Part 1..............
Please call me Holtzman.
For over a year now, I've been quietly gathering lines of computation until I felt I had some glimpse of the big picture. The lack of hard numbers on this subject is profound, but after much digging I've found enough to make a first approximation analysis. I look forward to having my better interpretations expanded on and my poorer interpretations rendered smartly with a three pound mallet. Both reactions are equally welcome as long as they bring us all nearer to the truth. I'm particularly keen to fill in the holes in my data where I've had to make assumptions. But before I get into Gold M2 and mining stock analysis, let me start with gold's place in today's world...
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Equal Footing
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Since 1971, gold has been an independent world currency on an equal competitive footing with dollars, rupiah, etc.
How can gold and rupiah be on equal footing? After all, it's been well established here that gold has intrinsic value while a rupiah note is intrinsically kindling.
But both depend on faith and confidence to make them work. Specifically, every seller in every sale makes a decision based on faith: if I accept that buyer's money (gold or paper) in return for my product or service, how likely is it that I will be able to turn around and pawn that money off to someone else for an equivalent product or service?
The public's level of faith in any particular fiat currency is the perceived likelihood that the issuing government will maintain the value of that currency long enough for the holder to buy something with it. Gold doesn't have a single issuing government to maintain its value. In fact, it has several governments trying their best to maintain their fiat currencies' value at gold's expense.
But that doesn't deny it equal footing as a currency. Joe in the U.S. is just as likely to want to own gold as he is to own rupiah because everything in Joe's world is bought with dollars and the dollar is stable from where he sits. But Sapta in Indonesia is just as likely to want to own gold as he is to own dollars because, from where he sits, either one is far more reliable than his own local rupiah.
Today's exchange rate between dollar/rupiah, or rupiah/gold, or gold/dollar, is a measure of the difference in levels of faith which humanity as a whole has placed on each of the compared currencies at that moment.
The rupiah tanked against the dollar in 1997 because, on balance, Clinton careening towards impeachment was not as disturbing as Soeharto careening towards blood in the streets. The rupiah tanked against gold to almost the same degree for precisely the same reason: faith in gold was stronger than faith in Soeharto.
Gold surged against the dollar in the 70s, then tanked against the dollar in the 80s and 90s, for precisely the same reason: faith in gold was stronger than faith in Nixon, Ford, and Carter, but faith in gold has been weaker than faith in more recent U.S. administrations.
>From 1971 back to the Great Depression, gold was intentionally obscured in both the communist bloc and in the anticommunist bloc. POG's track record during that time is no more useful than telemetry transmitted by Voyager 2 while it was still stowed inside its launch capsule. Gold had been mothballed then. Still, mining figures during that time are useful.
Prior to the Great Depression, gold was not an independent world currency. An ounce of gold was simply 4.25 Sovereigns or $20.70. More importantly, 4.25 Sovereigns WERE $20.70. Why be afraid of a One World Currency? We used to have one in the 1800s and it worked.
But for the present, gold is no different (no more or less special) than a dollar or a rupiah. You can no more redeem gold for a dollar than you can redeem rupiah for a dollar. Rather, you exchange one for the other, since all three are freestanding currencies.
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Gold is only barely a commodity
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The commodity vs. currency argument reminds me of the wave vs. particle argument about light. Gold is both, just like light is both. Unlike light, however, gold is nowhere near balanced between the two personas. Gold is overwhelmingly currency and only barely a commodity. Why so? Consumption.
Take oil for example. Oil is not and never can be a viable physical currency. It's too bulky for one thing. More to the point, oil is valuable because it can be destroyed with benefit. You destroyed a measure of petrol to get to work this morning. Its destruction produced value for you. Come to think on it, you ate food for lunch. The destruction of that plant or animal produced value for you. That's the definition of a commodity.
Now hold a Maple Leaf in your hand and ask yourself under what imaginable conditions it might be beneficial to you to destroy that coin? The same question applies to a $100 federal reserve note. Regardless of your pride (or lack thereof) in the Fed, how could it possibly benefit you to burn that paper? That's the definition of a currency.
On the other hand, it's fairly easy to think of a benefit from destroying silver... a Kodak moment. Silver is balanced about halfway between commodity and currency. In bullion form, it is universally recognized as a store of value, yet most annual production is consumed and destroyed by the photography industry.
Platinum and Palladium are firmly on the commodity side of the spectrum. They certainly can act as currency in the short term, but their aboveground supplies deflate at such a high rate that society won't accept them as long term currencies.
And then there's gold. Some gold is (effectively) destroyed into teeth fillings, gold leaf decoration, and more recently electrical connections. But that offtake is a tiny percentage of the total mass of gold ever mined. That makes gold very different indeed from any other natural resource, hence its character as 98% currency and only 2% commodity.
Speaking of intrinsic value, certainly food and clothing and shelter have intrinsic value. Even oil has intrinsic value as its destruction gets you where you want to go. But does gold have intrinsic value? Depends what you mean by intrinsic. If you're stranded in a desert with a couple thousand ounces of gold and only two literjons of water, suddenly gold doesn't seem so intrinsically valuable anymore. When people say gold has intrinsic value, they seem to be meaning something quite different. Gold the element is not all that valuable by itself.
Rather, humanity as a whole imbues gold with value as a currency for reasons of habit and faith, in all respects save one precisely as humanity imbues dollars and rupiah with value. Profiting from owning gold, then, is exactly parallel to profiting from owning dollars or rupiah.
Once you allow that gold is just another foreign currency, just as subject to market forces, you realize that gold has cycles. It isn't steady throughout time. Just like the dollar (though thankfully out of phase with the dollar), gold has times of phobia (POG lower than common sense would dictate) and times of mania (POG higher than it ought to be).
As it happens, today appears to be a phobia time for gold, so buying gold in spite of that fear is more rational than buying the disproportionately overvalued dollar. When things get the other way round, though (and they will), don't stay in maniacal gold. When you see Carlton Sheets on television offering to teach Joe American how to profit from the coming gold bull market by buying Franklin Mint coins, it'll be time to run away from gold.
Okay, enough philosophy. Let's get into numbers.
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Gold described as a currency
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Since gold is indeed just another freestanding currency, we can analyze it precisely as we would analyze euros, dollars, or rupiah.
Any particular currency, fiat or precious metal, has a supply and an inflation/deflation rate.
With fiat currencies, supply is categorized as to liquidity into M1 ready cash, M2 savings accounts, and M3 time deposits (penalty for early withdrawal). Privileged institutions create fiat cash out of nothing. People toss cash in the trashcan (pennies in particular). Governing bodies manipulate the supply and the inflation/deflation rate either by actual intervention or by making threats.
Precise parallels exist in the currency of gold:
Gold M1 - physical gold in individual-friendly form: bullion coins, 10 tola bars, etc.
Gold M2 - physical gold in government-friendly form: London Good Delivery bars
Gold M3 - physical gold in harder-to-get-at form: mining reserves, jewelry, scrap
Derivatives - paper gold: futures contracts, options, lease contracts
Inflators - mining, sales of long-hidden caches, recovery of scrap
Deflators - electroplating, gold leaf, high-end numismatic gold
Gold Fed - open market buying and selling of gold by central banks
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Going to the mattresses
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You can tuck money into your mattress either as fiat papers or as gold coins. In both cases, you receive no interest income, yet in both cases you leave yourself open to the rate of inflation of the currency you chose to tuck.
The Dollar M1+M2+M3 supply has historically been inflated by about 3.5% annually if I remember correctly.
The Gold M1+M2+M3 supply has historically been Inflated by about 2% annually due to mining.
The Gold M1+M2+M3 supply has also been Deflated by non-recoverable uses such as electroplating and gold leaf... how likely it is that the gold faithfully applied to Buddhist statues, or the gold coined into a Stella, will ever be reclaimed into bullion?
I don't have figures for this Deflator effect on gold (I would dearly love to know). But, in combination with the Inflator effect from mining, the net result is that gold supply increases at no more than 2% annually, and may well decrease. In contrast, the dollar supply increases at 3.5% over the long term and 13% in the recent term. Held over long periods, then, gold is better than dollars in a mattress.
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Passbook savings
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However, few dollars are in fact held in mattresses, even though most gold is. Dollars held in passbook savings have historically yielded about 1% or so above inflation. Held over long periods, then, dollars in passbook savings grow by 1% in purchasing power while gold dwindles by 2%. Measured over long periods of good economic times, then, dollars in the bank are better than gold.
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The value of immortality
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While gold is a very poor Growth vehicle, it does have the singular power of Remaining valuable even after the government which coined it has expired. This is that one significant difference between gold and fiat currencies I mentioned above.
A German pre-Nazi pre-hyperinflation 1911 twenty mark gold coin is still worth nearly a quarter of an ounce of gold. But a twenty mark banknote (which carried equal weight in the pockets and cash registers of 1911) is today worth next to nothing.
Having said that, let's say that someone took his twenty marks in 1911, exchanged them for Swiss francs, and deposited them in a Swiss bank. By today, enough interest would have been earned to buy several twenty mark gold coins at today's prices.
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Asset Allocation
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That's why I don't put all of my savings into gold coins, at least certainly not for long periods. I find the most constructive outlook on this is to begin with the assumption that no single investment will "make a killing." Rather, I assume that any single investment I make will, guaranteed, lose at least some of the savings I invest in it.
On that premise, my goal is to minimize that guaranteed loss by spreading my savings into many different assets: gold, dollars and other fiat currencies in the mattress, bank CDs, bonds, stocks, possibly real estate under better market circumstances, etc. With that broad a base, it's absolutely certain that one of those categories will take a mortal fall, but no single category is so big that my savings as a whole takes a mortal fall.
One of you posted an excellent sentiment a while back: you'll know you've reached the right proportion of gold ownership when you neither fear you have too little nor fear you have too much. I'd say that goes for every asset class. Each gives a different sort of reassurance. Gold offers assurance against apocalypse. Stocks offer assurance against everyone else in the country prospering while you sit on your mattress. CDs offer assurance against the possibility of an outcome somewhere in between. One scenario will be right in 2000, one will be right in 2001, one will be right in 2020. But no one can reliably guess which one will be right when.
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Transaction Costs
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Walk into your neighborhood bank and ask them to change a 100 for ten 10s. The teller may (pointlessly) act as if she's above that sort of task, but it won't really cost the bank anything to do this.
But hand Michael a 1-ounce Eagle and ask him for ten 1/10 Eagles in change, and it would financially damage him to make this swap. Why? Because even though gold is a world currency, it is nowhere near as often used as currency (at least, not Gold M1... Gold M2 is indeed swapped in exactly this manner between governments every day).
Common usage and broad acceptance reduce transaction costs. Infrequent usage causes painfully large transaction costs, for all involved.
One of the arguments in favor of establishing the euro was that a lorry driver going from Portugal to Denmark and hoping to eat 3 meals a day would have to perform half a dozen currency exchanges on his journey, each exchange wasting money for no particular benefit. By contrast, a truck driver going from Maine to California has no such overhead cost.
Precisely the same transaction cost happens between gold and other currencies. A 1-ounce Krugerrand is as near to spot as any Gold M1 object can get, but it still costs more than spot to buy, and less than spot to sell. Premium is a misleading term for that spread. It's a currency exchange fee.
Anything more than a few percentage points, however, and something else is being priced in. A St. Gaudens will always cost more than a Krugerrand because it's permanently rarer. A modern U.S. Eagle isn't going to be sold for a Krugerrand's price because it's temporarily rarer (and more politically correct). An Eagle is not a collector's item, however, any more than a $100 federal reserve note is. There are too many of both.
By the way, the Euro is not at all a new idea. In the 1800s, Belgium, France, Switzerland, Italy et alia unified their currencies on a common gold standard. A 20 Lire coin and a 20 Franc were identical in gold content and were even minted to the same diameter so they'd roll interchangeably. Bingo. No transaction costs across those borders.
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Lease rates
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Aboveground gold has been steadily increased by mining and steadily decreased by electroplating, resulting in a net increase in gold supply of less than 2% per year. I suspect this explains why central banks lend gold at 1-2% when those same banks lend fiat currencies at higher rates.
There've been several discussions both here and elsewhere on fractional reserve lending: when all borrowers in total are ultimately obligated to pay back more money than exists, the debt cycle winds in on itself. Issuers of fiat currencies can keep that nonsense going for long periods because they can print more paper when no one is looking, but lenders of gold don't have nearly as much leeway. They cannot, over the long term, charge a higher lease rate than the rate of gold supply inflation because they cannot demand more gold interest than can possibly be brought above ground in that timeframe. The price of gold soars versus fiat currencies (and commodities) following those periods when bankers forget that.
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Inflation between the Ms
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Big quandary: Gold M1+M2+M3 has been quietly increasing by less than 2% per year. Dollar M1+M2+M3 has been radically inflating at 13% over the past year. So why on earth is the dollar/gold exchange rate tanking by double digits?
Big contributor: the fear that massive chunks of Gold M2 are about to be moved into Gold M1.
Inertia is a wonderful thing for currencies, both fiat and gold. Untold billions of U.S. dollars are in mattresses outside the U.S., and so far they've stayed there because the risk of dollar devaluation is less than the risk of local currency devaluation. Result: the U.S. can export its inflation to the rest of the world. Those paper dollars overseas are more illiquid than domestic 10-year CDs. At least, so far they have been.
Gold M2 used to be just as illiquid. A London Good Delivery bar takes a fair amount of effort to be wrought and assayed. Once one is formed, there is powerful incentive to leave it that way. And how many individuals regularly buy or sell LGDs? At roughly 400 ounces each, recent events have brought their dollar price down to nearly $100,000, but what individual of normal means would dare own one (in other words, who could you possibly sell it to)? Talk about all the eggs in one basket. Until recently, this established two very distinct markets for physical gold: the M1 for normal people and the M2 for the big boys. There was very little if any cross-talk.
The onset of derivatives (futures, options, etc.), however, has changed all that. It's now possible for a citizen to buy a futures contract to buy an LGD bar at some future date, only he won't actually try to take delivery. He just hopes there'll be a profitable difference in an LGD's dollar price between the date he bought the contract and the date he sells that contract to someone who truly does want to take delivery of an LGD bar. Suddenly LGDs appear to be as liquid as sovereigns.
At the same time, the fiat confidence game gets longer in the tooth with each local currency panic. Holland's tulip mania crashed on the day a farmer, shown a tulip bulb which had just been purchased for the cost of a house, said in astonishment, "But this is just an onion." Everyone around him suddenly had a moment of clarity and ran for the exits. Holland ceased to be a world power when that bubble burst.
Important: the exact same free fall happened two decades ago when POG was north of $800. That which has happened before can happen again.
And, sooner or later, someone in today's world is going to ask how a U.S. dollar bill is any more trustworthy than a rupiah bill. I should think no other scenario puts so mortal a terror into the hearts of central bankers worldwide. Trying to prevent that unmanageable shock to the system, central bankers issuing both rupiah and dollars have phenomenal motivation to work in concert.
At least in public. Germany and the U.S. cheer on the efforts of other entities to sell their gold, but have no intention of selling any of their own. China's inconvertible fiat currency gives it the freedom to buy gold openly without a care as to the fate of its competitor central banks.
Still, it remains the prime task of central bankers to deride any alternative asset which the public might come to see as a safe haven from fiat. Ultimately, it's self-defeating, but that doesn't mean they can't prolong it for years more than we wish.
Complicating matters is that both derision and derivatives have intertwined. Recent BoE actions are motivated by both needs, but I agree with goldnbones (5/7/99; 13:16:12MDT - Msg ID:5719) that it's more to do with contractual obligation than with spin control.
I do not believe BoE is selling unfettered physical metal. Rather, BoE seems to be selling the title documents to gold it no longer physically holds. This would certainly explain why the auction is limited to LBMA & friends, the firms which have spent the past decade borrowing massive quantities of gold from BoE & other CBs.
This isn't a sale, any more than it's a sale when a car finance company hands you your car title following your payment of the last installment. The sale occurred years ago, you've just been paying interest on the debt to the bank since then. Now you're settling up.
Of course, to read that, it means that BoE has most likely lent out 2/3 of the gold it continues to tell the public it owns. Only of course the borrowers can't round up enough actual bars to pay back the debt in gold as originally promised (or are able to but choose not to for reasons of their own). So BoE is letting them balloon-payoff the loan in dollars/euros/yen. The alternative would be for one or more bullion houses to declare that they are not able to pay their debts. Systemic threat, a la LTCM.
Hmmm, if 2/3 of BoE's publicly held gold really isn't there anymore, I wonder what proportion of the whole 31,400 tonnes theoretically held planetwide by CBs and IMF is, in fact, still there. In other words, the threat of CBs having 15 years of accumulated mining poised to dump on the market may, in fact, be mostly bark and little bite.
This reminds me a lot of J.P. Morgan's sneak attack in the 1890s when he quietly exported so much gold from the U.S. to England that he was then able to corner the U.S. and outpower the president. Have you ever noticed how the presidents you never heard of were all from that time period? It's because they weren't the ones in charge.
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So where has the CB gold gone?
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We have a total aboveground gold supply of about 137,000 tonnes. What I don't know (and would love to know) is the proportions which are London Good Delivery bars, bullion coins, numismatic coins, and jewelry/other.
My guess is that LGDs outweigh bullion coins by at least 4 to 1. Central banks and their close kindred officially hold 31,400 tonnes (perhaps much less, and I should think 90% of whatever they hold is in the form of LGDs.
In the absence of firmer numbers, then, I make wild assumptions:
15% CBs/Governments
10% private citizens holding bullion
40% private citizens holding numis/jewelry/other
35% ?
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