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Government Gold Holdings Depress Price

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bartermania   Wednesday, 01/25/06 12:17:11 PM
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Government Gold Holdings Depress Price

By George J. Paulos

In 1971, President Nixon unilaterally withdrew from an international currency agreement called Bretton Woods. The Bretton Woods Accord was the standard for international currency transactions between 1944 and 1971. The agreement created an international currency trading system based on the dollar. The key to the agreement was a guarantee that the US would redeem one ounce of gold for every $35 held by foreign governments. The agreement collapsed because foreign holders of dollars started demanding gold but there were too many dollars in circulation to honor the redemption guarantee. The Bretton Woods Accord was the last remnant of a monetary gold standard that had lasted for centuries. Many economists and financial experts urge a return to gold-based currencies. These experts assert that the modern system of fiat currencies is creating an unreasonable risk of inflation or even financial collapse. Central bankers argue that fiat currencies are more flexible, allowing governments to manage economic cycles by expanding and contracting the supply of money. Basing currencies on gold would remove the central banker's power to moderate the ebb and flow of economic growth. They consider gold to be a "barbarous relic" of an unenlightened age.

Currencies without backing in gold or any other commodity are called fiat currencies. Most of the world's currencies are now pure fiat. Governments will not redeem fiat currencies for gold in any quantity to their citizens. Despite these policies, most governments still hold massive gold hoards as a reserve asset. This gold is used in international currency transactions to stabilize exchange rates, or just to bolster a government's image of financial strength. If there is no tangible commodity behind fiat currencies, then how is value assigned to them? This is a complex question to answer in its entirety. Within each country, citizens are essentially compelled to use the official fiat currencies by law. This by itself does not assign value, it just forces usage. Relative value between fiat currencies is determined in currency exchange markets where dollars, euros, pounds, yen, and many others compete with each other. Since all of these are fiat currencies their relative value does not imply intrinsic value. Ultimately, the value in a fiat currency is the willingness of people to accept the currency in exchange for goods and services. This same rule also applies to gold and other metals. Gold receives its value because many people will accept it as payment for goods and services.

Fiat currencies are convenient and universally accepted. They are not chained to any arbitrary commodity and can be managed proactively to achieve desired economic outcomes. So what's wrong with that? The core problem with fiat currencies is management. The central bankers who are entrusted with the maintenance of fiat currency systems are expected to have impeccable ethics and perfect knowledge of the economy. This is a tall order. There is enormous temptation for governments to debase the currency by creating too much of it. This causes inflation which destroys the value of the currency. Governments create excess currency because it is tantamount to an invisible tax increase that extracts value from the savings of citizens. A truly noble central banker would be immune from pressures by the political system to debase the currency. However, almost all central bankers are appointed by that same political system creating a fundamental conflict of interest. Even the noblest of central bankers would be subject to biased interpretation of economic conditions because of the political and social climate. The best economic forecasts are no better than long-range weather forecasts. Knowledge of economic conditions is always imperfect. This leads to faulty forecasts and poor currency management. Fiat currency management a job that is probably impossible to perform perfectly.

The cost of imperfect fiat currency management is chronic inflation, a steady decline in purchasing power. In extreme examples of mismanagement, hyperinflation occurs resulting in the total collapse of currency value. The history of fiat currencies is not good. All have ultimately collapsed over time. Some implode quickly and others suffer a long slow decline. As a result of currency collapses, many people returned to the precious metals, gold in particular, as a trusted store of value. The consequences of a currency collapse are dire, usually resulting in a severe depression and social upheaval. (We are now witnessing this process occur in Argentina as a result of their currency collapse.)

So what makes gold immune from such a massive decline in value? It is simply because gold cannot be created out of thin air. It must be extracted from the earth with great difficulty and expense. This limits the growth rate of the gold supply to just a few percent per year. Occasionally the gold supply can increase suddenly causing a brief spurt of inflation. This happened during the California gold rush when a large amount of gold was produced in a short period of time. Over the long run however, the total supply of gold has grown at a slow but steady pace. It is this characteristic that has allowed gold to retain value over long periods of time.

It is apparent from the above discussion that fiat currencies and gold fill two distinctly different roles. Gold is an outstanding store of value but is awkward for conducting transactions. Fiat currencies are outstanding as a medium of exchange but fare poorly as a store of value. The obvious solution to the problems of each system is a true 100% gold-backed currency. Unfortunately this solution is almost always subverted by the political needs of governments. Gold or silver backed currencies existed for many years but were ultimately revoked by governments who systematically broke the solemn promise to redeem currencies for precious metal. It seems that all metal-backed currencies are really fiat after all. Any promise can be broken.

In a freely traded gold market, a rising gold price signifies weak currencies. It is in the interest of governments to keep the gold price stable and avoid a dramatic price rise which could ignite a currency panic. Because of this, governments who issue fiat currency are in fundamental conflict with gold investors. Governments possess huge stockpiles of gold which could be sold into the markets any time there is excess demand to limit price increases. There is a big controversy about whether or not this is actually happening. The price of gold has languished near 20 year lows while demand has steadily increased. Many well-informed people believe that this is the result of governments actively managing the price of gold though bullion sales and leasing.

Whether a gold price-fixing conspiracy exists or not, it is apparent that governments have both the means and the motive to manage the gold price. In auction markets, just the threat of such manipulation would have a depressing effect on price. Putting at it another way, the possession of large amounts of gold by potentially hostile governments represents a real danger of massive gold liquidation at any time, which depresses the price. As long as governments hold so much gold, a truly free market in gold cannot exist to establish a fair price. Therefore gold cannot perform its function as a benchmark of value against fiat currencies.

How can gold investors who have an interest in a fair gold price fight the threat of government gold liquidation? Simply by buying gold and imploring others to do the same. Everybody will gain if everybody does it. The more buying pressure, the greater the price pressure. If governments do not respond by selling gold, the price will rise. If governments do sell into the price rise, then they will ultimately run out of supply and be unable to influence the market in the future. The US Treasury reports holding about 260 million ounces. This is less than one ounce per capita. If each person in the US purchased one ounce of gold, it could exhaust the US government supply.

Paradoxically, depleted government gold reserves might actually lead to better fiat currency management. A true free market would emerge with all gold in public hands, restoring a fair price for the metal that would properly reflect its value with respect to currencies. Fiat currencies would finally have effective competition in the marketplace for value. Governments could no longer hide inflation by selling gold to give the illusion of currency strength, yet they would still have the freedom to proactively manage their economies through flexible monetary policy. Without the safety net of a huge gold hoard, central banks would be forced to manage their currencies in good faith with gold being the ultimate arbiter of value. Gold is too important to be managed by government bureaucrats. The best stewards of the world gold supply are individual citizens who can use the metal to defend their savings against governments who would otherwise inflate it away.

George J. Paulos
January 15, 2002

(Link to article: http://www.gold-eagle.com/editorials_02/paulos011502.html )

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