Murray Pollitt: The gold monetization scheme is ending

By Murray Pollitt
Pollitt & Co., Toronto
Thursday, April 30, 2009

The G8 appears finished but their policymakers continue to try to bend the G20, and the world, to their will. The establishment, the Fed, the Bank of England, the Bank for International Settlements, the same gang that has been setting policy for decades, is still at it. They appear to remain in charge (with nary a whimper of criticism about the trillions of dollars' worth of damage their policies have caused) but, when it comes to gold, they are slowly losing their grip.

Besides setting the stage decades ago for sub-prime paper, CDSs, and so on, it appears policymakers embarked on a scheme, at more or less the same time, to monetize the hundreds of billions of dollars' worth of gold lying sterile in central bank vaults. The temptation was too much. One-percent income on gold for a central bank was better than nothing, so the argument ran, and for the Lehman types borrowing gold (and selling it) provided lots of money (capital) to play games with.

It was so easy. Besides, the gold carry trade involved selling lots of gold into the market and this helped keep the price down (and hopefully the dollar up), a subject near and dear to policymakers.

It also led to: a) huge mine hedging with the two biggest miners, each with a link to Morgan, together short over 30 million ounces ("making money on gold in the ground" was the argument) and b) significant outright central bank sales, which may have been interventionist or may have been for portfolio diversification, however ill-advised.

And if banks and markets didn't always follow the script, there was always high-level intervention. To illustrate the mindset, in 2004 one William White, advisor to the BIS, talked about the need for "international credits and joint efforts to influence asset prices (especially gold and foreign exchange) in circumstances where this might be thought useful." The idea of rigging markets is as old as the hills, and if the government is on your side. ...

Anyway, the great gold monetization (mobilization?) scheme appears to have started in the 1980s and the following events that, in part, characterize it are not necessarily in sequence.

1) Goldman bought gold dealer J. Aron.

2) In an early gold carry trade, Drexel borrowed hundreds of tonnes of gold from Portugal.

3) All the big swinging banks sought to get into the gold game and they bought all the London gold dealers except Rothschild, which was definitely in on the game on its own.

4) Mine hedging was pushed very hard, to a peak of about 120 million ounces.

5) Greenspan and others dropped broad hints that central Banks stood "ready" to supply gold to the market.

6) Drexel went broke and it apparently took Portugal five years to recover its gold.

7) Two long-term gold players, Republic and Safra, each with a somewhat checkered past, had a shotgun wedding. Later Mr. Safra was fried to death in his Monte Carlo apartment, presumably for nonrepayment of gold.

8) Two of the largest American players, JP Morgan and Chase, also had a shotgun wedding and now carry more gold derivatives than can be imagined.

9) Much of the Drexel brain trust apparently went to work for AIG, which promptly started boasting about mine hedging.

10) HSBC (often advised by Paul Volcker) bought Midland Bank (which had earlier bought bullion dealer Samuel Montagu) and, in another shotgun wedding, bought Republic, transactions that made HSBC one of the major gold players. HSBC's U.S. subsidiary is now the custodian for the SPDR ETF.

11) When the gold price started to move up, Rothschild said enough and sold its "book" (at a loss?) to Barclays.

12) Finally there was recently a shotgun wedding between Dresdner bank and Commerzbank.

Crisp details are rare, but the past generation has seen hundreds of millions of ounces of gold bled into the market. Canadian and Australian gold reserves are gone; Britain, Switzerland, and many others are down by two-thirds.

But this doesn't count the gold that has been lent. In general it seems that the same sort of banks that got into trouble investing in high-yield, low-quality sub- prime paper have also taken short positions in low-yield, high-quality gold. Too many favorite-son banks are on the wrong side of the market for policymakers to be rational. Given the option between common sense and helping a bank, well, the record is clear. This is probably the main reason the establishment remains anti-gold today -- the old ideological reasons are not that relevant.

So once again they trot out the idea of International Monetary Fund gold sales. What rubbish. The IMF hasn't sold gold since the 1970s, but every year the idea is advanced to frighten the gold market. Why would the IMF sell $10 billion of gold when central banks are printing $10 billion of new money every day? Gold is the only IMF asset worth 100 cents on the dollar -- everything else is junk.

As well the establishment hammers on the idea that the gold price is high, and GFMS continues its weird forecasts.

Well, the gold price is not high. Oil and several other commodities have outperformed gold since World War II. A good underground gold mine may grade 5 parts per million (ppm) while a good open pit may grade 1 ppm.

Nobody who has said the gold price is high has ever spent a nine-hour shift drilling rock -- it's a tough business. God only knows the blood-to-gold ratio for old Roman mines in Spain or Spanish mines in Peru, and getting the gold from mine to home base was often not easy. Much Victorian gold went from Ashanti by caravan through Timbuktu, the Sahara, and on to Europe -- the Brits were hardly keen to auction it off then.

Gold mine production is down about 12 percent from the 2001 peak (and still falling) and Barrick shares have barely moved in a decade. Much of the industry's cash flow is attributable to accounting magic, and the long years, even decades, of gold price suppression have taken their toll. There are few major new mines on the horizon, and lots of old ones on the way out.

Notwithstanding, GFMS has consistently forecast rising production for the past eight years (even though it has consistently fallen), raising the question: Why?

Our guess is that GFMS' big clients are the very banks we refer to above, the ones on the wrong side of the market, and for them Ms. Rosy Scenario needs the healthy, and expanding, industry model that GFMS gives them.

What are companies like Commerzbank and Societe Generale doing sponsoring GFMS anyway? Neither Germany nor France has any gold mining industry at all.

One would have to be barking mad not to see the benefits a higher gold price would have on vast chunks of the global economy. Even long-suffering Zimbabwe would be a huge beneficiary, and more wealth in Africa and Latin America would mean more exports of Fords and Cats from the United States. The establishment may not care, but that won't stop G20 members (and others) from connecting the dots and following China's lead in increasing gold weighting in monetary reserves.

Gold is again becoming a preferred central bank asset and the great monetization scheme is coming to an end. Western policymakers and banks have pushed their game too far for too long and the combination of the shift of power from G8 to G20, plus the reduced availability of gold, will turn the tide. You can sell gold only once, although, in the new wondrous world of derivatives, maybe somebody has actually sold it twice.

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Murry Pollitt is president of Pollitt & Co., a brokerage firm in Toronto, and a veteran of mining industry finance. This essay is excerpted from his latest letter client letter and reprinted by permission.