The Day the Bank of England Ran Gold Down to $256 -- Selling Its Gold at the Bottom. Here's Why.

Gary North

Reality Check (May 30, 2002)

At every recorded price, there is an exchange. For every buyer, there is a seller. Gold has a price. Someone is selling gold.

Why?

There are several possibilities. (1) He thinks the price of gold has peaked. (2) He thinks he has a better use for his capital. (3) It isn't his gold; he's selling it on behalf of someone else. If "someone else" is the electorate, then the seller can do what he wants. Voters have no meaningful understanding of gold. In this respect, they are a lot like University of Chicago economists.

Who are the major sellers of gold? Gold mining companies, central banks, gold speculators, and Indians. (Patel, not Tonto.) Then there are short-term speculators who sell promises to deliver gold in the future at a fixed price, but who own no gold. We call them short sellers.

Gold mining companies sell gold because that's their business. Their gold reserves in the ground are well known and are factored into the prevailing price. Those mines that have in effect sold short at a fixed price reap no profit from a rising price of gold. They already locked in a price, and this is what they are paid when they deliver. He who went long -- promised to buy the mine's output at a fixed price -- is the winner. For over five years, numerous mines have been selling short, called forward selling. They won when gold's price went down. Now they are losing. The amount of gold being sold by mines for future delivery is now drying up. The market has been going against short sellers, i.e., forward sellers.

Central banks have been big sellers, although in a disguised form. They have lent their gold for about 1% per annum -- the cheapest borrowed money on earth. They have not reported these loans as sales. Their official gold reserves remain constant. But the leased gold is gone. It was borrowed by large trading companies called bullion banks. They borrowed at 1%, sold the gold, took the money they earned by selling the gold and invested it at 5% or more. It was a sweet, multi-billion dollar deal. But now they are in a squeeze. They owe billions of dollars of gold bullion to central banks, but to get it back, they must buy gold bullion in the open market, which is now a rising market. They are losing money, big time. What has saved them so far is that the central banks are not demanding repayment. Meanwhile, the public doesn't know that the leased gold is gone. The central banks do not publish these figures.

Then there are direct sales of gold by the central banks. The most recent sales were made by the Bank of England. It sold off at least half of its gold reserves over a 3-year period which ended in March. The man officially responsible for the decision to sell gold is Gordon Brown, the Chancellor of the Exchequer. He has come under fire this month for having made horrendous investment decisions. The INDEPENDENT (May 26) published this story.

Chancellor under attack over sale of gold reserves

By Colin Brown and Jason Nisse

26 May 2002 Gordon Brown has "lost" over 400m pounds by ordering the sale of part of Britain's gold reserves by the Bank of England. . . .

Figures obtained by the Independent on Sunday also show that his decision to order the Bank of England to part with some of its gold reserves and switch into the euro and yen was also not a good bet for the taxpayer. The value of gold has soared on the world markets as investors have switched to gold.

However, figures issued by the Treasury last week showed that the Bank has lost out to the tune of $578m. Treasury minister Ruth Kelly said the Governor of the Bank, Sir Edward George, had sold 395 tonnes of gold as part of the restructuring of the United Kingdom's foreign currency reserves since May 1999. The last auction was in March 2002 when the price of gold was $296.50 per ounce. Gold was trading at $320.5 in London when the markets closed on Friday.

When the Chancellor announced the policy in 1999, he said he wanted to diversify our store of wealth. Germany, Australia, Switzerland were among the major holders of gold who were also selling. They agreed in September 1999 to limit sales to 400 tonnes a year in total until 2004. Gold prices started rising after 11 September.

No public official relishes the prospect of being made to look like a dolt. Mr. Brown looks now like a dolt. Sir Eddie George, who heads the Bank of England, looks no wiser. Other central bankers now must decide whether it is a good idea to sell gold. They may wind up looking like Sir Eddie. ("Sir Eddie" doesn't sound very impressive, does it?)

Of course, major central bankers have a problem. If the public ever learns that the central banks' gold leasing program has turned into an unannounced gold sales program, with the bullion banks in cahoots with the central banks, and the bullion banks can't repay the central banks, heads will roll.

A rising price of gold threatens to bankrupt the bullion banks, who dare not go into the market to buy gold for fear of what this will do to gold's price. So, it's a waiting game. The bullion bankers are hoping for gold to go down. So are the central bankers. But, at some point, the central bankers will have to demand repayment. At that point, the gold leasing game will end. The bullion banks will go bust, the central banks won't be repaid, and the public will find out -- once again -- that you should not trust central banking.

Will that point ever come? Yes. How soon? I think before the end of this decade. But even if it doesn't, the public will still win out. If the gold leasing game goes on, the public will buy back its gold, which was confiscated from our grandparents or great grandparents. If gold leasing ceases, the people who have bought gold and held onto it will earn enormous rates of return on their investments. Gold-haters will lose; gold bugs will win. That is the way it should be.

Can gold's price fall to below the bottom of $256? Anything can happen, but this now seems unlikely, short of one last sell-off by central banks.

GOLD INVESTORS

I have discussed gold sales by gold mining companies and central banks. What about gold bullion investors?

With the Federal Reserve System expanding credit money to push down short-term interest rates, and with a recession in capital investing still in force, the question is: "Where can I make a better rate of return than gold?" This year, gold has beaten all other investment categories. Gold investors have to search long and hard to find a better rate of return. Only if they think the price has peaked would they want to sell. But there is little evidence yet that gold's price has peaked. The predictable threat of the Bundesbank in early April to sell gold -- no amount specified -- in 2004 had no downward effect on gold's price. (See Issue 130.)

So, those who invest in gold have to decide: "What to do with the money I gain by selling my gold?" The U.S. stock market is performing poorly. It has been performing poorly for two years. The investor who thinks that inflation is beaten might sell gold to buy U.S. government bonds. But the Median CPI is still above 3.5% per annum for 2002. No deflation is visible in this statistic.

So, he is less likely to sell than in the past. There are no clear-cut alternatives. This reduces the supply of available gold at any price in today's range.

Then there is the traditional buyer of gold jewelry, the Indian father who has daughters. At some price, he will sell. India is becoming a modern economy. There are alternatives to gold for a daughter's dowry. But today, India is once again facing war. No one likes to think about it, but this war could go nuclear. The West avoided nuclear war, but religious hostilities are very high in the Indian subcontinent.

Pakistan is home base for revolutionary guerrilla forces in Kashmir. That India insists on retaining control over Kashmir seems nutty to the West. So what if Nehru was born there? It is overwhelmingly Muslim. Why not give the residents the right to secede from India? India's answer: Because they are mostly Muslims, and Nehru was born there.

In the mid-1960's, I met an Indian journalist who was on a fellowship in the United States. I think he was a Nieman Fellow, the most prestigious of all fellowships in journalism. He was therefore at the top of his profession. He was liberal: anti-caste, pro-democracy. But on the subject of Kashmir, he was adamant: democracy is an irrelevant issue regarding Kashmir. There was no arguing with him. You can imagine what his Pakistani peers believed, with equal fervency.

One million troops are now massed on the Kashmir border. India has a stronger economy and more money than Pakistan. It has far more people. Its conventional military forces are superior. But Kashmir's mountainous terrain is on Pakistan's side. If the war stays conventional, should it begin, India's economy will be strained to pay for it. If the war spreads to Pakistan, then Pakistan is at a disadvantage. The risk of the Pakistan's use of nuclear weapons rises in such a scenario. SALON (May 28) reports:

A new analysis by the Defense Intelligence Agency suggests that between 8 million and 12 million people would be killed in a nuclear war between India and Pakistan, according to a U.S. defense official, speaking on the condition of anonymity.

The report presumes that both India and Pakistan successfully use most of the weapons in their nuclear arsenals and target the weapons on populated areas, the official said. The death estimates are in the short-term, and do not include long-term deaths caused by fallout.

Both countries' nuclear weapons are thought to number in the low dozens and have yields at or below 20 kilotons, putting them in the class of the bomb the United States dropped on Hiroshima, Japan, in 1945.

Both can deliver the weapons with small fighter-bombers, such as Pakistan's F-16 and India's MiG-27, or ballistic missiles.

Why would an Indian father sell traditional gold jewelry in order to buy conventional paper-money investments in such a scenario? Why not stick with a traditional dowry that goes back thousands of years?

I predict that Indian sales of gold will decline, even though the price of gold is rising steadily. If hostilities cease, I am willing to reconsider. But hostilities are increasing. Kashmir isn't going to go away. Neither is Al-Qaeda. SALON also reports:

In a potential blow to the antiterror war, Pakistan appears to be preparing to pull troops away from the Afghan border to focus on its own dispute with India, U.S. defense officials said Tuesday.

The Pakistani military presence has been a key element of the U.S. strategy for capturing or killing Taliban and al-Qaida fighters who may have slipped across the border. Without Pakistan's help, the United States has little short-term prospect of finishing off al-Qaida.

American military officials made clear Tuesday they are worried that the dispute between Pakistan and India over the Kashmir region could disrupt the campaign against the al-Qaida in the anarchic tribal areas of western Pakistan.

"Attention and troops that cannot be focused there, because they're focused elsewhere, that's a concern for us, because we need as much assistance as possible in guarding that very porous border," Victoria Clarke, chief spokeswoman for Defense Secretary Donald H. Rumsfeld, told reporters.

"It is a concern when they have to focus attention and people to other parts of the country," she added.

She said U.S. officials "are encouraging Pakistan to remain involved, as they have been, extensively, in the war on terrorism."

Pakistan said last week that it might remove troops from the Pakistan-Afghanistan border region, where they are helping the United States search for al-Qaida and Taliban, and move them toward Kashmir because of the escalating conflict there.

SUPPLY AND DEMAND

There has been some increase in demand from Japanese investors this year. There is at least circumstantial evidence that the central bank of China has been accumulating more gold than was believed likely until recent months. But, so far, the upward pressure on gold's price seems to be from the supply side. Reduced supplies of ready sellers are leading to higher prices.

This is understandable. Reduced supplies of gold are the result more of fear than greed. Gold mining firms burdened with forward contracts see losses ahead: selling a commodity whose price is rising, but not for them. Those competitors who did not indulge in forward sales will prosper. They will bid up the price of mining equipment and labor. This will hurt those mines that are loaded up with obligations to sell at a fixed price. They will face a profits squeeze. So, they are less likely to add to their positions of forward sales.

The same fear factor affects Indian families. They are afraid of war's effect on rupee-based investments. War also increases demand for gold. So, they could get locked out of the gold jewelry market. Why sell? Stick with a traditional dowry.

Short sellers in the commodity futures market worry about losses. They buy gold futures to close out their positions. This raises gold's price. So does their departure from the short side of the market. Not only does the supply of gold get tighter, the supply of investors willing to promise to deliver gold gets tighter.

At some point, gold's rising price will attract the attention of conventional investors. This may be years in the future. I think it probably is. For two decades, gold has moved down. Investors have lost confidence in gold. But cycles do occur. Floors are reached. At some point, rising demand becomes more significant than contracting supply.

Traditional market bottoms occur when existing holders get discouraged and sell. Demand has falls for years. The market gets a reputation for producing nothing but losses. Interest by new investors wanes. Only highly entrepreneurial people are buyers. Existing holders grow discouraged about ever making a profit. They finally sell their positions. Capital shifts from older, experienced, but discouraged holders to new entrepreneurs. This sell- off is what the gold market experienced in 2001.

I believe there will be rising interest in gold over the next few years, but that demand, short of nuclear war in the Indian subcontinent, will be steady rather than greed-driven. Demand will increase, as more investors are brought back into the market. I don't expect a gold rush by Wall Street. Wall Street is too conventional. It is also allied at the highest levels with central banks and bullion banks. Wall Street is the Establishment.

There is a long-term re-education process ahead. Gold has been attacked, steadily, ever since 1914, when European central banks ceased to redeem their gold certificates, and their governments authorized this massive confiscation of private wealth. The United States joined in, but re- established convertibility after the war ended. Europe didn't, except for England in 1925, at a pre-war price that could not be maintained without deflation, which the economy got. Britain went off the gold standard in 1931. The United States followed in 1933.

The war on gold is a war of the centralized, grasping State against people with capital. This war is basic to modern democracy: the substitution of the welfare-warfare State for limited civil government. The bias against gold is in the textbooks. It is in the minds of three generations of bankers, industrialists, and investors. A reversal of this bias will not come from within the Establishment. It will be forced on the Establishment.

CONCLUSION

The tide seems to have turned for gold's price. As the truth about the one-way direction of the central banks' gold leasing programs becomes clear to a minority of investors (but very few voters and legislators), gold holders and entrepreneurs will conclude that gold's supplies are far more limited than previously imagined. When they recognize that the overhang of gold is based on a statistical fraud -- that the gold is gone and will not be coming back -- the upward pressure on gold's price will accelerate.

The gold leasing phenomenon could become an international Enron. I think it will. What one company got away with temporarily, with the connivance of its accounting form and the regulatory agencies, will be regarded someday as a minor event. What the central banks have done with their accounting systems dwarfs anything in the history of accounting. The stock market eventually exposed Enron as a gigantic accounting fraud. There will be a similar day of reckoning for the central banks.