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June 22, 2005

In Denial of Crisis: Part II
by David Jensen

David Jensen is the Principal of Jensen Strategic a Vancouver-based strategic planning and business advisory services company.

Central Banks and Their "Elastic" Currency

The founding fathers, being aware of the withering effect of monetary inflation which had occurred with the unbacked "Continentals" during the revolution forbade the use of a currency that was not gold or silver backed. Specifically Article 1, Section 10 of the Constitution stipulates : "No State shall... ...coin Money, emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; ...". Despite clear and express opposition of those who wrote the Constitution to un-redeemable fiat money as Legal Tender, through a series of hand-wringing decisions, U.S. courts in 1878 finally ruled paper money constitutional allowing the future removal of gold and silver from any disciplinary role in the issuance of US currency.³¹

There are many who have voiced concerns about the creation of the Federal Reserve and the elastic money it created including Warren Buffett's father³² (Congressman 1943-49, 1951-53) as well as Alan Greenspan himself in a previous manifestation.³³

From 1914 and on in the U.S. and in Canada we have the current age of Central Bank fiat currency, where the Central Bank in each country modulated the amount (stock) of money and its cost (the interest rate) in an effort to control the economy. Freed by the suspension of the fixed convertibility of money into gold, Canada and the U.S. were able to finance their war activities with an "elastic" (expandable) money stock.

Since the creation of the Federal Reserve, the U.S. has had three major price inflations corresponding with an increase in the money supply: 1914 to 1920, 1939 to 1948, and 1967 to 1980³⁴ - coincidentally corresponding to WW I, WW II and the Vietnam War, respectively.

The Federal Reserve Bank, while permitted to operate U.S. monetary policy by the U.S. government, are not Federal at all and they have no hard reserve backing the Federal Reserve notes. Instead, the Fed's shares are fully owned by a combination of national banks (who must own shares in the Fed) and state banks (who may own shares in the Fed). Thus the U.S. monetary system (interest rates, money stock growth, etc.) is controlled by an institution (the Federal Reserve), that, while approved to operate by the Federal Government, is a private institution owned by banks operating in the U.S.

In conjunction with the Fed, the U.S. Treasury prints Federal Reserve Notes (today's paper dollar currency) at the directive of the Federal Reserve. The Secretary of the Treasury is the principle economic advisor to the President and thus works with the Fed although he does not have authority over the US money stock - only the Fed Board of Governors and the Fed's FOMC has that control and operates independently.

The interest rate setting FOMC is composed of the 7 Fed Governors plus the president of the New York Fed plus 4 other presidents selected from the remaining 11 Fed Regional Banks.

The Fed has grown in its powers over time. Initially limited to controlling the money supply under the directive of the Secretary of the Treasury, the Fed's powers have been increased both by Congressional action and by the Fed's own edict. As an example of the latter, the Fed states that in order to maintain its "independence" the Fed of its own volition in 1962 began to intervene in foreign currency markets³⁵ that had been the strict purview of the U.S. Treasury. This raises the question how an independent, non-government body can expand its own powers giving it the ability to act in contravention to the Department of the Treasury which is overseen by the President and the executive branch of government.

In Canada, monetary policy is set by the Bank of Canada. Established in 1934 as a privately held bank, the Bank of Canada was nationalized in 1938.³⁶ Since Confederation, Canada's dollar had been redeemable at a fixed quantity for gold. Due initially to World War I, from 1914 to 1926, and forward from 1931 (de facto) and officially (by Cabinet Order) in 1933, Canada's currency was removed from the fixed gold standard.

The Age of Monetarism - Already Looking for a Place to Happen

In 1911, the famed economist, Irving Fisher published his "quantity of money" theory in his work "The Purchasing Power of Money" where he postulated that the level of economic activity was somehow related to the amount of money in an economy.

What Fisher did not show with his theory was causality - that the government could effect greater sustained and real economic activity by increasing the money stock. This was not an issue as the Central Banks in 1914 did not rely on Fisher's economic theory as justification for their massive increases in the money stock. A war was on and money needed to be created and spent in relation to the war effort - they now had the elastic money stock needed.

That there was immediately a price inflation in 1914 in both the U.S. and Canada followed by the stock market mania and crash of the 1920's tells us the machine was not quite perfected.

A tangible sigh of relief must have swept through central bank and government circles with the publishing of John Maynard Keynes' "General Theory" in 1936 which put forth that during economic slow-downs, falling prices were evidence of "insufficient" money in the economy and not only could the money stock affect the level of economic activity, the government and central banks should intervene with government spending and Central Bank injections to the money supply to counter this "insufficiency" made evident by falling price levels - this theory is accepted even today by government and Central Bank economists. Keynes' theory relied on humans acting neatly and predictably as aggregates who, no matter what the money stock levels, could and should be steered by government and central bank intervention using their mathematical models.

Not all embraced Keynes. As noted by economist Henry Hazlitt:

"I have been unable to find in [Keynes' General Theory] a single important doctrine that is both true and original. What is original in the book is not true; and what is true is not original. In fact, even much that is fallacious in the book is not original, but can be found in a score of previous writers." ³⁷

However, the ball was already rolling and Governments and Central Banks now had the ammunition backing the monetary and government expansionist policy they had already been using - creating money to allow activity beyond their means.

"In the long run we are all dead." - Keynes

Keynes trite argument for not waiting and rather intervening to spur on the economy should give us pause for our current monetary intervention in the economy.

Before monetarism and Keynes' belated theory to justify Central Bank expansion of the money stock and government spending to boost the economy, there was what is now referred to as the Austrian School. Starting in the late 1800's the name 'Austrian' was applied as a derisory term by German economists to attempt to portray this group as not being part of the mainstream Prussian-German body of economists.

In the Austrian school started by Carl Menger in the 1870's and extended most famously by Ludwig von Mises (1881 - 1973) in the 20^th century, the central tenet of this school was that analysis of economic phenomena and then attempted explanation by various mathematical models was not possible - humans are complex and cannot be predicted by aggregating their "average" behavior according to neat mathematician's curves.

The nub of von Mises' theory was as follows: the complexity of human behavior required that you could only develop a rational and objective economic theory based upon fundamental logical principles (deduction) of human action as opposed to the monetarists' and Keynesians' selected observation followed by attempted mathematical modeling (induction). (The latter method being the source of endless frustration of those who rely on economist's predictions as mathematical forecasting models have shown their failure. To wit: President Lyndon Johnson's exclamation "Will someone get me a one-armed economist!" after tiring of hearing "On one-hand.... Yet on the other hand...." from his economists with their insufficient models and need to hedge their predictions.). von Mises correctly identified that all individuals are independent actors and the effect of addition of money to the money supply would see individuals using it in different ways that could not be predicted - only observed after the fact.

von Mises identified that the pool of funding (loan availability from savings) in a gold standard economy is set by organic growth of the economy through productive enterprise and consequent savings. As a medium of exchange, the money stock in the economy and the associated bank interest rate of money transfers critical information about the state of the economy, self-adjusted economic activity and were thus not to be manipulated.

The Austrian / von Mises model works as follows: in a system with a given money stock, the availability of money through savings in bank accounts sets interest rates according to the laws of market supply and demand. With high consumer spending, bank accounts would be drawn-down and interest rates set by market forces would increase to attract savings so that banks could still provide loans. These higher interest rates would focus industry on activities which would give short-term financial return on the loans by satisfying current consumer and industry demand. As consumer/industry needs were met, demand for goods would slow somewhat and savings would increase thereby lowering interest rates as more money was available for lending. Less costly loans at lower interest rates allow industry to undertake longer-term project which give a return over a longer period.

"When a central bank expands the money stock, it does not enlarge the (real) pool of funds. It gives rise to the consumption of goods, which is not preceded by production (and savings). It leads to less means of sustenance. As long as the pool of funding continues to expand, loose monetary policies give the impression that economic activity is being boosted. That this is not the case becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens, the economy begins its downwards plunge. The most aggressive loosening of money will not reverse the plunge..." ³⁸
Frank Shostak

Under a gold standard monetary system, the availability and cost of money, as the signaling mechanism for self-adjustment of the economy, is continually adjusted by economic activity as a consequence of the decisions of consumers. Because there is no central bank intervention into interest rates and the money supply, the continual self-adjustment of the interest rate and industry and consumer response to these movements results in interest rates tending to be stable and varying little over time. As a result of this continual market driven adjustment of interest rates, economic growth and recessions also tends to be more steady under the gold standard. From 1850 to 1910, the U.S. average economic growth of 1.3% per worker³⁹ per annum which speaks to the relative strength of the economy during this period of industrialization and social upheaval. Compared to the contraction of GDP by nearly 50% during the Great Depression, the gold standard performed in a far superior manner compared to the Federal Reserve's elastic money era which quite literally started with a bang (and will likely end thus).

As a result of this stability, under the gold standard there is little variability between various bond maturities be they 1-year, 2-year, 5-year, or 10-year bonds; because interest rates vary little, bond market speculation over interest rates would be stopped and they would simply hold value for their intrinsic interest rate return of the bond. What economists today call the yield curve which graphs variations in bond yields based upon their maturity, simply reflects anticipation of central bank error and correction of interest rates. This guessing game and speculation over what the central bank will do with interest rates disappears under the gold standard⁴⁰ as does the opportunity for outsize trading profit, which depends upon changing sentiments as to where interest rates are headed. This would free up some of the greatest talents in our society to pursue truly productive activity - minds which today are locked-into the financial markets trying to find opportunities to make profit by clever trading of financial assets.

The effect of central planning intervention by central banks in manually enlarging the money pool and manually setting the interest rate, forces interest rates down to levels far below the natural market set-point, thus mal-structuring the economy and the demand for goods and services by distorting the market pricing mechanism of money. In addition, with excess money and credit available in the economy, growth of ineffective commercial enterprises, "investment" wagering, bubbles and crashes occur that otherwise would be limited when the availability of money meets the natural productive needs of society.

Artificially inflating the money supply (savings pool) to drive demand is no replacement for preceding organic growth and savings in the economy.

von Mises saw the folly of central planning of the economy and the distortions and overshoot created by interfering with the natural market pricing mechanism of money by Central Banks interfering with the money supply and the natural market rate of interest. The resulting distortions in the economy caused by excess credit creation ultimately reveal themselves when the credit and interest rate policy of the central banks are normalized as they always must (if not, crippling inflation explodes within the economy as the excess money creation starts to manifest itself in higher commodity and goods prices driving the price level higher). von Mises also identified that in prolonging the expansion of credit, in addition to mal-structuring the economy, by definition dictates that continually lower credit quality borrowers must be brought into the credit pool which further destabilizes the financial system.

When these distortions and uneconomic activities are revealed and shaken-out by rising interest rates, a sharp recession follows while restructuring the economy for future productive. If the credit and money supply distortions continue for a long-enough period, then this correction is strong and prolonged as was the 1930's Depression - von Mises indelicately named such a collapse and general depression a "crack-up boom".

von Mises' noted that when rationally arguing the monetarist/Keynesian model be abandoned because of the inevitable unsustainability, economic distortion and busts it produces, he found:

"It could not influence demagogues who care for nothing but success in the impending election campaign and are not in the least troubled about what will happen the day after tomorrow. But it is precisely such people who have become supreme in the political life of this age of wars and revolutions... ...Nearly all governments are now committed to reckless spending and finance their deficits by issuing additional quantities of unredeemable paper money and by boundless credit expansion." ⁴¹

On Keynes' "new economics" he noted:

"The policies he advocated were precisely those which almost all governments, including the British, had already adopted many years before his "General Theory" was published. Keynes was not an innovator and champion of new methods of managing economic affairs. His contribution consisted rather in providing an apparent justification for the policies which were popular with those in power in spite of the fact that economists viewed them as disastrous. His achievement was a rationalization of the policies already practiced. He was not a "revolutionary", as some of his adepts called him. The "Keynesian revolution" took place long before Keynes approved of it and fabricated a pseudo-scientific justification for it. What he rally did was right an apology for the prevailing policies of governments. This explains the quick success of his book. It was greeted enthusiastically by the governments and the ruling political parties. Especially enraptured were a new type of intellectual, the "government economists"." ⁴²

(One of Keynes' great advantages was that his "theory" necessitated legions of economists analyzing data and creating mathematical equations in an attempt to model the results - and thus it was quickly embraced and promoted by economists in both government and academia. It is telling that today there is no unifying and complete theory of monetarism and Keynesian intervention. Economics textbooks invariably state that the real world can be explained by macro-economic theory which is a patchwork of monetarism, a bit of Keynesianism, several other concepts - and a pinch of moon dust. Almost nowhere in University macro- economics texts can we find analysis of the "Austrian" school. This writer in completing his MBA heard months of monetarism and Keynesian theory. On the last day of lectures, the professor mentioned that there was another school of macro-economic thought and that they were called "fiscalists" - that was it. Fiscalists, indeed. They are also called the Austrian School.)

In discussion of the Keynesian philosophy of active monetary and government intervention with economists, one typically gets the response that monetary intervention is correct "you've just got to know when to stop". That government spending intervention, central bank monetary intervention and suppression of interest rates distorts the market pricing mechanism structuring the economy with unproductive enterprise and attendant speculation, and that the consumption of savings today at the cost of tomorrow's economic growth, is beyond their ken.

A final note on Keynes. Keynes well understood the damaging effect of a system of inflating elastic money. In 1919, in his book The Economic Consequences of the Peace, he made the observation about inflation:

"..By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.."

von Mises' theory did not win him many friends because they worked against the perceived interest of the political class, economists and academics, bankers and the investment industry. The tragedy of von Mises remains that, as a Jewish intellectual living in Switzerland during WW II, upon the publishing of his major work "Nationalokonomie" in 1940 which was written in German but went against the prevailing socialist winds of the National Socialist (Nazi) party in Germany (the book was later published as Human Action in 1949 by the Yale University Press), von Mises was pressured to leave Switzerland narrowly escaping through France to the United States. While almost all other socialist and communist economists who emigrated to the U.S. could find employ and despite von Mises keen and productive mind and extensive publishing of economic thought, he could find no paid economic tenure in the U.S.⁴³

The real testament to von Mises' strength of character is he never capitulated. He steadily supported an economic approach that he knew was superior despite the fact that easy personal reward, which his peers so easily accessed, lay in promoting monetarist economics.

Creative Numbers

von Mises saw the occasional and shallower slow-downs in the economy under the gold standard as a healthy restructuring of the economy for future growth where ineffective and unproductive enterprise are weeded-out. During periods where there is higher measured unemployment, those with jobs tend to spend less until the economy strengthens. Keynes called this phenomenon the "Paradox of Thrift" ⁴⁴. According to Keynes' theorem, citizens' response to an economic slowdown makes slowdowns worse than need be. During these periods, Keynesians and many political leaders feel that more money needs to be injected into the economy and government spending enacted to overcome this natural economic characteristic.

In the 1970's during a period of economic turmoil and high inflation, we saw the introduction of the "unemployment rate" that only included individuals actively looking for work; the unemployed who were discouraged were not counted as unemployed. In this way, citizens were presented with a better picture to prolong their spending (but deepening imbalances) and politicians, who liked to pretend they create jobs during good time yet not wanting responsibility for slow-downs and job losses, were offered an out.

As noted above, today we hear from Washington that inflation is subdued, the economy is strong, and unemployment is declining. If we look at the "employment participation rate" which is the percent of the population actually employed, we find that there has been a steady decline from 67% of the U.S. population employed in 2000 to 65.5% of the population employed in 2005. This while the Bureau of Labor Statistics states the Unemployment rate has dropped from 6.3% in 2003 to 5.2% in 2005.

In addition to inflation's human toll which aggravates voters, governments are averse to acknowledging inflation because it triggers the hoarding response which creates artificial shortages worsening the price inflation condition. Price inflation also increases the cost of entitlement costs (old age pension / social security payments, welfare payments, etc.) limiting the amount of new government initiatives that can be undertaken. Yet inflation is a feature of the fiat money system.

We've also had the introduction of the "core" consumer price index (CPI) that excluded "volatile" items such as food and energy. If a government understates inflation, pension and employment wage increases which are indexed to the "Core" CPI are diminished - Social Security payments alone constitute a $480 Billion per year expense for the U.S. government. Containing benefit increases that compound annually in the social security budget is not a trivial matter.

In addition, the Consumer Price index is now calculated using a tool called "hedonics". The term is derived from the Latin word "pleasure". For example, if a product such as a computer were to feature a 50% greater speed for, say, the same price year-to-year, the product would be deemed to be 33% cheaper ( 100% / 150% ).

More than 35% of the U.S. basket of goods in the CPI is hedonically adjusted including clothing. For a summary of how government statistics are massaged to make the consumer and business leader feel better while having less money left over see links below for papers by Gillespie Research.^v

In Canada, the CPI shelter component in Canada is now broken down into two components: Rented Accommodation and Owned Accommodation that together constitute 26.8% of the total CPI basket. The Rented Accommodation component accounts for roughly 1/3 of the Shelter Component while Owned Accommodation accounts for 2/3 of the Shelter Component.

The art in the Canadian CPI calculation is interesting. The Rent Paid portion accounts for approximately 6.0% of the total CPI basket while the Owned Accommodation cost is calculated using an "imputed user cost" or what "rent" for which a homeowner could rent the accommodation back to themselves. In calculating the imputed user cost, the mortgage interest composes 5.4% of the total CPI basket, building depreciation costs (excluding property value) are calculated at 2% per annum of the building value (3.3% of the total CPI basket) and property taxes (3.2% of the total basket) are utilized - it is assumed that the property is not amortized (i.e. the mortgage is never paid-off). Adding the above, the total direct Owned Accommodation housing costs (excluding insurance, hydro, water, maintenance, etc. ) accounts for 18% of the CPI. When all shelter costs are included, shelter composes 26.8% of the CPI.

According to the Royal Bank's Housing Affordability Index, rent accounts for 40 to 70% of renters' pre-tax median income while home ownership costs (including amortization of the home loan but excluding maintenance) accounts for 20 to 30% of home owners' pre-tax median income in Canada. In total, the Royal Bank finds that shelter costs for all households in Canada (overall rental and ownership costs combined) total 25 to 40% of Canadians' pre-tax household income. This compares to a total CPI shelter component of 26.8% of the consumer goods basket which would reflect post-tax costs and assume no amortization of mortgages.

New housing purchasers in Vancouver and Victoria will be heartened by the following March 2005 CPI statistic: without adjusting for inflation, owned accommodation dollar costs in Vancouver are 95.3% of their 1992 costs and in Victoria they are 96.9% of their 1992 - adjusting for the Bank of Canada estimate of 26.6% inflation since 1992, owned accommodation costs today are 75.3% of the 1992 cost for Vancouver and 76.5% of the 1992 cost for Victoria. (for reference: The Real Estate Board or Greater Vancouver gives a current detached house average selling price of $555,000 vs. $300,000 in 1992 (and $400,000 at the beginning of 2003) for an increase of 85% and a similar 81% increase in condo housing prices over the 1992 to 2005 period) - as amortization is ignored in the index.

In July of 2004 with interest rates at their bottom, it was determined that the mortgage interest cost at 8.4% of the Consumer Price Index basket was excessive and this component was reduced to 5.4% of the basket total (a 33% decrease). The total shelter component of the CPI was also decreased by 8% from its previous weighting - this at a time when real estate costs were climbing steeply across Canada and interest rates would start to climb.

What the CPI reflects is not clear, however, it should not be used to inflation adjust pensioner income and cost of living increases in labor agreements.

Back to the Gold Standard

"A major benefit of the gold standard was the fact that it was unencumbered by nationality and therefore could not be operated in a capricious irresponsible manner; America's policy on the dollar policy clearly is... ...We have long discussed America's growing financial imbalances and its consequent vulnerability to third world-style debt trap dynamics." ⁴⁵
Marshall Auerback, 2001.

It is clear from the past 8 decades of expanding central bank power and their expansion of the money-stock, the antiquated central-planning approach of central banks forcing interest rates and the artificial manipulation of the money stock can not nearly replicate the delicate self-adjustment, stability, and balancing of the gold standard monetary system. A central banking committee cannot ever hope to read the tea leaves of the economy and replicate the continual balancing of interest rates and economic activity effected by trillions of consumer decisions each day. There will be many criticisms of a return to a gold standard currency and statements that it will be absolutely impossible to reinstitute this currency system by parties who have an interest in today's volatile markets and interest rates (Greenspan suggested in 1981 that such a transition back to the gold standard was possible and even desirable⁴⁶). The volatility begets opportunity for trading gains in stocks, bonds and interest rate sensitive instruments such as derivatives, ultimately spawning bubbles. However, the volatility, bouts of inflation and ultimate busts are not in interest of a stable or just society.

Investors have today been lulled into a sense of security regarding perpetual low-interest rate while the potential for an inflation shock to the economy as a result past central bank monetary inflation begins leaking into commodities speculation / safe haven hedging or a shock from foreign investors slowing their purchases of the US debt is very real. The consequent rise in interest rates and the attendant investment and economic slowdown can rapidly deplete the inflated paper value of stocks, bonds, real estate and derivative investments and lead to a massive wealth transfer; those who are liquid and without debt will be presented an opportunity to acquire assets at significant discounts as investors scramble to stop losses and debt by disposing of losing asset classes which then overshoot to the downside.

Given the U.S.'s investment and real estate bubble, its dependence on foreign financiers, the unprecedented level of indebtedness, and Canada's almost complete dependence upon the U.S. economy through trade since the implementation of the Free Trade Agreement in 1989, both countries face the risk of economic disruption if interest rates are forced-up by the onset of inflation or outside economic shock.

Government action to restructure and stabilize the monetary system and to mitigate the economic consequences which approach is needed.

Gold : An Unwelcome Barometer of Fiat Currency Health

Gold (and silver^vi) are viewed unfavorably by central bankers exercising monetarist expansion of their money stock. Keynes referred to gold as a "barbarous relic" and pop economists such as Paul Krugman have applied other epithets to describe it. Why the hard feelings against a metal that has been used as money for 5,000 years?

Gold is an unwelcome barometer of the health of any paper currency but especially the US dollar that has had the privilege of being the World's central bank reserve currency (60% of central bank reserves have to date been in US dollar instruments). That status has allowed the U.S. to create and pay all its debt in its currency which other central banks were usually happy to hold. When a money stock is inflated, the price of gold in that currency compensates by rising thereby giving a signal of that dilution - this poses a problem for Keynesians and monetarists when they wish to increase the amount of currency to, in their minds, further spur or continue the economy. Given gold's signal of inflation, investors and citizens can roll-out of currencies that are being diluted (inflated) and into gold to maintain the buying-power of their savings and also indirectly influencing the bond market to demanding higher interest rates for bond and other debt instruments (please note: while central banks control the short term interest rates, longer term rates, while tempered by market intervention by the Fed and Treasury, are set by the bond market). Larry Summers who was Deputy Treasury Secretary until Rubin's retirement in July 1999 and then himself Treasury Secretary until December 2000, noted in his co-written paper "Gibson's Paradox Revisited".⁴⁷

(The Paradox was so-named by Keynes as he notes the gold price moved inversely to the real interest rate which is defined as interest rates minus inflation. Keynes noted if interest rates in debt markets give insufficient return while inflation rises, then the price of gold will shoot up. Interest rates would thus respond not to the published rate of inflation but instead to the absolute price level of gold as the indicator of inflation. This makes sense as gold has a long history as money. However it was an obstacle to Keynes as it limited application of his theory. Thus, in addition to the "Paradox of Thrift", he also called this natural phenomenon a "paradox". )

The U.S. has established the U.S. Treasury's Exchange Stabilization Fund for "exchange market intervention policy" and is utilized as a "stabilization fund" to effect an "orderly system of exchange rates". Accordingly, the Treasury Secretary "may deal in gold, foreign exchange, and other instruments of credit and securities."⁴⁸ Chairman Greenspan says that the Fed and Treasury do not "trade in gold"⁴⁹ - James Turk, a noted expert in the gold markets notes evidence to the contrary.⁵⁰ Given Greenspan's word parsing and obfuscation over the past 18 years, it will be interesting to see exactly what Greenspan's words on "trading in gold" mean - a critical question would be whether the Fed and Treasury, or their designees, trade in gold derivatives (a paper financial instrument rather than gold itself) which can steer the price of physical gold by holding dollar instruments rather than gold itself (see further discussion below).

In the 1960's during the U.S.'s monetizing effort to support it's war in Vietnam, the United States, U.K. and other European Powers' central banks openly coordinated gold sales in what was called the "London Gold Pool" to oversupply the market with gold bullion in an effort to keep its price from appreciating in U.S. dollars from the $35/oz. official peg. Again, in 1968 France realizing there would be no end to the printing of U.S. currency, asked for conversion of US dollar denominated debt and currency to US government gold as these instruments permitted at the time leading to the end of the visible central bank manipulation of the gold price.

The visible London Gold Pool coordinated central bank intervention to contain the price of gold was extremely costly to the gold reserve of participating central banks as shrewd investors (not just the French government) could see U.S. monetary policy, and knowing that the price of gold could not be contained forever, simply backed their trucks up to the London Gold Pool and waited for the gold of participating nations to be unloaded at obviously discounted prices. In the final days of the London Gold Pool, purchasers were taking delivery of up to 225 tons of gold per day.⁵¹

Ultimately 55% or 10,000 thousands tons of the U.S.'s gold stock which started at 18,000 tons in 1957 was consumed before Nixon decoupled the dollar from the gold standard and let its currency "float".

When gold is suppressed for a period to prevent its signaling of monetary dilution (inflation), it tends to explode in value when correcting to its true value. When President Nixon made the US dollar irredeemable to all foreign holders of U.S. currency and debt, the price of gold rose dramatically from it's fixed price of $US 35/oz. to over $US 850/oz by 1980 ($2,100 in 2005 dollars) before settling lower to average $400/oz. during the 1980's. As frequently quoted statement by Warren Buffett is "intervention always fails". And sometimes spectacularly.

From 1995 to 1999 with the implementation of the Fed's dollar printing spree, the dollar gained 18% against other currencies and gold declined 38% during the same period in US dollars from roughly $400 in 1995 bottoming out at $250 in 1999. How can this be when the markets when the M3 money stock was itself increased (the dollar diluted) during this period by 45% according to the M3 broad money measure? Instead of gold strengthening by 45%, gold weakened by 38%. A number of factors contributed to the decline of gold during this period.

• Investors were keen to hold U.S. investments - gold was not seen by some as a necessary store of value when U.S. dollar denominated assets were appreciating in the U.S.'s "new economy" home of the dot.com stock market.

• Exporters to the U.S. such as Japan and China were keen to invest the U.S. dollars that they received for the goods they exported back in U.S. government securities such as Treasury Bonds - a massive form of vendor financing (Warburton). This helped recycle the dollars that they received without flooding the world's currency markets with billions of U.S. dollars which would depreciate the dollar and driving up the price of exports to the U.S. - although the U.S. economy's productive manufacturing base was being gutted by globalization, the U.S. had a base of addicted "vendor financing" countries who couldn't say no to buying U.S. debt thereby contributing to the containment of interest rates at their historically low level.

• Instead of the public and extreme gold depleting policy used by the London Gold Pool in the 1960's, a 3-pronged approach appears to have been used by central banks to continue their monetary expansion and inflation of investments without gold signaling fiat currency weakness:

1. Central banks such as the Bank of England, the German Bundesbank and other European and Asian countries allied with the U.S. have made substantial independent gold sales since the mid 1980's (often counterproductively announced beforehand which lowers the price for the gold that they later sell). This has contributed approximately 10 to 15% of annual supply to the world's annual gold market.

2. Gold leasing: there is considerable evidence that central banks have also engaged in coordinated (and unannounced) leasing of their gold reserves. Leasing allows large amounts of gold to be introduced to the world gold market without Central Banks having to show it as a disposed-of asset from their balance sheet. Thus for a price of roughly 1% of the leased gold per year, central banks leased their gold to bullion banks which would then sell the gold onto the world gold market. This is a very profitable business for a bullion bank so long as the price of gold falls or remains constant (dollars could be accessed for 1% per year and then rolled into "guaranteed" profits in the bond or stock markets which would carry the interest of the gold - thus the term the "carry trade"). However, if the price of gold rises, these bullion banks would have to repurchase gold at the end of the lease period at a higher price than they were able to sell the gold - thus incurring a loss on the transaction. The other conundrum with such activity is that the world's gold supply from mines is approximately 2,500 tons per year (and declining) while world gold demand is approximately 4,500 tons per year and increasing. A substantial body of work has been completed by international banking consultant Frank Veneroso in his book "The World Gold Book Annual 1998" and subsequently, which analyzes historical bullion flows from England and has calculate that roughly 10,000 to 15,000 tons of all the world's official central bank gold reserves of 32,000 tons have been leased onto the market in off balance sheet transactions. If indeed 10,000 to 15,000 tons of gold have been leased onto the world gold market; simply drying-up such supply would send the gold price much higher and central banks are indicating that their planned sales of gold are slowing. If such an amount had to be purchased by bullion banks for return of the leased gold to the central banks, the price of gold would climb much higher. Given the supply/demand fundamentals of the world's gold market, it is very difficult to see how the leased gold can be returned to the central banks without substantial losses to those who leased the gold and without driving the price of gold strongly higher.

3. Derivatives: Gold derivatives reflect a bet on the underlying price of gold and are traded on exchanges such as the Commodities Exchange (Comex) in New York. It is well understood that shorting futures of a stock or a commodity can drive down the price of that item by influencing the daily selling price (or spot market) for that good by signaling to traders that someone selling an item short (for future theoretical delivery at a price lower than today's price) believes the price will be lower in the future. Derivatives sell for a fraction of the underlying commodity. For example a "call option" contract derivative (or bet) for gold at $10 dollars below the current price of gold which expires 3 months later is currently $1,380 for 100 oz. of gold (currently $43,000 worth at $430/oz.) Such trades are almost always settled in dollars to cover the loss or the gain for the trader giving an instrument which can influence the price of gold without having to acquire and sell the gold itself. The Bank of International Settlement (BIS) notes that gold derivatives are approximately 26% of the world's commodity derivatives market yet gold only composes 1% of the world's annual commodity production.⁵² Thus there are 26 times or 2,600% more derivatives structured against gold than against other commodities. This is a market in which there is a strong interest.

Peter Warburton provides his assessment of the current interest in controlling the price of gold and other commodities to prevent speculation from the 100 Trillion dollars of financial market investments which, if they roll sufficiently into commodities, would cause an explosive manifestation of central bank monetary inflation in the world's economies:

"What we see at present is a battle between the central banks and the collapse of the financial system fought on two fronts. On one front, the central banks preside over the creation of additional liquidity for the financial system in order to hold back the tide of debt defaults that would otherwise occur. On the other, they incite investment banks and other willing parties to bet against a rise in the prices of gold, oil, base metals, soft commodities or anything else that might be deemed an indicator of inherent value. Their objective is to deprive the independent observer of any reliable benchmark against which to measure the eroding value, not only of the US dollar, but of all fiat currencies. Equally, their actions seek to deny the investor the opportunity to hedge against the fragility of the financial system by switching into a freely traded market for non-financial assets.

It is important to recognize that the central banks have found the battle on the second front much easier to fight than the first. Last November, I estimated the size of the gross stock of global debt instruments at $90 trillion for mid-2000. How much capital would it take to control the combined gold, oil and commodity markets? Probably, no more than $200 billion, using derivatives. Moreover, it is not necessary for the central banks to fight the battle themselves, although central bank gold sales and gold leasing have certainly contributed to the cause. Most of the world's large investment banks have over-traded their capital so flagrantly that if the central banks were to lose the fight on the first front, then their stock would be worthless. Because their fate is intertwined with that of the central banks, investment banks are willing participants in the battle against rising gold, oil and commodity prices."⁵³

Warbuton's commentary was written in 2001 when there was little visible commodity price inflation. Commodity prices have risen by 65% since then. And the control of the price of gold with derivatives could only be maintained while there is physical metal supply available to satiate the current market. Physical gold held by central banks is limited and, if indeed a large portion has been leased onto the markets over the past years, as with the London Gold Pool scheme, market control by intervention cannot be maintained in perpetuity.

In addition to the work by Veneroso on the control of gold via leasing (oversupplying) of the market combined with derivatives on the various commodity exchanges, the Gold Anti-Trust Action Committee (GATA, www.gata.org ) and former V.P. of Canada's Royal Bank, John Embry⁵⁴ voice concern about the likelihood of such manipulation of markets which are said to be "free markets". The Veneroso / GATA / Embry information is dismissed by some, however it is first difficult to envision that the world's central banks would embark upon their inflationary monetary policy - especially with the inflation of the U.S.'s money stock starting in 1995 - without a more effective tool to contain gold and commodity inflation, and thus consumer price inflation and interest rates, as they had previously attempted to do in the 1960's.

Second, the open and clumsy London Gold Pool gold price manipulation by central banks in the 1960's was extremely inefficient and costly in its consumption of central bank gold reserves. If with derivatives market intervention giving a flat/declining gold price, investors could be made to believe that inflation was "dead" while allowing stimulation of the economy via money creation, then theoretically the best of both worlds could be obtained while minimizing the consumption of central bank gold and maximizing the amount of time such a policy could be effected. What is very difficult to understand is, as with the Fed's 1995 rapid expansion of the money supply and consequent stock market bubble creations then the follow-up 1% emergency interest rate spawning multiple bubbles(stocks, bonds, derivatives, and real estate), exactly what the Fed exit strategy for such a policy would be.

If the price of gold has been manipulated and other of what the Fed refers to as "unconventional methods" have been utilized in a scheme to hide inflationary monetary policy by distorting economic indicators all the while "juicing" the financial markets and ultimately destabilizing the U.S. and Canadian economies, all citizens - not just gold investors - need to be concerned.

Finally, it should be noted that Barrick Gold Corp. has been sued in U.S. Federal Court in New Orleans. The Statement of Claim⁵⁵ alleges that Barrick Gold Corp in conjunction with its investment bankers J.P. Morgan Chase combined in manipulating the gold market by funneling central bank leased gold onto the gold market while, at strategic points of such physical gold injection, shorting the price of gold using derivatives to gain $2 Billion in profits. Barrick has maintained that such activity is a part of its normal business activity. Former Prime Minister Brian Mulroney is a director of Barrick and Former President George Bush (Sr.), former U.S. Secretary of State James A. Baker (3rd ) and former U.S. Senator Howard Baker have all served on Barrick's advisory board. This matter is still before the courts and none of the accused are guilty until proved so nor is either party guilty by association. The trial is expected to start in the summer of 2005 and will be keenly watch by those with an interest in currencies and gold. Barrick continues to hold 13,300,000 oz. of forward sold gold contracts on its books at an average price of approximately $290/oz. representing a current book loss of $US 1.8 Billion with gold at $425/oz. It may be a matter of market intervention always failing or a prudent corporate policy carried too far. Whether Barrick was innocently generating profit on a declining gold price or whether it was engaged in contributing to the decline will be determined in court from the facts of this case. The plaintiffs recently withdrew their claim again J.P. Morgan Chase. The suit now only makes claim against Barrick.

Continue to: In Denial of Crisis: Part III
Back to: In Denial of Crisis: Part I

David Jensen
Jensen Strategic

^v For an analysis of government massaging of numbers see the following series of articles by John Williams at Gillespie Research:
(http://www.gillespieresearch.com/cgi-bin/bgn/article/id=340;
http://www.gillespieresearch.com/cgi-bin/bgn/article/id=342;
http://www.gillespieresearch.com/cgi-bin/bgn/article/id=343)
^vi Since 1945, 6 billion ounces of U.S. silver bullion stocks have been dishoarded onto the world silver market depressing the price of silver. The U.S. mint is now a buyer of silver for silver eagle bullion mintage. World silver bullion stocks stand at 200 million oz. ($1.4 billion at $7/oz.) and there is an annual mine production deficit of approximately 100 million oz.

³¹ Eugene C. Holloway, J.D., L.L.M., Gold, Money and the U.S. Constitution, www.gold-eagle.com/editorials_03/holloway011303.htm
³² Chris Leithner, The Other Notable Buffett, www.leithner.com.au/circulars/circular89.htm
³³ Alan Greenspan, Gold and Economic Freedom, www.321gold.com/fed/greenspan/1966.html
³⁴ www.econlib.org/library/enc/moneysupply.html
³⁵ www.rich.frb.org/publications/economic_research/economic_quarterly/pdfs/spring1996/hetzel.pdf
³⁶ www.bankofcanada.ca/en/dollar_book/dollar_book-e.pdf
³⁷ See also: Chris Leithner, A Tale of Two Islands, http://www.leithner.com.au/circulars/circular98.htm
³⁸ Frank Shostak, Inflation, Deflation, and the Future, www.mises.org/story/309
³⁹ Louis D. Johnston, More Light on a Statistical Dark Age: Output and Employment in the US, 1800 to 1930, Department of Economics, Saint John's University, 2004.
⁴⁰ Robert Blumen www.mises.org/fullstory.aspx?control=1579&id=71
^{41 42} Ludwig von Mises, Planning for Freedom, October 30, 1950, from Lord Keynes and Say's Law, www.mises.org/story/1803
⁴³ See von Mises Biography: www.mises.org
⁴⁴ Maurice Levi, Economics and the Modern World, D.C. Heath and Company, 1994, pg. 500.
⁴⁵ Marshall Auerback, America's 'Strong Dollar' Policy and Argentina's Default: A Root Cause That Dare Not Speak Its Name, http://www.prudentbear.com/archive_comm_article.asp?category=International+Perspective&content_idx=8977
⁴⁶ Alan Greenspan, Can the U.S. Return to a Gold Standard?, The Wall Street Journal, September 1, 1981.
⁴⁷ For a discussion of Gibson's Paradox, see: http://www.gold-eagle.com/editorials_01/howe082201.html
⁴⁸ US Treasury Exchange Stabilization Fund: http://www.treas.gov/offices/international-affairs/esf/
⁴⁹ www.usagold.com/gildedopinion/greenspan-gold.html
⁵⁰ http://www.resourceinvestor.com/pebble.asp?relid=10302
⁵¹ Philip Judge, "Lessons from the London Gold Pool", www.gold-eagle.com/editorials_01/judge052101.html
⁵² http://www.bis.org/publ/otc_hy0505.pdf
⁵³ Peter Warburton, "The Debasement of World Currency: It Is Inflation, But Not As We Know It", http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=8763
⁵⁴ http://groups.yahoo.com/group/gata/message/1149; See also : "Not Free, Not Fair" from Sprott Asset Management http://www.sprott.com/pdf/pressrelease/press_release_not_free_not_fair.pdf
⁵⁵ Statement of Claim: http://www.gata.org/BlanchardClassAction092204.pdf

David Jensen
Jensen Strategic

David Jensen is the Principal of Jensen Strategic (www.jensenstrategic.com) a Vancouver-based strategic planning and business advisory services company.

Copyright © 2005-2008 David Jensen. All rights reserved.

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