Political Derivatives in Campaign 2000

NEW ESSAY - AUGUST 2000
Copyright 2000 - Reginald H. Howe

GOLD OR DROSS?
POLITICAL DERIVATIVES IN CAMPAIGN 2000

More than a century has passed since gold and money played a leading role in the rhetoric of a presidential campaign. At the Democratic convention of 1896, William Jennings Bryan won the presidential nomination with a speech dishonoring the deeply held monetary beliefs of Jefferson and Jackson, thundering to the other party: "You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold."

William McKinley won and the Republicans promptly made good on their promise to complete the nation's return to the gold standard in law. Economic crucifixion, however, had to wait for more than 30 years. This unhappy event required the interaction of three phenomena almost unimaginable when Bryan delivered his famous tirade: the Federal Reserve (1913), World War I (1914-1918), and replacement of the classical gold standard with the bastardized gold exchange standard (1925).

If gold or the prospect of impending hard times plays any role in the current campaign, waged in conditions of unparalleled prosperity, it will likely be that of the ignored elephant in room. Ignoring the elephant is not always bad policy if the time is used to plot strategies for dealing with the beast. Can this election be won only by losing? Or is there some strategy by which each party might really win by winning? There are gold bugs in both political parties. They know the monetary and economic score. Never have their parties needed them more.

1. Wheels of Political Fortune

Only once before has the son of a former president been elected to the presidency. In 1824, after losing the popular vote to Andrew Jackson who nevertheless failed to win a majority in the Electoral College, John Quincy Adams, running without party affiliation, was elected by the House of Representatives with the support of Speaker Henry Clay, who had placed third in the popular vote. George W. Bush has already made history of a sort, for he is the first presidential son to secure the presidential nomination of his party.

Fatally discredited by its opposition to "Mr. Madison's War," the Federalist Party did not run a presidential candidate after the election of 1812. But years earlier its increasingly regional outlook alienated many, including the younger Adams. In 1808, he resigned in protest from his father's party and as senator from Massachusetts, an act that would later earn him a place in John F. Kennedy's Profiles in Courage. Afterwards, he served in several diplomatic posts and as a quite successful secretary of state in both Monroe administrations, being the chief architect of the Monroe doctrine. But his own administration started badly amidst allegations of the "corrupt bargain" when he appointed Clay as secretary of state. Bold plans for aggressive federal legislation to promote the nation's development fell victim to politics. Swept out of office in 1828 by the Jackson Democrats, the second president's son -- distinguished in the history books by his middle name -- found his four years in the White House among the unhappiest and least productive of his life.

Unlike John Quincy Adams, George W. Bush has succeeded in changing the face of his father's party and bringing it with him in his presidential campaign. The election that should most concern the younger Bush is not that of 1824 but of 1928. Indeed, both Republicans and Democrats should find much to think about in that election, when Herbert Hoover, riding eight years of Republican prosperity under Harding and Coolidge, easily defeated New York Gov. Al Smith, the first Catholic to run for president. By then, the scandals of the Harding administration were a distant memory. Indeed, they had not even touched Coolidge, who as vice president succeeded to the presidency on Harding's death from a heart attack in 1923 and won election in his own right the next year.

In 1928 neither the religious issue nor skirmishes over Prohibition, the great moral issue of the day, could shake the electorate's association of prosperity with the then-majority party. Accepting the Republican nomination, the "Great Engineer" proclaimed: "We in America today are nearer to the final triumph over poverty than ever before in the history of the land." One Republican slogan ran: "Hoover and Happiness or Smith and Soup Houses." According to some, a Smith victory promised a new three R's: "Rum, Romanism and Ruin." Few were predicting the future that did unfold: Hoover, soup houses and financial ruin. But these conditions made the 1932 Democratic presidential nomination a real prize, seized by Franklin D. Roosevelt from his friend the "Happy Warrior," whom FDR himself had placed in nomination just four years earlier.

2. Derivatives Revolution

Under the title Portraits of a Bubble in Market Observations (7/20) at ContraryInvestor.com, Brian Pretti has posted several charts, all derived from data published by the Federal Reserve and the U.S. Treasury, depicting trends in assorted forms of debt, the U.S. trade deficit, domestic personal savings, consumer confidence and different measures of equity market valuation. These charts are, as he puts it, "[a] little reminder that we happen to live in a very special time in U.S. financial market history. A new era? Or a new error?" He concludes: "They will not be the cause of an immediate market debacle beginning tomorrow (but, they will exacerbate it when it does finally arrive)."

All these charts deal with traditional financial and economic measurements. None addresses what is really new in the financial world of the past decade: financial derivatives in unimaginable quantities. Little understood by the public, derivatives are contracts whose value is based upon, or derived from, the price of some other underlying asset. Some are standard contracts traded on exchanges, but most are custom-tailored instruments traded privately in over-the-counter transactions. The OTC derivatives business is concentrated in a handful of large international banks with powerful political connections.

OTC derivatives are generally grouped into five categories: interest rate, foreign exchange, equity-linked, commodities (including gold) and other. Encompassing instruments such as swaps, forward contracts and options, often in complex and exotic variations, derivatives are generally measured two ways: (1) by notional values, which are the face or reference amounts from which derivative payments are determined; and (2) by replacement or market values. The Financial Pipeline offers a quite helpful online encyclopedia of basic information about derivatives. In connection with establishing appropriate bank capital adequacy requirements for derivatives, which are usually carried as off-balance-sheet items, the Bank for International Settlements has published a number of studies and reports also available online.

According to the BIS, at the end of 1999 the global derivatives market contained instruments with a total market value of almost US$3 trillion and a total notional value in excess of US$88 trillion broken down as follows: interest rate, $60 trillion; foreign exchange, $14 trillion; equity-linked, $1.8 trillion; commodities, $548 billion, including $243 billion of gold derivatives; and other, $11 trillion. The total notional value figure represents an increase of 22% in the 18 months from June 1998, the earliest date for which the BIS's evolving derivatives reporting system provides comparable numbers. The total notional value of gold derivatives increased by 26% over the same period.

The Office of the Comptroller of the Currency issues quarterly reports on the derivatives of U.S. commercial banks. Accessible at www.occ.treas.gov/deriv/deriv.htm, these reports show that at the end of 1999 seven banks accounted for almost 95% of the total notional amount of derivatives for all reporting banks, with 80% of the total being interest rate contracts, 17% foreign exchange, and 3% equities, commodities and credit derivatives. Of the total $34.5 trillion notional amount, Chase accounted for $12.7 trillion, Morgan Guaranty Trust (a unit of J.P. Morgan) for $8.7 trillion, Bank of America for $5.7 trillion and Citibank for $3.7 trillion.

Although tiny in comparison to the total derivatives market, gold derivatives are very large in relation to physical gold supplies. Annual new mine production is approximately 2500 metric tonnes. The total above-ground world gold stock is roughly 120,000 tonnes, of which around 33,000 tonnes is claimed as official reserves. Converted at the 1999 year-end gold price of about $290/oz., the total market value of the entire above ground stock is $1.1 trillion, official gold reserves amount to almost $300 billion, and annual new production to a little over $23 billion. Converting the $243 billion total notional amount of gold derivatives to tonnes at the same year-end price gives a figure of 26,000 tonnes, or over ten times annual new mine supply and almost as large as total official reserves.

Gold derivatives are also highly concentrated in a few large banks. According to the OCC reports, J.P. Morgan, Chase and Citibank are the dominant American bullion banks. Goldman Sachs is also a major player, but as an investment bank does not report through the OCC. The largest foreign bullion banks are Deutsche Bank, which acquired Bankers Trust in 1999, UBS and Credit Suisse.

In July 1998, the House Banking Committee held hearings on OTC derivatives during which Fed Chairman Alan Greenspan sought to distinguish financial derivatives from agricultural derivatives, noting that it would be impossible to corner a market in financial futures where the underlying assets (e.g., government debt, foreign exchange) are of virtually unlimited supply. The same point, he volunteered, also applies to certain commodity derivatives where the supply is also very large, such as oil. Then he added: "Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise." [Italics added.]

Since they are new and revolutionary, the legal status of derivatives under existing securities and commodities laws is uncertain. Last June, the Senate Banking and Senate Agriculture committees held a joint hearing on proposed legislation, the Commodity Futures Modernization Act, stemming from a study by the President's Working Group on Financial Markets requesting urgent legislative action on OTC derivatives. The written testimony of Fed Chairman Greenspan, Treasury Secretary Summers and CFTC Chairman Rainer indicates that important differences remain over how to handle oil derivatives. However, none of this testimony contains any specific reference to gold derivatives, nor are there reports that they came up during questions.

The absence of any discussion about gold derivatives is particularly odd. GATA has done yeoman work to bring the dangers they pose to the attention of Congress, including a 45-minute presentation to House Speaker Dennis Hastert, publication of an advertisement in Roll Call, the congressional newspaper, and delivery of an extensive written document, Gold Derivative Banking Crisis, to every member of the House and Senate banking committees. With this much exposure, even were there no merit to GATA's warnings, normal political caution would suggest putting an assurance to that effect on the record.

More generally, notwithstanding concentration of the vast derivatives business in just a few large international banks, all of which also trade in huge amounts for their own accounts in these same markets, Congress does not appear to have given much real consideration to possible abusive trading practices or other manipulative schemes by these banks through their derivatives activities. As set forth in more detail later, there is a large body of circumstantial evidence suggesting massive manipulation of gold prices through the use of gold derivatives. What should be of even wider concern is the possibility that these manipulative activities in gold are but the tip of the iceberg, the first surface expression of a much larger and more pervasive problem than is recognized.

3. Dangers of Derivatives

Today's vast derivatives business, which could not exist without modern computer power, is built on the theoretical foundation provided by the Black-Scholes option pricing formula and dynamic or "delta" hedging (described further in part 6 below). However, while the existence of a short position in physical gold adds a special vulnerability to gold derivatives, all derivatives share two Achilles' heels: (1) unexpected market volatility; and (2) loss of normal market liquidity. The first attacks the sole unobservable variable in the Black-Scholes formula, which requires use of assumed or implied levels of volatility. The second prevents effective delta hedging. Under ordinary conditions, therefore, derivatives can provide an effective means to reduce risk. Under extraordinary conditions, however, they can lead to disaster.

Notwithstanding the complexity of derivatives and wide range of informed opinions about them, three points are indisputable. First, derivatives have grown wildly in the past decade. Second, they have not been tested in a major economic downturn. And third, they have caused some dramatic and surprising business failures, including the collapse of Long-Term Capital Management in October 1998 during the Russian default crisis and the virtual bankruptcy of two prominent gold mining companies, Ashanti Goldfields and Cambior, in October 1999 due to a violent and unexpected rally in gold prices.

The LTCM incident is particularly noteworthy. Two of its principals, Myron Scholes and Robert Merton, quite literally wrote the book on which modern derivatives trading is based. This work, which earned them the 1997 Nobel Prize in Economics, is explained in layman's terms in a special PBS program, Trillion Dollar Bet, that also details the collapse of LTCM, the hedge fund they opened in 1993 with legendary Salomon Brothers bond trader John Meriwether and others to exploit the investment opportunities presented by derivatives.

The New York Fed orchestrated the rescue of LTCM because its failure threatened to reverberate throughout the international financial system much as the collapse of an Austrian bank, the Credit Anstalt, did in 1931. Recent confidential information from a highly reliable source confirms rumors that at the time of its collapse, LTCM was short a substantial amount of gold (300 to 400 tonnes is the range most often mentioned), and that this position was covered in some type of arranged off-market transaction. What is more, the source of the new information also says that the short gold position was the chief motivating factor underlying the rescue, and that LTCM's principals were granted immunity from prosecution on condition that they not disclose or talk about it.

Following the LTCM incident, the twelve major international banks (including all seven major bullion banks) most active in OTC derivatives formed the Counterparty Risk Management Policy Group, chaired by the managing directors of J.P. Morgan and Goldman Sachs, to make recommendations for reducing the systemic risk posed by derivatives. Its report, issued in June 1999, makes no express mention of gold derivatives. However, in a passage of particular relevance to gold, the report underscores (at page 20) the dual nature of liquidity risk: (1) funding liquidity, or the ability to meet when due the demands of counterparties; and (2) asset liquidity, or the ability to liquidate or cover positions in the relevant asset market.

4. Special Risks of Gold Derivatives

Although comprising what is by far the smallest discrete sector of the global derivatives business, gold derivatives seem to have created the worst problems. This result is testimony to gold's unique quality as the commodity that is also permanent, natural money.

The rocket fuel propelling gold derivatives is gold from central banks that is deposited with or loaned to bullion banks at normally very low rates of interest (typically 2% or less depending upon maturity) called lease rates. This so-called "leased" gold is immediately sold into the market and the currency proceeds delivered for investment or other use by the bullion bank and/or its customer. When the gold deposit is called or the gold loan comes due, the physical gold required for repayment must be repurchased in the market. But during the term of the deposit or loan, the central bank retains the leased gold as an asset on its books and as part of its official gold reserves notwithstanding that the buyer of the leased gold owns it free and clear.

In other words, although sold into the market, the leased gold remains on paper an asset of the central bank. The obligation to repay this gold to the central bank puts the bullion bank and/or its customer in a short physical position, i.e., they owe physical gold that they do not have. While benefiting from the low lease rates, they bear the risk of higher gold prices at the time of repayment. To cover or reduce this risk, gold borrowers ordinarily purchase forward contracts or call options, which in turn are usually delta-hedged by their purveyors. Bullion banks, acting for themselves or their customers, are usually on both sides of these transactions. The bullion banks' customers include gold mining companies, fabricators of gold products, investors, traders and speculators. Among the last three groups are many trying to take advantage of gold's low lease rates to fund higher-yielding investments, or the so-called gold carry trade. For a very interesting article about the gold and other carry trades, see Mervin Yeung, Carry Trade: Short Term Heaven Long Term Hell, at Sky Blue Monthly.

Borrowers in the gold carry trade ordinarily have only the market as a source of metal for repayment. Another large group of gold borrowers are the producers, who borrow gold through their bullion banks and sell it forward in order to earn the contango (the difference between the dollar interest rate and the lease rate) on a portion of their future production. Forward contracts also offer gold mining companies a measure of protection against falling prices. Typically written with maturities extending as far as ten years forward, they add future gold production to the spot market. However, almost entirely funded by gold deposits or other short-term loans mostly by central banks, they are also a classic example of borrowing short to lend long.

Given the popularity of the gold carry trade as a means for funding speculative investments in the period prior to LTCM's failure, not to mention the enormous leverage that it is known to have used, the absence of a large short gold position would have been more surprising than its presence. Any major financial failure with international implications is likely to put upward pressure on gold, but the collapse of an entity with a large short position is likely to turn that pressure into a booster rocket, creating a central banker's nightmare: an international financial crisis accompanied by sharply accelerating gold prices. Saving a single hedge fund with a short position of 300 to 400 tonnes is one thing. Rescuing one or more bullion banks with short positions running into the thousands of tonnes is quite another.

Gold leasing today is essentially traditional gold banking under a new moniker. The chief difference is that now the principal depositors are the world's central banks rather than private entities and individuals. However, gold derivatives are treated today not as gold banking but rather as ordinary commodity contracts. Prudential rules developed over centuries of experience with gold banking, such as provision for adequate bullion reserves, are largely ignored. As discussed in two prior commentaries, Gold: Can't Bank with It; Can't Bank without It! and Central Banks vs. Gold: Winning Battles but Losing the War?, the result is a huge inverted pyramid of interconnected paper instruments representing various types of claims and obligations denominated in gold but built upon a very small amount of bullion at the base. Making the structure even more shaky, most of the gold at the base is leased, and much of that has been sold into Indian and other Asian and Middle Eastern markets.

No commodity except gold is held by central banks as an international monetary asset. No other commodity (with the possible exception of silver) presents the danger that quantities equal to several years of new supply may be quickly called upon for immediate physical delivery, particularly under conditions of monetary stress or uncertainty. Gold derivatives hold the same two basic dangers for bullion banks that imprudent banking did a century ago: (1) bank runs by depositors or others to whom the banks owe gold, including today the counterparties on the long side of their gold derivatives contracts; and (2) impairment of their gold assets, which today are mostly derivatives subject to both counterparty and market risk.

Contrary to Fed Chairman Greenspan's 1998 testimony to the House Banking Committee, gold derivatives are not properly analogous to interest rate or foreign exchange contracts where the underlying assets are paper instruments of virtually unlimited supply. The gold supply is large, but it is not unlimited. There can be no assurance -- even to a lender of last resort as powerful as the Fed -- that in time of crisis gold will be available in whatever amounts necessary to rescue failing bullion banks. More worrisome yet, the largest bullion banks are integral parts of very large commercial or investment banks generally considered "too big to fail," a doctrine of limited or no application in gold banking.

The most frightening aspect of gold derivatives today is the size of the aggregate short physical position. The actual figure is unknown because, except for the Swiss National Bank, the major central banks that lease gold do not report the size of these loans or deposits even to each other. At the recent Financial Times World Gold Conference in Paris, the consensus figure of the bullion banks seemed to be around 5000 tonnes. However, many outside the bullion bank fraternity believe that the short physical position is larger, and quite possibly twice as large in the opinion of one knowledgeable expert. Last April at a gold conference in Australia, Dinsa Mehta, head of global commodities trading for Chase, suggested a possible total short position of around 7000 tonnes.

Noting this range of estimates, a recent Salomon Smith Barney report states: "[T]he aggregate short position ... equates to two to three years of world mine production, which is simply too large to ever be repaid." To put this short position in further perspective, total gold reserves of the United States, which claims not to lease any gold, are about 8150 tonnes, and the combined official gold reserves of the Euro Area countries are around 14,450 tonnes.

5. From Gold Derivatives to Gold Price Manipulation

Explaining his 1998 congressional testimony on gold derivatives in a formal letter to Senator Joseph I. Lieberman dated January 19, 2000 (reprinted at www.egroups.com/group/gata/346.html), Fed Chairman Greenspan wrote: "This observation simply describes the limited capacity of private parties to influence the gold market by restricting the supply of gold, given the observed willingness of some foreign central banks -- not the Federal Reserve -- to lease gold in response to price increases." [Emphasis supplied.] In other words, according to the Fed chairman himself, some central banks lease gold not to earn a return on it as they often claim, but primarily to supply this physical gold to the bullion banks during periods when strong demand is pushing up prices.

What is more, leasing is a far more effective method of putting downward pressure on gold prices than straight sales. Although the destiny of leased gold is ordinarily immediate sale, by reaching the market through the bullion banks while remaining an asset on the books of the lessor, leased gold provides certain fuel for derivatives. A sale, on the other hand, is a simple transfer. The new owner can use the gold for derivatives, but often it goes directly into the jewelry market, the vault of another central bank, or for some other purpose unrelated to derivatives.

Underlining his denial of any intervention by the Fed in the gold or gold derivatives markets, Mr. Greenspan's letter to Senator Lieberman asserts sanctimoniously: "Most importantly, the Federal Reserve is in complete agreement with the proposition that any such transactions on our part, aimed at manipulating the price of gold or otherwise interfering in the free trade of gold, would be wholly inappropriate." Why it might be "appropriate" for other central banks to lease gold for the purpose of affecting its price he did not say. Nor did he explain why the Fed apparently countenances these actions, which cannot help but affect the integrity of gold prices on the COMEX in New York.

Currently 7150 tonnes of gold belonging to foreign central banks and other foreign official monetary institutions are held at the Federal Reserve Bank of New York, down from almost 9900 tonnes in 1990. As detailed in a prior commentary, The Fed: Up to its Earmarks in Gold Price Manipulation, withdrawals of this foreign earmarked gold, especially in the 1996-1998 period, coincided remarkably with significant rallies in the gold price. What is more, the total amount of these withdrawals matched quite closely estimates of the amount of leased gold flowing into the bullion banks. Mr. Greenspan's congressional testimony on gold leasing by central banks seems to have been spoken by a man who, if he was not in on the action, at least had a ringside seat.

His testimony also began to pull the veil back on an official war against gold that likely originated in 1995-1996 as part of a coordinated G-7 effort to bail out Japan. The events and evidence supporting this thesis are described generally in a prior commentary, Two Bills: Scandal and Opportunity in Gold? It appears that following the LTCM affair in the fall of 1998 and the successful introduction of the euro in January 1999, the major central banks of continental Europe began to withdraw from lending new support to efforts to cap gold prices. In any event, the outflow of foreign gold from the New York Fed began to slow, grinding to a virtual halt in recent months.

However, for the Clinton administration in particular, rising gold prices -- considered by many a good leading indicator of inflation -- threatened unwanted consequences for interest rates and the dollar. For the bullion banks, rising gold prices jeopardized not just the profits they were earning on gold derivatives but also, and much more dangerously, their short physical positions. Any real run on gold, given the size of the short position, also posed a grave danger to the important London bullion market. And even without more leasing by European central banks, additional gold supplies were expected to come from the proposed sale of over 300 tonnes by the International Monetary Fund to fund aid to heavily indebted poor countries, an initiative strongly supported by the United States and Britain.

On May 7, 1999, just as gold threatened to surge over $300 in response to new doubts that the proposed IMF gold sales would go forward, the British announced that the Bank of England on behalf of the Exchange Equalisation Account in the British Treasury would sell 415 tonnes of gold in a series of public auctions. Although this announcement came with no warning and was completely unexpected by most, the previous evening Bill Murphy of GATA reported in his Midas column at Le Metropole Cafe: "[Deutsche Bank's] bullion desk is calling their clients saying that the gold market is stopping at $290." [Emphasis in original, copy at www.gata.org/graham.html.]

Various British officials have offered lame explanations of the gold auctions as an effort to diversify reserves. But British gold reserves were already low compared to those of other major European countries. British officials are also unable to agree on who made the decision. However, the timing virtually guarantees not only that it came directly from the prime minister, but also that he must have had extraordinary reasons for making it. His government was a leading supporter of the proposed IMF gold sales. The announcement clumsily put Britain in the position of front-running the IMF, ultimately a significant factor in forcing it to change tack. According to recent confidential information from a highly reliable source, the Blair government is treating certain information about its decision on gold sales as a national security matter.

The manner of the British sales -- periodic public auctions through the bullion banks rather than discreet sales through the BIS disclosed after the fact -- is so inconsistent with normal central bank practice and simple trading smarts that it has triggered an inquiry by Britain's National Audit Office. However, by limiting its examination to whether the Blair government chose a sales method likely to yield a maximum return, and by excluding any inquiry into the underlying reasons for the sales, the NAO has undertaken what appears a rather useless exercise.

Indeed, without ascertaining the true purpose of the auctions, the NAO cannot even determine whether the sales were "effective" under its own so-called "three Es" test (the other two are "economy" and "efficiency"). If the intention was to cap the gold price, which appears to be the only plausible explanation, the means chosen were if anything too effective. Within five months the gold price had collapsed to under $260, provoking severe displeasure among central banks who mark their gold reserves to market on a regular basis.

On September 26, 1999, following the IMF/World Bank annual meeting in Washington, the European Central Bank and 14 other European central banks announced an agreement to limit their total combined gold sales over the next five years to 2000 tonnes, not to exceed 400 tonnes in any one year, and not to increase their gold lending or other gold derivatives activities. The 2000 tonnes included the remaining 365 tonnes of British auctions as well as the then-planned Swiss sales of 1300 tonnes, which are now being conducted through the BIS in normal central bank fashion. The Bank of England signed the agreement on behalf of the British Treasury, but according to most reports, the British were informed about the agreement at the last minute and given a chance only to participate, not to negotiate. For references to European press commentary on the genesis of the agreement, see W. Smith, "Operation Dollar Storm," www.gold-eagle.com/editorials_99/wsmith111099.html.

Within days of the Washington Agreement, short covering caused the gold price to jump by nearly $60 to over $325 and gold lease to rates spike to over 9%. By late October, the price retreated back under $300 and a month later lease rates were nearly back to normal levels.

But as a result of the sudden sharp rally, two prominent gold mining companies, Ashanti Goldfields and Cambior, were in virtual bankruptcy due to hedge books loaded with what turned out to be imprudently chosen derivatives. Their bullion banks were threatened with large scale defaults. See, e.g., L. Barber et al., "How Goldman Sachs Helped Ruin and then Dismember Ashanti Gold," Financial Times (London), Dec. 2, 1999, reprinted at www.egroups.com/group/gata/299.html. And shareholders in gold mining companies everywhere were stunned to discover that derivatives could to turn rising gold prices into death sentences for the very enterprises expected to benefit most.

Ashanti and Cambior may not have been alone in suffering large losses in the October gold rally. Unprecedented recent trading losses by the U.S. Exchange Stabilization Fund are almost impossible to explain unless the Clinton administration, which denies making any interventions in the foreign exchange markets during the past couple of years, used the ESF to intervene in the gold market. Under the exclusive and unreviewable control of the president and the secretary of the treasury, and with around $40 billion in total resources together with an implicit call on U.S. gold reserves, the secretive ESF is well-situated to backstop gold derivatives -- particularly call options on gold -- that otherwise would be too risky for private bullion banks to write.

As detailed in a prior commentary, The ESF and Gold: Past as Prologue, and updated recently in another, the ESF's results over the past couple of years show a pattern of trading losses in quarters containing sharp or incipient rallies in gold prices and trading profits during quarters with generally weak or falling prices. This pattern was especially dramatic in 1999, when a trading loss of $1.6 billion in the the last calendar quarter (the first quarter of fiscal year 2000) wiped out not just the trading profit of $1.3 billion earned in the prior quarter but the entire trading profits for the prior fiscal year. In other words, the ESF's best recent quarterly trading results coincide with the price collapse caused by the May 7 announcement of British gold sales, and its worst with the sharp rally and complete reversal of sentiment brought about by the September 26 announcement of the European central banks.

Despite numerous requests both from GATA and from Senator Lieberman and other members of Congress on behalf of constituents, Treasury Secretary Lawrence Summers -- quite in contrast to Fed Chairman Greenspan -- has refused to provide any public clarification of the ESF's activities in the gold or gold derivatives markets.

6. Powers of Options and Politics

Almost certainly playing a key role in halting the October rally and turning the gold price south again were huge increases in the gold derivatives of just three bullion banks: J.P. Morgan, Citibank and Deutsche Bank. These increases are analyzed in two prior commentaries, House of Morgan: From Gold Bugs to Paper Hangers and Deutsche Bank: Sabotaging the Washington Agreement.

Prior to 1999, Morgan had never held more than about $20 billion in total gold derivatives, nor more than 28% of the total outstanding for all banks. But beginning in the second quarter of 1999, Morgan took on a much larger role in the under-one-year maturities, possibly presaging the the British gold sales. Then, during the last half of 1999, Morgan more than doubled its total gold derivatives, taking them from $18.4 billion to $38.1 billion, which amounted to 43% of the total for all U.S. banks reporting to the Comptroller of the Currency. What is more, Morgan's over 40% dominance stretched across all maturities. In the fourth quarter alone, it increased its gold derivatives with maturities over one year by more than 80% to $17.1 billion from $9.4 billion. Although considerably smaller in absolute scale, Citibank's gold derivatives in 1999 showed a pattern similar to Morgan's.

Deutsche Bank had precious metals derivatives (almost all are gold derivatives) the end of 1996 with a total notional value under US$5 billion. By the end of 1999, it had grown this business to a total notional value in excess of $51 billion, or by more than 10 times in three years. The increase in 1999 alone amounted to $35 billion or more than 200%, most of which came in the last half and in the longer maturities. Nor does this growth reflect derivatives added by Deutsche Bank's mid-1999 acquisition of Bankers Trust, for which the OCC reports showed precious metals derivatives with a total notional value of just over $1 billion at June 30, 1999, down from $6 billion the prior quarter.

Neither the OCC reports nor the figures in Deutsche Bank's annual reports give separate totals for forward contracts and options. However, these breakouts are available for the Swiss banks both from the Swiss National Bank and in the banks' own annual reports. At the end of 1999, UBS's precious metals derivatives had a total notional value of US$74 (SwF119) billion, with over $50(SwF80) billion in options, compared to $80(SwF110) billion at the end 1998, with about half in options. Options are plainly a major component of gold derivatives, and they appear to have taken on an increased role in 1999.

Some analysts have tried to portray the extraordinary increases in the notional values of gold derivatives at J.P. Morgan, Citibank and Deutsche Bank in the last half of 1999 as not unusual given the extraordinary volatility of gold prices during the period. But they cannot explain why the gold derivatives of UBS, the largest player in the business, and Credit Suisse remained flat to down during the exact same period. Morgan officials have refused publicly to discuss its increases. What could explain this odd picture is support from the ESF directed toward certain favored banks.

As discussed in a prior commentary, The New Dimension: Running for Cover, writers of uncovered options (puts and calls) typically limit their risk by delta hedging against their exposure. Delta hedging is described by mathematical formulas and requires quick, reliable access to a liquid market.

For example (and to oversimplify a bit), the writer of a gold call with a strike price of $300 when gold is trading spot at $250 will, if the gold price then rises, buy gold in increasing increments so that when the spot price reaches the strike price he is 50% covered. If the price keeps rising, he continues to buy in decreasing increments until he is fully covered at an average price equal to the strike price. Of course, in the real world the gold price will fluctuate up and down, but for each price the formulas tell the call writer exactly how much gold he should have to be delta or risk neutral, and he keeps adjusting his cover accordingly. But note, the purpose of delta hedging by the seller of an option, be it a call or a put, is to prevent loss on account of price changes in the underlying item (e.g., gold, commodity, stock), thereby retaining the premium received for writing the option as profit.

The purchaser of an option is in a very different situation. His risk is limited to the premium paid for the option even if he does nothing and the price moves against him. But if he is an active trader with quick, reliable access to the physical or futures markets, he can also use his calls to backstop a trading strategy designed to profit from shorting gold in a delta hedge whenever the spot price is at or near the strike price.

For example, the buyer of gold calls for 1 million ounces at $300 may choose simply to hold them as a bet on (or a hedge against) rising gold prices, but he can also employ them to backstop speculative short selling. In this event, when gold is at the $300 strike price, he could sell 500,000 ounces, an amount equal to his delta. If the sale, especially when combined with other traders doing the same thing, knocks the price down, he tries to cover quietly at lower prices, book his profits, and wait for another chance to repeat the strategy. That's a successful short sale. What is more, as long as the trader is successful, he can keep repeating the process until the expiry of his options.

But suppose the trader does not succeed, and the gold price does not return below the strike price. There are two possibilities. First, increased volatility may cause the value (price) of the calls to rise by more than the increase in the underlying gold price, so that profits from sales of the calls would more than offset losses on the short positions. If so, despite the unsuccessful short sales, he can close out his positions at a net profit. Alternatively, in the absence of any possibility for profit, he can cover his shorts with his calls at no net additional cost provided that he has managed his short position within the limits of his delta. Thus, the purpose of delta hedging by an option purchaser is to earn a profit on changes in the price of the underlying item while limiting his risk to the premium paid for the option.

In the absence of delta hedging, writers of options are exposed to potentially huge risk. Buyers of options, on the other hand, can at no additional risk use their options to backstop trading strategies designed to profit from price movements contrary to those that would benefit the option. In other words, holders of calls are positioned to try to profit from short selling. Buyers of calls can also use them to close out or cover short positions without actually going into the underlying market, but of course the writers of those same calls will have to turn to that market (or a reliable substitute) to hedge their risk.

Barrick Gold, a leading gold mining company with a large forward sales program, revealed in February that in the last quarter of 1999 it purchased call options on 6.8 million ounces of gold (or almost 212 tonnes) to cover its entire expected production from March 1, 2000, through 2001 at strike prices of $319 in 2000 and $335 in 2001. Along with other measures, these call options reduced Barrick's net exposure on forward sales from 18.8 million ounces at the end of the third quarter to a net 9.8 million ounces at year-end. While traders wondered what Barrick might do with the calls, others asked who would sell calls in this volume under these market conditions to this company. All indications now are that J.P. Morgan wrote these calls (although there have been rumors that Deutsche Bank might have written some).

Well-grounded rumors of severe liquidity constraints in the physical gold market, particularly when coupled with the high level of volatility prevailing in the last quarter of 1999, seemed to foreclose the possibility of effective delta hedging in physical gold. The initial delta on Barrick's calls must have approached 75 tonnes. What is more, Barrick itself might act in a way that could drive gold prices much higher, such as by quietly closing still more forward positions and then disclosing this fact. Indeed, announcement in February of planned hedging reductions by Placer Dome, another major gold mining company, set off the sharpest rally in gold prices since last October.

Accordingly, the magnitude of the apparent risk to the seller suggested that Barrick's calls were not an ordinary option transaction but were instead part of some special deal, most likely arranged with official support, to allow Barrick a measure of protection against rising prices while permitting (or persuading) it to remain out of the physical market, where any substantial short covering by it would have forced gold prices much higher.

Another feature of Barrick's call options also raised eyebrows: a provision for cash settlement. There are contradictory reports as to whether the calls are limited to cash settlement only or whether there are circumstances under which Barrick can demand physical gold. A special cash settlement provision appears peculiar in call options aimed at covering forward contracts that require delivery of physical gold. However, this type of provision would be quite understandable in any options written or ultimately backed by the ESF. With its large financial resources, the ESF might find the dollar risk of backing unhedged call options acceptable but not the risk having to deliver physical gold, especially under circumstances that might require use of official U.S. gold reserves.

The refusal of Secretary Summers to address directly suspected activities by the ESF in connection with gold and gold derivatives invites speculation about improper political influence. Robert Rubin, the former treasury secretary, is closely identified with two major bullion banks: Goldman Sachs, where he was co-chairman before his service in Washington, and Citibank, where he is now a top executive. Other current and former senior partners of Goldman Sachs have close ties to the British government and the Bank of England. Yet another is a former head of the New York Fed. Goldman Sachs participated in the bailout of LTCM, which counted among its principals a former vice chairman of the Fed. There may be nothing improper in this web of connections, but the way money flows through U.S. politics these days, the public deserves more than stonewalling by Secretary Summers.

Deutsche Bank apparently learned of the British gold sales a day ahead of the announcement, and perhaps not coincidentally at the very time that its acquisition of Bankers Trust was being finalized. As The Economist recently observed (May 27, 2000, p. 81): "Deutsche Bank is still striving for a place in investment banking's 'bulge bracket' of big American firms." The modus operandi of the Clinton administration offers little reassurance that it did not take advantage of the Bankers Trust deal, which the administration certainly could have killed, to secure the big German bank's cooperation in manipulating gold prices. In this connection, Deutsche Bank offered something of importance that J.P. Morgan and Citibank could not: a seat at the London fix.

7. Official Gold Sales

Several large, well-publicized official gold sales took place in the 1995-1998 period, including: Belgium (1995), 175 tonnes; Belgium (1996), 203 tonnes; Netherlands (1997), 300 tonnes; Australia (1997), 167 tonnes; Argentina (1997), 125 tonnes; and Belgium (1998), 299 tonnes. The Dutch and Belgian sales, which account for 977 tonnes out of the 1269 listed, were quite plausibly related to the launch of the euro in 1999. They were carried out through the BIS and announced after the fact, with these disclosures generally having a far more negative effect on gold prices than the actual disposals themselves.

Starting in 1999, official gold sales become much more difficult to explain or justify. In this connection, the peculiar juxtaposition of the announcement of British gold auctions with the proposal to sell up to 300 tonnes (or about 10%) of the IMF's gold reserves merits further comment.

Of the more than 40 nations targeted by the IMF's initiative to assist heavily indebted poor countries, gold exports are significant in almost a quarter, including several in sub-Saharan Africa. See A Glittering Future? Gold Mining's Importance to sub-Saharan Africa and Heavily Indebted Poor Countries (World Gold Council, June 1999). The danger that damage from falling gold prices would more than override any benefits accruing from gold sales provoked opposition to the proposal from many of the intended beneficiaries as well as the Black Caucus in the U.S. Congress, where an unlikely coalition of conservatives and liberals derailed the scheme. Only then did the IMF come up with a plan to finance its HIPC initiative through the revaluation of some of its gold reserves without any reaching the market. This plan is described in detail in a prior commentary, IMF's Off-Market Gold Sales: Toward the New Order?.

The collapse in gold prices that followed the British announcement played a major role in galvanizing opposition to the IMF's original proposal, which required congressional approval. Whether the IMF would have been forced to change tack absent this decline is open to question, particularly if gold prices had risen to higher levels as seemed likely just prior to the announcement. Unless there was something particularly critical about holding gold below $300, it is difficult to see why the British acted when they did. They had no urgent need to diversify their reserves, and given the strength of the pound at the time, buying foreign reserves with pounds would have made more sense than using gold. Indeed, Terry Smeeton, who retired in April 1998 as head of the Foreign Exchange Department at the Bank of England, made just this point in a letter to the Financial Times (London) on August 19, 1999.

The strength of the October 1999 rally in gold prices, not to mention the dangerously large short physical gold position that it revealed, seems to have surprised if not scared the signatories to the Washington Agreement. In any event, since their September 26, 1999, announcement, the European central banks have made gold sales at the maximum rate allowed under the agreement. On December 6, 1999, of the 335 tonnes of future sales not identified previously, 300 tonnes at a rate of 100 tonnes annually over the next three years were allocated to the Dutch. By the end of March, the Dutch had already sold their entire first year's quota. Then the ball was picked up by the Swiss.

The whole idea of Swiss gold sales seems to have originated in 1996 with former Fed Chairman Paul Volcker's efforts to mediate the Holocaust claims against Swiss banks. However, the legal and constitutional requirements for these sales were not completed until April of this year, and the Swiss remain divided and uncertain on how to use the proceeds. Nevertheless, without need or purpose and in the face of historically low gold prices, Swiss gold sales commenced through the BIS in April at a rate apparently targeting the maximum amount permitted. How these sales may fit into a broader pattern of central bank leasing and price manipulation in the 1996-1998 period is discussed in a prior commentary, Gold: Unchained by the Swiss; Ready to Rock!.

In the wake of the October 1999 rally, two very odd disgorgements of official reserves were disclosed by countries outside the Washington Agreement. That very month, Kuwait announced that it had made its total official reserves of 79 tonnes available to the Bank of England for leasing. Soon afterwards new U.S. military aid to the country was disclosed. With regard to the Kuwaiti announcement, a top BIS official observed that it was so far outside normal practice as to permit only one conclusion: someone was trying to manipulate the gold market. On the heels of Kuwait's transfer, Jordan revealed in November that it had sold half its gold reserves (13 tonnes) during October.

In July of this year, the World Gold Council reported that Uruguay had transferred all 56.6 tonnes of its gold reserves to London for leasing. This month, just prior to announcing a new effort to speed up trade talks with the United States, Chile revealed that it sold all 34 tonnes of its official reserves in June. Recently the World Gold Council quoted Gold Fields Minerals Services, once generally regarded as the pre-eminent source for figures on the world gold market but now suspected of operating more as a shill for the bullion banks, to the effect that about half of last year's gross official sales came from publicly unreported "non-monetary" gold reserves. Oil-rich nations of the Middle East are among the countries that report quite modest amounts of official gold reserves but are generally believed to hold large unofficial reserves.

Precisely where all this physical gold is going and to whom is unknown, but all these odd and unprecedented recent official gold disposals almost certainly are signs of a serious liquidity crisis developing in the gold derivatives business of the bullion banks. Because these disposals are so unusual and appear contrary to the interests of the countries making them, they also raise questions about exactly what forces may be causing them.

The United States has many ways of exercising influence, especially on the oil producers of the Middle East or the home countries of large international banks that in today's global economy require access to U.S. markets. Perhaps even more troubling, however, are the disposals from small nations with freely trading currencies and debt, both of which are susceptible to attack by the bullion banks through foreign exchange and interest rate derivatives. The potential for abusive practices by these large international banks is manifest, and some of these recent disposals cannot fail to arouse reasonable suspicions that abuses may in fact have occurred.

8. Gold Mining Industry

The circumstantial evidence pointing to massive official gold price manipulation in recent years is bolstered by the inescapable fact that current low gold prices are very hard to explain without it. Speaking in June at the Financial Times World Gold Conference, Jay Taylor, CEO of Placer Dome, described the gold market: "World demand for gold has increased over the past ten years by over 30%, fueled by jewelry fabrication demand. But during that same time period gold prices have fallen by about 25%, hitting a twenty year low last August."

In fact, according to most estimates, annual gold demand is now almost 4000 tonnes, exceeding annual new mine production by almost 1500 tonnes. This deficit, which has been growing for several years, has been filled mostly by sales of leased gold, i.e., the short physical gold position, and in lesser though significant amounts by official sales and some scrap recovery. India regularly absorbs 25% to 30% of annual world production and much of the rest goes to other Asian and Middle Eastern markets. Absent official leasing augmented by outright sales, many analysts believe that the market clearing gold price would exceed $500. Thus, at bargain prices caused by their own design or stupidity, central banks in recent years have quite literally transferred thousands of tonnes of gold from their own vaults to the wrists and necks of Indian women.

Trading in a range between $270 and $290, where it has been for much of the past two years, gold is below the total cost of production for many mines and not far above the cash costs of quite a few. According to Mr. Taylor, neither his company nor most other gold mining companies has managed to earn its cost of capital for some years. Inevitably, this situation has resulted in high-grading, lost reserves and reduced exploration. This year, for the first time in several years, new mine production is expected to decline. And even with much higher prices, rebuilding reserves and launching another strong uptrend in gold production would require years. In short, low gold prices over the past few years have decimated the gold mining industry.

Ordinarily an industry with difficulties this severe would be able to arouse a modicum of official concern for its plight. Not so in gold mining. After South Africa, the leading gold producing nations are the United States, Canada and Australia. In the latter two, gold mining is significant to the national economy, yet in recent years both the Reserve Bank of Australia and the Bank of Canada have sold off almost their entire gold reserves for no obvious reason. Not surprisingly, the international value of the Australian and Canadian dollars has declined right along with their gold reserves. In Australia's case, many believe that several recent bear raids on the currency were mounted by the bullion banks for the express purpose of enticing local gold mining companies into forward sales.

At least until very recently, the gold mining industry has appeared blind to the full degree of its peril as well as its true source. To some extent, this attitude is understandable. Too diligent a search for the truth about official policies relating to gold and money can quickly lead to conflict and confrontation with powerful political interests, who in turn may wield influence over the official permitting and environmental authorities with which mining companies must deal. Similar concerns affect the companies' relationships with their bullion bankers, many of whom are also closely connected to the highest levels of government. But now, with the very survival of the industry ever more visibly at stake, there are reports that many within it are ready to stop pussyfooting around the officials and bankers working so clearly against them.

9. Regulating Gold Derivatives

Despite GATA's efforts, so far as can be determined, no committee of Congress has considered the dangers presented by gold derivatives, never mind the now huge short physical gold position. Today as in the past, gold banking is a natural consequence of the fact that gold is money. To pretend otherwise is to invite trouble, particularly in an open global economy where gold trades freely. Accordingly, in modernizing banking, securities and commodities laws to deal more effectively with OTC derivatives, Congress ought to address gold derivatives for what they are: gold banking.

In this connection, two measures appear essential: (1) required public disclosure by each bullion bank of its total gold borrowings, including all deposits and loans; and (2) a minimum reserve requirement, including a provision that all delta hedging against the bank's gold borrowings be conducted in physical gold. Today both central banks and bullion banks regard the size of their gold loans and borrowings as state or trade secrets, making any reliable calculation of their own exposures or the total short physical gold position impossible. The BIS and G-10 central banks work tirelessly to promote market transparency in other contexts. There no plausible reason for the lack of basic transparency in the gold market except to hide abusive schemes and manipulative practices.

With regard to reserve requirements, it is entirely possible that delta hedging might permit a more flexible approach than the traditional rule mandating gold reserves of 35% to 40% against deposit liabilities. Interestingly, a delta of approximately 40% is rather typical for positions not too far from current prices, and it is quite possible that more flexible reserve requirements based on delta hedging would work as well or better than a fixed percentage. In this event, however, banks should be required to delta hedge in the physical market, i.e., to hold these reserves in bullion, not in futures or some other form of paper.

Long gold positions held by banks in the form of forward contracts calling for future delivery by mining companies (or others) are not tantamount to reserves. Rather, as bank assets, they are loans of varying quality depending upon the particular counterparty and the maturity. Additionally, the authority of bullion banks to write naked (or completely unhedged) gold call options should be closely regulated. This activity carries substantial potential for abuse, particularly during strong price rallies when the difficulty of hedging existing positions may make the temptation to engage in downward manipulation with paper alone irresistible.

10. Options, Stocks, Bonds and the Dollar

Like the gold price, the Dow Jones Industrial Average is frequently used as a thermometer of U.S. financial health. The Dow/Gold ratio as an indicator of the relative value of gold and stocks is discussed in a prior commentary, Dow/Gold Ratio = 1 at $3000: Don't Laugh!. Derivatives can affect both sides of the equation. While any full discussion of the role of options in the stock, bond and currency markets is outside the scope of this commentary, some brief comments are in order since derivatives operate in basically the same manner across all markets.

If, as the evidence suggests, large-scale availability and use of options has exaggerated and extended the decline in gold prices, the same process may also have worked in the other direction to inflate values in the stock market. That is, just as call options can fuel bear raids on gold, put options can fire bull runs in stocks. "The trend is your friend," say the traders, and astute use of options today allows traders to push trends further than ever before. As a consequence, reversals also tend to be sharper and deeper.

Based on fundamental or traditional measures, some of today's high stock prices are just as inexplicable as current low gold prices. To take one example, General Electric based on market capitalization is the world's largest company. At a recent $57/share, the market valued GE at over $550 billion, or roughly half the value of all the gold in world at $290/oz. But GE is no Internet or even high-tech stock. Rather it is an industrial and financial conglomerate. At its recent price, GE sported a trailing price/earnings ratio of almost 50 and a dividend yield of 1%. In the decade prior to 1996, GE's trailing PE seldom exceeded 15 and its yield ran around 3%. What is more, as reported by Value Line, none of its historic growth rates for sales, cash flow, earnings, dividends or book value for the past 5 and 10 year periods exceeded 14%, and none of its projected growth rates exceeds 16%.

What can explain the egregious fundamental overvaluation of GE is the popularity of indexing and the use of derivatives, particularly options. Given its large market cap, GE is necessarily a major holding of many index funds as well as a proxy for the stock market generally. Just as important, GE shares provide unsurpassed liquidity, making them ideally suited for option writing and delta hedging. Put options allow holders worried about GE's overvaluation to protect their gains. Put options also allow traders to try to push the stock higher for further gains. Nor is this process unique to GE. It applies to all stocks with sufficient liquidity to allow effective delta hedging.

Because there are no available figures on the amounts of OTC options or other derivatives written on individual stocks, the effect of equity derivatives on stock prices is practically impossible to gauge. Some companies (e.g., Microsoft) write OTC put options on their own shares, and these can be tracked through their SEC filings. This practice is part of a larger problem relating to the accounting and tax treatment of stock options awarded in lieu of salary, particularly in the high-tech sector. See, e.g., Share and share unalike, The Economist, August 7,1999. In this context, sales of put options are one of several means by which a company can try to keep its stock price on a rising trajectory.

Equity derivatives appear able to withstand even very large and swift declines in individual stocks. Not long ago Procter & Gamble shed almost $35 billion of market capitalization in a single day with no hint of systemic stress. From the perspective of shareholders, however, some disclosure of the amount of OTC derivatives outstanding on individual stocks might well provide useful information with respect to their vulnerability to sharp sell offs on adverse news. Indeed, if the disclosure of short positions in individual stocks is warranted, it is hard to see why some minimal disclosure of total OTC derivatives positions in these same stocks should not also be required.

According to a recent article (G. Zuckerman, "Long-Term Capital Chief Acknowledges Flawed Tactics," The Wall Street Journal, August 21, 2000, p. C1), LTCM lost $4 billion over a matter of months, global stock and bond markets almost seized, and the bond market has never fully recovered its former liquidity. The article, which makes no mention of any gold position, focuses on LTCM's inability to sell many large stock, bond and other positions into falling markets with deteriorating liquidity. Precisely why $4 billion of losses mostly in bonds required a $3.6 billion bailout to save the world's financial structure is not explained. However, here is what seems to have happened.

With LTCM's capital base shrinking rapidly due to its high leverage, its creditors became nervous. However, calling in its loans would have forced more distress sales of its investments, roiling markets still further and generating even greater losses for LTCM and its creditors. As alarming as this picture must have been, a short gold position of 300 to 400 tonnes would have made it immeasurably worse. On a position of 350 tonnes, every $100 increase in the gold price equates to over $1 billion. Any effort to cover a position this large, particularly in the circumstances of an unfolding international financial crisis, would almost certainly have driven gold prices much higher, ballooning the dollar amount of LTCM's gold-denominated debt. What is more, given the already large aggregate short physical gold position of the bullion banks, gold loan defaults by LTCM might easily have set off a sudden and severe contraction in gold banking generally, sending gold prices upward by several hundred dollars and quite likely precipitating a massive international financial panic across all markets.

Derivatives on interest rates and foreign exchange have almost certainly played an important role in facilitating unprecedented inflows of foreign capital into U.S. debt and equity markets. As discussed in a prior commentary, It's the Dollar, Stupid, inflows of foreign capital have permitted the United States to run gargantuan trade deficits, now amounting to over $30 billion monthly. That commentary includes some tables detailing the astonishing growth in foreign official and private holdings of U.S. securities. For those who prefer pictures to words, a recent Forbes charticle (Peter Brimelow, "Signs of a Bubble?" August 7, 2000, p. 80) presents the trends in total foreign holdings of U.S. Treasury bonds, U.S. corporate bonds and U.S. equities graphically. To the extent that equity derivatives may have acted as steroids for the bull market of the 1990's, they have added further impetus to these inflows.

In a recent front-page article in The Wall Street Journal ("The Outlook: Will the Trade Gap Lower the Boom," August 14, 2000), Michael Phillips reports on widespread concerns that at its current level of 4.2% of GDP, the U.S. deficit on current account has reached a danger zone in which some unexpected event might well set off mutually reinforcing dollar and stock market declines together with a substantial rise in U.S. interest rates. Exactly how this potential economic doomsday scenario might unfold is anyone's guess, but guessing that derivatives will exacerbate any severe or sudden contraction that does occur is a pretty safe bet, particularly in light of LTCM..

11. Monetary Discipline of Gold

Today the gold price is commonly considered a leading indicator of inflation and an important reflection of the international health of the dollar. However, for gold to play these roles in a meaningful way, it must trade in a truly free market unaffected by official manipulation.

Changes to the international monetary system that weaken the discipline of gold have never before produced permanent prosperity, but only larger and more destructive economic cycles. The gold exchange standard permitted a much larger expansion of credit in the years after World War I than would have been possible under the classical gold standard. The Bretton Woods system allowed a similar unprecedented expansion after World War II. But these two great global booms ended in the worst economic decades of the 20th century: the 1930's and the 1970's.

In both great cycles, gold prices were held at unrealistically low levels during the peak years to hide inflation and make governments look better than they were. As a result, much higher gold prices were in each case a necessary part of the adjustment process. By the end of the last cycle, gold prices were so low relative to mining costs that much of the gold mining industry had closed down amidst a level of devastation not since approached until today. In his recent speech to the Democratic National Convention, President Clinton noted that the current U.S. economic expansion is now the longest ever, last year surpassing that of the 1960's, which beat the Roaring 20's. He also claimed that the policies of his administration deserve much of the credit.

As discussed in a prior commentary, The Greatest Con: The Rubin Dollar, intentionally misleading the world about the true gold value of the dollar may be good short-term politics, but it carries the seeds of long-term disaster. The end of the 1960's expansion came with the collapse of the Bretton Woods system, an event presaged by French demands for gold. Then as now, most economists believed that gold was essentially irrelevant. None expected the price to soar. Today gold price manipulation by the ESF may be a similar harbinger of change, except that it is being hidden from the public.

History suggests that great booms are the products of fundamental monetary forces. As President Clinton said, Americans have a choice to make in November. But before making it, they should consider carefully whether their current good fortune rests on financial underpinnings of enduring strength, or on yet another elaborate monetary con erected to evade the discipline of gold and quite possibly destined to collapse on the next president's watch.

Senator Lieberman has done far more publicly at least than any other member of Congress to press officials at the Fed and in the Clinton administration for answers about official activities in the gold market. Added to the Democratic ticket to give it some moral weight, he could immeasurably assist Americans to make the right choice in November by getting out the facts on the ESF and gold, a subject that should also interest his Republican opponent.

12. Some Strategic Implications of Gold

Former Secretary of Defense Richard M. Cheney not only has a true conservative's belief in free markets, but also comes most recently from the top job at Halliburton Co., an international oil services and construction engineering firm, which is about as close to the mining business as you can get without actually being in it. Added to the Republican ticket for his wide experience in government, business and national defense, he is well-equipped to appreciate gold not just in its monetary and economic aspects but in some of its wider strategic implications as well.

For example, in September 1999 Ai Dang Cheng, deputy director of the Gold Bureau under the China State Economic and Trade Commission, told Bridge News that China's gold reserves of 394 tons were too low relative to its foreign exchange reserves of US$146 billion (less than 3%) and population of 1.3 billion, and suggested that they could rise to 1000 tons. The next day AFX Europe reported that the People's Bank of China had disclaimed any intention to increase its gold reserves. At the time, critical negotiations were underway regarding China's entry into the World Trade Organization. Were these contradictory statements intended as a subtle threat directed toward the dollar?

It is impossible to answer the question with any certainty. But the gold trading practices of the British government notwithstanding, neither the Chinese government nor any other is likely to announce plans for the purchase of large amounts of gold if its intent is simply to add to official gold reserves at favorable prices. What the question does point up, however, is the potential vulnerability posed to U.S. interests by large dollar balances in the hands of other governments. Actual or threatened dumping of dollars for gold could quite conceivably form a key part of any Chinese plan to retake Taiwan. In these circumstances, unleashing the Seventh Fleet could precipitate a dollar debacle. The doctrine of mutually assured destruction is not necessarily confined to nuclear war.

South Africa is a country where gold prices carry special strategic and political implications. The world's top gold-producing nation faces two Herculean challenges: the transition to multiracial democracy under black majority rule and battling the world's most severe HIV/AIDS epidemic. Gold mining plays a major role in the South African economy, directly and indirectly, and contributes importantly as well to the economies of other countries in southern Africa. Few things could do more to advance economic development and prosperity in South Africa and surrounding nations than a gold price at or close to $500, which is the level that many analysts believe would prevail in a free market unaffected by official sales and leasing.

In a recent article ("Cheney on the Issues: He Was Right All Along," The Wall Street Journal, August 1, 2000, p. A22), Herman Nickel, U.S. ambassador to South Africa from 1982 to 1986, reviews the circumstances and events surrounding the Republican vice presidential nominee's congressional votes on South Africa in the 1980's. He notes the "necklacing" of opponents by the African National Congress and diplomatic efforts apart from sanctions of questionable effectiveness to, in his words, "nudge South Africa's leaders toward negotiation and a peaceful end to apartheid." Pointing out that one duty of the vice president is to co-chair semiannual meetings of the U.S.-South African Bilateral Commission, the former ambassador concludes: "[Mr. Cheney's] preference for substance over symbolic gestures should be good news for South Africa -- and for the U.S."

The issue today is not simply one of substance over symbolism. Rather, it is one of help over hypocrisy. It is also an issue of strategic importance for a future in which gold may play a greater monetary role than in the recent past. No two major world leaders cry bigger tears for the plight of South Africa, or express more desire to support its struggle for democracy and fight against HIV/AIDS, than President Clinton and Prime Minister Blair. Yet the governments they lead have done everything possible to trash gold prices, presumably for domestic political reasons. But the day may not be too distant when South Africa recognizes that it must act on gold in its own interest rather than to please its supposed Anglo-American friends. Indeed, the June agreement by a South African investment bank to supply a minimum of 15 tonnes of gold annually for an unlimited period to the People's Bank of China could represent a first step in this direction.

13. Gold and Money in the Developing World

In a recent article ("The Good Deficit," Barron's, August 14, 2000, pp. 41- 42), Marc Chandler, chief currency strategist at Mellon Financial Corp., attempts to assuage worries over the U.S. trade deficit. Arguing that the gap is not as great as it appears due to trade among affiliates of multinational corporations based in the United States, he continues: "[T]he U.S. absorbs the world's surplus savings that cannot be more profitably employed in domestic economies. If the U.S. did not do so, the return on capital to foreigners would be lower. It would be put to inefficient and wasteful uses."

Many countries might challenge the view that they cannot provide profitable opportunities for investment of local savings and that the United States is doing them a favor by siphoning these savings into its investment markets. Particularly in developing countries, the real problem is not so much an absence of sound opportunities as the lack of a sound currency in which to make them. As discussed in a prior commentary, National Gold and Forex Reserves: Use and Misuse, in certain countries a currency board can offer a reasonably effective solution to the problem of an unreliable paper currency. See S. Hanke, How to Abolish Currency Crises, Forbes, March 20, 2000, p. 145; D. Keiger, "The Way According to Hanke" at www.jhu.edu/~jhumag/0999web/hanke.html.

However, a country that is prepared to accept the discipline of a currency board is also ready to accept the discipline of gold, which in most circumstances is a better option. A currency board operates much as the classical gold standard except that the reference money is another country's currency rather than gold. Consequently, the currency board country ties itself to the interest rate policies (and inflation rate) of the reference currency instead of the low interest rate structure historically associated with credible gold-based monetary regimes. The general behavior of gold interest rates is discussed in a prior commentary, Interest Rates: The Golden Connection. If the economy of the currency board country is closely synchronized with that of the reference currency country, having the same interest rates normally will not be too much of a problem. But if the two countries have economies that run on different cycles, the interest rate linkage can on occasion cause significant difficulties and even threaten to undermine support for the currency board itself.

The IMF in recent years has tended to oppose the creation of currency boards, most notably in the case of Indonesia, and has usually required standard central bank nostrums such as high interest rates, deregulation and more open capital markets as conditions for its assistance to troubled third world economies. While Steve Forbes's description of the IMF as a sort of economic Typhoid Mary may be a bit strong, it has not had much success in restoring sound or stable currencies to the smaller nations of the world. More indefensible, however, is the IMF's prohibition on currencies linked to gold.

Adopted in 1978, the second amendment to the IMF's Articles ratified after the fact the closing of the U.S. gold window in 1971. Pushed by the United States to protect the dollar's hegemony, the second amendment aimed generally at reducing the use of gold in the international monetary system. It provided that member countries could link or target their currencies to anything or nothing as they saw fit except gold, which also was no longer to be used in settling balances between countries. Accordingly, any member country that fixes its currency to gold would most likely disqualify itself from further IMF support, a rather strange result given the original purpose of the IMF to help countries stabilize their currencies against a dollar linked to gold.

Until the euro, every major currency in the world had developed from a currency at one time credibly tied to gold or silver. Whether the euro can survive without making a more explicit link to the combined gold reserves of the Euro Area remains problematic. In any event, explicitly to deprive developing countries of the route to monetary stability that all major industrialized nations have traveled lacks any plausible justification. There are reports that some developing nations are now negotiating with the IMF about scrapping its prohibition on currencies linked to gold. The U.S. position on this possibility is not known.

An even more complete abandonment of monetary sovereignty is dollarization, i.e., giving up the local currency altogether and using dollars directly. For a general discussion of dollarization, including the possibility of sharing seigniorage, see U.S. Senate Report, Joint Economic Committee, Encouraging Official Dollarization in Emerging Markets, April 1999. Like currency boards based on the dollar, dollarization ties a country to U.S. interest rates whether or not at any given time they are suited to local conditions. Not coincidentally, official U.S. policy on dollarization seems to be swinging from opposition to support just as the need to find foreign homes for U.S. dollars becomes ever more acute. See Press Release on proposed International Monetary Stability Act (www.senate.gov/~jec/press-D1.html).

From leaving the gold standard in 1933 to today, excessive economic nationalism has characterized American conduct in international monetary affairs. But all tyrannies end, and the tyranny of the dollar will be no exception. Developing nations will not forever accept being milked of wealth and economic opportunity by dollar imperialism.

14. Campaigns and Legacies

A failed presidency did not break John Quincy Adams, nor did it lessen the esteem in which his neighbors held him. In 1829, at the request of the voters in his district, he agreed if elected to represent them in Congress, but only upon the conditions that he would not campaign and that he would act as he thought best independent of the wishes of the party and people electing him. Serving on this basis, "Old Man Eloquent" became an early leader in the struggle against slavery, a role adumbrated in the recent movie about the Amistad affair.

Nor did the Great Depression break Herbert Hoover. But when the last new era collapsed on his watch, it very nearly broke the Republican Party, which did not regain the White House for twenty years, and even then only by drafting a very popular war hero to run as its candidate.

If today's new era dissolves into another big new error under a President George W. Bush, the legacy candidate will be remembered above all else for fixing his predecessor's legacy: "Apres moi, le déluge." If a President Al Gore is at the helm during the upcoming financial storm, "Gored" will likely replace "Hooverized" as a descriptive term for political castration.

But these unhappy outcomes are far from the rhetoric of the campaign. Each candidate promises to manage prosperity better than the other. Apparently oblivious to the extraordinary economic distortions built up over the past decade, neither candidate even hints at the possibility of hard times unless perhaps the other guy wins. In the event of victory, each is leaving himself and his party with little room for maneuver should economic conditions change for the worse. Yet the victory each seeks is likely to come with a dangerous political derivative: the chance to be crucified on cross of gold far more real than any imagined by William Jennings Bryan a century ago.

Reginald H. Howe
www.GoldenSextant.com
row@ix.netcom.com