Development Through Wage-Led Growth
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
Part VI: The London Gold Market
Part VII: Weak Political Response to Ineffective Financial Regulation

Part VIII: Gold and Fiat Currencies
This article appeared in AToL on February 11, 2010.

The continuous upward trend in gold price in 2010 can be partially explained by market response to post-crisis economic conditions created by reactively loose monetary policy developments and aggressive market intervening measures by both the central bank and the Treasury in the US. This approach was duplicated in varying degrees by many other governments in the Group of Twenty (G20).
While both the Obama administration and the supposedly independent Federal Reserve argue forcefully that quantitative easing was an unavoidable emergency measure to prevent a pending total meltdown of the financial market, the equally unavoidable consequent post-crisis stagflation for up to a decade is reluctantly acknowledged by all.
Gold remains a safe haven asset much sought after by investors in a market increasingly sensitive to deliberate and consequential fiat currency debasement by central banks through quantitative easing (QE), a term that describes the process of central bank injecting money into the market by buying debt from distressed financial institutions with money the central bank creates ex nihilo (out of nothing), resulting in an expansion of the central bank’s balance sheet. This was evidenced by sustained net inflows of funds into all sorts of gold-based investment vehicles.
Bernanke Asserts the Fed Did Not Practice Quantitative Easing
However, in the Stamp Lecture at London School of Economics on January 13, 2009, Federal Reserve Chairman Bernanke, about three years into office, asserted that the Fed’s approach to supporting credit markets during the financial crisis was conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. The Fed’s approach–which Bernanke suggested could be described as “credit easing”–resembles quantitative easing in only one respect: Both approaches involve an expansion of the liability side of central bank balance sheet without adding balancing assets.
Accordingly, Bernanke asserts that in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank’s balance sheet is merely incidental. The implication is that the balance sheet can stay unbalanced due the fact that the asset side is a phantom number the underlying basis of which is the central bank’s newly-created money. Nevertheless, QE is now the term generally used in the financial press to describe Fed “credit easing” monetary measures taken during the current financial crisis. The Fed’s past, current and future stimulus monetary measures are popularly referred to as QE1, QE2, QE3 … etc.
Gold and Sovereign Credit Crisis in Euroland
Sovereign credit woes in Euroland resulting from market concerns about the public finance crises faced by Eurozone member states in the final years of the first decade of the 21st century negatively impacted market outlook for the euro and the pound sterling. This development has made the already much impaired dollar appear as not the only bad choice as a reliable store of value.

Consequently, many investors, affected by Pavlovian conditioned reflex, sought out gold as an alternative to fiat currencies. This herd behavior trend is evidenced by large consumer purchase of coins and small bars in retail markets around the globe. Similarly, the gold exchange traded funds (ETFs) sector experienced consistently strong inflows of funds all through 2010, adding in aggregate over 270 tonnes of gold by Q2 to assets under management by ETFs.
Furthermore, net long positions on gold futures contracts, which are a proxy for the more speculative end of investment demand, also returned to high levels close to those seen during Q4 2009. Conventional wisdom suggests that longs on gold are essentially shorts on fiat currencies even though in reality, the simplistic correlation does not always hold.
On the other hand, jewelry consumption in the advanced economies was hit by record high gold prices and by an increase in volatility toward the end of 2010. Retail gold jewelry prices simply could not rise as fast as commodity gold prices without adversely affecting consumer sales. While retail gold jewelry merchants saw appreciation in their gold inventories, they were actually losing money on every gold ring they sold from their inventories if cost to restock at some future time were taken into account, unless they were protected by hedges. Yet if retail gold jewelry merchants raised the retail price of their gold jewelry, they would suffer sharp drops in sale in a consumer market already hit by a protracted severe recession and would suffer financial loss from not having enough sale volume to cover fixed overhead cost.
However gold jewelry demand from emerging markets such as India and the Middle East remained strong in 2010, relative to falling consumption levels experienced in 2009 in the advanced economies. Moreover, solid economic growth at near double-digits in China, the biggest emerging market, has been positive for gold consumption there.
The price of commodity gold reached new highs not only in dollar terms, but also in term of all other fiat currencies, especially those in Europe where government fiscal austerity measures to resolve noxious public finance has created a gloomy economic outlook and a negative market view on the euro. In early Q2, 2010, many other fiat currencies around the globe not only fell against the benchmark dollar but also experienced abnormally higher levels of volatility.
Gold Prices in Different Fiat Currencies
Consequently, since currencies did not depreciate in locked steps, gold prices in Q2, 2010, rose by 11.5% in dollar terms, 23.1% in euro terms, while rising 13.2% in sterling and 14.3% in Swiss francs, reflecting the relative strength of the currencies. Both the Canadian and Australian dollars did not fare much better as lower commodity prices impacted those two natural resource producing economies, with gold having seen a price increase of 16.6% and 20.9% in those local currency terms respectively. At the other end of the spectrum, gold posted its lowest quarterly return of 5.7% in Japan, where the yen appreciated substantially versus a range of other currencies, including the benchmark dollar. In Q1 2010, both the dollar and the DJIA out-performed gold, which ended the quarter at $1,115.50 per troy ounce.
Gold Bubble
Gold price performed strongly during Q3 2010, ending the quarter at US$1,307.00 per troy ounce on the London PM fix, compared with US$1,244.00 at the end of Q2 2010 and $1,115.50 at the end of Q1 2010. This represented an increase of 5.1% in gold price in US dollar terms between Q2 and Q3, in line with its quarterly average gain over the past 5 years which, in turn, reinforces the view held by some that gold’s appreciation appears steady and measured and does not exhibit the same statistical characteristics observed in previous asset bubbles.
Indeed, the upward move in gold price during Q3 2010 was more modest, rising by $30.01 per troy ounces (2.5%) to $1,226.75, from $1,196.74 in Q2, due to a pullback in gold price in the early part of the quarter. Gold price had fallen to $1,157.00 per troy ounce on the London PM fix by July 28, before beginning a steady rise that lasted throughout the rest of Q3. Gold price broke through previous highs, breaching the $1,300.00 per troy ounce level for the first time on September 29, 2010.
This bullish trend continued through the rest of 2010 with gold price reaching as high as $1,432.50 per ounce during intraday trading on December 7.  However, every time gold rose above $1,400, substantial profit-taking prevented it from going higher. Gold ended 2010 at $1,414.50 per troy ounce. Goldman Sachs has told clients to expect gold to top in 2012, peaking at $1,750 per troy ounce, while Jon Nadler, senior analyst at, said gold could continue rallying in 2011, but would peak by the end of the year.
Price Effects on Supply of and Demand for Gold
When gold price rises in dollars terms, all other fiat currencies depreciates against gold in proportion to their exchange rate to dollars. On the other hand, while falling gold prices lead to higher physical demand for gold in the consumer market, lower gold prices depress mining output as marginal mines are shut down. As the gold demand/supply gap widens against supply, central banks can help fill the widening supply gap with easy-rate gold leasing to keep the market price of gold from rising too fast, or in a reverse scenarios of an imbalanced gap against demand, to raise gold leasing rates to slow the flow of gold into the market to keep the market price of gold from falling too fast.
The bullion banks borrow gold from central banks in hope of selling it in the market for cash profit in dollars, by buying back the gold later at lower prices to return the borrowed gold to the central banks. However, while central banks continue to hold legal title to their gold that has been leased out to the market, the physical gold is not expected to come back to them because of the standard practice of continuous rollover of gold leasing contracts.

Marked to Market Profit of Gold Borrowers

In addition to the already-booked arbitrage on interest rate/gold lease rate differential, borrowers of gold were all sitting on huge “marked to market” virtual profits as the gold they had borrowed earlier and sold at higher value could then be bought back at lower prices at the end of their leases, at below $300 per troy ounce in 1985 and 1989, and again at the all-time-low of $250 per troy ounce in late 1999.
The quandary of this virtual profit was that if central banks should demand actual physical delivery of all their leased gold at the maturity of their leases, there might not be enough physical gold in the market to meet delivery requirements of astronomical notional values. Under such conditions, a buying frenzy to acquire physical gold for delivery would be set off, driving up gold prices to astronomical ranges to accelerate the debasement of fiat currencies against gold.
Central Bank’s Need to roll over Gold Leases
For all maturing gold leases to be settled with physical delivery, either future mining output would have to vastly exceed anticipated future demand and/or some central banks must sell their gold holdings to make more gold available for delivery back to them. To slow down the rise of the market price of gold, some central banks may have to sell their gold in order to provide enough gold to bullion banks to cover physical delivery back to central banks to close out maturing gold leases from central banks. But the penalty would be that central banks, as sellers of gold, could put themselves in danger of suffering huge capital loss when they need to replenish their gold reserve if gold prices continue to rise over time in a secular bull market for gold. The advantage gained by central banks from rising gold price does not cover the disadvantage of the resultant debasement of their fiat currencies.
To avoid financial loss from gold leasing, central banks would have to keep selling gold in massive amounts in order to shift in gold option markets from contago (prices in future higher than spot) to produce backwardation (price in future lower than spot price). Further, a massive selling of gold for dollars by central banks will shrink the money supply to cause recessionary monetary cycles in the economy. It would negate the very intended stimulus effects from central bank measures of quantitative easing, without countervailing benefits.
Under such backwardation conditions, leasing out gold for central banks would risk a net transaction loss despite lease income because gold price would have declined when it is time for the leased gold to be returned to the central banks, and a capital loss would show up in the central banks’ balance sheets. Systemically, backwardation causes economic recessions because it increases preference for liquidity on the part of market participants waiting for still lower asset prices, and therefore creates a liquidity drought in the market. Thus there is an unspoken agreement among central banks to continuingly rollover their gold leases rather than demanding the return of their gold physically as leases mature. The whole process is virtual, based on a notional amount of gold since physical gold had not been delivered at the beginning of gold leases.
A gold leasing market not constrained by physical delivery either at the commencement or maturity allows central banks to lease gold unconstrained by the physical gold they actually own. Gold leasing then operates as a derivative sector in which the underlying amount of gold is only a notional value. With central banks not required to disclose the amount of gold they actually hold, there is strong incentive for central banks to lease out more gold than they actually physically own.
Central Bank Response to Market Effects of Volatile Gold Prices

For future production from gold mines to exceed future market demand for gold, the price of gold must go up from previous levels and stay up with little price volatility for a long time because gold mining is an industry that cannot be started or wound down quickly. But rising gold price would bankrupt the big bullion banks (who are big borrowers of gold that needs to be returned later at higher prices, even virtually) to create a chain of credit defaults in the gold market. While central banks cannot go bankrupt from liabilities denominated in their own currencies, they face insolvency risk in their gold transactions unless the loss is denominated in the central bank's own currency.
Central banks became aware of this danger and started to sell their gold reserves when gold prices rose between 1985 and 1987, again between 1989 and 1996, and since July 1999, to bail out some too-big-to-fail, so-called systemically critical market players who had been shorting gold. The Bank of England sold part of its gold reserves to keep the price of gold from rising too much in order to protect some big bullion banks that were big players in the London gold market. Other central banks also sold their gold reserves when the price of gold started shooting upward during these periods.

It is an institutional mandate of all central banks to correct imbalances in the financial markets and in the economy through a balanced monetary policy of money supply elasticity to support sustainable economic growth without inflation. Yet central bank actions in the gold market during the last three decades had added to the explosive imbalances in both the financial markets and the economy.
In the past, the gold demand/supply gap had widened in favor of demand when the price of gold was falling, until all the gold available for lease and/or sale had been gobbled up by retail consumers, institutional investors and hedge funds. At that point would begin the mother of all short squeezes, which occur when a short fall in supply and an excess demand for gold would force the price of gold upward. When that happened, central banks had intervened to keep the price of gold from rising.
The day will come when not even the combined market power of the solid central banks of the G7 rich member states of the G-20 would be able to bail out distressed bullion banks and/or other systemically important market participants caught massively short on gold in a gold bubble.
Central Banks Can Produce Fiat Money, but Not Gold
The Fed has recently demonstrated to the market that in addition to keeping Fed funds rate at near zero for almost three years after the credit crisis began in mid 2007, it could also create money ex nihilo and deliver the new money to distressed institutions in the market through quantitative easing (buying long-term debts) to keep down long-term interest rates, and to try to push liquidity on the impaired market to help bring about economic recovering.\.
However, to bail out any systemically important party shorting gold, the Fed would need gold, which the Fed cannot create ex nihilo (out of thin air) like it could with fiat currency, and must buy gold from the market, thus pushing up the price of gold further, and making the task of bailing out too-big-to-fail distressed parties shorting gold more costly. It is unclear how much of the credit crisis that started in July 2007 was exacerbated by gold short squeezes since the overwhelming size of the debt securitization market was the obvious catalyst. But gold short squeeze was undeniably a contributing factor.
Central Banks Create Gold Market Imbalances
The evidence that central banks created gold market imbalances surfaced when these systemic “lenders of last resort” were forced to continue to sell gold when gold price was at 20-year lows in 1999, at a time when the physical demand in the market was far in excess of the concurrent output from mines. The US Federal Reserved, head of the global central banks snake, sold gold after the 1997 Asian Financial Crises contagion hit the New York stock markets, as part of the massive monetary easing by Fed Chairman Alan Greenspan to provide liquidity to the market.
The artificial increase in aggregate demand in the US economy was clearly a consequence of the Fed’s loose monetary response to a series of foreign and domestic financial crises beginning with the Asian crisis in 1997, sustained by the collapse of Long Term Capital Management and the Russian default in 1998, and ending with the Brazilian devaluation and the anticipated Y2K crisis in 1999. The Fed’s easy money policy led to a bubble in aggregate demand that was nearly synchronous with the equity bubble, and Fed tightening to deflate the demand bubble contributed to the sharp reduction in equity prices and the shallow recession of 2001.
Chinese consumer demand for gold at every Spring Festival around February is massive. Similarly, Indian consumer demand for gold also rises with festive points in the Indian calendar. Keynes reportedly described Indian gold consumption as reflecting the “ruinous love of a barbaric relic.”  But gold, instead of rising in price, fell to a historical low of $250 per troy ounce in late 1999, two year after the 1997 Asian Financial Crises, and the year that Fed Chairman Alan Greenspan injected massive liquidity into the US financial market to ward off contagion from Asia. (Please see my July 29, 2010 article: Financial Globalization and Recurring Financial Crises)
For the 18 years (August 11, 1987 to January 31, 2006) of his tenure as chairman of the Federal Reserve, Alan Greenspan repeatedly bought off the collapse of one debt bubble his monetary policy had created, with a bigger debt bubble funded by more monetary easing. During that 18-year period, inflation was under 2% in only two years: 1998 and 2002, both times not brought about by Fed policy.
Paul Volcker, who served as Fed chairman from August 1979 to August 1987, had to raise both the Fed funds rate and the discount to 20% to fight hyperinflation of 18% in 1980 back down to 3.66% in 1987, the year Greenspan took over the Fed just before the October 1987 crash, when inflation rose to 4.53%.
Gold Price and Inflation and Interest Rates
Under Greenspan’s market-accommodative monetary policy, US inflation rate reached 4.42% in 1988 when gold’s cumulative average price for the year was $436.98 per troy ounce.
In 1989, inflation rate rose to 5.36% when gold fell to $381.40. In 1990, inflation rate rose still higher to 6.29% when gold price remained low at $384.51.
The inflation rate was then moderated to 1.55% by the 1997 Asian financial crisis, when Asian exporting economies devalued their currencies to lower their export prices, and gold price fell still lower to $331.02 for the year.
When Greenspan allowed US inflation rate to rise back to 3.76% by 2000, gold was traded at $379.11.
In 2001, the Fed funds rate hit a low of 1.75% when inflation hit 3.76%, and gold fell to $271.04. In 2004, the Fed funds rate hit 1% when inflation was lower only slightly to 3.52%, and gold was up at $409.72.
In 2005, the Fed funds rate hit 2.5% when inflation rose to 4.69%, and gold rose higher to $444.74. 
The cumulative average price of gold to date was $1,420 for 2011.
Gold hit its all time low of $252.84 on July 20, 1999 and its all-time high to date at $1,420.00 on December 6, 2010. From these historical data, one can see that the price of gold is mostly driven by technical market forces and not by fundamentals.
For the 18 years of Greenspan’s tenure at the Fed, US real interest rate was mostly negative after inflation. Factoring in the falling exchange value of the dollar, the Fed was in effect paying US transnational corporate borrowers to invest in non-dollar markets, and paying US financial institutions to profit from dollar carry trade, i.e., borrowing dollars at negative rates to speculate in assets denominated in other currencies with high yields.
In recent years, the US has been allowing the dollar to fall in exchange value to moderate the adverse effect of high indebtedness on the economy and using depressed wages, both domestic and foreign, to moderate US inflationary pressure. This trend went on for almost three decades, but it is not sustainable because other governments responded by intervening in the foreign exchange market to keep their own currencies from appreciating against the dollar to remain competitive in global trade. The net result will be a moderating of drastic changes in the exchange rate regime but not a halt of dollar depreciation.
Global Devaluation of Fiat Currencies Agianst Gold
What has happened is a global devaluation of all fiat currencies against gold, with the dollar as the lead sinking anchor in terms of purchasing power. The sharp rise of prices for assets and commodities around the world has been caused by the sinking of the purchasing power of all currencies. This is a trend that will end eventually in hyperinflation while the exchange rate regime remains operational, particularly if central banks continue to follow a coordinated policy of holding up inflated asset and commodities prices globally with loose monetary policies, i.e., releasing more liquidity every time markets face imminent corrections.
Keynesian View on Gold
Keynesian economics viewed demand for gold beyond personal consumption as a sign of socio-economic backwardness that creates an inverse relationship of market demand for gold to economic progress. Gold as money distorts the very economic function of modern money in a market economy because a rise in market preference for gold is in essence a pathological distrust in the fiat money monetary system of modern time.
Stability of Gold
While gold is fungible and indestructible, its real stability as a monetary metal lays in the fact that it cannot be created by government fiat. This fact denies gold the elasticity required for a responsive monetary system of the modern financial economy.
However, gold leasing by central banks has provided a way for governments to create a synthetic supply of gold to give this monetary metal a measure of elasticity, albeit a cumbersome one.
Gold as Fiat Currency Substitute
Thus gold as currency robs government of one of its most important authority and function: the provision of a properly elastic monetary system to serve economic growth and security. Yet with an adequately elastic and responsive money supply, the gold market turns gold into a fiat currency substitute by using gold synthetically, detached from actual inventory, as a notional value in derivative structured finance. The need for gold as a monetary substitute for fiat currency increases only with the decline in market confidence in fiat currency issued by government. Yet gold derivatives undermine the safe haven characteristics of gold itself.
Further, gold possesses only limited palliative power against loss of market confidence in a diseased fiat currency. On the contrary, it makes a diseased fiat currency tolerable by providing market participants with an economically inert or even counterproductive hedge against fiat currency debasement.
Gold and Wealth
Gold quantitatively increases wealth, but only if the increased quantity does not affect its rarity. That is what distinguishes gold from fiat currency. Quantitative increases in fiat currency supply, unlike gold, do not increase wealth, only the illusion of wealth through price inflation. As the price of gold rises, wealth has not been increased by it, only the diseased fiat currency has declined further in real value.
The discovery of gold in the New World created gold inflation in Europe in the 17th and 19th centuries that transformed the European socioeconomic structure from feudal agricultural to bourgeois financial. Gold hedges weaken systemic incentive to restore impaired monetary health by re-stabilizing fiat currency. However, a mild inflation caused by a controlled increase in the supply of fiat currency can be economically stimulus to increase wealth by expanding the economy. Monetarists think a steady 3% annual expansion of the money supply is optimally constructive economically.

But a quantitative increase in gold creates wealth only if the demand for gold remains undiluted. Yet, ceteris paribus, a quantitative increase in gold weakens demand for gold because the appeal of gold is based on its rarity. Therein lays the inherent limit of gold as a store of value.
The Decades of Bearish Gold Market
Many traders in the early 2000s were convinced, wrongly, that gold had lost its function as a reserve asset, as sentiment among gold investors turned bearish. They thought that the demand for gold both as a consumer commodity and as a store of value was dwindling in the brave new market of synthetic security.
The two decades between 1982 and 2002 were bear markets for gold, bottoming at $250 per troy ounce in 1999, despite the loose money monetary policy of the Federal Reserve under Alan Greenspan.  Gold started to climb steadily after 2000 to hit the all time high of $1,420.00 on December 6, 2010, mostly to reflect blatant currency debasement policies adopted by central banks to keep a debt-infested financial system from total collapse. Inflation destroys wealth by deflating the value of outstanding debt. Inflation does not make the debtor richer, only the creditor poorer.
February 7, 2010
Next: International Gold Agreements - Historical Political Context