Another awesome article by FOFOA. This is Phd level stuff on the topic of gold versus paper and requires patience. It isn’t that it is overly complex, it isn’t, it requires a re-adjustment of perspective. FOFOA attempts to expand on the principle of Freegold here, read slowly and deliberately. When you do not understand something, read it again. I also suggest you either read the articles in the FOFOA drop down menu on my sight or go to FOFOA’s site and start from the beginning and read about how Freegold works.
Wednesday, January 19, 2011
It has been fun to stumble across a number of sites where readers are attempting to explain my writings to others. It feels a little weird, yet pleasing. Some of you are amazingly apt at this difficult undertaking. While others I have seen fall a little short of the mark that I strive to hit. It’s tough. Freegold is a deep subject with new angles each new way you look at it. I am constantly discovering this myself. And I know that a few of you know exactly what I’m talking about, while others are wondering whether old FOFOA has slipped off his rocker and scrambled his noodle.
So I thought it would be helpful to both me and you if we explore a few of the more fundamental angles (for lack of a better term) on Freegold. I am the originator of none of the conceptual perspectives I will present in this post. They all come from a few others, primarily FOA, but also Aristotle and others.
Someone wrote in the comments that I use “woolly language” (smile), meaning, I suppose, that I am unclear at times. I can only respond that I teach this thing just as I understand it. If it is not simple enough for you, then perhaps that’s a reflection of your own special needs more than of the subject or presentation.
That said, in this post I will attempt to develop precise definitions where possible. But do not confuse precision with universality. If you find yourself emotionally in conflict with my words, I would point out that they are being delivered in a cold (whilst warm and inviting) calculated manner. Emotions – and/or pretentious moral judgment – have no place in this discussion. Check your ego and your dogma at the door, for none of these concepts carry a universal definition. My definitions offered here are for the purpose of this post, which is to help you understand Freegold. It could be said that my definitions are the proper ones for understanding what is actually unfolding right in front of us. If said, I would probably have to agree with that statement.
I will also tackle the term Freegold itself. What does the “free” in Freegold portend? This is an important question. More on it in a moment.
I’m not going to go into great detail on the concept of capital, other than to give you a mental exercise. Because the term “capital” can be quite confusing in our modern paper/electronic world, I want you to imagine a much simpler human civilization. Imagine an ancient Greek city. All the buildings made of stone and mud, the horse carts and agricultural tools, the linens and skins worn as clothing, the knowledge base passed down through generations; all these creations of man’s intellect were the capital of the time.
Now imagine the destruction of capital. Imagine an earthquake or volcano that destroys the fruits of many generations. Or a plague or war, perhaps, that destroys the knowledge base. That’s the loss of real wealth you are imagining. And it is this cycle of capital creation and destruction that tells the story of mankind throughout many civilizations.
In modern economics, the word “capital” accounts for many specific things. But I think it is helpful to consider this word in a more basic, fundamental way. Think of it in terms of capital creation, capital employment and capital consumption or destruction. Modern economics would not call consumables capital, which is why I am suggesting a different approach to the word. When we are productive, imagine we are creating this thing called capital. We may figure out a way to turn someone else’s capital, combined with our own prowess, into more capital. This would be the employment of capital. And sometimes we simply consume it, or use it up.
If I build a house I have created capital. By owning and living in a home, I am consuming that capital slowly. If I were to buy a specialized tool and use it to make something new, then I have employed capital to create more capital. Is this view of “capital” clear, or woolly?
Savings are the result of one’s production being greater than his consumption. Saving is the convention for deferring the fruits of capital creation—earned consumption—until later. Savings is also the way we hand off capital to the next person who will use it to create more capital. And when it is done right, saving results in the accumulation of capital throughout society at large. When it is done poorly, saving results in the aggregate destruction of capital through frivolous consumption and mal(bad)investment (the misguided employment of capital) resulting in unsustainable infrastructures built on unstable levered foundations.
Here’s where it may get a bit counterintuitive. You might, if you were Charlie Munger, think that the best way to pass your earned capital on to another producer is through paper. If you save in paper notes then you are loaning your earned capital to the next producer in line, right? And if you buy gold Charlie says you’re a jerk, even if it works, because he thinks you are pulling capital out of the system. But are you really? I bring this up (and please watch a minute or so of that video starting at 1:04:05) because it is the key to this discussion about savings.
We should think about the global economy in terms of production and consumption in the physical realm as opposed to the financial or monetary realm, what I like to call the physical plane versus the monetary plane. A “net producer” produces more capital than he consumes. Likewise, a “net consumer” consumes more than he produces. The global aggregate is generally net-neutral on this production-consumption continuum. I say “generally” because there are times of expansion and times of contraction, so taking time into account, we are “generally” net-neutral (or close to it) as a planet. At least that’s the way it is under the global dollar reserve standard.
On the national scale, however, we are all both blessed and cursed by the presence of government. Governments are always net consumers, as it is their very job to redistribute part of our private savings into the infrastructure and secure environment that enables us to produce capital in the way that we do. Government’s job is not to produce capital, but to enable and support the private production (and accumulation) of capital!
Being such that human society has evolved in this way, we private citizens must, in aggregate, be net producers so that government can net consume. And we become net producers by saving. Therefore we enable and support our own future net productivity by saving some of our past production of capital today, in the form of savings.
The financial system is really just the monetary plane’s record-keeper of this vital process that actually takes place on the physical plane. In its modern incarnation, the global financial system has allowed for a strange international balancing act whereby (literally) one whole side of the planet’s net production has allowed the other side to net-consume for decades on end. But this is an unsustainable anomaly, and it is beside the point of this discussion. So please push this giant, global imbalance-elephant in the room over to the corner while we continue this discussion about savings.
The question we must answer here is: Is Charlie Munger right? Are you a good person only if you put your savings into paper where it can be easily redistributed, and a jerk if you buy gold, depriving the paper whores of your savings? Is this the way it works in reality? Or is this simply the sales pitch of one with great bets riding on the continued popularity of paper savings?
The government confiscates a portion of the physical capital created in the private sector through several means. Taxation is one way, forcing you to keep a portion of your earnings in paper so that it can be easily transferred to the government and then used to buy up capital from the marketplace. This forces you to leave some of your production in the marketplace to be taken by the government, preventing you from consuming an amount equal to your productive output.
Printing money, or its modern equivalent, quantitative easing, is another way the government can confiscate real capital from the marketplace without first producing a commensurate amount. This method inflicts what we call “the inflation tax.” The “victims” of this confiscation are anyone and everyone holding (and saving) the currency or any paper asset fixed to it, and the damages are relative to the amount of currency each “victim” is holding. Because this form of confiscation is spread so wide and thin, it is mostly not even noticed by the private sector.
The last way the government confiscates capital is by borrowing it directly from the net producers in the private sector. When you buy US bonds, it is you that are loaning your earned claims on capital to the government. So we can see that the government has plenty of ways to create its own claims on capital in the marketplace without first producing a commensurate market contribution (because governments are always net consumers).
In fact, the modern financial system has bestowed these same powers, creating market claims without contribution, upon the private sector as well. I’m not talking about private banks loaning money into existence, for this process has no market contribution from which to feed. It is directly price inflationary until the debtor makes a market contribution to work it off.
What I’m talking about is the private sector’s ability to sell unlimited amounts of this debt to the savers, funding the marketplace claims to consumers/debtors with real marketplace capital (contributed by the savers). Private banks that would normally be constrained by their balance sheets for their own survival can now offload that constraint onto the net producers, making themselves—the banks—totally unconstrained.
The banking system sells all kinds of packaged debt to net producers, the savers. It creates this stuff at will to meet demand. And if necessary, it drums up new debtors one way or another to keep this stuff financially funded. Even corporations can dilute their paper shares to take in new claims from the savers without giving up a commensurate marketplace contribution.
This is the process of paper savings hyperinflation. It is a self-feeding, self-fulfilling, self-sustaining, self-propelling system that will ultimately lead to real price hyperinflation. When you produce capital and decide to leave it in the marketplace, postponing your earned consumption until later, and you do so in any paper investment, you are feeding this process of capital destruction through paper savings hyperinflation.
If you buy government debt you are feeding, enabling the growth of government beyond its most basic mandate, providing the infrastructure and secure environment that enables us to produce capital. And if you think an expanding government is good, just beware that all governments are stupid!
“The institution of government was invented to escape the burden of being smart. Its fundamental purpose is to take money by force to evade the market’s guidance to have the privilege of being stupid.” Richard Maybury goes on (in the linked video) to say that private organizations that petition government for special protections, subsidies and incentives are asking for the same privilege. They want to be relieved of the burden of being smart.
(Not since the Agriculture Adjustment Act of 1933 that paid farmers to destroy crops during the Great Depression in an attempt to raise the price of crops, has there been a more obvious example of government’s propensity for destroying real world capital than the 2009 “Cash for Clunkers” program, whereby government literally paid private car dealerships to pour sugar into running car engines ensuring their permanent destruction.)
This is why, when you save in government paper, you are enabling malinvestment and the destruction of capital that goes along with it. And it’s the destruction of the capital that you just contributed to the marketplace that you are feeding. The same goes for the private sector. When you save in private paper you are enabling the expansion of frivolous consumption (beyond natural market constraint) and the destruction of your capital contribution to the marketplace that goes along with it.
So what’s the alternative? If both public and private paper savings contribute to the expansion of malinvestment, net-consumption and systemic capital destruction, what is a net producer to do? If one wants to produce more capital than he consumes—for the good of the economy—yet he doesn’t want to work for free, what is he to do? Or if one wants to produce more than she consumes—for the good of her retirement years and her family’s future—what is she to do?
The monetary plane, the modern dollar-based global financial system, has failed these individuals. So what is left? The physical plane? If these individuals trade their earned marketplace credits in for physical capital without employing that capital in productive enterprise, then they are either consuming that capital (capital destruction) or denying other producers the use of it (hoarding, also destructive to the capital creation process). This is not only detrimental for society at large, but also for the future value of your savings that depends on new capital being plentiful in the marketplace when you deploy your savings in the future.
But of course there is one item, one physical asset, that stands out above all the rest. And this isn’t some new discovery by FOFOA. Man discovered that this was gold’s highest and best use thousands of years ago. Once you’ve produced capital for the marketplace, whatever asset class you choose to deploy your earned credits into will feel the economic pressure to rise in price. If the monetary plane was volume-fixed (or even constrained), it too would rise in price as real capital is added to the economy. But it has become a system that expands in volume rather than rising in price.
This is hyperinflation: quantitative expansion of savings! If the pool of savings rose only in value and not quantity, then each new net producer would have to bid “savings” away from an old net producer, and “savings” would retain their proper relationship to the pool of real marketplace capital available for purchase.
If you choose to deploy your credits into the everyday physical plane, the tangible goods plane, prices will rise. If all the savers chose oil for example, we’d all pay very high prices at the gas pump. Or choose agriculture for your savings and we’ll all have to work an extra hour to feed ourselves. No, you want to choose something that both rises in price (rather than expanding in volume) and also something that does not infringe on others or economically impede the capital creation process that feeds value to your savings. And as an added bonus, if everyone chooses the same thing, it works extra well. This is called the focal point.
But for gold to fulfill this vital function in the capital creation process, it needs to trade in a fixed (or at least constrained) quantity that will allow its price to rise every time a new capital net-increase is contributed to the marketplace. And, unfortunately, paper gold and fractional reserve bullion banking doesn’t allow this process to work properly. In fact, it makes paper appear generally competitive, even to gold.
So what about Charlie Munger? Is he right? Are you a jerk if you buy gold? Well, yes and no. If he’s talking about paper gold, then yes! But likewise, it seems you are jerk if you buy Charlie’s paper as well! And you’re an even bigger jerk if you buy physical commodities and tangible goods without the intention of employing them in real economic activity. It seems—and correct me if I’m wrong here—that physical gold (along with a few other discreet collectible items like real estate, fine art, antique furniture, ancient artifacts, fine gemstones, fine jewelry and rare classic cars) may be the only true wealth holdings in which you are not a jerk. What do you think?
The Money Concept
Use of the term “money” in these discussions seems to be the root of most of the confusion we encounter. Especially for those of us who have spent our entire lives immersed in the last several decades of monetary confusion and change. And that would be all of us. I think it is therefore perfectly rational to define money as a concept rather than a physical thing.
So if money is a concept, then by definition it is an abstract idea or a mental symbol, sometimes defined as a “unit of knowledge,” built from other units which act as its characteristics or elements. Currency is but one element of this concept. And the main characteristic of money is that it is a shared idea that enables economic activity and commerce.
Some of you like to imagine a utopian world without money (presumably to get rid of the bankers), where people freely exchange their goods and services with others and everyone sings cumbaya. I see this a lot. A beautiful, peaceful barter world! But what you are imagining is actually a world without currency, not one without money.
In this fantasy paradise you might exchange a service for a good, right? Or perhaps you would part with a good in exchange for a service from someone else. But how do you think the relative value would be determined in this world without currency? Of course “prices” would be abstract ideas or mental symbols, but surely you wouldn’t pay someone for a car wash with the title to your car. So what would determine the relative value of a car wash versus a car in this Xanadu?
The answer is the concept of money. This is the ability, unique to humans, to use numbers, mental constructs, to relatively value the goods and services of barter in a way that enables economic activity and commerce. It is the enabler of economic activity and commerce. It is a primeval instinct.
FOA: So, you think we have come a long way from the ancient barter system; where uneducated peoples simply traded different items of value for what they thought they were worth? Crude, slow and demanding, these forms of commerce would never work today because we are just too busy?
Lean back and think of all the items you can remember the dollar price for. Quite a few, yes? Now, run through your mind every item in your house; wall pictures, clothes, pots and pans, furniture, TVs, etc. Mechanics can think about all the things in the garage: tools, oil, mowers. If one thinks hard enough they can remember quite well what they paid for each of these. Even think of things you used at work. Now try harder; think of every item you can remember and try to guess the dollar value of it within, say, 30%. Wow, that is a bunch to remember, but we do do it!
I have seen studies where, on average, a person can associate the value of over 1,000 items between unlike kinds by simply equating the dollar price per unit. Some people could even do two or three thousand items. The very best were some construction cost estimators that could reach 10,000 or more price associations!
Still think we have come a long way from trading a gallon of milk for two loaves of bread? In function, yes; in thought no! Aside from the saving / investing aspects of money, our process of buying and selling daily use items hasn’t changed all that much. You use the currency as a unit to value-associate the worth of everything. Not far from rating everything between a value of one to ten; only our currency numbers are infinite. Now, those numbers between one and ten have no value, do they? That’s right, the value is in your association abilities. This is the money concept, my friends.
This is the concept of money. It is our shared, primeval ability to associate relative values of barter able goods and services. It cannot be destroyed by eliminating currency any more successfully than it can be bottled up and sold. It is an abstract unit of shared knowledge, not a thing. You can dispute this section based on your favorite writer’s opinion about the term “money” or “honest money” all you want, but this is the proper way to view the concept of money in its original context and in order to understand Freegold.
So the “thing” in our modern monetary and financial system that is closest to the concept of “money,” the holistic (largely mental and lately derivatized) concept, is the system of institutional bookkeeping accounts of credits and debts. The currency element, alternatively, provides you the “in your hand,” “on the run,” “money to go” element, so that discrete (and discreet!) “amounts” (“amount” being a truly strange concept as applied to such a non-dimensional item) of said money-system can be transferred among individuals conveniently while operating temporarily outside of the institutional monetary ledgers. (I realize I’m getting a little woolly here, but bear with me.)
Hence, gold was never “the money.” It was only ever a barter item, or else a currency item. Similarly, the term “fiat money” seems somehow bogus. Money is a commercial and economic enterprise. It exists even in the absence of a functioning currency. The term “fiat” ought to apply only to the system of “currency” that the government has organized as a suitable non-dimensional yet unitized and standarized “on the go” representative hand(/wallet)-friendly form of “the money system.”
“fiat money” = NO
“fiat currency” = YES
And for all the many reasons discussed on this blog, a worthless token fiat currency is a better systemic component than a precious gold currency. Gold is too precious to capital creation and accumulation in the savings function to be squandered in the currency role. And the CBs now know this too!
F A Hayek: I do believe that if today all the legal obstacles were removed… people would from their own experience be led to rush for the only thing they know and understand, and start using gold. But this very fact would after a while make it very doubtful whether gold was for the purpose of money really a good standard. It would turn out to be a very good investment, for the reason that because of the increased demand for gold the value of gold would go up; but that very fact would make it very unsuitable as money. You do not want to incur debts in terms of a unit which constantly goes up in value as it would in this case, so people would begin to look for another kind of money: if they were free to choose the money, in terms of which they kept their books, made their calculations, incurred debts or lent money, they would prefer a standard which remains stable in purchasing power.
I have not got time here to describe in detail what I mean by being stable in purchasing power, but briefly, I mean a kind of money in terms which it is equally likely that the price of any commodity picked out at random will rise as that it will fall. Such a stable standard reduces the risk of unforeseen changes in the prices of particular commodities to a minimum, because with such a standard it is just as likely that any one commodity will rise in price or will fall in price and the mistakes which people at large will make in their anticipations of future prices will just cancel each other because there will be as many mistakes in overestimating as in underestimating.
So, the point about currency is, and mainly for those of you that fret over a NWO currency, or “whatever currency,” an Amero or SDR or euro-whatzit… chill TF out! Currency is no big deal. Currency is not the issue that matters here. What matters is what we, as a planet, choose to save.
RS Comment: So often in commentaries of this sort that propose a “solution”, the author is strangely obsessed with the notion of replacing the dollar (as a reserve currency unit) with simply another institutional emission of similar ilk (such as currencies of other nations, SDRs, bancors and whatnot). Their avoidance of any meaningful discussion of the most obvious remedy is almost pathological in the extreme. To be sure, we don’t need to invent any manner of universal reserve currency to fill the role of a unit of account because that role is already served in a fully functional capacity for any given country by its own monetary unit.
What IS desperately needed, however, is a universally respected reserve asset capable of filling our current void with a reliable presence that serves as a store of value. And far from needing to be conjured or created by complex international committees, that asset is already in existence and held in goodly store by central bankers and prudent individuals around the world — it’s known as gold. From amid the ruins of a chaotic financial crisis that was brought about by its own complexity, a degree of sanity will prevail, and gold as a freely floating asset will arise in stature as THE important element of global monetary reserves. The floating aspect is the vital evolutionary improvement over all previous structural monetary failures which tried to use a gold standard at a fixed price (i.e., unit of account) perversely joined to the very elastic money supply of any given country’s banking system.
Gold as a Barter Item
Hard money advocates, or as FOA and Aristotle dubbed them in jest, “Hard Money Socialists,” will readily explain to you how gold naturally emerged as money in antiquity. But as FOA argued—in great detail—this is not really the case.
In antiquity, gold was merely a barter item, a physical good for trade. In some cases it was the best, most efficient barter item and in others it was not. For instance, within the locality of one’s home, oil might be a more common barter item. Gold was reserved for “on the road” trade, because it carried the most exchange value in a portable item. But at home, you’d be more inclined to perform the labor required to create some of your own capital for trade rather than to part with some of your precious gold.
Eventually gold emerged as a common unit of account. But the physical stuff still wasn’t money, or even currency. It was still just a (somewhat standardized) barter item and a physical store of value, an “asset,” a “tradable wealth item.” It is this role that gold is returning to today, believe it or not.
FOA: We were first alerted to the “gold is money” flaw years ago. When considering the many references to gold being money, in ancient texts, several things stood out. We began to suspect that those translations were somewhat slanted. I saw many areas, in old text, where gold was actually more in a context of; his money was in account of gold or; the money account was gold or; traded his money in gold. The more one searches the more one finds that in ancient times gold was simply one item that could account for your money values. To expand the reality of the thought; everything we trade is in account of associated money values; nothing we trade is money!
The original actual term of money was often in a different concept. In those times barter, and their crude accounts of the same, were marked down or remembered as so many pots, furs, corn, tools traded. Gold became the best accepted tradable wealth of the lot and soon many accountings used gold more than other items to denominate those trades. Still, money was the account, the rating system for value, the worth association in your head. Gold, itself, became the main wealth object used in that bookkeeping.
This all worked well for hundreds and perhaps thousands of years as fiat was never so well used or considered. Over time, society became accustomed to speaking of gold in the context of money accounting. Translations became all the more relaxed as gold and money accounting terms were mingled as one in the same. It was a subtle difference, then, but has become a major conflict in the money affairs of modern mankind; as gold receipts became fiat gold and bankers combined fiat money accounting with gold backing.
(Read more of FOA’s historical account starting with “The Gold Of Troy!” found on Gold Trail III – The Scenic Overview.)
Gold as Currency
At some point along the evolutionary trail of the money concept, gold was employed by the power of government fiat and stamped into currency. As I have written before, this was done for the purpose of profit (for the government). The official stamp on these coins designated the overvaluing of the underlying metal. Otherwise there would be no profit in it. And sooner or later, that profit ran out and the gold content had to be debased.
These gold coins were the first fiat currency! Not fiat money; such a thing doesn’t exist. The money concept is the creation of private enterprise and finance. Government can only create currency, the portable “on the go” element of the concept.
In the more recent past, while gold shared the currency role along with many national paper fiats, and before we had a globally integrated, computerized, efficient and trusted system of payments (notice I said “payments” and not store of value) gold was the go-to currency for certain payments, especially among less trusting trading partners. And among these, certain “super-producers” accumulated quite a lot of this gold currency.
Do you realize that somewhere out there, there is perhaps four billion (with a b) ounces of gold in private hands (in many forms, including coins, bars and jewelry)? A lot of this gold was accumulated by families over many generations. It is only in modern times (and in the West) that we think of our “nest egg” as something that should be deployed into the marketplace in search of a yield. That we must trust it to a “manager” who we pay to churn us an ROI. This is a very modern and Western view. The rest of the world (the rest of time for that matter) views wealth a little differently.
ANOTHER: This brings us back full circle, to the problem of “digital currencies” and the “mind set” of much of the simple ( and rich ) third world persons. To many of these people, wealth is the surplus of life’s work that you pass on after death. Currency is something you, spend, trade or hold for a few years. It isn’t wealth.
When Another spoke of “rich third world persons” and “old world giants,” what quantities of gold do you think he was talking about? Mr. Gresham asked him once:
Mr. Gresham: “We who read here generally buy the coins, one ounce and less. The “Giants” you speak of are usually buying the large bars (100 ounce?), yes?”
ANOTHER: “I ask you, how many of your bars in tonne? This is the small purchase size.”
Good question. How many 100 ounce bars are in a tonne? The answer is 321 and a half. Or 32,150 ounces. And this is a “small” giant! 4 billion ounces in private hands. Let’s take just half of that and wonder how many of these “small giants” there might be in the world. 2 billion divided by 32,150 = 62,208. So I’m going to go out on a limb and say, conservatively, that there are probably “tens of thousands” of these so-called “giants” in the world. That 4 billion ounces is out there somewhere, in private hands, and that kind of family wealth doesn’t necessarily show up on things like the Forbes list.
So what is my point? My point is that today is not just the sum of the last 10, 20 or 30 years, like it probably seems to most Westerners. To the giants, to the world outside of the West, today is the net sum of centuries of production minus consumption.
Some in the West might argue that the overweight value of Western “paper capital” is justified by the overweight capital contribution from the West for the last half century, reflected in the high development of the developed world, the West. But Another observer might point to that same high level of development and call it capital consumption from the effort to use debt to rebuild the West following WWII. And he might point to Wall Street and suggest that the accumulation of “paper capital” represents real capital consumption, destruction and malinvestment.
The West believes it has much wealth stored in paper promises of never ending debt service, but it hasn’t actually been paid yet. The West is hoping to be paid someday. But there is a whole other world out there that, for centuries, has already been paid in full, in gold.
Gold in Modern Bullion Banking
In the not-so-distant past, gold shared the currency role with various national fiats. Gold was a currency, more or less, right alongside this paper. And because the two traded at a fixed parity within the banking system, there was no such distinction as a Bullion Bank.
Modern bullion banking is a carryover from this past. When Nixon abruptly took the dollar off the gold standard in 1971, the billions of ounces in private ownership didn’t just disappear. They weren’t cast into the streets in disgust. And these giants with 100,000 ounces or more didn’t take those tonnes home to the basement. No, they stayed right there in the bank vaults and literally JUMPED in value.
In fact, the banking system never really stopped “banking” with all that gold, even though Nixon demonetized it. While gold was currency, deposits of gold generally went into unallocated accounts just like your deposits of physical dollars do today. Putting gold in an allocated account in the past would be akin to putting cash in a safety deposit box today. Sure, it happens, but it is not common because it has a cost associated with it.
And what is it that banks do with unallocated accounts? They make loans to generate income for the bank, and they use fractional reserve accounting to juggle the deposits and (hopefully) keep everyone happy. And in the rare situation where they come up short on reserves, the Central Bank stands ready to backstop their fractional reserves with a loan of extra reserves.
Even today, a few of the biggest banks still have bullion departments where they can take deposits in physical gold. These banks are what we now call the Bullion Banks. This bullion banking practice seems very foreign to us shrimps with a little gold in the family safe. But yes, just like the billions of ounces that existed during the gold standard era, this practice of bullion banking still exists.
And today the bullion banks still operate with fractionally reserved unallocated gold. Some reports put the remaining amount of unallocated gold being juggled within the banking system at about half a billion ounces, or 15,000 tonnes. But so far, this is apparently enough to support the meager delivery demands on the spot gold trade as well as the allocation needs of the bullion bank-operated ETFs. (More on this in a moment.)
Things have changed in the last decade. The Bullion Banks no longer have the same income-producing uses for this unallocated gold on deposit that they did in the 80s and 90s. Back then they lent it out to hedge funds and mining operations. For mines, a gold loan made great sense because it carried a lower interest rate than a dollar loan and could be paid back with just what they pulled out of the ground. For hedge funds, it also made sense with the low gold interest rate. Funds would just sell the gold into the market for cash and buy it back later, called the gold carry trade. But today, with the rising price of gold, gold loans no longer make sense for anyone. And in 1999 the WAG ended the CB backstop for this Bullion Bank lending practice.
So guess what income-producing activity the banks found to do with some of this unallocated gold today? As the mutually reinforcing factors of rising prices and termination of mine company hedging and waning carry trade activities in the wake of the 1999 CBGA left bullion banks with their full store of unallocated gold deposits but a shrinking base of usual customers for their gold lending services, the ETF mechanism provided the ideal means to relatively safely put these deposits back into play. By delivering them into an allocated account with the ETF in exchange for ETF shares that could be lent or sold for cash, these same Bullion Banks found a new path to dollars that could then be used to churn an income.
I don’t think the issue is whether or not the gold in the ETFs actually exists, but rather, how many claims exist on that gold and who (of the claimants) has an actual pathway to take possession of it?
Where do you think the 40 million ounces allocated to GLD came from? Were they purchased on the spot market? And who can withdraw actual physical from the ETF? Here’s a hint: Authorized Participants can exchange shares for physical. And who are these “authorized participants?” You guessed it, other Bullion Banks that allocated gold to the ETF.
And it seems that some of these authorized participants are doing just that…
Jan 14th, 2011 08:27
“… large bullion-backed exchange-traded funds continued to see outflows.”
RS View: Silly reporters. Instead of calling these “outflows” from the ETFs, it should be called what it is — a redemption of a basket of shares for physical gold by the Authorized Participants (e.g. bullion banks). Such share redemptions would actually be a bullish sign because it entails a reduction in the global supply of paper gold while at the same time signifying a preference by the redeeming party for having the metal over the ETF shares. That is, of course, unless the drawdown in physical gold merely represented the routine sales of the gold inventory that occur to cover the ETF’s administrative expenses.
And why do they do this? Because more and more of those “small giants” are converting their unallocated accounts into allocated accounts. This very act stretches the Bullion Bank’s fractional reserves ever thinner. So there is a sort of tug-of-war on those scarce gold bars in the Bullion Bank’s vault, between the unallocated account holders and the ETF shareholders. And the unallocated accounts outnumber the shareholders by a large margin. Furthermore, they have an actual pathway to physical redemption while the shareholders do not.
And as this fractional reserve rubber band is stretched thinner and thinner, how confident are you that all of the “authorized participants” are following the rules to a T? And since you have no recourse to the actual physical, as an ETF shareholder, how sure are you of the ETF denouement come Freegold, which will be a physical-only market for gold? Will shares still trade at par with physical when that comes? I don’t know, but it is a valid question.
Bullion banking is no different than regular banking. They do what all banks do. They take unallocated deposits and loan them out for profit. Then they juggle their fractional reserves to keep everyone happy. And if they ever get in trouble, the central bank comes to the rescue. But no longer for physical gold. Only for fiat currency. That will likely be the denouement of this fractional reserve conundrum, and it is what Another and FOA both predicted. You will ultimately be settled out in cash and told to source your own physical in the physical marketplace.
And for those of you that think all bankers, by nature, are anti-gold, guess again. A better way to view banking versus gold is that “the past” was anti-gold, but “the future” is pro-gold. The first Central Bank Gold Agreement in 1999 (the CBGA, aka the WAG) signaled this change.
The Washington Agreement is most well-known for its cap on central bank gold sales. But much more important than the sales cap was the cap on gold lending! From the Joint statement on gold (the Washington Agreement):
1.Gold will remain an important element of global monetary reserves.
2.The undersigned institutions will not enter the market as sellers, with the exception of already decided sales.
3.The gold sales already decided will be achieved through a concerted programme of sales over the next five years. Annual sales will not exceed approximately 400 tons and total sales over this period will not exceed 2,000 tons.
4.The signatories to this agreement have agreed not to expand their gold leasings and their use of gold futures and options over this period.
5.This agreement will be reviewed after five years.
And from ANOTHER:
Date: Sun Nov 16 1997 10:20
ANOTHER (THOUGHTS!) ID#60253:
In today’s time the CBs do not sell physical gold with a purpose to drive the price down. They sell to cover open orders to buy what cannot be filled from existing stocks. Look to the US treasury sales in the late 70s. They sold 1 million a month using open bid proposals with much fanfare. If the CBs wanted physical sales to drive the price they would sell in the same way.
The sales today are done quietly with purpose. The gold must go to the correct location. That is why these sales do not impact price as they occur, there is a waiting buyer on the other side…
… Banks do lend gold with a reason to control price.
Date: Sun Apr 19 1998 15:49
ANOTHER (THOUGHTS!) ID#60253:
If they sell gold, a way is clear to “bring gold back” for the nation! Canada has local mines, Australia has local mines, Belgium has South African mines! If they lease gold, it is for a purpose…
This is the real significance of the Washington Agreement! The end of the CB’s backing (through lending reserves to the BBs) of the fractional reserve gold practices of the Bullion Banks.
My purpose here is not to pick on the gold ETFs. Admittedly, all gold ETFs are not created equally. But they are all a reasonable current example of “paper gold” in that they are (for the most part) just claims on gold held by Bullion Banks, not gold itself. The paper markets exist because the public believes gold is a commodity like any other. And I say, paper markets schmaper markets, it’s not really about the paper markets, it’s about gold being a fractional reserve in the banks.
It is much less important to Freegold that the investing public believes gold is a commodity. Those that really matter already know it’s not. And the paper markets and the public’s misunderstanding of gold simply help the banks manage their fractional reserves to keep everyone happy.
Yes, the paper markets by their very nature, and only because gold has the highest stock to flow ratio, automatically act in harmony to suppress the price of the actual product. And yes, they do provide a means for the banks to occasionally control the price of paper gold in an effort to manage where their fractional reserves of the real thing actually go.
But the actual physical portion of the paper markets is tiny compared to global gold. COMEX does not project its price discovery globally because it is so powerful. That price is accepted, not projected, because the Bullion Banks choose to use it in their fractional reserve gold banking. The paper markets are a markets for claims on gold held by the BBs, not for gold itself.
To put it another way, if the Bullion Banks and their fractional reserve gold banking is a dog, then the COMEX (or “the paper markets”) is its tail, not its heart. And the tail doesn’t wag the dog. Paper markets will be the price discovery mechanism for gold as long as fractional reserve gold banking exists. Simple as that. Will beating on the tail of a dying dog kill it faster? I don’t know the answer to that question. Never tried it.
Also, I’m not here to ask you to avoid “paper gold” on moral grounds. Buy paper gold or ETFs if that’s what works for you, by all means. I’m only saying that when you hold “paper gold” you are the same as those that held (external) dollars from 1970 right through until 1972. Dollars were once paper gold too.
There may be a very high price to be paid in the future for the high liquidity of paper claims on gold held by the Bullion Banks today.
FOA: Somehow, the BIS and the major private gold holders know the total claims, as does Another. The Euro group is going to force those claims into real bids instead of just claims!
(The illustrations are from my post Relativity: What is Physical Gold REALLY Worth?)
The Gold in Freegold
One question I see over and over and over and over again is this, presented in its most recent email incarnation:
Another has stated, as have you, that behind the scene, gold trades between the giants for many times what the posted price is. If this is so, then when the phase change comes, and gold is used to recapitalize the central banks and to redress trade imbalances, could it not continue to be used for those purposes behind the scene at inflated values, with the “posted price” remaining at much lower prices?
The Central Bankers NEED gold to be precious in the hands of the people, fiat currency NEEDS Freegold, just as much as gold needs fiat currency in order to be set free from the fractional reserve practices of the bullion bankers, a carryover from the gold standard. Let the bankers play their fractional reserve games with fiat currency, backed by the CBs as their fiat lenders of last resort, just not with precious gold, and certainly not with the backing of the most precious CB asset.
This isn’t about anyone financially screwing anyone else. That stuff happens regardless. This is about the emergence of a stable foundation on which the global economy (and central banks) can operate. To date, there isn’t one, only the U.S. dollar.
The same thing that has given the dollar exorbitant privilege all these years is now bringing it down. And that thing is the self-referential foundation on which it is built. It is the mountain of debt, highlighted by China’s pile of Treasuries, but also including every dollar denominated savings in the world. That pile of “implied dollars” no longer has a recoverable relation to reality. Freegold provides this base, this stable foundation, for the fiat currency system of the future.
Gold trading behind the scenes at a much higher price was never the CBs way of excluding us from the fun. It was their way of protecting their assets from what is inevitably coming. For the CBs to redistribute their gold among themselves in preparation, it made sense that gold’s value (future price) was more than its present price. What Another described was never a parallel trading universe. It was merely preparation for what is coming to everyone.
Nothing is gained for the masters of fiat (the CBs) by having gold trade at a suppressed price, fractionally reserved by bullion bankers, except systemic instability. This is why Another told us that in the future your government will ENCOURAGE you to save in gold. That’s because this will bring monetary stability back to a world that has just experienced (past tense used for a future event) the worst INSTABILITY ever.
It’s not a gold standard. It is saving your earned credits by buying a physical asset, outside of the currency. Buying a currency asset provides a temporary privilege to the currency issuer, but it ends in collapse. Buying a physical item transfers that purchasing power to the physical plane by exerting upward pressure on physical things and downward pressure on the currency. Buying gold isolates, contains and focuses that pressure on one point for the benefit of all.
The Free in Freegold
Okay, here it is. What you’ve been waiting for patiently, I presume. This is what gold will be freed from: The fractional reserve banking practice, which is a carryover from the gold standard.
This is the free in Freegold.
A Final Word
As you can probably tell from this post, I believe that understanding Freegold requires a slight shift in your perspective. It is not sufficient for me to simply describe it in terms as they exist within our present financial and monetary paradigm. I know that some of you think I should be presenting a simple, fully articulated scenario. But I have tried this before. It does not work. It doesn’t do a lick of good. It’s not an easy task to explain something that requires a totally different point of view (before it actually happens; after it happens, of course, everyone gets it… but too late to act on it). My grandfather once taught me that anything in life that is really worthwhile will not be easy. This applies to Freegold.
Some of you have wondered why I am the only one talking about this. Why are none of the other well-known gold analysts acknowledging Freegold? Well, the reason should be self-evident. I am anonymously trying to share that which is easily ridiculed from within the current paradigm. But I will share with you this. Some big names in the gold analyst community have let me know (indirectly) that they are fans of this blog. Take that for what it is worth. But if I told you the names, you’d probably say, “no way!” Way.
Others of you are here looking for “concrete, actionable advice.” Fine. Here it is: Buy. Physical. Gold. Now. Simple is as simple does.