Gold sales by central banks were back in the news this past year. The Dutch central bank announced plans to sell 300 tons, thus reducing its total holdings to 752 tons. Britain has greatly reduced its holdings, following in the footsteps of Australia, which did the same a few years ago. Canada has been reducing its stockpile for some time, as have many other countries.
Most, if not all, of the countries that recently sold part of their gold holdings have placed the proceeds into U.S. interest-bearing notes. The U.S. has not sold any of its gold, and is estimated to hold about 200 million oz. of the yellow metal. However, the value of this gold stockpile (an estimated US$20 billion) pales in comparison with the U.S. dollars floating all over the world.
Why is the world holding U.S. dollars and American dollar instruments? Because, unlike gold, they earn interest. Also, the U.S. dollar can be used to purchase goods anywhere. The Asian crisis and currency weakness in other parts of the world have made the greenback the de facto currency of the world. The general view now is that gold and U.S. dollars are interchangeable, and everyone expects that they will continue to be.
Politicians and bureaucrats are claiming that gold’s role as a storehouse of value has diminished, and that this function has been replaced by the strong U.S. dollar. But what happens if the American dollar weakens? What if there is a recession, or a depression? Where will people put their money then?
When the world was on the gold standard, every country was limited in the amount of paper money it could print, since each country was expected to have gold to back its currency. Thus, the more paper money a country printed, and the less gold it had to back it up, the lower the value that currency had when compared with other gold-back currencies. Those days are gone.
Gold demand has remained strong in spite of the selling by central banks; prices, however, remain weak. Why hasn’t the price of gold gone up or at least remained stable over the past few years? One reason is low inflation. Another is speculation. Central banks, which traditionally have held tons of gold as currency reserves — while seeing that value going up and down as the price of gold varied — became sympathetic to the idea of lending gold to speculators at low rates. This allowed them to get a return, however modest.
The speculators would borrow the gold and sell it at the current price, hoping that huge sales would weaken the price. They bought the gold back at a lower price, returned the borrowed gold to the central bank, and kept the difference as profits.
With the price of gold dropping as more and more speculators borrowed and sold gold, producers of the yellow metal worried that falling prices would put them out of business. They found that they could protect themselves by selling their gold forward, and that’s exactly what they did.
A producer would sell future production to a dealer for delivery at some later date. The dealer would then borrow the gold bought for future delivery from a central bank, or other source, sell it in the market and pay the producer. When the producer makes the gold available, as promised, to the dealer, the dealer pays back the quantity of gold he originally borrowed. In the meantime, he has earned interest from the money he originally received when he first sold the borrowed gold. And if, after paying the producer for his future gold production and returning the gold he borrowed, he has some money left from the interest he has earned, this constitutes his profit.
And that’s where we are today. Central banks are busy selling part of their holdings in the belief that they need much less to protect their currency. They are also worried that their remaining holdings will decrease in value if the price continues to drop. Of course, they ignore their own role in the weak prices, and rely more and more on paper currencies.
Gold is likely to return to being a storehouse of value in the event of a loss of confidence in the U.S. dollar. What could set off such a crisis? An economic slowdown in the U.S (remember, American goods are becoming costly to produce), a return of inflation, or even rumours that there are millions of top-quality counterfeit American dollars floating around the world.
Having faith in just one financial instrument — the U.S. dollar — may not be prudent, as there are too many variables subject to manipulation, both by individuals and governments.
Gold offers cheap protection from uncertainty. At today’s prices, peace of mind doesn’t come cheaper.
— The author is a retired economist and stockbroker based in Gloucester, Ont.
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