Greg Canavan is the editor of Sound Money. Sound Investments, a weekly report on the best value investment ideas in the Australia share market, with a commentary on the global economy and economics. For a free four-week trial to Sound Money. Sound Investments, go here.
A few weeks ago a momentous event occurred in the precious metals market. As we detailed in a report to paying subscribers, a London metals trader by the name of Andrew Maguire recently blew the whistle on gold and silver price manipulation orchestrated by JP Morgan.
He provided exact details of the fraudulent trading to officials at the Commodity Futures and Trading Commission (CFTC) before and during the manipulation episodes. Unbelievably, the CFTC ignored these claims. Even further, they did not allow him to give evidence at the recently held CFTC hearings into position limits in the commodities markets.
(The hearing was in part designed to investigate whether allowing market players to hold large positions would lead to price distortions or manipulations).
So Mr Maguire went public and told his story to Gold Anti-Trust Action Committee (GATA) member Adrian Douglas. GATA have been claiming for years that the precious metals prices are manipulated in order to boost confidence in fiat currencies. Without the manipulation, gold prices would be much, much higher.
There are many who dispute this claim. But to be honest their reasons are flimsy. It’s far easier to reject something out of hand than to be labelled a ‘conspiracy theorist’, as GATA and their supporters are. But if you take the time to actually think about the claims and study a bit of history, you’ll see that government manipulation of the gold price is nothing new.
Let’s take just a few examples.
Roosevelt’s Attempts to Manage Gold
Soon after Franklin Roosevelt’s inauguration in 1933, he set about the highly controversial policy of ‘inflationism’. Funnily enough, the same policy is accepted wisdom today.
His first step was to ‘temporarily’ – which actually meant permanently – end the export and hoarding of gold. The next step was to announce that the US was off the gold standard.
The impetus for this was, as always, political. Roosevelt’s primary motivation was to appease the farmers, who were groaning under the size of their mortgage debt and were demanding higher prices for their product. His aim was therefore to raise the price level for commodities, agricultural commodities in particular.
He became wedded to the theories of a Professor Warren from Cornell University. Warren believed that if the price of gold was increased, commodity prices would follow. Even the inflationist Keynes thought the theory was ‘rubbish’.
But it didn’t stop Roosevelt. He arranged for the Reconstruction Finance Corporation (RFC) to purchase gold on the US Treasury’s behalf. Each day for weeks on end, the RFC would announce the price it was willing to pay for gold, a price that was always higher than the prevailing free-market price.
Needless to say the plan did not work, commodity prices did not benefit but the policy was causing grief in other parts of the economy. And faith in the value of the US dollar was at rock bottom.
Roosevelt convened a meeting to halt the experiment. With some of his advisers fearful of the effect of a weak dollar, Roosevelt said: ‘…if at any time the dollar should get too weak, the RFC could always reverse itself and sell some gold to the world markets’.*
And a few days later, that’s just what they did. But it wasn’t long before the period known as the ‘gold standard on the booze’ came to an end. In January 1934, Roosevelt announced the return of the US to gold at the prevailing market rate of $35 an ounce. In nine months the US dollar had lost 40% of it value against gold.
The London Gold Pool
Fast forwarding a few decades and we come to the second example of blatant government manipulation of the gold price. It concerns the London Gold Pool, established in 1961 to maintain the price of gold at $US35 an ounce. The paragraphs below are taken straight from Wikipedia.
‘The London Gold Pool was the pooling of gold reserves by a group of eight central banks in the United States and seven European countries that agreed on 1 November 1961 to cooperate in maintaining the Bretton Woods system of fixed-rate convertible currencies and defending a gold price of US$35 per troy ounce by interventions in the London gold market.
The central banks coordinated concerted methods of gold sales to balance spikes in the market price of gold as determined by the London morning gold fixing while buying gold on price weaknesses. The United States provided 50% of the required gold supply for sale. The price controls were successful for six years when the system became no longer workable because the world’s supply of gold was insufficient, runs on gold, the British pound, and the US dollar occurred, and France decided to withdraw from the pool. The pool collapsed in March 1968.’
Once again, this method of controlling the price of gold to maintain faith in the value of paper currencies (or in Roosevelt’s case, to placate special interest groups) proved to be useless. A few years after the London Gold Pool collapsed, the US refused to exchange dollars for gold and the dollar price of gold went from US$35 and ounce of over US$800. It took a decade to get there but the gains, even if you participated in some of the move, were sensational.
Today’s Gold Market
A similar situation is unfolding today. Andrew Maguire’s revelations and subsequent testimony at the CFTC hearing, which basically conceded that 100 times more gold is traded than actually exists, will eventually produce a massive short squeeze in physical gold.
A short squeeze means that players who are ‘short’, i.e. those that owe gold to someone else but don’t actually have any, will be forced to buy gold on the spot market to honour their contracts. Either that or default.
We think there will at some point be a scramble for physical metal and the price will surge higher.
This will happen because gold is like no other asset. The whole reason you own it is to avoid counterparty risk. Gold is a store of wealth and by owning physical gold you are not relying on the solvency of any other party.
So while some might think that $100 of outstanding claims on gold versus $1 of actual gold availability is ok because that’s how other markets operate miss the point completely. They say the leverage inherent in the gold market is ok because if short sellers cannot deliver, ‘cash’ settlement is always available.
But gold is the ultimate form of cash, and those owning physical gold do so because they want to diversify away from paper currencies. Why would they settle for a paper cash settlement?
Up until now, hedge funds have been predominant in the gold futures market and they have been willing to settle for cash. They have simply been playing the theme that increasing monetary disorder will be good for gold. In other words they have participated in the gold bull market without actually owning bullion itself.
But that might be about to change. Recent revelations have highlighted a weakness in the market structure. In financial markets, weaknesses eventually get exploited.
We believe more and more large gold investors will begin to take delivery of their bullion to ensure that they actually possess what they own. The benefits of having ‘exposure’ to gold (via the futures markets or in unallocated accounts) without the costs of storage, insurance etc will soon be outweighed by the risk of not actually owning gold when its most needed.
This move to take possession or have gold securely stored has already begun on a small scale but it will intensify. Physical gold will slowly diminish in circulation, producing the short squeeze discussed above.
This process is known as Gresham’s Law, named after 16th century English financier Sir Thomas Gresham. Its basic premise is that bad money drives out good money. It’s happening right now and will continue to do so.
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