November 16, 1999. Dow/Gold Ratio = 1 at $3000: Don't Laugh!

From an historical perspective, the possibility that the Dow Jones Industrial Average and the gold price could converge at around $3000, i.e., the Dow at 3000 and gold at US$3000/oz. sometime in the next decade is quite supportable. Nor does this possibility invoke Y2K disruptions, terrorist events, or any other unanticipated geopolitical disturbances. But adding them to the analysis might have produced an even more catchy heading: Dow and gold at $2000 in 2000. Then again, with luck maybe the Dow/gold ratio will next bottom at 2 or 3 with gold at $2000 or $3000 and the Dow at 6000. Traumatic as that sounds, it is well within historic parameters.

Many think that gold peaked in January 1980 at just over $800/oz., or around $1600 in today's dollars. But according to a charticle in Forbes (May 4, 1998, p.50), gold hit its all-time high in 1492 at around $2400 in current dollars. That the real price of gold peaked in the year that Columbus sailed for America is not wholly coincidental. Over the next century, as the Europeans plundered the gold treasure of the New World and transferred it to their own economy, the real gold price declined to a level that notwithstanding periodic wild oscillations has remained remarkably stable from Shakespeare's time to the present day. Roy Jastram makes the same point in more academic fashion in the The Golden Constant (see Reading List).

From the start of the industrial revolution to World War I, constraints of the classical gold standard that might have forced a real upward revaluation of gold were eased by several great gold discoveries, first in California and Australia, later in the Yukon and above all, South Africa. As another Forbes charticle (Jan 12, 1998) points out, the twentieth century is unique for a consumer price explosion averaging almost 3% annually in the U.S. and a worldwide paper standard of value. But the century of global war and global inflation has also produced a global economy in which large national economies that formerly had little or no connection to those of America or Europe now impact them directly.

As the new millennium approaches, any extraordinary changes in gold supply relative to worldwide monetary demand appear more likely on the demand side of the equation. Perhaps there is another Eldorado waiting to be found, but the declining gold prices of the past decade have not encouraged the search. At the same time, the trend of monetary demand from Asia is increasing and looks to do so for the foreseeable future. Most Asians have a strong historic and cultural affinity for gold, an appetite further whetted in recent years by crummy paper currencies based on mostly western ideas: central banking, floating exchange rates and IMF policies. With literally billions of smart, industrious people just entering the world economy, Asia could be to gold demand in the 21st century what the New World was to gold supply in the sixteenth.

The Dow/gold ratio is virtually useless as a short term indicator. Rather, its logic and utility relate to the great cycles of the international economy. The Dow is a standardized measure of the value in U.S. dollars put on ownership of the leading American businesses of the day. Although the companies in it change at the discretion of its proprietor and are not weighted for capitalization, the Dow tracks quite closely with the S&P 500. Gold is permanent natural and international money. All over the world, people can tell you the gold price in their own currency even though they may have little or no idea of the local price of other currencies. While the Dow is more affected by the domestic credit environment, gold is affected by both national and international monetary and credit conditions. Thus the Dow/gold ratio gives an international perspective on the value of U.S. stocks that purely American indices cannot provide.

The Dow/gold ratio moved from 1.01 in 1897 to 18.4 in 1929 before the crash, then fell to 2.01 at the bottom in 1932 (gold fixed at $20.67/oz.). From 28.26 at the Dow peak in 1966 (gold fixed at $35/oz.), the ration fell to about 3 at the bottom in 1974, and to 1.04 in January 1980 at the modern peak in gold. At the Dow's peak in August 1999, the ratio was over 40, an all-time high. Portrayed on a chart covering this century, the Dow/gold ratio presents a violent saw-tooth pattern that would scare a roller coaster fan. For a long term Dow/gold chart, see; for more recent charts updated weekly, see The peak ratios of 1929 and 1966 both resulted from credit expansions that ultimately strained the existing international monetary order to the breaking point. The 1932 and 1974 troughs in the ratio coincide with those breakdowns, events virtually unavoidable in retrospect but not widely anticipated in advance.

The circumstances of the 1929 and 1966 peaks have three features in common: (1) an unreasonably low official gold price relative to monetary demand; (2) a multi-year domestic credit expansion beyond anything previously known; and (3) a pervasive feeling of optimism and perpetual prosperity. The unrealistic gold prices largely reflected the stigma attached to devaluation and official distaste for embarrassment by gold. The credit expansions were facilitated by government monetary policies rooted in the demands of wartime finance, but permitted to come to full flower only in the relaxed atmosphere of the subsequent peace. And in both periods, unbounded faith in the future came amidst astonishing technical and scientific advances. All these conditions are present today.

Although the gold price is no longer fixed by government decree, the Bank of England's gold sales are inexplicable except as part of what has likely been a multi-year effort by certain governments and central banks to keep a lid on the gold price. As discussed in prior commentaries, these official manipulations no longer command the support of the ECB and other European central banks, leaving the BOE and the Fed with the job of cleaning up a market mess mostly of their own making. The public announcement by Kuwait that all its official gold reserves are now available for lease through the BOE is part of this effort. Historically, extraordinary ferment in the gold market caused by unusual government disposals or acquisitions are indicative of peaks in the Dow/gold ratio.

However, official distortion of the gold price today is not limited to these more recent interventions. A far more fundamental distortion was created by the 1978 amendments to the articles of the IMF seeking to oust gold from the international monetary system and largely to replace it with U.S. dollars. When the dollar can no longer support this international burden, the suppression of gold will likely unwind with the force of a coiled spring.

Egregious departures from historical standards of stock valuation and prudent financial practice are characteristic of all great bubbles, and thus also of peaks in the Dow/gold ratio. Many analyses support the proposition that stock valuations now exceed historical norms by wide margins.

Although not added to the Dow until only a couple of weeks ago, Microsoft as measured by stock market capitalization is the world's largest company. Even after its antitrust setback and despite the obvious new challenges it faces, it continues to trade at a trailing PE around 60, nearly twice both its 5-year earnings growth rate and its average annual PE as reported by Value Line. It pays no dividend and has a book value around $5, but these criteria are deemed of no relevance at all in the current new era. In a recent online analysis (, a Portland, Oregon, investment firm contends that under proper accounting practices, Microsoft is not even profitable. It is not necessary to accept this startling conclusion to appreciate two fundamental and very real problems that this study points up.

The first is the effect of stock options on reported wage expenses, particularly in the technology sector. In a bull market, employees are willing to take stock options in lieu of salary. When exercised, the employee is taxed on the basis of market value. That is, the difference between the exercise price and the market price is treated as income, on which the employee is then taxed regardless of whether the stock is sold. The market price thus becomes the new basis for future capital gains taxes. The company takes an income tax deduction equal to its tax rate times the employee's calculated income, but typically records no corresponding charge to earnings on its P&L. Thus, while the newly issued stock causes dilution in per share earnings, the wage or salary expense that it represents -- the difference between the market price at issuance and the exercise price -- does not impact earnings and increases reported cash flow by the amount of the tax deduction.

Whatever one thinks about the accounting conventions that apparently allow this treatment, it is clear that companies compensating large numbers of important employees in this fashion are headed for significant financial and personnel problems should their stock prices merely level out, never mind fall. What is more, this situation produces substantial incentive for companies to try to push their stock prices ever upwards by managing earnings, repurchasing shares, or in Microsoft's case even selling put options to institutional holders of large blocs of its stock. Indeed, sale of put options has in recent quarters generated a not insignificant amount of cash for Microsoft while allowing some of its largest shareholders to enjoy at least the illusion of protection.

The second problem underlined by the Microsoft study is the danger of stock indexed investing done with no regard to underlying stock values. The 1972-1974 bear market, which took the Dow from over 1000 to under 580, ended the "Nifty-Fifty" era and discredited the widely held belief that smart investing consisted merely in buying and holding a few blue chip or so-called "one-decision" stocks. As a practical matter, this belief is reincarnated today under the guise of index investing, a perfectly valid and useful concept until taken (or gamed) to nonsensical extremes. Throwing funds at capitalization-weighted indices while remaining blind to the underlying value of their largest components has produced extreme overvaluations in certain "gorilla" stocks.

Like Microsoft, many of them are technology stocks, allowing their "new era" aura to trump more mundane considerations relating to profitability and sustainable growth rates. Among the Dow stocks, they now include after the recent changes: AT&T, Hewlett-Packard, IBM, Intel, SBC Communications and Microsoft. Others include: AOL, Cisco, Dell, Lucent, MCI Worldcom and Sun Microsystems, six stocks which on November 15, 1999, had a total combined capitalization just over $1 trillion, a median PE ratio over 70, and an average PE ratio over 100.

Industrial and consumer stocks, too, have been swept up in the indexing mania. More than anything else, index investing explains why General Electric, the next largest stock based on capitalization after Microsoft and also a Dow stock, can trade at a trailing PE over 40 when until 1996 it almost never traded at an average annual trailing PE exceeding 15. What is more, not one of its historic or projected growth rates (sales, cash flow, earnings, dividends or book value for the past 10, 5 and next 5 years) as reported by Value Line exceeds 15%.

A few months ago an experienced investment manager asked rhetorically in a Barron's interview: "Who is going to buy GE at a PE over 30?" Now he has his answer: index investors, the same people who buy other gorilla stocks at eye-popping PE ratios. Who are these index investors? Many of them are the country's largest pension funds, making the prospect of fair valuation in the largest cap stocks so unnerving as to render a bear market virtually unthinkable. According to the Microsoft study cited above, the California State Teachers Retirement System owns more than 16 million Microsoft shares with a value of about $1.4 billion based on its commitment to indexing against the S&P 500, of which Microsoft accounts for about 4%. Unfortunately, particularly in the investment world, "unthinkable" and "impossible" are not the same thing.

These, then, are the three factors that make convergence of the Dow Jones Industrial Average and the gold price at US$3000 possible before 2010: (1) the prospect of a millennial change in the gold supply/demand equation brought on by the demographics of worldwide economic growth; (2) a stratospheric Dow/gold ratio, reflecting enormous credit excesses in the U.S. but masking conditions of severe international monetary stress and ferment; and (3) unprecedented U.S. stock valuations reaching truly bizarre levels for some very large companies.

The Dow/gold ratio is signaling acute danger. History suggests that when it turns, as it may be just starting to do, the descent is not only swift and violent, but also unlikely to end short of fundamental change in the worldwide monetary order. The new millennium could well start with a ferocious financial roller coaster ride spanning the planet. Hold onto your hats, your stomachs, and the gold coins in your pockets!

November 12, 1999. Gold Bricks, Glass Houses and the Web: Retooling Gold Funds

Managers of gold mutual funds have not been reticent in their criticisms of Ashanti, Cambior and other heavily or imprudently hedged mining companies. Granting the validity of their complaints, they are not without some responsibility themselves for the problems recently plaguing gold investors, notably their own shareholders. As a group, gold fund managers are the principal professional investors in this sector. They have the required analytical skills and technical support. What is more, many of them understand both the monetary role of gold and the dangers of gold banking far better than the mining companies or even the bullion bankers. Yet many gold funds apparently bought the bear case for gold sufficiently to sprinkle their portfolios with a significant number of heavily hedged miners while failing to do very complete investigation or analysis of their hedge books. What is more, few gold funds with the authority to invest in gold bullion actually held any. Seeking the leverage traditionally associated with shares, they spurned bullion while failing to appreciate fully just how quickly ill-advised hedging could turn leverage against them.

The purpose of this commentary, however, is not to criticize gold fund managers for falling victim to the pervasive bearish sentiment that engulfed the gold market in recent years. Rather, it is to offer some thoughts on what they might think about now.

1. Requiring Greater Transparency. No group is better situated than gold fund managers to insist that gold mining companies make full disclosure of all relevant information, including their hedge books. Put bluntly, gold fund managers need to remember their ABC's, which in this case are Ashanti, Bre-X and Cambior. All these disasters blindsided more than a few gold fund managers who were just a little too careless, a little too ready to follow the crowd, and not demanding enough of the companies in which they were investing. Gold funds operate in a quite restricted universe, making it understandably difficult to avoid investing in a major company which others seem to like. In the gold sector particularly, the temptation to lower or waive established investment criteria because of the actions of others must be resisted.

2. Participating in Mining Finance. Due principally to their own greed and self-interest, the bullion bankers have failed the gold mining industry. With their eyes set narrowly on earning a spread, whether from mining finance or the gold carry trade, the bullion banks have failed to give their mining company customers sound and prudent financial counsel. This failure now gives gold funds a good opening to become more active in mining finance themselves. Gold funds, their shareholders, and the companies in which the funds invest all have a community of interest in stronger gold prices. Bullion banks searching for profit or official favor in trashing gold are not part of this community.

In this respect it is useful to compare a gold loan to a mining company with a gold bond or gold preferred issued by the company. In each case the basic idea is to repay the obligation out of future gold production. Interest costs are typically comparable, i.e., based on gold lease rates rather than ordinary interest rates. However, in a gold loan, gold is borrowed and simultaneously sold into the market at spot, putting immediate pressure on the gold price. With a gold bond or a gold preferred, the company receives cash but there is no immediate sale of gold, and the loan principal when due is paid directly out of production. While issuing costs for gold bonds or gold preferreds, particularly those which are publicly traded, generally exceed gold loan fees, the swift pace of financial reform could lead to a narrowing of this gap too.

Gold loans and forward sales have a legitimate role to play in mining finance, but when they are conditioned on margin requirements or required call/put hedging that jeopardize a company's financial viability, the time has arrived to consider other alternatives, e.g., debt instruments or preferreds convertible into equity or with accompanying equity options, gold bonds, gold preferreds. All these vehicles are appropriate investments for most gold funds, and to a limited extent could be bought by many even on a private placement basis. A portfolio consisting of bullion, gold bonds or preferreds, established producers who hedge prudently or not at all, and a few carefully selected smaller companies should more than hold its own against a portfolio of all the usual suspects, i.e., the better known gold equities.

3. Buying Gold Bullion. As of August 1999, the U.S. gold funds covered by Morningstar had total assets of about $2.5 billion. At $300 gold, 40% of that amount or $1 billion would buy more than 100 metric tons of gold, or more than three times the current COMEX stocks, more than Kuwait recently made available to the Bank of England, and four full tranches of the current BOE gold sales. At US$18 per share, the market capitalization of heavily hedged Barrick Gold is just over $7 billion, of which more than 75% is public float. Sale of 20% of Barrick's float at $18 would yield more than a $1 billion. In other words, gold funds have sufficient resources to be an important factor in a tight physical market, particularly if they take delivery or insist on allocated storage. And many if not most have the ability under their existing charters to substitute bullion for shares. What is striking in reviewing the August portfolios of the gold funds covered by Morningstar is how similar they were and how little bullion they contained.

Indeed, physical gold can be as or even more useful in a gold fund portfolio than an individual portfolio. Not only does it serve as insurance and to reduce risk and volatility, but also it enables a gold fund to stay reasonably fully invested in gold even when good mining investments are hard to find, such as during periods of low gold prices and excessively hedged mining companies, or periods of high gold prices and overvalued mining equities. A gold fund manager who prefers bullion at low gold prices to the shares of a mining company that has hedged away much of its upside does more than just benefit his fund's shareholders. He acts both to support the gold price and to discourage new or additional production at low prices.

4. Offering Internet Gold Bullion Accounts. So far as I am aware, only e-gold ( offers bullion accounts on the internet. My knowledge of e-gold is limited to what can be observed at its site. I have no connection with it, and I take no position on whether one should or should not use it.

An e-gold account, which can hold gold, silver, platinum or palladium, is fundamentally a storage or custodial account as opposed to a bank account, meaning that e-gold promises to hold a 100% metal reserve against its deposits, which e-gold describes as a "spendable bailment." Profits come from bid/ask spreads and certain transaction and storage fees. Through arrangements with online merchants and other intermediaries, an e-gold account can be used to make or receive payments in any of several major currencies converted to equivalent metal values at current market rates. Various other features and details of an e-gold account can be viewed at its website, which is well worth a visit if only to see the idea in practice.

The concept of online accounts that can be used for both investing in gold bullion and making or receiving payments appears not just viable but probably inevitable. What is surprising is that so far only one company is offering such an account, and it has no discernible connection with any of the big names in gold, be they bullion banks, gold funds or mining companies, nor with any of the recognized financial services firms so intent on worldwide growth via the internet.

The concept itself is really no more than applying in the internet age pretty much the same basic ideas that resulted in the development of gold banking by ancient goldsmiths. While the bailment concept may work best for a relatively small or unknown entity like e-gold, there is really no conceptual reason that old-fashioned retail gold banking could not be practiced on the internet by a financial or other entity with sufficient name recognition, reputation and resources to do so credibly.

Certainly there are numerous legal, tax and other questions that would have to be addressed, and probably a gold mutual fund itself could not offer such accounts. But open-ended gold funds that are tied into large fund groups or banks have the required electronic infrastructure and software capabilities largely in place, not to mention the necessary accounting and legal resources, regulatory contacts and political clout. Just as large fund groups offer linked investment and money market accounts, they could offer linked gold fund and internet bullion accounts. In the U.S. internet commerce enjoys various tax advantages, both existing and proposed, that could be particularly beneficial to gold. In the arena of international financial services, an internet bullion account might in many situations be of far more interest to prospective customers than retreads of existing American investment products.

Successful young internet entrepreneurs are driven by opportunities that the more experienced do not see, undeterred by obstacles others proclaim insurmountable. Someday, somehow, someone will offer internet bullion accounts in an increasingly prosperous India moving toward fuller and freer integration into the world economy. At internet speed that day may not be too far in the future. And most who could have been players will be spectators.

November 9, 1999. Beyond the G-7: People, Dollars, Gold and Oil

China and India, with 1.2 billion and one billion people respectively, are on the basis of population alone potentially the two largest economies in the world. Taken together, the three Chinese monetary authorities (People's Republic, Hong Kong and Taiwan) hold the world's largest hoard of dollar foreign exchange reserves, more than $325 billion. The people of India, with some 35,000 metric tons of gold mostly in the form of high carat jewelry, possess nearly one-third of the total existing above-ground supply, about one ounce per person. The oil producing nations of the Persian Gulf contain the lion's share of the world's known reserves of oil -- black gold --, the single largest component of international trade and the world's most important industrial commodity. All three, China, India and the Persian Gulf oil producers, will be important players in any dollar/Euro showdown.

China is the most exposed by reason of its huge holdings of dollar reserves. The People's Republic alone holds around $150 billion notwithstanding that its currency, the renminbi, is not freely convertible. The Hong Kong Monetary Authority, which operates as a quasi-currency board linking the Hong Kong dollar to its U.S. counterpart, holds $90 billion. And Taiwan, which targets its dollar to the U.S. dollar, holds another $90 billion. Mainland China's gold reserves of just under 400 tons are a relative pittance compared to its dollar reserves or its population. China is, however, a significant gold producer, but all gold trading remains under strict government control. For its size, Taiwan with 422 tons has quite robust gold reserves. Hong Kong has no significant gold reserves, but is home to the Chinese Gold and Silver Exchange Society, one of the world's more important physical gold trading centers distributing principally to mainland China, Taiwan, Vietnam and South Korea. For a brief history of this exchange see

Rumors of an impending official devaluation of the renminbi refuse to die, bolstered by continuing reports of economic slowdown in China. The Hong Kong Monetary Authority this week is unloading through the Tracker Fund of Hong Kong some of the shares it purchased in August 1998 to support the Hong Kong stock market. See Neil A Martin, "Bought Low, Selling High," Barron's (Nov.1, 1999, p. 22). Besides the damage that this intervention did to its reputation as a bastion of free-market capitalism, Hong Kong faces continuing doubts about its long term future since the changeover from British rule on July 1, 1997. Also, its economy still suffers from heavy dependence on property values as well as balance of payments deficits. Like Hong Kong, Taiwan has a modern, relatively free economy and a freely convertible currency, but as recent events demonstrate, questions about its long term future loom even larger.

Ultimately, however, it seems almost certain that the future economic success of both Hong Kong and Taiwan will be closely bound to that of mainland China, for whom they are, with their close British and American ties, respectively, both a strength and a challenge. Successful integration of these two western-oriented enclaves into the Chinese economy would carry huge benefits for China, not least of which would probably be increased investment by offshore Chinese.

Future Chinese monetary policy is impossible to predict. Its heavy dependence on U.S. dollar reserves seems anomalous for a great power. Short of foreign invasion, nothing is potentially more powerful as a unifying force than a sound common currency. One based on gold could replace the three existing Chinese currencies without requiring any of the three Chinese monetary authorities to cede its monetary sovereignty to another. While gold-based money is an important protector of economic freedom, it does not demand for its implementation an immediate grant of political freedom. Many autocratic regimes throughout history have thrived on gold money. What is more, a Chinese currency credibly linked to gold could well become the dominant currency for much of Asia, just as the Euro is now establishing itself as the key European currency even outside the EA countries.

India, China's great Asian rival and neighbor, is currently far better positioned than China to weather a dollar/Euro showdown. With about $30 billion in foreign exchange reserves and official gold reserves of about 360 tons, India is not heavily exposed to dollar depreciation. Its balance of trade is in rough equilibrium. Unlike the Chinese renminbi, the Indian rupee is freely convertible at market rates although Indian citizens remain subject to exchange controls, particularly on capital account.

The great bulk of Indian gold rests in the hands of its people, and for all practical purposes is largely beyond the reach of the government or banks. Indeed, due to regulations in effect prior 1992, a lot of Indian gold was smuggled into the country, much of it from Dubai. And even today import duties and other restrictions keep the Indian price of gold some 10% higher than the international price.

In Following the Equator Mark Twain observed: "In religion all other countries are paupers, India is the only millionaire." An inherent part of this religious heritage is a strong affinity for gold. In a piece entitled Why Indians Love Gold (, Sunil Madhok presents a detailed account of the Indian gold market, which currently absorbs about 700 tons annually, most of it fabricated into high carat jewelry. "Hindus believe," he says, "that Gold is a metal of demi-Gods and monarchs." For all Indians, however, gold has a practical side that includes ornamental use, wedding gifts, ready portability in emergencies (e.g., floods), tax shelter strategies, and insurance against currency depreciation and inflation. In a more recent piece dealing with the failure of central banks to appreciate Indian gold demand (, Mr. Madhok estimates India's GDP adjusted for purchasing power parity at about US$ 1 trillion.

For the better part of two centuries "the brightest jewel in the British Crown," India today benefits from widespread use of English and familiarity with British traditions of parliamentary democracy. Since the economic liberalization of 1991, a significant computer software industry has developed, particularly around Bangalore (see, e.g.,, the Indian version of Silicon Valley. Adapting well to the information age and having an appropriately skilled and relatively inexpensive labor force, India threatens to become a formidable competitor in the international economy of the future. Its economic success, absent radical changes in customs and culture, should translate into increased gold demand in the world's largest physical market.

Recent government attempts to interest Indians in gold-backed bonds have proved notably unsuccessful. [Note (11/17/99): Sunil Madhok has just posted an analysis of the Indian government's newest gold deposit scheme (] As Indians become more prosperous, how to channel their historic preference for gold jewelry into savings that can be more readily invested in economic enterprise is a challenge that will confront Indian monetary authorities with increasing urgency.

Daniel Yergin's The Prize (Simon & Schuster, 1991) traces the history of oil, money and power from the middle of the nineteenth century through the Gulf War. Much of the story revolves around Anglo-American efforts to dominate the Persian Gulf's great oil producers: Iran, Iraq, Saudi Arabia, Kuwait and the United Arab Emirates. As Mr. Yergin points out (p. 773), the lesson of all this history is "to expect the unexpected -- 'the surprise' -- that becomes perfectly obvious only after the fact." Today the major Persian Gulf powers have varied, changing and complex relationships with each other, with the less oil-rich Moslem nations, and with the outside world, particularly the developed industrial nations who remain quite reliant on Middle Eastern oil.

Today oil is priced and traded in dollars. But in the Middle East as in India, for Moslems as for Hindus, gold -- not foreign paper -- remains the most trusted measure of wealth. Hence the suggestion for a gold-based Islamic dinar. See Averaging over many years, there is a rough equivalence of 20 barrels of oil to one ounce of gold. Thus $20 oil implies $400 gold, or $15 oil, $300 gold. When the gold price is lower than the formula suggests, the oil producer who saves in gold a portion of the price received actually gets more gold. For example, $20 oil at $300 gold means that if 10% of the price is saved in gold, $2 buys one-third more gold at $300 than it would at $400. But at $500 gold, $20 oil would be underpriced in terms of gold, fetching 20% less than it should.

Accordingly, low oil prices that may be tolerable to Middle Eastern oil producers under conditions of relatively low gold prices are unlikely to remain so should gold prices rise for whatever reason. Having for many years thought of gold prices as tracking oil prices, the world may be surprised to find oil prices tracking gold in the future. Indeed, the following October 7, 1998, quote attributed to a former Fed governor appearing on CNN's Moneyline seems to reflect considerable sensitivity to the oil-gold link: "The Fed has precise control over the price of gold and therefore over commodities such as crude oil. No inflation, therefore no need to raise rates." Note that this statement came not long after Chairman Greenspan's July 1998 assurance to Congress that gold derivatives posed little systemic risk because "central banks stand ready to lend gold in increasing quantities should the price rise."

Relative tranquility among the nations of the Persian Gulf depends significantly on adequate oil prices. In this sense, world economic growth, even if it means marginally higher oil prices in the industrial world, is probably a plus. But world economic growth requires a satisfactory international monetary system just as domestic prosperity needs a reliable local currency. American policies aimed more at preserving U.S. dollar hegemony than fostering a sound international payments system will ultimately lead to both dollar depreciation and lower world growth. Such a double whammy to the oil producers of the Persian Gulf could well be the source of another of the region's unexpected events clear only in retrospect.

November 1, 1999. National Gold and Forex Reserves: Use and Misuse

In the bygone days of Empire and the gold standard, the Bank of England and most others in the world knew the purpose of national gold (or silver) reserves: they anchored the domestic money supply and provided the medium for international settlements. Today national monetary reserves consist of gold, foreign exchange (mostly U.S. dollars) and SDR's at the IMF, and there is great confusion about the purposes for which they are held. Not infrequently this confusion shows itself in the view that national gold and foreign exchange reserves should be managed to increase yield rather than to stabilize the currency, support monetary sovereignty, and provide international liquidity in times of extreme financial distress.

Thus the Old Lady of Threadneedle Street, once a pillar of the gold standard, is today more frequently associated with a futile defense of the pound that enriched George Soros to the tune of one billion dollars, or the inexplicable decision to sell 415 metric tons of British gold in a manner that not only assured a poorer price than necessary, but also now appears to have resulted in sale of the first 50 tons at a multi-year nadir in the gold price. Indeed, the British auction price was so attractive that one of the world's largest gold mining companies, Gold Fields, used a winning bid to close out forward gold sales at higher prices. Unfortunately for the British taxpayer, betting against the BOE seems to have become one of the surer routes to investment profits.

Under today's floating exchange rate regime with the U.S. dollar as the key currency, different countries or groups of countries have different reasons for holding gold and dollar or other forex reserves. My prior commentary discussed in some detail the composition of U.S. and Euro Area reserves, and future commentaries will pursue further the currency competition (or war) that I see developing between these two monetary superpowers. The purpose of this commentary is to focus on other nations and where their interests may lie as this competition heats up.

Among the G-7 countries, Britain, Canada and Japan fall outside the two monetary superpowers, although Britain is a member of the European Union and thus a potential member of the EMU and the EA. This question -- whether to join the EMU -- is becoming a major political issue in Britain precisely because it forces the nation to confront a loss of monetary sovereignty, which will in any event be further undermined as the plan to reduce its total gold reserves to a mere 300 tons is carried out.

Japan holds large dollar reserves (around US$200 billion) but not much gold (754 tons), and runs large balance of payments surpluses, particularly with the U.S. While the yen is generally considered the third major world currency after the dollar and the Euro, yen balances do not constitute a very large portion of world foreign exchange reserves. For both political and historic reasons, there is considerable doubt whether a true "Yen Area" can ever be created among a significant group of Asian nations. What is more, Japan's unique trade and security relationships with the United States impinge upon its international monetary policies, making both too weak a yen and increases in its gold reserves forbidden ground.

Canada's economy is closely linked to that of the U.S., and Canada in recent years has sold nearly all its gold reserves. Accordingly, the Bank of Canada has little choice but to conduct a monetary policy reasonably in tune with that of the Fed. Indeed, just as Britain seems fated ultimately to join the EMU, Canada will probably be forced someday to abandon its currency for the U.S. dollar. By running down their gold reserves, these two nations have greatly reduced their room for manoeuvre in any currency competition between the dollar and the Euro. Perhaps that is why the new Nobel laureate in economics, born a Canadian, recently characterized as "idiotic" the gold sales carried out over the past several years by a few central banks.

Through their central banks, Japan, Britain and Canada utilize their dollar reserves on occasion to intervene in the foreign exchange markets in support of their currencies. While these interventions may act at the margin to smooth violent fluctuations, they cannot fundamentally change market perceptions of relative currency values. The simple truth is that the currency markets today are so huge that even interventions by countries with large dollar reserves backing important currencies rooted in major developed economies can be quickly overpowered. In this respect, central banks have less power today than under the gold standard when they at least in combination controlled the great bulk of monetary gold and could arrange for each other short periods in which to try to right what appeared to be temporary imbalances.

Central banks of countries with smaller, less-developed economies and weaker currencies sometimes try to "target" their currencies to a major currency, often the dollar. They struggle to earn dollar reserves and then use them to try to maintain their currency within some sort of valuation band to the dollar. But at any hint of difficulty, such as declining reserves, domestic inflation, balance of payments problems or political uncertainty, a country operating in this fashion can quickly find its entire national economy devastated by a sudden blast of negative sentiment in the foreign exchange markets leading to swift and massive capital outflows and a precipitous decline in the exchange rate. By its nature, this sort of exchange rate regime tends to breed capital controls, subtle and not-so-subtle. What is more, its management is not an easy task even for a competent, honest and politically independent central bank. For a poorly run central bank or one subject to significant political interference, targeting the dollar has typically proved a recipe for disaster.

Indeed, a long train of unhappy experiences in this respect has led certain countries, e.g., Argentina, Estonia, Lithuania, Bulgaria, to replace their central banks with currency boards. Professor Steven H. Hanke of Johns Hopkins is generally considered the leading advocate of this approach. See D. Keiger, "The Way According to Hanke" at The currency board is empowered to issue local currency but only in direct proportion to its holdings of a reference currency. For example, in Argentina the peso is fixed at a 1:1 rate against the dollar, and the Central Bank of Argentina (now effectively a currency board) issues and permits to circulate only as many pesos as it has dollars in reserve. By selling its gold reserves, Argentina added dollars to its reserves but made more irrevocable its link to the dollar. It also effectively made the IMF its lender of last resort since that is practically the only place it can obtain additional dollars in the event of a banking crisis.

A strict currency board regime such as Argentina's operates much as the classical gold standard except that the reference money is another country's currency rather than gold. Consequently, the currency board country ties itself to the interest rate policies (and inflation rate) of the reference currency instead of the low interest rate structure (and zero inflation rate) historically associated with credible gold-based monetary regimes. If the economy of the currency board country is closely synchronized with that of the reference currency country, having the same interest rate policy normally will not be too burdensome. But if the two countries have economies than typically run on different cycles, as do Argentina and the U.S., the interest rate link can on occasion cause significant difficulties and threaten to undermine support for the currency board.

An even more complete abandonment of monetary sovereignty is represented by dollarization, i.e., giving up the local currency altogether and using dollars directly. For a general discussion of dollarization, including the possibility of sharing seigniorage, see U.S. Senate Report, Joint Economic Committee, "Encouraging Official Dollarization in Emerging Markets," April 1999 ( This approach, suggested recently as a logical next step for Argentina to remove lingering uncertainty about its ability to stick with the currency board regime in the face of severe domestic recession, has been followed since 1904 by Panama with reasonably good results. However, as pointed out by Juan Luis Moreno-Villalaz in "Panama: No Central Bank, No Capital Controls, No Problem," (The Wall Street Journal, Sept. 10, 1999, p. A19), "it is not dollarization per se which has brought so much stability to Panama but rather dollarization together with a 1970 banking law that allowed Panama's monetary system to integrate with world financial markets." Panama may control the canal, but monetarily it is simply an extension of the United States.

Dollarization has also been suggested for Mexico, but any serious movement in this direction will have to overcome not only instinctive Mexican distaste for Yankee domination but also active opposition by a group urging Mexico to reestablish its own silver-based monetary system. This group operates a Spanish language website, La Plata (see Recommended Links). The site offers one article in English, "Why Are the Americans Smiling?" ( by Hugo Salinas Price, the group's leader, arguing that the dollar key currency system is little more than a means for the U.S. to exact tribute from the producing nations of the world. Mr. Salinas, who built Elektra (now listed on the NYSE) from a small radio factory into Mexico's largest retailer of home durables, has turned management of the company over to his son and now makes a second career of speaking up publicly for a sound Mexican currency based on silver.

There would be remarkable irony in Mexico declaring monetary independence from the U.S. through a modern restoration of pieces of eight -- the Spanish milled dollar --, the very coin that the framers the American Constitution knew as a dollar and to which they specifically referred in that great document. Indeed, under the first coinage acts passed by Congress, the average weight of Spanish milled dollars then circulating in the new United States was determined to be 371.25 grains of silver, which remained the official weight of the U.S. silver dollar from 1792 until the dollar's convertibility into silver was terminated in 1968.

The La Plata proposal is interesting as a means not only to preserve Mexican monetary sovereignty with hard money but also to circumvent IMF restrictions on the use of gold. In 1978 the Second Amendment to the IMF's Articles, which ratified after the fact the 1971 closing of the U.S. gold window, generally sought to reduce the use of gold in the international monetary system. In this connection, it provided that member countries could link or target their currencies to anything or nothing as they saw fit except gold, which also was no longer to be used in settling balances between countries. Accordingly, any member country that fixes its currency to gold would most likely disqualify itself from further IMF support, a rather strange result given the original purpose of the IMF to help countries stabilize their currencies against a dollar linked to gold.

The IMF in recent years has tended to oppose the creation of currency boards, most notably in the case of Indonesia, and has usually required standard central bank nostrums such as high interest rates, deregulation and more open capital markets as conditions for its assistance to troubled third world economies. While Steve Forbes may be guilty of some hyperbole in describing the IMF as a sort of economic Typhoid Mary, it certainly cannot claim much success in restoring sound or stable currencies to the smaller nations of the world.

At the opposite pole from the small countries of Latin America or Eastern Europe, all linked in varying but significant degrees by geography, economics and culture to the two monetary superpowers, are the two great powers of Asia outside Japan: India, whose one billion people hold almost one-third of the world's above-ground gold supply; and China, where the combined foreign exchange reserves of the three existing monetary authorities (People's Republic, Hong Kong and Taiwan) exceed $300 billion, held mostly in dollars, plus over 800 tons of gold. Finally, there are the oil-producing nations of the Middle East, endowed with the bulk of the world's known oil reserves, and all with an historical affinity for gold. These three -- India, China and the Middle Eastern oil-producing countries -- require a separate commentary. None currently possesses a world-class currency. But each, though for varying reasons, has the power to conduct its monetary affairs quite independently of American or European wishes, to ignore the IMF, and to assert on the world stage in credible fashion its own monetary sovereignty.