300 an ounce. Since then, as anyone who glances at the gold chart on this blog would know, the price of gold has doubled, and then some.

Now let’s suppose you or I had 400 tons of gold that we wanted to sell. Obviously our objective would be to obtain the best price possible under circumstances where we knew we would be flooding the market with supply. Don’t you think you or I would go about it quietly, slowly feeding the gold into the market in order not to drive down the price?

The British government, however, is not you or I. With trumpets blaring Mr. Brown announced, in advance of any sale, that Britain would be auctioning off 400 tons of gold over the next few years. The result, not surprisingly, was that the gold price, during the course of those sales, remained in a price range that was the lowest in twenty years. If the gold had been kept until today rather than sold, it would have increased in value by more than two billion pounds (four billion dollars).

Needless to say, Mr. Brown did not announce that the reason for his selling orgy was to suppress the price of gold. He gave the usual litany of reasons that Central Banks gave then, and continue to give now, for selling gold. Here is the short list:

1. Retaining the gold serves no purpose since, in this modern age, gold is what Dr. Keynes called a “barbarous relic.”

2. Gold is a pain in the neck to maintain and store.

3. Gold earns no income, but the proceeds of a gold sale can be invested in assets that provide a stream of income.

None of these arguments is even vaguely plausible. The “barbarous relic” canard is both wishful thinking and begs the question. And the “income stream” argument ignores the fact that when a Central Bank needs an income stream all its needs to do is print it. Obviously there are always other factors at work in Central Bank gold sales.

There have been some recent revelations about that 1999-2002 British gold sale. It appears that some gold traders were quietly consulted by the British Government before the sales were announced and they advised the government, in no uncertain terms, that the result would be to guarantee that Britain would sell its gold at the worst possible price.

Of course the worst possible price was exactly what Brown wanted. With smoke pouring out of the overworked printing presses at Her Majesty’s mint, suppressing the gold price was like taking the battery out of a smoke detector.

The British gold sale made no sense whatsoever except in terms of gold price suppression. Brown has taken some heat over the years for costing the British taxpayers a couple of billion pounds, but not enough to prevent him from becoming Prime Minister. He must have done one hell of a job of polishing up the handle on the big front door.