Tuesday, 2 September 2003

With Chinese Freegold from a reserve currency to a world standard

At the end of August 2003, the euro, although still above parity, was declining against the US dollar. The press was arguing that economic revival was arriving in the US of A. Europe would however still be slipping further into recession. Nowhere did the press refer to the fact that the 1.17 figure at which the euro started trading on January 01, 1999 against the dollar was nothing but a “nanosecond” spurt, more similar to an IPO (initial public offering), relative to almost no actual goods trading. Another reason why this euro decline is no reason to worry for the European Central Bank (ECB) is that the euro wants to take over the role of the US dollar in international trade and wants to transform this role from a reserve currency to a world standard. What should a libertarian think of this? I repeat the question which this short paper tries to answer is: “What should a libertarian think of the euro?” The question is not: “How should I invest my savings?”

Until the birth of the euro, international trade was completely dominated by the US dollar. Since the end of the 19th century, the dollar was freely convertible to gold. Man had however since ages the craving to forge gold and to disconnect money from real gold. President Franklin D. Roosevelt was the first to accommodate this craving in 1933 and he retained this convertibility only for foreigners. Americans were ordered to hand in all their gold. President Nixon knew even better in 1971 and he put also an end to this convertibility, then $35 an ounce, for foreigners.

The oil producers from the Middle East could therefore obtain less gold than before with the dollars received for their oil. Out of love for gold, they were thus forced to increase their prices, which caused the first oil crisis. The price of gold rose to over $800 up until 1980. Since then gold has fallen back to $230 and on August 28, 2003 it was sold for $370 at the closing in New York.

Why has the price of gold retreated like that? Is there not enough demand for gold, or, to view it from another standpoint, is there too much supply of gold? No, there is big demand for gold. If this demand would be allowed have its effects on the price of gold, that price would rise dramatically and this would demonstrate the bad consequences of the policies pursued by the central banks. The central banks started therefore to look for a way to increase the gold supply so that the price of gold would decrease.


The first way in which the central banks tried to influence the price of gold downwards was the outright sale of their reserves. But the central banks realized already before 1980 that gold sales didn’t influence the gold price downwards. Their next idea was to convince from 1980 onwards the gold mines to sell their not yet mined gold. The argument given by the central banks to the mines was that they could in that way secure their future income stream. Those sale contracts have been concluded between the gold mines and the bullion banks like JP Morgan Chase and Goldman Sachs. The contracts concluded by the former bank had in 2001 as their object every ounce of gold which would be mined in the coming two and a half years (many of those contracts are still in existence.) Those contracts have been sold by the mines to the hedge funds and by the bullion banks to the oil producers and others.

The bullion banks were prepared to conclude those contracts because the central banks guaranteed the obligations of the mines. This guarantee took the form of granting the bullion banks, which had concluded the forward contract with the mines, a marketable claim to the gold in the central bank vaults for immediate delivery. By selling those claims, the bullion bank could hedge itself against a drop in the gold price. Indeed, if the gold price has dropped at the moment of the mining, then the bullion bank has contracted to buy gold at a higher price than the market price, which is of course a stupid thing for a bank to do, but, granted, a good thing for the mine to do.

For the mines/hedge funds it became necessary to hedge against steep increases of the gold price because in that case, the hedge fund must, in theory at least, deliver gold, which it does not possess and which it therefore does have to buy at the market price, at the contractually agreed price which is much lower than the market price. That’s why the hedge funds are indoctrinating the public by saying that gold is no longer an investment vehicle.

A third, and last for the central banks, way to hide the bad consequences of their policies, was for the central banks to provide their gold to the bullion banks at the ridiculous (but with the present low interest rates, which signify therefore the death knell of this carry trade, no longer ridiculous) interest rate of 1% pro annum. By selling this gold immediately and invest the price at a higher interest rate, the bullion bank was assured to gain upon refunding the gold to the central bank. The bullion banks therefore also had an interest in keeping the price of gold low and like the hedge funds, they started indoctrinating the public by saying that gold is no longer an investment vehicle.


The flourishing on the stock market at the end of last century of derivates like options and futures was a symptom of the fact that it this society, which would be our society, most individuals think that from the moment you have a claim to a tangible thing, you possess that thing, even though there is no way in which that debt could by settled by the debtor through a physical transfer of that thing. Translated into gold terms, this means that so-called gold bugs are not interested in the possession of gold as a hedge in case of monetary disorder, but only in concluding wagers over the gold price in order to pocket the monetary surplus value. In that way, the bullion banks, who had learnt their mischievous behaviour from the central banks, came up with a fourth way to lower the price of gold. Knowing that more than 90% of the counter parties would be satisfied with a settlement of the contract in paper money, or the conversion of the obligation of the hedge fund into an obligation in paper money which involves only money and does therefore not influence the demand for physical gold, there just needs to be enough gold available to fulfil the demand of the next real gold buyer. Only to be repeated again and again as the paper system produced another lower value for each new buyer/ owner. Eventually bringing gold to its plateau price today.

This gold market is a completely free market in the sense that the supply of those contracts is almost unlimited and is only limited by on the one hand nine times the gold, which can be mined and by on the other hand the costs of mining under which the price of paper gold cannot (be allowed to) fall. The contracts have therefore been offered to anyone who was prepared to conclude such wagers concerning gold price movements and it was not difficult to sell three wagers that gold would decline for every wager that gold would rise.

As long as more than nine tenth of the counter parties were prepared to settle the contracts with paper money, no gold is being displaced on the physical gold market. The only influence it exercises is upon the increased supply of (paper-)gold so that the price of (paper-)gold drops.

Until the day that more counter parties rise who insist upon the gold being actually delivered to them and who are not satisfied with receiving (or paying – if a real lunatic gold bug wants to knuckle down the paper gold market, he can insist upon the gold being delivered to him at the contractual price even though he could theoretically obtain that gold at a lower price on the spot market) paper money. At that moment the paper gold market collapses, as the physical gold is not available. The reader will remember the problems caused to the bullion banks in September 1998 when the US central bank had to bail out hedge fund Long-Term Capital Management (LTCM). The reason why LTCM was in trouble was due partly to i
ts gold hedges.


Even the politicians realised that paper gold contracts are limited due to the fact that gold cannot be mined at a price below the mining costs. This explains why on Sunday September 26, 1999, 15 European Central Banks concluded the Washington Agreement on the sidelines of an IMF-World Bank meeting. By this Agreement, the politicians wanted to set limits to gold lending. This agreement recognised that gold will remain an important part of global monetary reserves and that the involved central banks will, apart from the sales which have already be decided, not sell gold in the next five years.

Following this Agreement the gold price skyrocketed from $268.4 on September 24, 1999 to $336,5 just before the New York opening on October 04, 1999, thereby bankrupting the gold mines Ashanti Gold en Cambior whose contracts with the bullion banks failed to take a quick and substantial rise in the gold price into account.

The ECB reserves consisted in 1999 for 15 percent of gold and were then, and are still being, marked to market on a quarterly basis. The Agreement which expires in 2004, but which probably will be renewed on stricter terms between more than the 15 original parties at the IMF-World Bank meeting in Dubai on September 23-24, 2003.

Since the trade balance euroland is, in contradistinction to the American trade balance, positive, it was expected that a rising gold price would support the value of the reserves of the euro and thus the euro itself. And what have the markets taught us? Whereas gold closed in New York on Friday September 24 1999 at $268.4, it closed on Monday, September 27, 1999 at $281.9 and on August 28, 2003 at $370. One euro was worth on those dates $1.04658 , 1.04299 en 1.08954, the dollar thus euro 0.956201 , 0.958785 and 0,917820. The gold price has thus increased from euro 256.64 over 270.28 to 339.60.

Since the Washington Agreement entire gold operations at international financial institutions have been shut down with more rumoured in the works. With the present low interest rates, it is senseless for the central banks to lend gold. Those low interest rates will lead within 24 months to inflation for the reserve currency, the dollar. Only this inflation can indeed lower the present debt mountain. This inflation will lead to a further increase in the price of gold which will make the refunding of the borrowed gold by the bullion banks to the central banks impossible. This will force the Federal Reserve Bank of the US of A to declare an official delivery moratorium for the bullion banks in the US of A. This political declaration in the US of A becomes then a market fact, and not a political fact, for the European bullion banks. This market fact enables them to reimburse the gold loans with paper money. The paper money which they have, are euros, not dollars. The European central banks, which have then lent out gold receive then euros instead of that gold, euros which they then keep in their reserves. At that moment, they know what to do with their superfluous dollar reserves. They buy gold with their dollars at high prices. By throwing dollars at gold, the value of the dollar drops. At that moment the dollar is broke and the euro the sole survivor and this survivor is the new world standard which takes the role of the failed (dollar) reserve currency. In the meantime the oil producing shorts will have been able to obtain all the gold necessary to refund it to the central banks, but the central banks will at that moment be satisfied with receiving euros to the effect that the oil producers will sell their oil for euro.

In Russia, the Middle East and India, there is an increasing aversion against the dollar and is a search for a replacement under way. The present gold fever in China where individuals are since early 2003 again allowed to possess gold implies that in order to be an economic world power by 2012, China could well accede to this world standard, Freegold. At that moment only physical gold will be traded as the natural vehicle to incorporate one’s wealth, the value of paper gold will be reduced to nothing, and the value of the euro will increase quarterly upon the marking to market of its gold reserves.

The ECB will not define the euro like the old gold standard as a certain quantity of gold, but will use it as a free trading financial reserve so that each increase in the price of gold will bring about an increase in the value of the euros reserves and thus an increase in the value of the euro itself. This currency concept is closer to the tenets of libertarianism than a gold standard because of the exchange restrictions which inevitably follow

Done on Siquijor, on August 29, 2003

Ivo Cerckel