Dow Jones story quotes GATA chairman

9:05p EDT Wednesday, October 13, 1999

Dear Friend of GATA and Gold:

Here is another brilliant essay by Reginald Howe,
Harvard-trained lawyer, financial analyst, and former
mining company executive. I think it belongs in the
same rank as the recent prophetic essay by John
Hathaway of Tocqueville Asset Management, quot;The
Golden Pyramid.quot;

Howe easily beats 99 percent of the people writing
about economics and investment. You can review his
other essays at www.goldensextant.com, from which I
copied this one.

Please post this as seems useful.

CHRIS POWELL, Secretary
Gold Anti-Trust Action Committee Inc.

* * *

Real Gold, Paper Gold, and Fool's Gold:
The Pathology of Inflation

By Reginald Howe
www.goldensextant.com

October 10, 1999

There was a time when, as someone recently said,
everybody and his cat knew the difference between real
gold and paper gold. But today's kool cats, if they own
gold at all (which few do), are too smart to pay
storage or insurance on allocated gold, too
sophisticated to tie up funds in stodgy old coins or
bullion bars with no yield, and too greedy to forswear
the allure of maximum leverage.

On the other hand, gold investors know gold first and
foremost as a portfolio anchor to windward, a shelter
in a monetary storm.

Ashanti and Cambior are examples of apparently good
hooks that dragged badly at the first stormy blasts.
Why?

The nub of the problem is to recognize that while the
line between real gold and paper gold is quite clear,
the line between paper gold and fool's gold can be a
moving target.

Paper gold is all paper instruments credibly repayable
in, or otherwise linked to, gold. Fool's gold is paper
gold that lacks credibility. Typical examples include
unallocated gold in unsound banks, options or futures
on gold from parties that may not be able to deliver,
and mining shares in companies whose ore deposits or
finances are questionable.

To appreciate the potential force of the coming
monetary storm, a basic understanding of gold, gold
banking, inflation, and deflation is essential. Forget
the Consumer Price Index and other such price indices.
They are generally lagging indicators of prices in
certain sectors of the economy. What is more, the CPI
is now subject to so many quot;adjustmentsquot; that its
usefulness except perhaps as a tool to reduce
government expenses tied to it (e.g., Social Security
payments) is suspect.

Forget as well most blather about whether gold does
better in an inflation or a deflation. Gold is
insurance against severe currency or credit
destruction, whether its precipitating cause be
inflation or deflation.

Inflation and deflation are, respectively, expanding
and contracting credit relative to some reliable
measure of money. Historically, the monetary measure
was gold, which does not do well in periods of
controlled or hidden inflation precisely because more
credit can be built on less gold without arousing
widespread public alarm. Measuring inflation today is
difficult because what passes for money -- unlimited
paper currency -- is itself so intermingled with credit
as to make the two virtually indistinguishable. A money
market fund is nothing really but short-term credit
obligations aggregated to look like what was once a
bank account backed (in a sound bank) by a 40 percent
reserve in gold coin or bullion resting in the vault.

Measuring the amount of real money in the world is no
more difficult today than a century ago. It is the
total above-ground physical gold stock, now somewhere
around 120,000 metric tons (excluding the double-
counting of gold leased by central banks but still on
their balance sheets). Going off the classical gold
standard and the quasi-gold standards that followed has
not change gold's inherent nature as real, permanent,
natural money. What it has done, besides changing for a
time at least general public perceptions about gold, is
to reduce to a small but elite group (international
financial institutions like the Bank for International
Settlements and the International Monetary Fund,
national central banks, bullion banks and their
customers, and the gold markets themselves) that
portion of the international currency/credit structure
directly tied to gold.

The short gold position created by the bullion banks
with leased gold mostly from the central banks is a
fractional reserve position. This physical gold sold
short must at some point be replaced, either by
purchase in the market or new production. Be this short
position 6,000 metric tons, 10,000 tons, or higher, it
is a significant multiple of annual new production of
around 2,500 tons. Some portion of this short position
represents forward sales by gold mining companies; the
remainder is largely borrowed gold used in the so-
called carry trade.

Accordingly, counting forward sales by gold mining
companies as existing gold (which they really aren't)
and assuming these contracts cover approximately half
of the total short position (as good a guess as any),
the gold banks are operating with fractional reserves
not far from the minimum safe level of 40 percent
sanctioned by historic experience. Half the physical
gold they owe to their lessors must be obtained on the
market. What is more, the other half is not really in
the vault. It is underground, but in an ore deposit,
where it must be dug out, processed, and refined before
it can be delivered.

On top of this shaky reserve position the bullion banks
have created gold derivatives, principally options and
futures. Cambior's hedge book shows how the gold banks
have created options for gold in amounts that far
exceed the amounts already sold forward by producers.
What is more, they have done so primarily in the over-
the-counter market out of public view. The gold banks'
exposures particularly as they relate to the gold
mining industry are detailed in an excellent article by
John Hathaway of the Tocqueville Gold Fund entitled
quot;Simple Math and Common Sense: A $66 Billion Problem.quot;

(www.tocqueville.com/brainstorms/brainstorm0041.shtml).

All that is reported about the activities of the London
Bullion Market Association is its monthly average daily
clearing volume, a figure that will be quite
interesting to watch in the months to come. The LBMA
dwarfs the two best-known public markets, the COMEX and
the TOCOM, which, though smaller, are more transparent.
They offer gold futures contracts where open interest
now exceeds warehouse stocks by multiples of 20 or
more. On the COMEX open interest is north of 600 tons
(200,000 contracts x 100 / 31250 = 622) against
warehouse stocks of some 30 tons. On the TOCOM, where
the percentage of coverage appears even lower, open
interest has very recently shrunk from over 500 tons to
400 tons on Oct. 7. Fear, perhaps, is hitting the TOCOM
a bit before it hits New York.

As I have discussed before, TOCOM futures, which are
priced in yen, are in backwardation. But the degree of
backwardation is more than accounted for by interest
rate differentials between the dollar (in which gold is
almost universally priced internationally) and the yen.

In other words, the implied yen forward rate is not
what the difference between gold lease rates and yen
interest rates would suggest, but less (that is, a
smaller negative percent or discount) than on
dollar/yen futures. But as a result of the
backwardation, open interest on the TOCOM is mostly in
the further-out months, although this too is beginning
to shift.

The COMEX also offers options on futures contracts,
where the call open interest at strike prices between
$310/oz. and $335/oz. running from November to February
exceeds 500,000 contracts, representing futures on
another 1,500 tons. Including options, the two public
futures markets could be asked to deliver about one
full year's production within a year, mostly in
December and next spring. This potential obligation has
been assumed on the erroneous assumption that because
gold is just another commodity, there is no possibility
of ever having to make actual delivery of the total
outstanding open interest.

With another quick $60 on the gold price, all the
options will be well in the money, and futures on gold
will almost certainly be fool's gold.

But what is most alarming about the strained condition
of the gold banks is the larger world financial picture
of which they are a small but very important part. At
the macroeconomic level, not only are there eye-popping
figures on credit creation, derivative exposures, and
stock market valuations, but the potential collapse
last year of a single hedge fund, Long-Term Capital
Management, threatened sufficiently dire consequences
for the entire international financial system to
warrant a bailout orchestrated by the Federal Reserve
and backed by three discount rate cuts.

Determining what paper gold is credible and what isn't
is difficult enough under ordinary circumstances. Far
harder, and in extraordinary times much more crucial,
is gauging the external factors -- macroeconomic,
geopolitical, cultural, whatever -- that paper gold and
even real gold may have to survive.

The bullion banks and their customers were not caught
wrong-footed by a free gold market. They were caught
out of position by the first attack in a monetary war
they they didn't expect and on terrain they thought
they controlled. The full story of how British-American
manipulation of the gold market led to a counterattack
by the European central banks is yet to be told, but
Ashanti, Cambior, and their shareholders are among the
first victims.

Before the gathering monetary storm is over, there will
be many more casualties, caught in the crossfire as
nations fight a currency war the likes of which the
world has never seen. Governments that try to wage this
war with the weapons of old -- foreign exchange
interventions, interest rate changes, currency
controls, gold restrictions, competitive devaluations,
etc. -- are likely to be overwhelmed by the very free-
market principles that they have recently preached if
not always followed. For in a truly free market for
money, one with no legal tender laws, gold wins.

In the United States the legal and cultural settings
are vastly different from the 1930s or 1970s. As a
matter of law at least, gold is in a free market,
hugely complicating the legal basis for any effort at
confiscation. Trust in government officials, starting
with the president, has never been lower. So turned off
to their government are Americans that nearly half the
eligible voters no longer participate. So offended are
they by the shenanigans of the two major parties that
third-party or otherwise apparently independent
candidates arouse astonishing levels of interest and
support.

And then there is the Internet, giving freedom of
speech and debate rein to affect public policy as never
before while restraining the power of the mass media.
What is more, the Internet is now as international as
gold, giving gold bugs worldwide their own web in which
to catch miscreant officials and expose official scams.

So-called quot;gold clausesquot; were a standard feature of
many private contracts from the quot;greenback eraquot; of the
Civil War to the midst of the Great Depression, when
the monetary measures of the New Deal made them invalid
by government fiat. Thus fell at a blow supposedly
certain protection against the gold devaluation of the
dollar, catching off-base the most prudent and best-
advised lenders of their era. For ordinary American
citizens in that particular financial cataclysm, mining
shares proved a much better refuge than physical gold
or gold dollars, ownership of which was made illegal on
the ridiculous theory that government gave gold its
value by making it money.

So too in 1971 not even an international treaty, the
Bretton Woods Agreements, could protect those nations
that had placed their reserves in U.S. dollars from a
second unilateral gold devaluation by the United
States. Only the French, by redeeming dollars in gold
quot;avant le deluge,quot; gained a partial measure of
protection. The monetary history of the 20th century,
for both individual nations and the world at large, is
a story of swift and devastating discontinuities, not a
linear progression of events.

Today the evidence points to an impending conjunction
of macroeconomic and geopolitical events that will
almost certainly sweep from the scene the entire
monetary and credit structure erected on floating
exchange rates with the U.S. dollar as the key reserve
currency. This lopsided international structure --
imposed by and so favorable to the United States that
it has for years run balance of payments deficits of
truly gargantuan proportions -- is hopelessly
dysfunctional, often placing smaller economies at the
mercy of forex market speculators. As this structure
disintegrates, gold will retake its accustomed place at
the heart of the world monetary order not so much by
official choice as by international necessity enforced
by free-market principles that will be virtually
impossible for free governments at least to resist.

To ask at what price gold is to misunderstand both the
problem and gold. No one could foresee in 1929 that
gold, then $20.67/oz., would be $35/oz. in 1934?
Similarly, no one could could tell in 1971 that gold,
then $35/oz., would rise as high as $800/oz. within a
decade. What a few could and did predict in the months
and years immediately preceding these devaluations was
that the world would soon be forced to confront the
effects of then unprecedented credit inflation built
with far too little regard for the underlying amount of
gold available to support it. What they also could and
did predict was that the existing dollar/gold exchange
rate (or price) was too low and would have to rise
substantially to offset what would otherwise be
devastating credit deflations.

As they say, history repeats though never in quite the
same way.

Eight years ago in The Golden Sextant I discussed the
problem of setting a new official gold price in the
context of an orderly return to an international gold
standard. Today 40 percent gold cover for U.S. currency
in circulation would require a gold price above
$800/oz., almost twice the figure of eight years ago.
Yet we are constantly told that this is the decade when
inflation was vanquished. When gold was at $800/oz., in
January 1980, one ounce would buy the Dow Jones
Industrial Average, as it would have done in 1932 if it
had been fixed at $35/oz. two years sooner.

If you must guess a future gold price, ask yourself
what will be the price when next one ounce, two, or
even three will buy the Dow.

Eight years ago I also held little hope of an orderly
return to a gold-linked dollar. By then American
officials of both political parties and all three
branches of government had decreed by their actions
over many years that any formal return to gold would
come, if at all, only under almost unimaginable crisis
conditions, when the golden lifeboat was the only
lifeboat.

What historians may call quot;The Great Gold Scandalquot; and
Americans may call quot;Moneygatequot; did not begin just a few
years ago only to surface with the Bank of England's
gold sales. It began in 1971 when President Nixon
closed the gold window and for the first time in U.S.
history cut the dollar free from any meaningful link to
gold.

Compared to what is coming, Watergate was a bagatelle.

It is no accident that Moneygate began with the first
president to be driven from office and will likely end
with the first in this century to be impeached. Scandal
-- indeed, the most egregious breaches of public and
private trusts -- are part of the pathology of all
great inflations, a pathology not unlike that of the
drunk or the addict.

Nowhere is this pathology better described than in
today's addition to my reading list: quot;Fiat Money
Inflation in Francequot; by Andrew Dexter White, founder
and first president of Cornell University. This essay,
written in 1876 and read by its author to members of
the House and Senate in connection with the debate over
returning to the gold standard after the Civil War,
tells the story of the French assignats of the 1790s.
This great paper money inflation, originating in the
French Revolution, ended quot;in the complete financial,
moral, and political prostration of France -- a
prostration from which only a Napoleon could raise it.quot;

The tragedy for today's America is not just that the
looming monetary shipwreck could have been avoided by
more honest policy decisions, but that it would have
been avoided if mostly well-intentioned but misguided
officials had stuck to the letter and spirit of the
monetary provisions of the Constitution. Its framers
knew when they met in Philadelphia in the hot summer of
1787 what the French were about to prove to themselves
the hard way despite their inflationary experience 70
years before in John Law's Mississippi Bubble.

Nobody can predict with certainty or in detail the
consequences of a hundred-year storm, be it financial
and monetary or meteorological. Gold will more than
survive; it will prevail as it always has.

Gold mines will prosper, though certain mine owners may
fail. With clear thinking, preparation, nerve, and
luck, gold investors will survive; some may even
prosper.

As for the nation, let's hope that aided by their
ability to speak directly with each other on the
Internet, exercising their good judgment and common
sense, the American people will demand for themselves,
their children, and their Constitution -- as is their
right in accordance with its exact terms -- early
passage on the golden lifeboat.