Central Banks and Gold Liquidity

Development Through Wage-Led Growth

By
Henry C.K. Liu

Part I:    Stagnant Worker Income Leads to Overcapacity
Part II: Gold Keeps Rising as Other Commodities Fall
Part III: Labor Markets de-linked from the Gold Market
Part IV: Central Banks and Gold

Part V: Central Banks and Gold Liquidity

This article appeared in AToL on January 8, 2011

Aside from issuing the nation’s currency, formulating monetary policy and implementing it though interest rate measures and managing the money supply, a central bank is also a regulator of the nation’s banking system, and as such it can set the discount rate, the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility--the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured. A central bank also acts as a lender of last resort to commercial banks and other financial institutions. Further, invoking authority under the rarely used Section 13(3) of the 1932 Federal Reserve Act, the Federal Reserve can even lend to non-financial corporations during periods of systemic financial stress. It aims at applying a monetary policy that will stablize the credit and money markets by providing needed liquidity to the banking system and the credit markets in times of systemic financial distress.
(Please see my April 18, 2010 article: The Fed’s Extraordinary Section 13(3) Programs)

To add liquidity to the gold market, many central banks provide gold to bullion banks and commercial banks with proprietary gold trading desks. According to the World Gold Council, bullion banks are investment banks that function as wholesale suppliers dealing in large quantities of gold. All bullion banks are members of the London Bullion Market Association (LBMA).

Bullion banks differ from depositories in that bullion banks handle transactions in gold and the depositories store and protect the actual bullion. For example, the Federal Reserve Bank of New York stores and protects gold for a number of central banks and foreign governments. The US Bullion Depository in Fort Knox, Kentucky houses most of the gold bullion belonging to the United States.

Significantly, central banks choose to release gold to market participating institutions by leasing out gold for fees denominated in dollars instead of selling gold outright for dollars. This is because central bankers know from experience in recent decades that fiat currencies, led by the US dollar, had been repeatedly devalued against gold by deliberate Federal Reserve policy.

Gold Price and the Debasement of Fiat Currency

This policy-induced debasement of fiat currency by central bnaks can be expected to continue well into the foreseeable future until market confidence in fiat currencies is exhausted, and new international finance architecture is formulated. Before that final crisis happens, central bankers would look for another white knight in the form of a reincarnated Paul Volcker to slay the inflation dragon with another blood-letting cure of sky-high short-term interest rates, as he did in the 1980s.

However, within the pattern of protracted steady decline in the purchasing power of fiat currencies over the long run, the price of gold can be highly volatile at any one time for a range of obscure reasons. Peaking at $850 per troy ounce on January 21, 1980, gold fell to $285 in February 1985 and recovered to reach $800 in November 1987, all within a period of seven years. Having failed to overtake its historical peak price for the second seven-year period, gold fell back down to $357 in July 1989. It rose to a high of $417 seven years later in February 1996, only to fall back to $250 in July 1999. Gold was $35 cheaper per ounce in 1999 that it was on 1985, 14 years before, and $35 was the price set for a troy ounce of gold at Bretton Woods in 1945.

Gold Not a Good Store of Value

Notwithstanding common perception, gold is not a totally reliable store of value even for the long run. The price of gold had been and still can be detached from general inflation rate in the global economy for extended periods. For example, from its peak of $850 per troy ounce set in January 1980, gold price was falling towards the end of the same year when economic data and central bank policy would suggest that it should be rising, with US inflation rate reaching 14.5%, bank prime rate at 20.5% as a result of Fed Chairman Paul Volcker’s blood-letting anti-inflation monetary policy that set the Fed funds rate at 20% by December 1980, with the unemployment rate at 10.8%, and 30-year fixed rate mortgage at 18.5%.

Gold Price Unrelated Directly to Inflation Rate

In 2008, gold price kept rising when economic data would suggest that it should be falling, with US inflation rate falling from 5.6% abruptly to 1.07% by November, and bank prime rate fell to 3.5% while the Fed funds rate was lowered to 0-0.25% in December, with unemployment at 10.7% and 30-year fixed rate mortgage at 6%. These figures were clear signs of a severe liquidity trap, which Keynes defines as a drastic fall in market confidence giving rise to a liquidity preference that overrides otherwise normal stimulus effects of low interest rates on the economy.

Gold Stayed Below its Peak Price for 28 Years

The peak gold price of $850 per troy ounce set in January 1980 was not breached for 28 years, an extraordinary long period for a bear market for gold. It fell to a historical low of $250 per troy ounce in July 1999 while inflation was rampant, after which gold took off to reach a historical high of $1,421 on November 9, 2010, an extraordinary rise of 569% in just eleven years, in a period of general deflation.

Gold Price Volatility Not Driven by Supply and Demand

The volatile gold price pattern in the past three decades obviously was driven by more than market supply and demand for the precious metal, or by the persistent debasement of fiat currency. In fact, central bankers know that central bank monetary policies and continuing central bank intervention in the gold market had much to do with this wide volatility in the price of gold.

A secondary reason why central banks lease out gold is to earn interest and to capture arbitrage profit from the differential between dollar interest rate and gold lease rate. Central banks do this to lower carrying cost in a contangoed forward price curve, while at the same time capturing anticipated gains in gold price.

Contango depicts a pricing situation in which futures prices get progressively higher as maturities get progressively longer, creating negative spreads as contracts go further out in time. The time-related price increases reflect carrying costs, including storage, financing and insurance. Contango is a term used in the futures market to describe an upward sloping forward curve (as in the normal yield curve). Such a upward sloping forward curve is said to be “in contango” (or sometimes “contangoed”). Formally, it is the situation where, and the amount by which the price of a commodity for future delivery is higher than the spot price, or a farther future delivery price higher than a nearer future delivery.

Reasons Why Central Banks Lease Gold to the Market

But focusing on gold leasing fees is a diversion from the fundamental reason why central banks lease out gold. Central bankers know from experience that even as the price of gold rises, the monetary profit gold owners make from holding gold does not necessarily add up to net gains after inflation. Gold owners are merely hedging to reduce, but not avoid fully, monetary losses from the inevitable debasement of fiat currencies caused by escalating loose central bank monetary policies.

Gold leasing does allow central banks to earn rental income with the gold they hold to cover some holding expenses. But more importantly, gold leasing by central banks provides gold-backed liquidity to gold-related financial markets. In a fundamental manner, adding gold liquidity slows the rise in the price of gold which in effects slows the debasement of fiat currencies caused by deliberate central bank monetary easing policies.

Gold and Fiat Currency Debasement

When a government issues fiat money that is legal tender for payment of taxes (the public's debt ot the government) and private debts, it is in essence issuing interest-free sovereign credit to the bearer of its currency, which is “legal tender for all debts, public and private” – a declaration that appears on all US dollar bills – which are Federal Reserve notes.

Tax liabilities until paid to the government are debts to the government owed by members of the public within its juridiction. The government charges no interest for its sovereign credit in the form of fiat money it isssues, unless new fiat money is issued to quantitatively increase the exisiting money suppy to reduce through inflation the purchasing power of the money in circulation.

Thus mild inflation, up to 3% annually, is a benigh way the government charges the bearer interest for holding its fiat money in the form of sovereign credit certificates. In that sense, the mild debasement of fiat money orchestrated by the central bank is an inherent structural characteristic of sovereign credit. In addition to other positive economic effects, mild inflation increases tax revenue from fixed progressive tax rates, through bracket creep. Milton Friedman’s monetarist conclusion that a steady expansion of the money supply at 3% annual rate is the optimum rate that balances inflation and economic growth is a confirmation of this fact.

The issuing of fiat money as sovereign credit certificates shoud not be confused with government fiscal spending of fiat money already in circulation in the form of sovereign credit certificates already issued. Only the Federal Reserve, as a central bank, can issue fiat money. The dollar is a Federal Reserve note, not a bank note. The word “bank” doe not appear in any dollar bill. The US Treasury cannot and does not issue money. It receives money by way tax revenue denominated in dollars issued by the Federal Reseerve.

Fiat money in the form of sovereign credit certificates issued by the central bank is accepted by members of the public because, by law, fiat money can be used by the bearer to discharge tax liabilities to government. Payment of taxes with fiat currency is in essence the canceling of tax liability with sovereign credit earned by the taxpayer. The debasement of fiat currency is caused by central bank new issuance, but not by government deficits if such deficits are repaid with higher future tax revenue in the form of sovereign credit certificates (fiat money issued by the central bank) already in circulation. Fiscal deficits are only inflationary if a government pays for them with newly issued fiat money from the central that enlarges the money supply without expanding the economy.

History and Politics of Central Banking in the US

In the United States, central banking was not born until 1913 with the establishment of the Federal Reserve System. The first national bank in the US was the Bank of the United States (BUS), founded in 1791 and operated for 20 years, until 1811. A second Bank of the United States (BUS2) was founded in 1816 and operated also for 20 years until 1836.

The first national bank (BUS) was modeled after British experience, was established by Federalists as part of a nation-building system proposed by Alexander Hamilton, the first secretary of the Treasury, who realized that the new nation could not grow and prosper without a sound financial system anchored by a national bank.

Jefferson's opposition to the establishment of a national bank was key to his overall opposition to the entire Hamiltonian program of strong central government and elite financial leadership. Jefferson felt that a national bank would give excessive power over the national economy and unfair opportunities for large certain profits to a small group of elite private investors mostly from the New England states. The constitutionality of the bank invoked the dispute between Jefferson’s “strict construction” of the words of the constitution and Hamilton's doctrine of “implied power” of the federal government.

Hamilton's idea of national credit was not merely to favor the rich, albeit that it did so in practice, but to protect the infant industries in a young nation by opposing Adam Smith's laissez-faire doctrine promoted by advocates of 19th-century British globalization for the advancement of British national interests. This is why Hamilton's program is an apt model for all young economies finally emerging from the yoke of Western imperialism two centuries later, and in particular for opposing US neo-liberal globalization of past decades.

The creation of a national bank was one of the three measures of the Hamiltonian program to strengthen the new nation through a strong federal government, the others being 2) an excise duty on whiskey to extend federal authority to the back country of the vast nation and to compel rural settlers to engage in productive enterprise by making subsistence farming uneconomic; and 3) federal aid to manufacturing through protective tariff and direct subsidies.

To Hamilton, a central government without sovereign financial power, which had to rely on private banks to finance national programs approved by a democratically elected congress, would be truly undemocratic and to rely on foreign banks to finance national programs would be unpatriotic, if not treasonous.

Hamilton's national program was opposed effectively by the two special-interest groups with controlling influence in Congress: the Northern trading merchants and shippers who had secured a Navigation Act to protect US shipping in 1789 and Southern planters who depended on export of unprocessed agricultural commodities, neither of which had any interest in curbing foreign trade even when such trade was harmful to the development of the national economy. Domestic manufacturing interest did not become strong enough to obtain much government protection until after the War of 1812. The dynamics of this politics is visible in the 21st century in many developing nations where the financial elite prefers comprador opportunism to economic nationalism.

Congressional opposition to the first BUS resulted in its charter expiring in 1811 without renewal. However, the financial pressure after the War of 1812 created demands for another national bank.

The Second Bank of the United States (BUS2) went into operation with a capital of $35 million in 1816, with the federal government owning only 5 percent of the stock. For a decade after the War of 1812, there existed no clear-cut party division in US politics, thus the term “Era of Good Feeling” was applied. The Republican Party abandoned its original Jeffersonian opposition to Federalism and adopted Federalist policies, starting with the establishment of the second BUS, adopting tariffs to protect struggling US industries and federal appropriation for infrastructure development.

Henry Clay proposed the “American System”, based on Hamiltonian ideals, but unlike Hamilton, Clay cultivated popular support, not only appealing to the upper class, and sought support from the agricultural South, not just the mercantile New England states. It was a national program of federal aid to domestic development and tariff protection for struggling US industry.

The disappearance of the first BUS in 1811 had left the nation’s currency system in a chaotic state. Since 1791, a large number of state banks had been chartered, reaching 208 by 1815, and except in New England, these banks were allowed to issue notes very much in excess of their capital ratio and to make loans without sufficient reserves.

BUS2 fulfilled its basic function during a period of relative prosperity and operated with popular support. The charter empowered BUS2 to act exclusively as the federal governments fiscal agent, hold its deposits, make inter-state transfers of federal funds and deal with Federal payments or receipts.

Like state chartered banks, BUS2 also had the right to issue banknotes on the basis of a fractional reserve system and to carry out conventional commercial banking activities, in return for which certain conduct of a central-bank-like nature was expected of this institution: in the words of the charter, “the bank will conciliate and lead the state banks in all that is necessary for the restoration of credit, public and private, and to steer the banking system toward serving the national interest”, at a time when profit might be higher in serving foreign interests.

Despite being 80% privately owned, BUS2 operations were subject to supervision by Congress and the president. BUS2 was dominant relative to all other banks, being responsible for some 20 percent of all bank lending in the national economy and accounting for 40 percent of the banknotes then in circulation. It was conservative in its note-issuing function, holding a specie reserve of 50 percent of the value of its notes while the norm for the remainder of the banking system was between 10-25 percent.

The 1820s and 1830s in the United States were a time of extremely rapid but also volatile economic growth. New natural resources were being exploited as the frontier expanded and the new techniques of the industrial revolution were being introduced. The old money supply of gold and silver specie was stretched and found inadequate for the liquidity needs of the growing economy. In 1830, the total value of the gold and silver specie in circulation in the economy amounted to one-fiftieth of the gross national product.

The emergence of a number of banks operating fractional reserve note-issuing systems was the automatic result. The private banknotes were underwritten by varying proportions of specie and although not legal tender, they were widely accepted in payment for debts, albeit usually discounted below their par value. The quality of banknotes varied. Fraud was commonplace by unscrupulous bankers who managed to persuade or bribe local state legislatures to grant them liberal charters to commence a banking business.

In 1828, the 17 banks chartered in Mississippi circulated notes with a face value of $6 million from a specie base of $303,000. The classic conflict between easy money and good money ensued, with the economic benefits of easy money regularly destroyed by bad money.

It was in such an environment that BUS2 operated. Among its functions was to discipline and support the state-chartered banks without shutting off easy money. As the federal government's fiscal agent, it received banknotes in payment for taxes. The Bank would then present these banknotes to the issuing state-chartered banks in order to redeem them for the gold necessary to pay the taxes it had collected to the federal Treasury's account.

In this way, state-chartered banks were forced to keep a higher stock of specie on reserve than would otherwise be necessary. Conversely, BUS2 could also act as a lender of last resort to state-chartered banks in trouble by not presenting these notes for redemption but rather allowing these banks to run into debt to BUS2. The state-chartered banks were institutions of economic democracy, offering credit to the masses, not just to big business. Some were named people's banks or other names of democratic or socialist connotation. They generally financed local small business, farms and homes.

The political environment of that period was marked by the populist ideology of Jacksonian democracy. Focused around Andrew Jackson, who was elected president in 1828, this ideology was an coalition of convenience among agrarianism, nationalism, populism and libertarianism. The one unifying element of this group was a deep hostility to a privileged East Coast-based moneyed aristocracy. The Philadelphia-based BUS2 with its patrician president, Nicholas Biddle, became an easy target in this new climate.

Libertarians, while sounding sensible on a small individual scale, always fail to understand that unencumbered individual liberty has no place in organizing large-scale national enterprises. Complex organizations, whether in business or government, require wholesale compromise of individual liberty.

The ideology that underlay the struggle against a national bank was highly variegated, with contradicting internal inconsistencies. It was a peculiar blend of moral judgment, economic logic and populist sentiment fused by pragmatic calculations to attack the political legitimacy of a national bank, its legality and its economic rationale.

The role played by vested interests in motivating the anti-BUS forces can also be traced to the substantial personal gains that would accrue to key members of the Jackson administration should BUS2 be discontinued. The New York financial community at the time was competing with Philadelphia to be the country's premier commercial center. Martin Van Buren, Jackson's second-term vice president and eventual successor, was particularly identified with Wall Street in this Wall Street (New York internationalist) versus Chestnut Street (Philadelphia nationalist) battle.

The state-chartered banks disliked being constrained by BUS2's practice of redeeming their banknotes with little or no notice, and with blatant arbitrariness in the selection of a target, often based on thinly disguised sectional bias. This forced a much higher bank reserve ratio and hence restricted their lending activities in geographic sections deem contrary to national priorities.

A new class of nouveau riche, self-made entrepreneurs and speculators, emerged, a class to which Jackson and many of his associates belonged. They disliked the restriction of credit generally, and credit allotment controlled by established Northeastern financiers particularly, as they relied on liberal credit from the friendly state-chartered local banks for needed funds, the way leverage-buyout financiers and corporate raiders and New Economy entrepreneurs relied on junk-bond investment bankers in the 1980s and '90s.

The New York financial community was divided over the question of the wisdom of the attack on BUS2. Some of the state-chartered banks grudgingly acknowledged BUS2's positive role in disciplining the banking system and its activities as a lender of last resort. Political ideology and economic logic also played a role behind the opposition of a national bank. The opposition had much popular support in national politics which enabled Jackson to dismantle BUS2. Like Ronald Reagan, Jackson was elected to Washington to rein in Washington.

The strongest opposition came from states-rights advocates who vehemently opposed the substantial power wielded by a federally chartered national bank. Many considered the chartering of the bank an unconstitutional extension of the power of Congress, particularly when, in their judgment, the first national bank had failed to serve the national interest without sectional bias and had pandered to sectional interests around the northeastern seaboard. This position was summarized by Jackson, who described BUS2 bank as an unconstitutional threat to democratic institutions by the federal authorities.

With the dismantlement of BUS2, the power of intervention in the banking and monetary systems was left in the hands of individual states until the Civil War. State-chartered banking systems served the separate interests of each state, which often were at odds with the national interest.

A key strand in the anti-national-bank thread was the libertarians. They challenged the legitimacy, more on moral than constitutional grounds, of any government intervention in the economy or in society beyond minimum necessity. Libertarians, while sounding sensible on a small scale, fail to understand that individual liberty to organize large-scale national enterprises is a mere fantasy. "Small is beautiful" remains merely a romantic slogan of hippiedom.

The 1800s were an age of primitive laissez-faire philosophy in the United States when domestic markets were not yet sophisticated enough to require government intervention against trade restraint in the sense that Adam Smith used the term “laissez-faire” to denote activist government action to keep markets free. This libertarian philosophy was related to and associated with the Free Banking school, which challenged on ideological grounds the necessity of government intervention in the monetary system.

Free Bankers were in favor of a paper currency based on a fractional reserve system. But they argued that BUS2's regulatory function was unnecessary and ineffective because in a completely unregulated financial system, free competition would automatically protect the public against fraud through market discipline, on the principle that fraud was basically bad for business. They argued that what was wrong with the banking system was that free competition was obstructed by the monopolistic privileges granted to BUS2 in its charter and this created an unhealthy reliance on regulatory protection rather than market self-discipline, in a form of consumer moral hazard that believed naively that if a business was regulated, consumer interest would automatically be protected.

In the context of the dominant economic paradigm of the 1830s, the importance of the central government’s role in regulating the money supply was not as self-evident as is today. And for the Western frontiersman, his love of individual liberty exposed him to easy victimization by organized finance from the East.

Economist Joseph A Schumpeter (1883-1950) observed that in the first part of the 19th century, mainstream economists believed in the merit of a privately provided and competitively supplied currency. Adam Smith differed from David Hume in advocating state non-intervention in the supply of money. Smith argued that a convertible paper money could not be issued to excess by privately owned banks in a competitive banking environment, under which the Quantity Theory of Money is a mere fantasy and the Real Bills doctrine was reality. Smith never acknowledged or understood the business cycle of boom and bust.

The anti-monopolistic and anti-regulatory Free Banking School found support in agrarian and proletarian mistrust of big banks and paper money. This mistrust was reinforced by evidence of widespread fraud in the banking system, which appeared proportional to the size of the institution. Paper money was increasingly viewed as a tool used by unconscionable employers and greedy financiers to trick working men and farmers out of what was due to them. A similar attitude of distrust is currently on the rise as a result of massive and pervasive corporate and financial fraud in the so-called New Economy fueled by structured finance in the under-regulated financial markets of the 1990s, though not focused on paper money as such, but on derivatives, which is paperless virtue money.

Andrew Jackson in his farewell speech addressed the paper-money system and its natural association with monopoly and special privilege, the way Dwight D Eisenhower warned a paranoid nation against the threat of a military-industrial complex. The value of paper, Jackson stated, is liable to great and sudden fluctuations and cannot be relied upon to keep the medium of exchange uniform in amount.

In contrast to the Free Banking School, the anti-paper specie-currency zealots aimed at abolishing the system of fractional reserve paper money by removing the lender of last resort. They were further split into gold bugs, silver bugs and bimetalists.

Both advocates of the Free Banking School and proponents of specie currency saw the dismantling of the bank as very fundamental, but to divergent and conflicting ends. Against this coalition, supporters of a national bank, such as BUS2 president Nicholas Biddle and politicians such as Henry Clay and John Quincy Adams, faced a political dilemma. Both anti-federalist and primitive laissez-faire sentiments were in ascendancy at the time. The BUS2 was being attacked from both the extreme left (Free Banking advocates) and from the extreme right (anti-paper advocates).

The monetary expansion that preceded and led to the recession of 1834-37 did not come from a falling bank reserve ratio but rather from the bubble effect of an inflow of silver into the United States in the early 1830s, the result of increased silver production in Mexico, and also from an increase in British investment in America. Thus a case could be made that central banking’s role in causing or preventing recessions through management of the money supply is overstated and oversimplified.

Libertarians hold the view that the state had no right to regulate any commercial transactions between consenting individuals including paper currency. Thus all legal tenders, specie or not, are government intrusions. Yet a medium of exchange based on bank liabilities and a fractional reserve system and/or government taxable capacity are essential to an industrializing economy. Instead of destroying the fractional reserve system, the hard-money advocates had merely removed a force that acted to restrain it.

After 1837, the reserve ratio of the banking system was much higher than it had been during the period of BUS2's existence. This reflected public mistrust of banks in the wake of the panic of 1837 when many banks failed. This lack of confidence in the paper-money system could have been ameliorated by central-bank liquidity, which would have required a lower reserve ratio, more availability of credit and an increase of money supply during the 1840s and 1850s. The evolution of the US banking system would have been less localized and fragmented in a way inconsistent with large industrialized economics, and the US economy would have been less dependent on foreign investment.

This did not happen because central banking was genetically disposed to favor the center against the periphery, which conflicted with democratic politics. This problem continues today with central banking in a globalized international finance architecture. It remains a truism that it is preferable to be self-employed poor than to be working poor. Thus economic centralism will be tolerated politically only if it can deliver wealth away from the center to the periphery. Central banking carries with it an institutional bias against economic nationalism.

The Jackson administration's assault on BUS2 began in 1830 and became a campaign issue for a second term. In 1832, Jackson used his presidential veto to thwart a renewed federal charter for BUS2. Jackson then used his second-term presidential election victory later that year as a mandate to order the withdrawal of all federal funds from BUS2 in 1833. When the BUS2 charter expired in 1836, the Philadelphia-based institution succeeded in being rechartered only as a much reduced state-chartered bank under the auspices of the Pennsylvania state legislature as the United States Bank of Pennsylvania. In 1841, without a lender of last resort, it went bankrupt in a liquidity squeeze speculating in the cotton market.

The dismantling of the second national bank in 1836 preserved the authority of the states over banking. Large-scale federal intervention in the supply of money did not take place again until the Civil War. However, Jackson's victory turned US political culture against centralized institutions in the banking system. The United States did not develop a central banking agency until 1913. Even then, the Federal Reserve System was highly decentralized, consisting of 12 autonomous component banks, one in each of the regional large cities. Some historians attributed the incoherent response of the monetary authorities to the 1929 crash and the resultant run on the banking system. The 1930s Great Depression was due partly to this decentralization of monetary authority. (Please see my November 16, 2002 AToL article: Critique of Central Banking: Part IIIa: The US Experience)

Central banking insulates monetary policy from national economic policy by prioritizing the preservation of the value of money over the monetary needs of a sound national economy. A global finance architecture based on universal central banking allows an often volatile foreign exchange market to operate to facilitate the instant cross-border ebb and flow of capital and debt instruments. The workings of an unregulated global financial market of both capital and debt forced central banking to prevent the application of the State Theory of Money (STM) in individual countries to use sovereign credit to finance domestic development by penalizing, with low exchange rates for their currencies, governments that run budget deficits.

STM asserts that the acceptance of government-issued legal tender, commonly known as money, is based on government's authority to levy taxes payable in money. Thus the government can and should issue as much money in the form of credit as the economy needs for sustainable growth without fear of hyperinflation. What monetary economists call the money supply is essentially the sum total of credit aggregates in the economy, structured around government credit as bellwether. Sovereign credit is the anchor of a vibrant domestic credit market so necessary for a dynamic economy.

By making STM inoperative through the tyranny of exchange rates, central banking in a globalized financial market robs individual governments of their sovereign credit prerogative and forces sovereign nations to depend on external capital and debt to finance domestic development. The deteriorating exchange value of a nation's currency then would lead to a corresponding drop in foreign direct or indirect investment (capital inflow), and a rise in interest cost for sovereign and private debts, since central banking essentially relies on interest policy to maintain the value of money. Central banking thus relies on domestic economic austerity caused by high interest rates to achieve its institutional mandate of maintaining price stability.

Such domestic economic austerity comes in the form of systemic credit crunches that cause high unemployment, bankruptcies, recessions and even total economic collapse, as in the case of Britain in 1992, the Asian financial crisis in 1997 and subsequent crises in Russia, Turkey, Brazil and Argentina. It is the economic equivalent of a blood-letting cure.

A national bank does not seek independence from the government. The independence of central banks is a euphemism for a shift from institutional loyalty to national economic well-being toward institutional loyalty to the smooth functioning of a global financial architecture. The international finance architecture at this moment in history is dominated by US dollar hegemony, which can be simply defined by the dollar's unjustified status as a global reserve currency. The operation of the current international finance architecture requires the sacrifice of local economies in a financial food chain that feeds the issuer of US dollars. It is the monetary aspect of the predatory effects of globalization.

Historically, the term "central bank" has been interchangeable with the term "national bank". In fact, the enabling act to establish the first national bank, the Bank of the United States, referred to the bank interchangeably as a central and a national bank. However, with the globalization of financial markets in recent decades, a central bank has become fundamentally different from a national bank.

The mandate of a national bank is to finance the sustainable development of the national economy, and its function aims to adjust the value of a nation's currency at a level best suited for achieving that purpose within an international regime of exchange control. On the other hand, the mandate of a modern-day central bank is to safeguard the value of a nation's currency in a globalized financial market of no or minimal exchange control, by adjusting the national economy to sustain that narrow objective, through economic recession and negative growth if necessary.

Central banking tends to define monetary policy within the narrow limits of price stability. In other words, the best monetary policy in the context of central banking is a non-discretionary money-supply target set by universal rules of price stability, unaffected by the economic needs or political considerations of individual nations. (Please see my November 6, 2002 article in AToL: Critique of Central Banking: Monetary Theology)

Why Central Banks own Gold

Central banks own gold to supplement the backing of their fiat currencies beyond that provided by their governments’ taxing authority as approved by the legislature, which in the US is the Ways and Means Committee in the House of Representatives.

Central banks choose to lease out their gold in preference to selling it for the following reasons:
1. Even though all fiat currencies are now backed by tax revenue and not by gold, central banks continue to back their fiat currencies with a fractional reserve of gold. Leasing allow central banks to continue to own gold while using the gold they own to augment the management of liquidity in money markets. Central bankers know that gold is still the ultimate store of value and ownership of gold is a good hedge against long-term fiat currency debasement. Despite loose monetary policies that all central banks have adopted in recent decades, central bankers want to have their monetary cake and eat it also by slowing the debasement of fiat currencies through gold leasing. Gold leasing helps in achieving synthetically this policy oxymoron of fiat currencies backed by fractional gold reserves.
2. While the institutional mandate of all central banks is to regulate and stabilize financial markets by monetary means, i.e. interest rate policies and quantitative measures, and not to seek profit in sale/purchase of gold and/or other precious metals to destabilize currencies, gold leasing turns an otherwise inert asset into an active instrument of monetary policy.
3. Central banks lease out their gold not because they need to earn monetary profit. In the US, all Federal Reserve net income from seigniorage revenue is turned over to the Treasury. Seigniorage is the amount of real purchasing power that the issuer of money, generally a government, can extract from the market for the use of that money.

Central banks can literally “make” money denominated in its own currency by fiat. The term “making money” has a literal meaning to central banks than it does with all other market participants who cannot legally “make” money and have to earn it. When government makes money, it enlarges the money supply. When a private entity earns money, no new money is created. It changes only the distribution of the existing money in circulation.

Fiat Currency and the Shadow Banking System

Hyman Minsky observed that whenever credit is issued, money is created. In that sense, banks can create money with a fractional reserve regime regulated by the central bank. The non-bank financial system, recently dubbed as the shadow banking system, consisting of money-creating non-depository entities, such as investment banks, hedge funds, private equity funds, mutual funds and proprietary trading desks of commercial banks active in debt securitization and structured finance (derivatives), is now twice as big as the traditional banking system. The shadow banking system can only operate with fiat money and not operate with species money backed by gold because gold, unlike fiat money, cannot be created merely by the issuance of credit. The amount of gold-backed money is limited by the amount of gold held by the issuer.

The New York Federal Reserve Bank described the growing importance of the shadow banking system as follows: “In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.” The equivalent of a sudden “bank run” on the unregulated shadow banking system contributed significantly to the freezing of the credit markets in the financial crisis of 2007–2010.

Central Banks Leases out Gold to provide Liquidity to the Market

Central banks lease out gold to provide gold-based liquidity to financial markets to stabilize the price of gold and indirectly stabilize the value of fiat currencies. As such, central banks have no incentive to allow the price of gold to rise because rising prices in gold is a market manifestation of increasing debasement of fiat currencies.

Still another purpose of central banks leasing out gold is to prevent potential market squeezes due to short-term upsurges in market demand for gold in excess of a relatively stable rate of supply, and/or the cornering of the gold market by big speculators. The continuity with which central banks lease gold to market participants at low lease rates has the effect of capping the market price of gold, a policy goal of all central banks, to stabilize the value of their respective fiat currencies.

Gold and Liquidity

One of the effects of the global financial crisis that broke out first in New York in mid 2007 was a sudden evaporation of liquidity in the financial markets even on supposedly triple-A rated assets. The Federal Reserve had to organize emergency currency swaps with other central banks to provide dollar liquidity. During the period between 2007 and 2010, the Federal Reserve entered into emergency agreements to establish temporary reciprocal currency arrangements (central bank liquidity swap lines) with a number of foreign central banks in need of help with liquidity of US dollar and of other foreign currencies.

Two types of temporary swap lines were established: US dollar liquidity lines and foreign-currency liquidity lines. These temporary arrangements expired on February 1, 2010. In May 2010, temporary dollar liquidity swap lines were re-established with some central banks, in response to the re-emergence of strains in short-term US dollar funding markets.

The Federal Reserve operates these swap lines under the authority of Section 14 of the Federal Reserve Act and in compliance with authorizations, policies, and procedures established by the Federal Open Market Committee (FOMC).

Section 14 authorizes that “any Federal Reserve Bank may, under rules and regulations prescribed by the Board of Governors of the Federal Reserve System, purchase and sell in the open market, at home or abroad, either from or to domestic or foreign banks, firms, corporations, or individuals, cable transfers and bankers’ acceptances and bills of exchange of the kinds and maturities by this Act made eligible for rediscount, with or without the endorsement of a member bank.”

Section 14 also stipulates, inter alia, that “every Federal Reserve Bank shall have power:
           (a) To deal in gold coin and bullion at home or abroad, to make loans thereon, exchange Federal reserve notes for gold, gold coin, or gold certificates, and to contract for loans of gold coin or bullion, giving therefore, when necessary, acceptable security, including the hypothecation of United States bonds or other securities which Federal Reserve Banks are authorized to hold;
           (b) 1) To buy and sell, at home or abroad, bonds and notes of the United States, bonds issued under the provisions of subsection (c) of section 4 of the Home Owners' Loan Act of 1933, as amended, and having maturities from date of purchase of not exceeding six months, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental United States, including irrigation, drainage and reclamation districts, and obligations of, or fully guaranteed as to principal and interest by, a foreign government or agency thereof, such purchases to be made in accordance with rules and regulations prescribed by the Board of Governors of the Federal Reserve System. Notwithstanding any other provision of this chapter, any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market;
           (b) 2) To buy and sell in the open market, under the direction and regulations of the Federal Open Market Committee, any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States.

Dollar Liquidity Swap Lines

In December 2007, the FOMC announced that it had authorized dollar liquidity swap lines with the European Central Bank and the Swiss National Bank to provide liquidity in US dollars to overseas markets, and subsequently authorized dollar liquidity swap lines with additional central banks. The Fed Open Market Committee (FOMC) authorized the arrangements between the Federal Reserve and each of the following central banks: the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Korea, the Banco de Mexico, the Reserve Bank of New Zealand, Norges Bank, the Monetary Authority of Singapore, Sveriges Riksbank, and the Swiss National Bank.

Those arrangements terminated on February 1, 2010. In May 2010, the FOMC announced that it had authorized dollar liquidity swap lines again with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank.

In general, these swaps involve two transactions. When a foreign central bank draws on its swap line with the Federal Reserve, the foreign central bank sells a specified amount of its currency to the Federal Reserve in exchange for dollars at the prevailing market exchange rate. The Federal Reserve holds the foreign currency in an account at the foreign central bank. The dollars that the Federal Reserve provides are deposited in an account that the foreign central bank maintains at the Federal Reserve Bank of New York.

At the same time, the Federal Reserve and the foreign central bank enter into a binding agreement for a second transaction that obligates the foreign central bank to buy back its currency on a specified future date at the same exchange rate. The second transaction unwinds the first. At the conclusion of the second transaction, the foreign central bank pays interest, at a market-based rate, to the Federal Reserve. Dollar liquidity swaps have maturities ranging from overnight to three months.

When the foreign central bank loans the dollars it obtains by drawing on its swap line to institutions in its jurisdiction, the dollars are transferred from the foreign central bank's account at the Federal Reserve to the account of the bank that the borrowing institution uses to clear its dollar transactions. The foreign central bank remains obligated to return the dollars to the Federal Reserve under the terms of the agreement, and the Federal Reserve is not a counterparty to the loan extended by the foreign central bank. The foreign central bank bears the credit risk associated with the loans it makes to institutions in its jurisdiction.

The foreign currency that the Federal Reserve acquires is an asset on the Federal Reserve’s balance sheet. Because the swap is unwound at the same exchange rate that is used in the initial draw, the dollar value of the asset is not affected by changes in the market exchange rate. The dollar funds deposited in the accounts that foreign central banks maintains at the Federal Reserve Bank of New York are a Federal Reserve liability.

Foreign-Currency Liquidity Swap Lines

In April 2009, the FOMC announced foreign-currency liquidity swap lines with the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank. These lines, which mirrored the dollar liquidity swap lines, were designed to provide the Federal Reserve with the capacity to offer liquidity to U.S. institutions in foreign currency. The foreign-currency swap lines could have supported operations by the Federal Reserve to address financial strains by providing liquidity to US institutions in sterling in amounts of up to £30 billion, in euro in amounts of up to €80 billion, in yen in amounts of up to ¥10 trillion, and in Swiss francs in amounts of up to CHF 40 billion.

The FOMC authorized these liquidity swap lines with the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank through February 1, 2010. The Federal Reserve did not draw on these swap lines.

Liquidity in the Gold Market

The irony is that gold is a liquid asset because it is a solid value benchmark. The gold market remained liquid even at the height of liquidity drought in other asset markets during the 2007-2010 financial crisis because of its relatively large size, broad diversity holding and its traditional role as a flight to quality haven. Many central banks used their gold reserves at the height of the credit crisis to finance temporary liquidity assistance to too-big-to-fail institutions in their jurisdictions.

Gold is virtually indestructible, so almost all of the gold that has ever been mined still exists, albeit some of it might have gone down to the bottom of the ocean during transit and many gold teeth might have been buried with the dead. GFMS, a precious metals consultancy specializing in research on the global gold, silver, platinum and palladium markets, estimated there were 58,500 tonnes of gold in the market in 2009, worth US$2.1 trillion at the year-end close price, or $2.7 trillion at December 2010 price.

On a dollar basis, the gold market is larger than each of the Eurozone bond markets, save Italy. It is considerably larger than the UK Gilt market, and it dwarfs smaller sovereign debt markets such as Australia and Norway that are popular with reserve managers in recent years.

The OTC Gold Market

Most gold trading takes place in the global over the counter (OTC) market centered on gold stored in London. The London Bullion Market Association (LBMA) represents bullion dealers active in the global OTC market.

London is considered by traders as the largest global center to operate OTC transactions placed in by New York, Zurich and Tokyo. Gold is also traded in the form of securities such as exchange traded funds (ETFs) which are traded on stock exchanges in London, New York, Johannesburg and Australia.

As the ETF industry grew and evolved, the product lineup has become increasingly sophisticated. Many of the products now available in the market are designed to address issues posed by earlier indexed products, as issuers strive to devise new strategies for accessing both traditional and new exotic asset classes. In the commodity space, a number of issuers have introduced products that seek to address what some perceive as an excessive impact of contango on fund returns.

Contango occurs when longer-dated futures contracts are more expensive than those that are approaching expiration; in other words, the futures curve is upward-sloping. This may be the result of a number of factors, including market expectations, costs incurred in storing the underlying commodities, or inventory levels.

Because exchange-traded commodity products do not want to take delivery of the commodities underlying each futures contracts, they must “roll” holdings on a regular basis–selling those that are approaching expiration and using the proceeds to purchase contracts that expire at some point in the future. When markets are contangoed, commodity ETFs will generally be forced to sell low and buy high, creating ongoing headwinds that must be overcome just to break even.

When the “roll yield” is incurred on a regular basis, the gap between a fund’s return and the hypothetical return on spot prices can become significant. As the commodity market has eveolved, a number of strategies designed to mitigate the undesirable effects of contango have been developed:

1) Maintaining Spot Exposure

The simplest and most effective way to eliminate the effects of contango is to invest in the spot commodity. Because the underlying assets of physically-backed ETFs are the actual commodity, the net asset value (NAV) of these funds should always move in lock-step with the spot market price. The returns will be the same as if the investor had bought and stored the commodity, minus expenses.

The problem, of course, is that not all natural resources lend themselves to the physically-backed ETF structure.

ETF Database (ETFdb), a data provider, is an authoritative source of information used by ETF investors. ETF Database has allocated each of the US-listed exchange-traded products to one of approximately 70 “best-fit” ETFdb Categories.

The mapping between an ETF and ETFdb Category utilizes a “1:1” methodology; each ETF is assigned to one and only one ETFdb Category. When a new ETF is launched, ETF Database staff reviews the fund’s stated objective, underlying index, and constituent holdings to determine the most appropriate ETFdb Category. The mapping between ETFs and ETFdb Categories is reviewed on an annual basis.

Each ETFdb Category is grouped by asset class: Bond/fixed income; Commodity; Currency; Diversify Portfolio; Equity; Exotic; Inverse; Leverage; and Real Estate.

The Precious Metals ETFdb Category contains 18 ETFs with a total market capitalization of approximately $78.7 billion (as of December 14, 2010).

The following are the three largest ETFs in this ETFdb Category by market capitalization as of December 14, 2010:

Ticker	ETF	Market Cap
GLD	State Street SPDR Gold Trust	$57.8 billion
SLV	iShares Silver Trust	$10.4 billion
IAU	iShares COMEX Gold Trust	$4.8 billion

As of December 14, 2010, the only US-listed ETFs that invest in physical commodities are those in the Precious Metals ETFdb Category.
Please note that the list may not contain newly issued ETFs. Gold ETFs are listed in order of descending total market capitalization.

Symbol	Name	Close	Change	Market Cap*	Avg Volume	YTD	200 EMA**
GLD	SPDR Gold Shares	$136.18	-1.09%	$57,072.39	16,239,400	25.52%	$122.70
IAU	iShares Gold Trust	$13.63	-0.97%	$4,813.43	3,706,420	-87.43%	$41.79
PHYS	Sprott Physical Gold Tr	$12.29	-1.30%	$1,177.20	1,103,630	26.49%	$11.40
SGOL	ETFS Physical Swiss Gold Share	$138.80	-0.92%	$1,134.54	137,189	25.69%	$125.29
DGL	PowerShares DB Gold	$49.33	-0.99%	$322.34	63,821	24.53%	$44.59

* Market Cap is shown in millions of dollars.
** The 200 Exponential Moving Average (200 EMA) is one of the most popular technical analysis indicators amongst forex traders.

The high value-to-weight ratio of gold, silver, platinum and palladium–as well as the physical properties of these metals make creating a fund that offers spot exposure is straight forward. But for low value-to-weight commodities, such as many industrial metals, the costs of storage may become significant. And for many agricultural commodities, inevitable spoilage makes a physically-backed structure impractical (though constructing a physically-backed livestock ETF would be quite entertaining).

The first physically-backed industrial metal ETFs recently began trading in Europe and multiple firms have filed for approval of physically-backed copper ETFs in the US, meaning that options in this corner of the market could increase in the near future. In the meantime, there are a handful of other options for fighting contango:

2) Spreading Out Exposure

Because the “roll yield” associated with contango is incurred when exchange-traded funds must sell underlying holdings approaching expiration, it makes sense that those funds with the greatest turnover will generally feel the greatest impact of contango. Conversely, those that roll their holdings less frequently can potentially dampen the adverse impact.

The trade-off from this approach comes in the sensitivity to changes in spot prices. In general longer-dated futures contracts will be less sensitive to changes in spot commodity markets, meaning that funds that spread exposure beyond front-month futures will lag spot when prices are rising [see Natural Gas ETFs: Investing in the Fuel of the Future].

There are two primary approaches to spreading futures contract holdings over multiple months:

2)a. 12-Month Approach: There are a couple commodity ETFs that spread exposure across 12 different maturities, starting with the next-to-expire and including each of the next 11 contracts. These include cousins of the ultra-popular UNG and USO, the United States 12-Month Natural Gas Fund (UNL) and United States 12-Month Oil Fund (USL). These funds roll only a fraction of their holdings every month, limiting turnover relative to funds that swap out their entire asset base 12 times each year.
This might seem like a light shift, but the impact on returns can be significant; since its launch in 2007, USL has beaten USO by more than 25%:

2)b. Teucrium Approach: Oil and natural gas futures are unique in that there are contracts expiring each month. For most commodities, futures expire four or five times a year, meaning that balancing exposure across 12 different maturities would require significant holdings in some very long-dated contracts, which can be illiquid.
Teucrium utilizes a modified version of this approach for its Corn Fund (CORN), splitting exposure between the second-to-expire CBOT Corn Futures Contract (35%), the third-to-expire CBOT Corn Futures Contract (30%), and the CBOT Corn Futures Contract expiring in the December following the expiration month of the third-to-expire contract (35%)
CORN is the only product on the market now that implements this strategy, but the company has filed for a number of additional commodity products that could hit the market sometime in 2011.

3) Optimum Yield

In addition to the options presented above, the commodity products offered by PowerShares and Deutsche Bank take a unique approach to minimizing the adverse impact of contango on fund returns. Many of the commodity products offered by this partnership are linked to “Optimum Yield” versions of Deutsche Bank indexes, which are designed to minimize the negative effects of rolling futures contracts when a market is in contango and maximize the benefits of rolling when markets are in backwardation.
This approach has more flexibility than those outlined above, as the composition of the index is determined based on observable price signals and a proprietary methodology. For example, the PowerShares DB Commodity Index Fund (DBC), which seeks to replicate the Deutsche Bank Liquid Commodity Index — Optimum Yield Diversified Excess Return, recently included Brent Crude contracts expiring in January, zinc contracts expiring in May, and silver futures expiring next December.
In addition to the broad-based DBC, there are a handful of resource-specific funds linked to Optimum Yield versions of commodity indexes [see Under the Hood of Optimum Yield Commodity ETFs].

DGL Tracks This Index: Deutsche Bank Liquid Commodity Index-Optimum Yield Gold Excess Return
Description: The Index is a rules-based index composed of futures contracts on gold and is intended to reflect the performance of gold.

4) “Contango Killer” ETF

One of the most innovative products to hit the market this year is the United States Commodity Index Fund (USCI), which has been described as both a “contango killer” and a “third generation” commodity ETF. USCI isn’t actively managed, but rather seeks to replicate the performance of a commodity benchmark that rebalances monthly based on various pricing factors.
The composition of the underlying index is basically determined based on two criteria. First, from a universe of 27 potential components, the seven exhibiting the steepest backwardation or most moderate contango are selected for inclusion. The remaining commodities are then ranked by price increase over the past year, regardless of whether the related futures market is backwardated or contangoed. The seven commodities with the best performance over the last year are included to round out the index. The manner in which this strategy softens contango should be obvious, though it is worth noting that the “momentum screen” may allow for inclusion of commodities for which the futures curve slopes upward.

ETFS Physical Swiss Gold Shares (SGOL)
Most investors looking to gain exposure to gold prices through ETFs settle on the SPDR Gold Trust (GLD) unaware that a similar product from ETF Securities offers identical exposure at a lower cost. In addition to the almost negligible cost gap (0.39% vs. 0.40%), this fund sets itself apart from GLD by offering geographic diversification: SGOL stores its gold bars in secure vaults in Switzerland. A repeat of the gold confiscation of 1933 is unlikely, but for those investors overcome with paranoia (many gold bugs are), this peace of mind might be worth the lack of additional cost.

By size and trading volume, SGOL pales in comparison to the gold SPDR. But with assets of more than $300 million and average daily volume of more than 150,000 shares, SGOL offers plenty of liquidity for almost any investor.

The idea behind the fund is not that backwardation leads to strong performance, but rather that tight physical inventories are often associated with price appreciation. Based on thorough research done by a team that includes Yale professors K. Geert Rouwenhorst and Gary Gorton, there is evidence to suggest that the slope of the futures curve can provide some insights into inventory levels. The theory of storage states that when inventories are low, users of commodities may be willing to pay a premium for owning a spot commodity relative to futures prices in order to avoid facing a ‘stock out.’ A building cannot be heated with futures on heating oil. So when inventories are low, buyers are willing to pay a premium to own spot heating oil to avoid the risk of running out. This premium is sometimes called the convenience yield, and can lead to a backwardated futures curve. [See Closer Look at the Contango Killer ETF].

USCI is relatively new, so it is perhaps too early to declare it as a superior means of accessing commodities. But the early returns have certainly been impressive; since debuting in August, USCI has gained about 21%. Over the same period, the aforementioned DBC (which has more than $5 billion in assets) has gained a more modest 14%.

December 23, 2010

Next: The London Gold Market