Why Central Banks Want the Gold
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Source: Covert Geopolitics
A Great Wealth Transfer is Underway: How the West Lost Control of the Gold Market
April 8, 2024 | By Henry Johnston
Pricing power in a market long dominated by Western institutional money is moving East and the implications are profound.
The gold price has risen to a series of new all-time highs of late, a development that has received only cursory attention in the mainstream financial media. But as is the case with so much else these days, there is much more going on than meets the eye. In fact, the rise in the dollar price of gold is almost the least interesting aspect to this story.
For thousands of years, gold was the ultimate store of value and was synonymous with the concept of 'money'. Trade was often settled either in gold itself or in bank notes backed by gold and directly exchangeable for it. Currencies backed by nothing but government decree – called 'fiat' currencies – have tended to eventually fail.
However, in 1971, gold found itself cast out of this ancient role when the US unilaterally suspended dollar convertibility into gold as enshrined in the Bretton Woods agreement that established the framework for the post-war economy. Shortly thereafter, in an act that medieval alchemists only dreamed of, gold was created out of thin air in the form of futures contracts, meaning bullion could be bought and sold without any metal changing hands – or even existing.
Besides the obvious ramification of all of this – the removal of gold backing to the dollar and thus implicitly to nearly all currencies – there are two important features of how the gold market has subsequently functioned: first, gold has essentially been reduced to trading like any other cyclical financial asset; second, the price of gold has largely been determined by Western institutional investors.
Both of these longstanding trends are now breaking down. As we will see, the importance of this development is hard to overstate. But let's begin with a very quick examination of how gold went from being the ultimate source of value to just another ticker moving in predictable patterns in the constellation of financial instruments.
How paper replaced metal
The collapse of Bretton Woods in the late '60s and early '70s – culminating in the gold window being shut in 1971 – was a messy period of transition, uncertainty, and instability. The dollar devalued and a fixed-rate system was negotiated and soon thereafter abandoned. But what was clear was that the US was steering the world away from gold and toward a dollar standard.
Jelle Zijlstra, president of the Dutch central bank, chairman of the Bank of International Settlements from 1967 until 1981, and a prominent figure at the time, recalled in his memoirs how "gold disappeared as the anchor of monetary stability" and that "the road… through endless vicissitudes to a new dollar hegemony was paved with many conferences, with faithful, shrewd, and sometimes misleading stories, with idealistic visions of the future and impressive professorial speeches."
But, he concluded, the ultimate political reality was that the "Americans supported or fought any change, depending on whether they saw the dollar's position strengthened or threatened."
Nevertheless, gold was lurking in the shadows like a deposed but still-living monarch and thus represented an implicit guard against the abuse of what had become fiat currencies. If nothing else, as dollars continued to be printed, the price of gold would surge and signal a debasement of the greenback. And this is more or less what happened in the 1970s after the gold window was shuttered. After breaking the $35 per-ounce peg in 1971, gold rocketed all the way up to $850 by 1980.
So the US government had a strong interest in managing the perception of the dollar through gold. Most importantly, it didn't want to see gold recreate a pseudo reserve currency by strengthening substantially. Legendary Fed chairman Paul Volcker once said "gold is my enemy." And indeed it traditionally had been the enemy of central banks: it forced them to tighten rates when they didn't want to and imposed on them a certain discipline. [Editor's note: We assert gold has never been an "enemy of central banks"; gold is a weapon used by central banks.]
This framework helps make sense of the rise of the unallocated – i.e. 'paper' – gold market in the 1980s and the countless gold derivatives that emerged. This actually started in 1974 with the launch of gold futures trading but exploded in the next decade. What happened is that bullion banks began selling paper claims on gold for which there was no actual gold attached. And buyers were not actually required to pay upfront but could simply leave a cash margin.
The setup is reminiscent of the old communist joke that went "we pretend to work and you pretend to pay us." In this case, the investor pretends to pay for the gold and the seller pretends to own it. This is about as close as you can get to pure speculation.
Thus was born the fractional-reserve paper gold scheme that persists to this day. And indeed, there is now vastly more paper gold than physical, some $200-300 trillion compared to $11 trillion, according an estimate by Forbes magazine. Others put the discrepancy even higher.
Nobody really knows. Comex, the primary futures and options market for gold, has also become more paper-driven. According to analyst Luke Gromen, whereas 25 years ago some 20% of the gold volume on Comex was related to a physical ounce, that number has fallen to around 2%.
Gold as just another cyclical asset
What is important to understand here is that the creation of a derivative market satisfies demand for gold that would otherwise go to the physical market. Only a limited amount of gold exists and can be mined but an unlimited amount of gold derivatives can be underwritten.
As Gromen explains, when monetary expansion drives demand for gold (due to the inflation this brings), there are two ways this demand can be dealt with: let the price of gold rise as more dollars chase the same amount of gold; or permit more paper claims to be created on the same amount of gold, which allows the pace of gold's rise to be managed.
There are several important implications of this. The rise of the paper market has clearly played an important role in defanging gold in its role as exerting a hard limit on expansionary policy, thus implicitly reinforcing the credibility of the dollar. But it has also meant that the gold price has largely been determined by investment flows rather than physical demand. And when we're talking about investment flows, we mean first and foremost Western institutional investors.
Please go to Covert Geopolitics to continue reading.
However, in 1971, gold found itself cast out of this ancient role when the US unilaterally suspended dollar convertibility into gold as enshrined in the Bretton Woods agreement that established the framework for the post-war economy. Shortly thereafter, in an act that medieval alchemists only dreamed of, gold was created out of thin air in the form of futures contracts, meaning bullion could be bought and sold without any metal changing hands – or even existing.
Besides the obvious ramification of all of this – the removal of gold backing to the dollar and thus implicitly to nearly all currencies – there are two important features of how the gold market has subsequently functioned: first, gold has essentially been reduced to trading like any other cyclical financial asset; second, the price of gold has largely been determined by Western institutional investors.
Both of these longstanding trends are now breaking down. As we will see, the importance of this development is hard to overstate. But let's begin with a very quick examination of how gold went from being the ultimate source of value to just another ticker moving in predictable patterns in the constellation of financial instruments.
How paper replaced metal
The collapse of Bretton Woods in the late '60s and early '70s – culminating in the gold window being shut in 1971 – was a messy period of transition, uncertainty, and instability. The dollar devalued and a fixed-rate system was negotiated and soon thereafter abandoned. But what was clear was that the US was steering the world away from gold and toward a dollar standard.
Jelle Zijlstra, president of the Dutch central bank, chairman of the Bank of International Settlements from 1967 until 1981, and a prominent figure at the time, recalled in his memoirs how "gold disappeared as the anchor of monetary stability" and that "the road… through endless vicissitudes to a new dollar hegemony was paved with many conferences, with faithful, shrewd, and sometimes misleading stories, with idealistic visions of the future and impressive professorial speeches."
But, he concluded, the ultimate political reality was that the "Americans supported or fought any change, depending on whether they saw the dollar's position strengthened or threatened."
Nevertheless, gold was lurking in the shadows like a deposed but still-living monarch and thus represented an implicit guard against the abuse of what had become fiat currencies. If nothing else, as dollars continued to be printed, the price of gold would surge and signal a debasement of the greenback. And this is more or less what happened in the 1970s after the gold window was shuttered. After breaking the $35 per-ounce peg in 1971, gold rocketed all the way up to $850 by 1980.
So the US government had a strong interest in managing the perception of the dollar through gold. Most importantly, it didn't want to see gold recreate a pseudo reserve currency by strengthening substantially. Legendary Fed chairman Paul Volcker once said "gold is my enemy." And indeed it traditionally had been the enemy of central banks: it forced them to tighten rates when they didn't want to and imposed on them a certain discipline. [Editor's note: We assert gold has never been an "enemy of central banks"; gold is a weapon used by central banks.]
This framework helps make sense of the rise of the unallocated – i.e. 'paper' – gold market in the 1980s and the countless gold derivatives that emerged. This actually started in 1974 with the launch of gold futures trading but exploded in the next decade. What happened is that bullion banks began selling paper claims on gold for which there was no actual gold attached. And buyers were not actually required to pay upfront but could simply leave a cash margin.
The setup is reminiscent of the old communist joke that went "we pretend to work and you pretend to pay us." In this case, the investor pretends to pay for the gold and the seller pretends to own it. This is about as close as you can get to pure speculation.
Thus was born the fractional-reserve paper gold scheme that persists to this day. And indeed, there is now vastly more paper gold than physical, some $200-300 trillion compared to $11 trillion, according an estimate by Forbes magazine. Others put the discrepancy even higher.
Nobody really knows. Comex, the primary futures and options market for gold, has also become more paper-driven. According to analyst Luke Gromen, whereas 25 years ago some 20% of the gold volume on Comex was related to a physical ounce, that number has fallen to around 2%.
Gold as just another cyclical asset
What is important to understand here is that the creation of a derivative market satisfies demand for gold that would otherwise go to the physical market. Only a limited amount of gold exists and can be mined but an unlimited amount of gold derivatives can be underwritten.
As Gromen explains, when monetary expansion drives demand for gold (due to the inflation this brings), there are two ways this demand can be dealt with: let the price of gold rise as more dollars chase the same amount of gold; or permit more paper claims to be created on the same amount of gold, which allows the pace of gold's rise to be managed.
There are several important implications of this. The rise of the paper market has clearly played an important role in defanging gold in its role as exerting a hard limit on expansionary policy, thus implicitly reinforcing the credibility of the dollar. But it has also meant that the gold price has largely been determined by investment flows rather than physical demand. And when we're talking about investment flows, we mean first and foremost Western institutional investors.
Please go to Covert Geopolitics to continue reading.
________
The central banker Janet Yellen goes to China. A central banker and not a US policy decision maker goes to China. How was the beer, Janet?
Monetary reform:
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