Paper Gold Ain’t as Good as the Real Thing
By Doug French, Contributing Editor, Casey Research
The growing skepticism towards the federal government has reached an unprecedented level among Americans. According to a Pew Research poll, over half (53 percent) believe that the government jeopardizes their personal rights and liberties.
Additionally, confidence in the government’s currency is waning. Instead of accumulating dollars and traditional financial assets, many investors are now opting to invest in tangible items such as art, wine, and classic cars. As reported by The Economist in November, this surge in alternative assets stems from a diminishing trust in financial holdings.
While high-value artworks and luxury real estate are achieving record prices, the prevailing skepticism hasn’t necessarily drawn investors to gold. Since September 2011, the value of the dollar has surprisingly increased against gold.
Despite central bankers pledging allegiance to Keynesian monetary policies, the price of gold has notably declined, falling nearly $700 from its peak of $1,895. The expansive creation of fiat money seems limited only by the imaginations of central bankers and their willingness to lend. However, John Hathaway, Portfolio Manager and Senior Managing Director at Tocqueville Asset Management, attributes gold’s lackluster performance to other factors in his insightful report titled “Let’s Get Physical.”
Hathaway highlights the challenges facing gold production today. The cost of mining gold has escalated to the point where it often exceeds the selling price. The exploration and extraction processes are no longer as fruitful as they once were, with new large deposits becoming increasingly rare.
“Production post-2015 seems set to decline and perhaps sharply,” Hathaway observes.
The advent of Bitcoin in 2009 introduced a form of digital gold, capped at 21 million bitcoins, with fewer than 12 million currently in circulation. Initially easy to mine, Bitcoin extraction has grown increasingly complex, now necessitating advanced computational technology to verify transactions and create new coins.
Unlike the government currency, Bitcoin’s value has skyrocketed, climbing from under $25 per bitcoin in May 2011 to nearly $1,000 recently. This surge can be partially attributed to its portability. In a globally connected business environment, the ability to carry Bitcoin on a mobile device is far more convenient than transporting physical gold, such as Krugerrands.
No Paper Bitcoins
While Bitcoin’s portability contributes to its popularity, it does not entirely explain the stark contrast in the performance of Bitcoin and gold. Hathaway identifies a key factor in the two assets’ price movements: financial institutions have yet to find a way to leverage bitcoins for trades. Currently, there are no Bitcoin futures exchanges or derivatives, meaning anyone wishing to speculate must purchase actual bitcoins, thus driving up demand and price.
On the other hand, gold benefits from a well-established financial infrastructure that allows for substantial amounts of gold to be traded on paper, inflating its perceived supply. As quoted by Hathaway, gold expert Jeff Christian noted in 2000 that “an ounce of gold is now involved in half a dozen transactions.” This means while the physical volume has remained stable, the frequency of trades has multiplied.
The process begins with gold being mined and refined, after which it is sold to bullion banks, primarily in London, along with some being sold to jewelers and mints.
“The physical gold that remains in London as unallocated bars is the foundation for leveraged paper-gold trades. This chain of events is perfectly ordinary and in keeping with time-honored custom,” Hathaway explains.
Hathaway estimates that around 9,000 metric tons of gold are traded daily, while only 2,800 metric tons are mined each year.
The gold market engages in extensive practices of lending, leasing, and hypothecation, leading to significant confusion, such as the ongoing struggle of the German government to repatriate its 700 tonnes of gold from New York and Paris. Despite a request made a year ago, only 37 tonnes have been delivered due to complications in ownership claims.
Leveraging Up in London
The City of London is known for its permissive regulations, allowing mega-banks to leverage customer deposits extensively. This regulatory environment came under scrutiny following the collapse of MF Global, where former CEO Jon Corzine leveraged high-risk bets.
Christopher Elias commented on the potential dangers of excessive leveraging, emphasizing how it amplifies both gains and losses. At its peak, MF Global reached a leverage ratio of 40 to 1, and the firm’s downfall was triggered not just by external market factors but by its overly ambitious leverage.
Hathaway presents a convincing argument that the gold market may be just as precarious as MF Global was, built upon a vast expanse of paper transactions supported by a comparatively small amount of physical gold.
“Unlike the physical gold market, which is not able to absorb large capital flows, the paper market, through nearly infinite rehypothecation, is ideal for hyperactive trading activity,” Hathaway writes.
This situation mirrors the housing debt crisis seen a decade ago in America, where mortgages were easily securitized and traded electronically. Everything appeared stable while home prices were climbing until the market faced a significant correction, revealing deep-rooted inconsistencies.
A breakdown of a few counterparties in the paper-gold market could lead to a catastrophic scenario where multiple entities claim ownership of the same physical gold. Such a situation would lead to extended market paralysis, affecting millions of ounces of gold and creating long-term supply issues.
Hathaway believes that potential regulatory actions could necessitate stricter collateral standards and rules on rehypothecation, prompting a frantic search for the physical gold that remains.
The “murky pool” of unallocated gold in London has, until now, supported excessive paper-gold trading. However, this pool is dwindling, setting the stage for an unprecedented short squeeze.
If this occurs, individuals holding gold ETFs and similar paper claims may find themselves at a disadvantage, as they could receive “polite and apologetic letters from intermediaries offering to settle in cash at prices well below the physical market.”
It may not be inflation that drives gold prices up, but rather the unwinding of substantial leverage within the market.
While Americans have good reason to be wary of their government, they should also maintain a healthy skepticism towards their financial system. History shows that governments can render paper currencies worthless, and while paper claims to gold may provide reassurance, they offer little protection in times of panic.
Ultimately, possessing the physical asset itself is the most prudent course of action.
Sincerely,
Doug French
for Economic Prism
[Editor’s Note: One form of paper gold worth examining right now is junior mining stocks. These small-cap companies engaged in exploring for new gold deposits often see significant rewards for successful discoveries, benefiting their shareholders. Despite the overall downturn in the gold market, the best junior mining firms—backed by effective management and solid gold deposits—are now available at historically low prices. For insights on how to capitalize on this market anomaly, click here.
Douglas E. French writes for Casey Research and is the author of three books: Early Speculative Bubbles and Increases in the Supply of Money, The Failure of Common Knowledge, and Walk Away: The Rise and Fall of the Home-Ownership Myth. He is also the former president of the Ludwig von Mises Institute in Auburn, Alabama.
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