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XMFRedwood (65.08)

The Gold War Explained



April 28, 2010 – Comments (17)

A interesting gold war flared up in recent days… namely between what I’ll call gold insiders (Jeffrey Christian of CPM Group, a metals consultancy), and those on the outside GATA (Gold Anti-Trust Action Committee).  You can see this war of words here:

I find it amazing that people can argue forever without getting to the crux of the issue.  And in this case the core disagreement is blindingly simple.  GATA says banks have sold gold that doesn’t exist, creating “paper” gold, and that this action is fraudulent.  Insiders acknowledge this but say there is nothing wrong with it.  This is the core issue – that banks have treated gold like paper money and loaned it out on a fractional basis.  Just about everything else is secondary or builds on this concept. 

Is this wrong?  After all banks have been loaning money on a fractional basis for hundreds of years and it is legally accepted.  But there is an immense difference between cash and gold.  Gold is a physical asset that is no one else’s liability while paper money is a liability of a central bank.  People own gold specifically because they don’t want to own paper money.  Conflating the two items is flat out wrong.  However, that’s what banks and the regulatory system do. 

Imagine it this way.  You want to buy a diamond as an investment and store it at your your bank.  The bank says sure, but because it has to create space to store the diamond, it will cost 1.5% per year to store it.  But the bank offers you another option.  It has a bunch of identical diamonds in a big room and it can sell you one of them, but not a specific one.  Since they are all together, this reduces its storage fees.  At any time you can ask for your diamond back.  OK, that’s a much better deal you say. 

The catch is that bank has sold more diamonds than it has in inventory.  When the bank takes your money it records a liability, but doesn’t go out and buy another diamond, it loans your money out and earns interest.  This interest is what enables storage costs to be lower. 

In effect, you are told you own a diamond, but you really don’t, you own 1/10 of a diamond.  This is because the bank has sold that diamond ten times over. 

This fractional system is widely accepted in checking accounts but you can see how the logic melts away when you consider physical objects.  People own gold, diamonds, or whatever to have that specific, physical asset.  That’s the whole point.  Of course, the benefit of not getting your own specific one is lower fees, but that is completely superficial and overwhelmed by the fact that you have claim on far less of a diamond than you think you do.  The gold people think they own doesn’t actually exist. 

But this doesn’t matter, say the insiders.  For every customer liability (someone that owns a gold claim from the bank), there is an asset.  If people ask for their diamonds, the bank can convert some of those assets into cash and buy enough diamonds to give them to their owners.  The problem is the price of diamonds will go through the roof, affecting the ability to deliver the physical good.  It’s similar to a bank run. 

The fundamental difference between the two parties is that Christian does not see anything wrong with a fractional gold banking system but GATA does.  GATA thinks the fractional gold system is flat out wrong on many levels and the banks are in essence perpetrating fraud.   

My view is that it’s shocking that insiders like Christian cannot comprehend the difference between gold and paper.  I can sort of see how he might support the fractional banking system because it is so ingrained in our society, but how he justifies a fractional gold system is beyond me. 

It’s an open and shut case that banks are committing fraud.  When you tell clients they own gold and they don’t it is fraud.  There’s nothing more to be said.  In many cases, banks have hedged themselves with their language, but in some cases, it is blatant fraud. 

Where it gets more interesting (and exciting for the gold owners!) is when you consider what could happen if the situation unravels.  I’ll tackle that issue in a future post. 



17 Comments – Post Your Own

#1) On April 28, 2010 at 4:37 PM, vriguy (62.07) wrote:

TMFSinchiruna has been beating this drum for some time.  Investors need to know the risk they run with GLD, SLV, and other precious metal ETFs.  My question is - if GLD cannot make good on its promise that it holds 0.1 oz of Gold per share floated, will anyone in the US or UK go to jail?

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#2) On April 28, 2010 at 4:48 PM, MikeMark (29.07) wrote:

Nicely written Andrew.

The concept of fractional reserve banking has been around since not long after goldsmiths began storing gold and giving out depositary receipts. That's a long time.

So you get a bank handing out more depositary receipts than they have asset to cover. Two things happen: fraud and inflation. Fraud occurs when the bank doesn't have proper asset coverage. Inflation occurs because now you have a paper money (depositary receipts are the basis of paper money) that is commonly circulated instead of the gold itself.

The larger problem really occurs in the government. Here's why:

One of the most basic purposes of government is to protect the people from fraud. However governments love to inflate. Inflation benefits the first receiver of the newly created money. That's normally the government and those in the favored circle. So the government ignores and even embraces the fraud instead of protecting the people. Of course it doesn't want the people to know this, so it engages in reeducation, finger pointing, war, spin control, media control, anything to keep the people from really understanding.

The owners of the bank (or goldsmith, jeweler etc.) benefit in the same way. They are the first users of the inflated supply. They get the best benefit, as long as the fraud is allowed to continue. That's probably why Mr. Christian really shows a lack of concern about the apparent fraud. He is on the benefit side.

This also explains the real reason why the Federal Reserve exists. It isn't to "keep price inflation" from occurring or constant or anything. The Fed, coupled with the fractional reserve banking system inflates the money supply to give to congress, big banks, big corporations and other favored first receivers of money.

But you may already know all this.

I'm looking forward to your future post. :)


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#3) On April 28, 2010 at 4:48 PM, CMFEldrehad (99.99) wrote:

 First of all, I know very little about this subject -- just what I have gathered from a few blogs like this one...  so I certainly admit that I have a lot to learn. 

That said, my initial inclination would be to say that as long as it is disclosed to the people who buy the one-tenth of a diamond the nature of the transaction, I have to come down on the side of Christian.

Disclosure is the key, in my mind.  If disclosure is full and fair, investors can make up their own mind if the reduction in fees is worth the risk.


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#4) On April 28, 2010 at 8:14 PM, easynow7 (< 20) wrote:

Its not solely the pros and cons argument around fractional reserve banking but to what ends this can be used to manipulate markets.

The point is in the gold market where the commodity supply is limited if you use the practice of fractional reserve banking to control supply and make it look like there is more gold than there is thereby keeping the price artificially low its a different argument altogether.

The recent example where there is more proof is that banks themselves have been doing this to control the results of futures contracts.  This is controlling the market though use of monopoly or oligopoly for individual gain and goes against every free market principle we should stand for and thats the point GATA are trying to make. 

HSBC, Goldman and JPS have been named in the recent hearing and if found guilty no doubt punishments will ensue but central banks may have been doing the same thing to control the perception of currency value.

We will have to see what happens next!  


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#5) On April 29, 2010 at 11:39 AM, leohaas (30.08) wrote:

The gold bugs flee from paper money into gold because they don't trust paper money (and the governments issuing it). And now it turns out you cannot trust gold held by a bank either. Isn't that ironic?

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#6) On April 29, 2010 at 1:45 PM, XMFRedwood (65.08) wrote:


Nice analysis!  I liked your description of the first receiver of newly created money as the one that benefits most.  I think that's a good view of what happens: ultimately everyone pays but if you captured the spread on leverage you got that additional boost that the ordinary people didn't.  Then again, the masses also get reduced costs for banking services too.  

It's an attractive argument, but I'm not exactly sure if a fractional system generates positive second and third order effects that outweigh the fraud and inflation?  Proponents of fractional banking say expansion of credit enabled the developments that built modern society.  Would this have happened under a 1:1 system, vs. the 10:1 system we have today?  I'm not sure.  Maybe, maybe not.  Then again perhaps it is fallacious to think that expansion of credit was the reason for the growth of Europe starting in the Renaissance.  Many other factors were involved.  I'd love to see some research on that specific topic.  I do know that in a free market, the leverage we currently have wouldn't be sustainable because trust in individual institutions isn't that high; it has to be done by decree.  

Your point that this is not well understood by the public and there are plenty of people in power to keep it going is extremely valid!   

I also agree with your point, easynow7 -- the fact of the matter is things have gotten out of control in terms of the paper that has been sold as gold.  It's a huge pyramid of paper built on a small pile of gold (all the gold in the world is the size of the bottom of the Washington Monument).    

In all my readings on the subject, I have yet to come across a rational perspective on what will happen to the monetary system, fiat money, and gold.  There are plenty of opinions out there but not enough real analysis to back them up.  Obviously it's a ridiculously difficult question, but hopefully I can reach some conclusions.  I'll share them here (if I can come up with anything)!  :)  


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#7) On April 29, 2010 at 1:56 PM, XMFRedwood (65.08) wrote:


It's is incredibly ironic!!  I'm glad you spotted it.  It is truly unbelievable what has gone on... we'll look back with awe.  Assuming we can look back, that is... the status quo is difficult to change.  After all, the goldsmiths kept this scam going on for years, even up to the present day in the form of the LBMA (which incidentally tells you you don't own gold).  

But it certainly can change.  Confidence in the financial system is the key to the whole thing.  Less confidence forces gold into private hands and out of the economy.  More on this later, I hope.  

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#8) On April 29, 2010 at 2:46 PM, JakilaTheHun (99.92) wrote:

Great explanation of fractional reserve lending, Redwood.  Thanks for this post.

However, I would agree with Eldrehad on the issue.  There's no "fraud" being committed.  Banks lend out assets --- that's their business.  If you contractually agree to the bank's practice, then it's not fraud, even if one has a different view of 'how it should be done.'  

I'd also suggest that maybe this is a case of gold investors trying to have their cake and eat it, too.  The common argument I hear is that gold has value because it's currency.  (I disagree to a large extent, but we'll ignore that for now).  Ok ... but if it's currency, then why can't the bank treat it like currency?


I'd also disagree with the implication that if the banks were required to physically store all the gold, this would somehow increase the price.  Actually, it would merely expose the heavy expenses associated with gold storage (coupled with an absence of cash flows resulting from it).  It would make gold less attractive as an investment vehicle.  ETFs like GLD dramatically lower these expenses.  If it weren't for these ETFs, major institutional investors and hedge funds wouldn't invest nearly as heavily in gold.  I can't imagine Soros and Paulson pouring so much money in gold without these sorts of instruments. 

While people often talking about the limited supply of gold, this is somewhat flawed as well.  Gold, for the most part, is not consumed. There's a massive supply of gold that could be unleashed at any time upon the market.

Most of the projections of $5000+/oz gold are based around invalid assumptions.  Gold is semi-currency at best, and an industrial metal used in jewelry and dental applications at worst. 

Gold is a commodity with some vague currency-like elements that are remnants from a previous era.  Its pricing is based mostly around production costs; just like oil. However, the vague currency-like elements coupled with steadier demand give it more stable pricing than industrial metals.  (Silver is purely an industrial metal at this point.)

If the price of gold were to increase to $2000/oz, there would suddenly be a massive supply of gold being produced every year.  There is a lot of gold in the world --- it's just that some of it isn't economically feasible to mine at $1000/oz.  At $2000/oz, even remote locations in northern Canada are suddenly potentially profitable. 


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#9) On April 29, 2010 at 7:45 PM, MikeMark (29.07) wrote:


Hey, I'd be happy to give you $650 an ounce for any gold you have. Unleash the massive supply! Lay it on me!

But seriously, my understanding here is that there really isn't a massive supply that could be unleashed. If there were, there would be no need to create more paper "depositary receipts" than actual physical asset. Instead, the insiders (if they wanted to be more trustworthy) would just go get more physical gold. It may also be as Eldrehad said: the ownership contract may not specify 100% physical reserves for your holding.

There is a company in the world that does offer physical ownership coupled with vault storage. In their case, there's a fee for storage and an independent audit to prove to the owners that there is 100% reserve. The same company offers a way to transact business in gold or silver. Of course you must have a holding with them, but these metals are being treated as currency.

As far as money is concerned, if gold isn't money, then why does every major government and the IMF have holdings? If it isn't, why have it? There is only one reason: it is the true money. When markets emerge without meddling, gold is the normal money. Other monies have been used, like tobacco and tea, but gold is the most common throughout history. By the way, I have a chunk of trade tea. It's pressed and formed tea leaves. The chinese used big blocks of tea as money back in the time of Marco Polo (and before...). Everyone needed tea, so it was easy to trade with, so it became money. That's the free market way and the only way that money really comes into existence. Free market money must exist before a government can take it over and begin to inflate or debase.

As far as monetary inflation effects and who benefits and how it propogates, studies on that have been around a long time. It seems that Richard Cantillon first noticed it. Here's a recent article on what it can cause.

There's a suggestion that we couldn't have the "modern world" we have today without that inflationary ability. That may be true. But is this the better result or the worse one? I think the current inflation caused result may actually be the worse result. It's probably true that some people would be worse off without the inflationary result, but many more would probably be better off, just due to the fact that the rich and pollitically well connected are the ones who become better off in inflationary environments.

Still looking forward to that next post.


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#10) On April 30, 2010 at 9:59 AM, lubum (< 20) wrote:

The goldsmiths of yesteryear realised that they could issue more credit letters than the gold they owned. Up to 60% more. It was a fraud from the start. The difference resides in the fact that once they were caught those goldsmiths had to face hefty penalties.

When all is said and done, it remains that one cannot sell what he does not own. Period. 

That people still swallow that it is normal for the bankers to issue 10 or 100 times more money than they own, speaks volume about how much we have  been brainwashed over the years.


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#11) On April 30, 2010 at 10:16 AM, JakilaTheHun (99.92) wrote:


Why would I sell you an ounce of gold at $650, when there are fools all over the place who believe gold is going to $5000/oz based on silly ratios and conspiracy theories?

However, if I had a gold mine, I'd be happy to extract the gold for $700/oz and sell it out to people for $1200/oz.  I'd be even happier to sell it out at $2000/oz. Hell, I could start my own mine in the Northwest Territories and have ridiculously high extraction costs and still make a killing selling people gold if it got that high. 


Don't think you actually read all my post because your point about currency suggests that you didn't.  Gold has 'currency-like elements', due to its historical status since central banks keep it.  It, however, has absolutely no value for the average individual in facilitating consumer transactions.  Hence, gold occupies some bizarre middle-ground.  

Silver used to occupy this space of semi-currency, as European governments began shifting away from it in the late 19th Century.  The US began its own experiments with silver at that time.  But at this point, silver has been relegated to a purely industrial metal. 

I don't know that gold's fate is similar, but I do think goldbugs are ignoring reality when it comes to long-term trends in currency.  Gold is a commodity and a semi-currency.  Like silver was at one point --- but now silver is just a commodity. 

Your point about tea as a currency only further reiterates my point about gold.  Is tea a currency right now?  No, it's not.  It trades like a commodity; not a currency. 

Gold is more deeply engrained in the popular consciousness, but long-term, is probably going to suffer the same fate as 'tea as a currency'.  The fact of the matter is that we couldn't go back to a gold standard even if we wanted to.  Gold is too rare --- which to some goldbugs is proof that there's too much money in the world.  They should consider the other side --- gold's rarity is its ultimate doom, because it makes it an impractical everyday-currency in a world of 7 billion people. 


I bought into gold back in late '08 because of fundamentals.  My basic problem with all the gold hype right now is that people aren't buying because of fundamentals --- they are buying because of ideology, conspiracies, and flawed views of the concept of hyperinflation.  I'm not saying it won't 'go up.'  Merely that there are much greater risks associated it with it than most people are pricing in right now --- sort of like how people assumed real estate was a 'can't lose' bet in 2002 - 7.  Once people start ignoring fundamentals, bubbles form. 

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#12) On April 30, 2010 at 11:10 AM, lubum (< 20) wrote:


Gold has 'currency-like elements', due to its historical status since central banks keep it.  It, however, has absolutely no value for the average individual in facilitating consumer transactions. 

You know why? Because gold is much too valuable to be used for small transactions.  You better use silver or even better nickel or copper.

The US began its own experiments with silver at that time.  But at this point, silver has been relegated to a purely industrial metal. 
You know why? Not an experiment. They had not enough silver left to print money. Once a country gets rid of its silver money, it is on its way to bankrupcy.

I do think goldbugs are ignoring reality when it comes to long-term trends in currency.  Gold is a commodity and a semi-currency.  Like silver was at one point --- but now silver is just a commodity. 

Which reality are you talking about? Gold is a store of value as much as tea or ties or potatoes for that matter. The difference is that gold packs a maximum of value for a minimum of volume. To discuss whether gold is money or a commodity is an exercise in futility.

Gold is more deeply engrained in the popular consciousness, but long-term, is probably going to suffer the same fate as 'tea as a currency'. 

You simply don't know what you are talking about.

The fact of the matter is that we couldn't go back to a gold standard even if we wanted to. 

 We don't need any gold standard. This was a British trick to control the price of gold. If free market has any meaning its means that one has to let gold find its own value according to its availibility.

 Gold is too rare --- which to some goldbugs is proof that there's too much money in the world.  They should consider the other side --- gold's rarity is its ultimate doom, because it makes it an impractical everyday-currency in a world of 7 billion people.

You don't have too. Gold should be used only for big transaction not to buy a bread. Nickel and copper fit the bill much better. Beside one could print paper denominated in weight of gold, silver or whatever. But he has better to have enough of each to cover his papers short of finding himself in  the slammer.


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#13) On April 30, 2010 at 1:45 PM, MikeMark (29.07) wrote:


Busted! That's what I am. You're right: I quickly penned that first paragraph without reading through your whole post. :)

But it started me down that writing path, so I'm not sorry. And thanks for replying instead of just ignoring my jab.

I think you are right that many people are buying without understanding the whole story. Any marketed item in a free market has price swings. Gold has had some slow but massive swings from 1973 forward. When you look at those swings from a historical statistical perspective, gold has appreciated at a rate of about 7.8% per year to the current price, but on average, buying at essentially random times, you would more likely see 3%. Not really your stellar investment.

But I also think the more important part of that story is the rarity part rather than any potential massive supply about to hit the market. See, the number of players in the gold market has been increasing. It is one of and possibly the most liquid market in the world. The asset value of gold is generally well accepted and seemingly increasing. As an example, the Chinese government told it's citizens that they should own some gold or silver. That increases demand. US and world mine production has been declining for about 10 years. From 1997 to 2006 consumption in the US increased by 33%. It jumped about double from 1997 to 1999, dropped and flattened from about 2000 to 2006. The IMF just announced that they are curtailing gold sales. Their wording is phased, but it amounts to ending sales after the next 191.3 tons. They don't seem to want to part with what they have left. That's a reduction of available supply on the market. Demand up, supply down: price up.

As far as your gold mine goes. Do it. Go open the mine. I'd like to help. I'll even put some capital up. With some developments in mining technology, I think there's a potential for true capital gain. That will also increase supply and help bring the price down.

As far as money or currency is concerned, we do have a problem here in the US. Gold has essentially been outlawed as a contract currency. Many states are trying to change that. So are some of the US Representatives. The reason why is that those people recognize that the only way to control government growth is buy giving the power of the purse to the people. There has been a proposal to allow free market money to develop. That's part of what lubum is referring to. Money only develops in a free market.

People must survive. They will work and trade to gain a better living. They will do that in spite of and even under laws that try to prevent it. As they do that, they create a market driven money.   It might not be gold, but it will be a commonly traded commodity that tends to keep its value. That's what history shows.

But the world market knows the world's best commodity to use: gold. It has all the qualities you want. One of which is that it remains. Even if you burn down or blow up the building that it's in, the gold is still there (baring nuclear action). Which is what you said.

I think a larger but hidden part of the story here isn't about whether gold is or isn't a usable currency. History shows it is. It's about who wants it to be and who doesn't. Let's start with who doesn't. That's easy. Governments and those in the government favor. Why? Because it prevents their favorite pastime: spending on anything they want. Who does want it? Anyone who wants a truly free market. Why? Because of the benefits. Benefits being good savings through appreciation of money, price stability, understandable markets, clear visibility of fraud, control of runaway government, ease of international exchange, lower total costs of living.

I think part of the story that's being played out here is the slow demise of big government. It won't go without a fight, but the few can rarely control the many for long without their consent. In addition to that, the declining asset base eventually renders it impotent.

What do you think?


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#14) On April 30, 2010 at 5:04 PM, lubum (< 20) wrote:

Most people still have to understand what gold or silver means. I am sick and tired to hear people willing to invest in gold. Which means they expect to make money.

This is why we are now in such a predicament. Everyone wants to make money and end up in bankrupcy. 

One does not buy gold to make money. One buys gold to save its belonging. Period. In the long run every FIAT money will end up worthing less than toilet paper. Gold, silver and other metals will keep their value. For the simple reason that it takes sweat and money to produce an oz of it.

This is a notion that starts to sink in those thick heads who call themselves economical analysts.


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#15) On April 30, 2010 at 7:28 PM, tobernator1000 (< 20) wrote:

I think a larger but hidden part of the story here isn't about whether gold is or isn't a usable currency. History shows it is. It's about who wants it to be and who doesn't.

I think the arguments for and against gold tend to track pro and anti-government arguments, but I think you're mistaking corrolation with cause. Gold, or any fixed currency, leads to deflation. This rewards people who already have money because their money becomes more valuable just by existing in a world where new value is being created. Inflation (usually created by fiat currencies) rewards people who make money ("make" meaning either to create, like governments, or to earn, like workers) because they have the ability to replace the lost value of their money with new money.

People who support a gold standard tend to be focused on the past, while people who don't tend to be focused on the future, and I think that's where the line is really drawn.

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#16) On May 01, 2010 at 12:58 AM, MikeMark (29.07) wrote:

Howdy tobernator1000,

But I'm totally focused on creating a better future for myself, my family, my children, their children and so on. That means fostering a free market with a free market monetary system and a smaller government that protects the property of the people instead of hijacking it. Looking to the future, there is really only one sustainable self-regulating possibility: free market money.

I also feel like I'm beyond my limit for redirecting Andrew's great post, so I'm just going to guide you to a few important books.



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#17) On May 01, 2010 at 11:50 AM, lubum (< 20) wrote:


Gold, or any fixed currency, leads to deflation

There are different kind of deflations. When it is the result of better productivity it is a boon for the little guy who can buy more with same earnings. This is what happened in the last years of the 19th century.

On the other hand, the deflation we have to face now is a quite different kind of bird. It is the result of mismanagement and outright theft by an oligarchy of bankers who set the rules to benefit them at the expenses of everybody else.

Gold produce the first kind of deflation which is a good thing. And forget about a fixed currency unless it is backed by a solid current account. Which is true for the Yuan but nor for the US dollar.

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