Gold: The Ultimate Wealth Consolidator

Can you remember back to 2004, 2005 and 2006, when your home value (and equity) was at its all time high? Do you ever wish you had sold your house during those years? At that time did you consider the tremendous equity in your home to be your reserves? Do you sometimes wish you had consolidated those "reserves" before they vanished into thin air?

I had a house I bought in 2000. In 2005 I sold it for 233% of what I paid for it. But when I look at the actual cash I put down for that house, 5% down!, my down payment yielded a 2,500% tax-free gain! I consolidated my "reserves"!

Of course there were costs along the way, to defend my 5% leveraged "investment". I had to regularly pay the interest on my loan, and I had to maintain and secure the property. But boy was I lucky I decided to sell in 2005! I wish I could say that I made that brilliant decision out of economic foresight. But alas, I did not. And later I made a few not-so-great decisions.

Some are still clutching their bygone perceived reserves

Wouldn't it be exciting to have such an opportunity come along again? Only this time to be able to see it coming? How about if you could gain TWICE the "leverage" without the risk and expense of actual leverage (debt)? And what if you didn't have to worry about consolidating your reserves by timing the peak? What if this next opportunity was in buying THE ultimate wealth consolidator? Sound too good to be true?

In order to understand why this is absolutely true, no matter how good it sounds to the exceedingly small and paranoid segment of society we call the gold bugs, we need to clarify a few definitions. Reader Jeff comments, "FOFOA, I find your writing in 'plain english' highly readable, putting you head and shoulders above [those] who engage in foolish jargon. Don't change a thing."

Thank you Jeff. This is something I strive for, and I am pleased that you noticed. I don't believe it is fancy words that make for a high-level discussion. Instead it is deep thoughts, fully understood and clearly articulated. In fact, fancy words are often used to intentionally obfuscate the meaning (or lack of meaning) in what is being said. And sometimes words have different meanings to different people, hopelessly confusing any discussion.

So what I'd like to do here is to explore the definitions of a few relevant words in plain English. To do this I will utilize various online dictionaries, a few friends, and my own plain English. Fair enough? I had a list of six words I was going to tackle, but as you can see by how long this post turned out I had to cut it down to three: recapitalization, liquidity and reserves.

Recapitalization

This is an especially tricky word because it definitely means different things to different people. At its root is the word "capital" which has been redefined through 66 years of $IMFS rule. But redefined or not, the only definition that actually works in times of systemic transition hasn't changed. After all, "money" is just a temporary intermediate surrogate for "real capital".

Imagine a family unit that has found itself to be bankrupt. How would it undertake a recapitalization? Would it borrow more money, or take a large cash advance and consider itself "recapitalized"? Of course not. It would immediately stop unnecessary spending and start saving its income. The same process we call "austerity" when applied to countries like Greece.

Investorwords.com defines recapitalization as a change in the permanent long-term financing of a company, including long-term debt, stock, and retained earnings. It says recapitalization is often undertaken with the aim of making the company's capital structure more stable.

So in plain English, recapitalization means reorganizing your ways and means for long-term financial survival, sustainability and stability. And this applies on all scales, not just to companies, but also to individuals, sovereign nations and even the global economy.

I mentioned above that individuals and nations (that cannot print their own reserve currency) both recapitalize by decreasing spending and increasing saving. This goes for most private corporations as well. But in a recent ECB press conference, Jean-Claude Trichet stressed the need for commercial banks to recapitalize themselves through other means. He did mention "retaining earnings" (saving), but he also encouraged banks to "use the markets" and to "take full advantage of government support measures for recapitalisation."

Jean-Claude Trichet at a press conference

This made me wonder if the banking system defines
"recapitalization" the same way the rest of us do. So I went back to Investorwords.com and read more about "recapitalization":

"Recapitalization is often undertaken with the aim of making the company's capital structure more stable, and sometimes to boost the company's stock price (for example, by issuing bonds and buying stock). Companies that do not want to become hostile takeover targets might undergo a recapitalization by taking on a very large amount of debt, and issuing substantial dividends to their shareholders (this makes the stock riskier, but the high dividends may still make them attractive to shareholders)."

Hmm... Does this sounded familiar? Borrow lots of money at almost 0% and then use it to buy (pump) your own stock? Interesting concept. Especially since I found it in the definition of "recapitalization" on a $IMFS financial website. Not exactly a "long-term", sustainable or stable recapitalization. But what the heck do I know?

In another article I read recently, titled funny enough, Cash Is Now King, Worthless Or Not, So Buy Dollars, John Taylor, Chairman and CEO of FX Concepts (Foreign Exchange Concepts), "one of the world's oldest and most established independent currency managers", explained that the entire world is now in the process of recapitalization. Everyone is doing the "austerity two-step"; cut spending, start saving. Everyone is saving their income (rather than spending every penny they earn plus more through debt). Everyone is hoarding dollars. And you should too.

John R. Taylor, Jr.

Taylor correctly points to the difference between macro and micro views of the economy in explaining misleading GDP data. The micro view looks only at individual entities, each recapitalizing, saving and repairing their balance sheets in one way or another, while ignoring the fact that when everyone is forced to do this all at once it lubricates the real economy like C&H pure cane sugar lubricates a Formula 1 engine. He goes on to quote Keynes in this regard:

"Keynes famously noted that there was a savings paradox. As I would paraphrase it, if one family saves, it is good for the family, but if all families save, the economy will be ruined. This is happening everywhere. The S&P 500 companies are all saving, by cutting costs – and building giant worthless cash mountains (like they did in the 1930’s) – but this is shrinking nominal GDP as their saved costs are others’ lost earnings. The global economies are all trying to grow by increasing exports, which is the same as saving. If there are no countries stimulating consumption, the world economy will shrink. If all countries try to balance their fiscal books, they are clearly saving. The Eurozone, the UK, and the American states are dramatic examples of this. And if consumers build up their savings, we know what happens to retail sales and the GDP."

Remember that unlike gold, which can simply be mined (dug up) from the ground by anyone, cash cannot. Dollars are not so easily gathered in nature. Only one person (Ben Bernanke) can produce real dollars, while ANYONE can dig up more gold. And Taylor says that everyone is hoarding dollars today, meaning the velocity of the buck stops here. So you should hoard them too. Greenbacks will be very hard to come by, especially for the debtors who will most likely have to default, while the whole world recapitalizes itself on scarce (even though they're worthless) dollars.

In other words, even if paper money completely ceases to perform its primary role - medium of exchange - it can still be counted on to gain value in its secondary role - store of value - "worthless or not."

Remember at the top of this section I said that the definition of "capital" had been rewritten over the past 66 years? And I also said that only the OLD definition would work in times of transition? If you are consolidating your wealth today, or even if you're doing the bankrupt-debtor-version of consolidation - recapitalizing your long-term financial prospects - how far down this pyramid do you think you should go for safety and/or return? And if the dollar is failing profoundly in its primary transactional function (to lubricate the real economy through new debt creation) then how long do you think it can possibly hold its value (GLOBALLY) being ONLY a "worthless" store of value?


Liquidity

Liquidity is another one of those hard-to-define words. Investorwords.com says it is "The ability of an asset to be converted into cash quickly and without any price discount."

In the above press conference Trichet said, "...we are in a situation of liquidity withdrawal. But it was the will of the banks [not the ECB], because they had an unlimited supply of liquidity [from us]... I would say that we [the ECB] are still in a mode of unlimited supply of liquidity."

BusinessDictionary.com says liquidity is the measure of the extent to which an entity has cash to meet immediate and short-term obligations, or the ability of current assets to meet current liabilities.

So, to me, liquidity seems to mean our day-to-day ability to meet our day-to-day needs. Fair enough?

But in the $IMFS-ruled banking world liquidity seems only to mean the availability of credit (debt), waiting to be lent (borrowed), at an interest rate that is advantagious to borrowers (not savers). Trichet's statement (above) was in response to a question about the rising interbank interest rates. The question was:

"Do you think that the current interbank borrowing costs are appropriate? And do you expect them to rise further? And were you happy with the recent increase? In the same context, if you are not happy with the market developments, what options does the ECB have to steer interbank market rates in the future?"

So from this, I think we can make a few observations about how "liquidity" really works in the $IMFS.

The first is that rising interest rates correlate with "liquidity withdrawal" -- or let's just say "lack of liquidity". Causation is unclear within this observation alone. Did the withdrawal of "liquidity" cause interest rates to rise? Or did rising interest rates cause the withdrawal of the "liquidity"? Which came first, the chicken or the egg?

The second observation helps us answer the above causality question. And this is that "an unlimited supply of liquidity" does not create liquidity. As Trichet himself said, the ECB is providing an "unlimited supply of liquidity" yet the banking system is in a "situation of liquidity withdrawal." Does this sound like it might violate some universal principle, say, Aristotle's Principle of Non-contradiction?

Aristotle

He who examines the most general features of existence, must investigate also the principles of reasoning. For he who gets the best grasp of his respective subject will be most able to discuss its basic principles. So that he who gets the best grasp of existing things qua existing must be able to discuss the basic principles of all existence; and he is the philosopher. And the most certain principle of all is that about which it is impossible to be mistaken... It is clear, then, that such a principle is the most certain of all and we can state it thus: "It is impossible for the same thing at the same time to belong and not belong to the same thing at the same time and in the same respect."

-Aristotle, Metaphysics, 1005b12-20
Formulation for the Law of Non-contradiction
http://www.non-contradiction.com/

In plain English, it is impossible to be (unlimited liquidity) and not to be (the opposite - a situation of liquidity withdrawal) at the same time and in the same respect.

Our third observation (closely tied to the second) is that it is not the lender (supply) that creates "liquidity", but the borrower (demand). If systemic liquidity is being "withdrawn" (in reality it is disappearing into thin air, withdrawn is the causally-wrong way to look at it) at the same time "unlimited liquidity" is being offered, this is the only conclusion we can draw. That demand for more debt creates $IMFS liquidity, not supply. And perhaps demand is dead?

Stepping back from the banking world's "ledge of risk and doom" and onto the solid ground of the real world, liquidity seems to mean something entirely different. ANOTHER gave us a clue back in 1998:

Date: Fri Jan 23 1998 19:01
ANOTHER (THOUGHTS!) ID#60253:

Do you really hold dollars?

It is important to understand that few persons or governments hold US dollars! Look at any investment portfolio and what you will find are "assets denominated in US$". This sounds simple, but it is not. You have heard the phrase, "money is moving into real estate, land, oil, stocks or bonds". It is a bad meaning, as it does not what it says.

All modern digital currencies do not go into an investment, they move THRU it. The US unit is only an exchange medium to acquire assets valued in dollars. US government bonds are the usual holding. No CB holds any currency! They hold the bonds of that currency. The major problem today, is that digital currencies have erased the currency denominations of all government/nation debt holdings! Even though a debt is marked as DM, USA, YEN, they are in "real time" / "marked to the market" and cross valued in all currencies! No currency asset, held by CBs today are valued in the light of a single issuing country, rather "all currencies are locked together". To lose one large national currency, is to lose the entire structure as we know it!

There is an alternative. Gold! It is the only medium that currencies do not "move thru". It is the only Money that cannot be valued by currencies. It is gold that denominates currency. It is to say "gold moves thru paper currencies". Gold can be used to revalue any asset, and not be destroyed in the process!

Viewed this way, liquidity can be pictured as the ability to traverse my dual pyramid introduced in Gold is Wealth, level by level, and from the top to the bottom. The top pyramid is "the monetary plane" or "matrix" and the bottom is "the physical plane".


Here are a few more very relevant Thoughts on liquidity and gold from FOA and friends. These are not in The Gold Trail. They are from the regular forum archives prior to The Gold Trail, so many of you may not have seen these posts before now. Enjoy!

Friend of Another (10/29/98; 10:28:53MDT - Msg ID:845)

Even in today's engineered society, it is the interaction of human wants and desires that make the world turn. In the simplest of terms, modern fiat currencies are created through borrowing (the creation of debts as assets) by individuals. When enough debt is created that all assets have been borrowed against, the borrowing, on a net basis, no longer expands the currency. With the currency no longer functioning as an economic expansion tool, its most useful reason for existence is lost. In this stage, the federal treasuries and CBs no longer have the power to control their money. The
government response concerning local money takes on the function of only lowering interest rates to protect the economy / banking system.

Friend of Another (10/13/98; 10:51:03MDT - Msg ID:556)

The central purpose behind the Yen Carry trade and the Gold Carry trade is to place liquidity into the world financial structure. This action was made necessary by the failure of the US dollar to function any further as a money creation vehicle. In these last days of the dollar, worldwide debt as denominated in dollars has ceased to expand and is indeed contracting. This is a natural event that occurs in the latter time cycle of un-backed paper currencies. This contraction was expected to complete the fiat money cycle back in the late 1980s. It has been the Central Banks, lead by the BIS that created ingenious ways to expand liquidity until another currency system could be introduced. In these 1990s, the Yen / Gold Carry was one of those ways.

Much of the Gold lending dealings is more a function of paper contracts than actual gold sales. Using my "water flow" point above, if that much gold was actually sold out into the industry, we would have seen major reductions from the gold asset side of the Central Banks. The true purpose of the leasing (not all of it , just most of it) was to create cheap money that could flow into other aspects of the economy and help perpetuate a boom, worldwide. As seen in the LTCM debacle, a little money in the right hands can be multiplied into billions of new found liquidity. Now consider that some have stated that the gold loan contracts amount to 8,000 tonnes or more! Another has said that they, if actually closed out as gold deliveries would amount to over 14,000 tonnes! Suddenly we see where the money has come from to gun the world asset markets. A market of
trillions!

So, why are they called gold loans if the gold isn't used? The point is the gold is used. It is the final commitment or backup if the deals fail. When a hedge fund (or mine) cannot repay the "cash equivalent" of the gold or "the gold itself", then the Central Bank, as the originator of the deal must deliver Real Gold or PAY IN A HARD CURRENCY!

One of the things that Another has been guiding us to for over a year is that the current gold deals amount to an all out corner on the CB gold supply. The major people that are on the other side of these Gold Loans (lets call them what they really are: currency loans on a worldwide scope that is backed, ultimately with much of the CB gold) will call for this gold that was already paid for over many years! The intent of the Euro Group CBs was to have these loans self liquidate in a normal fashion. If they did not them they would pay the equivalent of the gold owed in Euros! A function, in actuality, of issuing Euros for already sold gold! Furthering a pending proposition between the ECB and its EMCBs.

Now, my friends, you understand why a Euro price for gold of $6,000+ (current rate), if in effect a year or so after that currency debuts will create a reserve currency of tremendious debth and holdings worldwide. It will be a welcome development. With the dollar falling from reserve status and the total default of dollar based gold contracts, physical gold will be an "investment for a lifetime" as Another has said! The demand for gold as a currency reserve by governments and as a currency alternative by citizens, will amount to more metal than exists.

I credit Another with most of this input. It is his wish that these thoughts be discussed by all, for all to see.
Thanks FOA

Aragorn III (10/29/98; 15:37:25MDT - Msg ID:848)

As the banks still hold the gold that was promised on paper as a result of the short sale/forward sale/gold loan (call it whatever you like), rather than give up the gold, they will settle the short seller's default with CASH--euro cash, not the gold. This will add new euro liquidity into the world that is effectively backed by gold...100% in terms of THAT cash amount. The gold stays in the bank, and the world has a new pricing mechanism for gold...euros. A lot of 'em! Non-inflationary liquidity! What started as a means to prolong USDollar liquidity (and remove gold from investor psyche through falling prices -- remember, the euro has been in the works for years) becomes a natural (and brilliant) means to generate a non-inflationary world supply of euros sufficient to fill non-european national vaults as the new world reserve currency."

FOA (4/25/99; 17:40:44MDT - Msg ID:5145)
GOLD?

As I mentioned in an earlier post a few days ago, the IMF / dollar engine is shutting down. Just look at M3 money supply GROWTH, straight down!

The IMF must quickly find liquidity through government gold sales to support dollar debt reserves held in other countries. If not, the dollar will be destroyed in a nuclear currency event. By selling gold receipts, they can leverage the those assets ten times plus, using derivatives. That money will be used as loan collateral. Ever wonder why we never see the physical trail of the real gold assets? It's because they never move the gold, just free it up to write derivatives against it in the OTC market.

Who will gain from this? Anyone that has leveraged dollar reserves into gold derivatives reserves that will be bailed out using Euros! Not to mention that gold will soar into the thousands. I wonder what entities would have purchased so much gold?

FOA

FOA (4/26/99; 10:10:31MDT - Msg ID:5183)
M3 money supply!

This is why they want to free up and leverage the IMF gold. The other world CBs are not selling so the only way to force it out, for paper liquidity creation is through an existing IMF structure! The game continues. FOA

Aristotle (4/28/99; 0:05:40MDT - Msg ID:5258)
"Camdessus Says IMF 'Will Certainly' Sell Some Gold to Fund Debt Relief"

America essentially has veto power with 17.5% of the IMF Board vote--85% needed to approve the sale. As we've seen from a recent post from Aragorn, the 11 unified EMU nations would effectively have veto power also (with 22.4%) if this sale were seen as a legitimate threat to their cause. So, from the IMF Director characterizing these Gold sales as a done deal, may we conclude that this has already been worked out behind the scenes, and is ultimately (somehow) in the best interest of all?

These international institutions clearly don't hold their Gold as future inventory for jewelers. It is NOT being demonitized, and for that reason, I think the characterization of this coming IMF Gold 'redistribution' as a SALE is misleading, at best. But frankly, as one who is thrilled to acquire Gold month after month at these prices, I welcome their choice of words and the accompanying rhetoric. I know it must be hell on the mining companies and people acting on short time horizons, but much evidence points to the end of this incredible span of time in economic history. Looking back, I will surely take comfort in knowing that I acquired as much as my means allowed me to, and even at that, I will surely be saddened by the smallish box that accomodates the total. So be it. Such is the high value of this rarest and most important monetary asset on Earth.

---Aristotle

FOA (4/28/99; 7:04:43MDT - Msg ID:5261)
IMF

Aristotle,
I think the IMF gold sale has been worked out already. Any further public statements are just political posturing. The term "sales" is indeed misleading and true words like "leveraging assets to provide further loan guarantees" will never be used. Aristotle, gold is now the last asset and the US / IMF factions are going to have to make it rise to provide liquidity. As I said before, the BIS and its European / other allies have (for the past year or so) blocked any further lowering of the gold price. If the US wants to protect its remaining dollar reserve viability, (by maintaining all foreign dollar reserve debt) it now must allow it to depreciate against gold to provide liquidity.

That, my friend is the only avenue left for them! This will, as Another has pointed out, drive assets to the other new reserve system. As I mentioned to Christine, national entities will have a choice as will you and I and Christine. That being, stay with a falling dollar or move into Euros and gold.

Free choice is what it's all about, not conspiracy. FOA

SteveH (07/24/99; 14:20:29MDT - Msg ID:9584)

PS. FOA, the first paragraph above seems to describe what a Gold contract for oil is. Did I get it right?

Central Banks guarantee or deliver gold to a bullion bank for a small fee of 1 or 2%. Most probably only guarantee gold backing in the event a bullion bank defaults. A bullion bank cuts a deal with a miner for physical gold in return for money to operate. The mine pays back the loan over time with gold plus gold interest. One or more oil countries buy the contract from the Bullion Bank for the repaid gold from the mine with dollars from oil production. The oil country now receives the gold that the mine repays. The bullion bank's guarantee from the CB goes with the contract to the oil country. So, if a mining company defaults on a repayment, the Bullion Bank will guarantee the oil country payment against the default. It may actually have to go to a CB for the gold to repay the default. This is what I believe is happening in the Bank of England Auction.

FOA (07/24/99; 15:37:27MDT - Msg ID:9588)
Reply

Steve,
It's right in that that is one of many ways. When one reads "Aristotle's Work", it's so easy to see the purpose behind it all. The maintenance of a world fiat currency system requires a constant expansion of liquidity (more money) to keep it working. In the old days, when a borrower defaulted on a "gold loan" (that was what a dollar loan was back then) the entity that held that debt paper lost his buying power. Be it the bank or an individual, the loan security became worthless and was written off. The write-off was certain because no one could (or would) come up with the gold to pay off the loan. Eventually, the US did issue more "gold loans" in the form of the dollar ("a gold contract currency") than it had gold to honor the $35 contract. Just a plain old fraud of creating new money so someone of importance didn't have to fail (lose some of their wealth).

Today, all kinds of loan guarantees are used to back modern fiat dollar loans. If they default, someone (a national treasury) prints the money to buy the loan so no one loses anything. Usually, if the loan is guaranteed, the lending institution just lends more money to try and keep the business going. However, in real life, a fiat reserve system, just as in a gold money system, is always in a natural state of deflation as bad loans appear. So, in time, a paper money system always swells large enough to pass the point that it can create more liquidity (money).

That's what happened with the dollar reserve world. Every US treasury obligation held as a Central Bank reserve was used to create its maximum amount of liquidity. Sometime in the 80s or so they had to start borrowing against gold as debt defaults were destroying wealth faster than the dollar system could supply replacements.

We all worry so much about CBs lending gold reserves, my friend, every other reserve they hold is in the form of lent assets! I won't find any crisp, unlent dollar bills in any of their reserve hoards. The gold represented the last asset for the expansion of the world money supply. It's lent because they can fractionalise it just like a fiat currency. One ounce sold creates only one ounce of liquidity. One ounce lent, can create 90 ounces of paper gold and the dollar liquidity that provides. When they do actually sell it, most of it goes to other CBs. A "fact" supported by the WGC that no one wants to factor, because it destroys their argument about the CBs supplying physical to fill the deficit. Check it out, 300 tones or so over ten years is the net out reduction of gold reserves.

All of this bears out why this entire "new gold market" is SO important to the present dollar / IMF system. It's entirely a paper gold arena that really trades CB vault gold "as guarantees". Crash this Arena and the dollar is history as we know it.

thanks steve, I'm here for a while. More later FOA

International Liquidity

There is one type of liquidity that is of absolute importance. And that is "international liquidity". It is the kind of liquidity that lubricates the cross-border flow of real, essential goods like heating oil, food and medicine. It is the very existence of this imperative for sufficient international liquidity that puts the greatest strain on a fiat currency system at the very end of its timeline while it desperately tries to push out "unlimited liquidity", but fails to do more than push on a string.

In 1969, shortly after the collapse of the London Gold Pool and the devaluation of the pound sterling, while the Bretton Woods gold exchange standard was imploding, Alexandre Lamfalussy gave a speech at the IMF titled The Role Of Monetary Gold Over The Next Ten Years. In it he addressed the fact that gold, being of relatively fixed supply, when also fixed at a specified par (price) with the inflating currency, automatically disappears as a source of new international liquidity. Here is a short excerpt:

The striking fact apparent from this Table is that over the last ten years, gold has practically no longer contributed to the growth of international liquidity. In ten years, total foreign reserves rose by nearly 19 billion dollars; the greater part of this increase -- some 14 billion -- was due to increased holdings in foreign currencies, whereas the increase in the reserve positions with the International Monetary Fund was about 4 billion. The increase in gold stocks was less than one billion; in fact, there was a decline between 1963 and 1968 [thanks to the London Gold Pool]. Consequently, the share of gold holdings in total reserves, which was 66 per cent at the end of 1958, fell, to 51 per cent at the end of 1968.


It is therefore right to say that over the last ten years and in particular since 1963-64, we have witnessed a gradual decline in the role of gold as a means of reserve and its complete disappearance as a source of new international liquidity. At the same time, the mechanics of the gold-exchange standard have ceased to function: the creation of reserves by the spontaneous holding of dollars or Sterling has come to a halt and has been replaced by the creation of negotiated reserves.

Alexandre Lamfalussy speaks at the Bank of Greece in 2006 on Monetary Policy and Systemic Risk Prevention - Challenges ahead for Central Banks

I would like to draw your attention to the almost interchangeable way Lamfalussy used the terms "international liquidity" and "reserves". It seems that gold's share (percentage) of total reserves has something to do with that most important type of liquidity, "international liquidity". That's because, when properly defined, they are ONE AND THE SAME!

Reserves

Reserves is another tough word that means different things to different people. Investorwords.com offers two seemingly relevant definitions:

1. In asset-based lending, the difference between the value of the collateral and the amount lent.

2. Funds set aside for emergencies or other future needs.

But the definition I will be focusing in on is closest to #2, because that is how central bankers define reserves and it is how we as individuals should as well. It is also the definition most closely related to the aforementioned and most critically vital "international liquidity".

In your monthly bank statement you probably have two accounts, a checking and a savings account. Well, maybe not you, per se, dear FOFOA readers, but most people do. In addition to these two accounts you probably also work for an income, unlike some bloggers I know. ;) And as your paychecks come in you probably put most of that money into your checking account for your day-to-day needs and hopefully you put your excess money into your savings account (or some other savings "vessel").

My point is to demonstrate that we all differentiate between our normal assets set aside for everyday trading needs (income and checking account) and our reserves (savings account/reserve assets) which are set aside specifically "for a rainy day". Central banks are no different. As I said earlier, the principles discussed in this post work on all scales, personal, corporate, national and international.

So let's take a look at a central bank's balance sheet. How about the latest Eurosystem ConFinStat (Consolidated financial statement) released on July 7, 2010? It is published by the ECB but it is called "consolidated" because it covers the entire Eurosystem.


You can click on the image to see it full-size or the link above will take you to it on the ECB website. Now, you will notice the left side is a list of assets and the right side is a list of liabilities, just like anyone's financial statement, even yours! So how can we tell the "everyday assets" from the reserves?

Well central bankers have a very quick and easy way to tell the difference between their normal, everyday assets and their reserves. The regular assets are all claims denominated in their own currency... and the reserves are not. One is internal (domestic) and the other is very decidedly foreign/external (international).

With the key exception being gold, credit is at the very core of the phenomenon we call "money". And insofar as credit on any balance sheet is concerned, a liability is when another entity has a claim on you, and an asset is where you have a claim on another entity.

Those credits can be denominated in various currency units, and it is the goal of the balance sheet to help a bank keep score on itself to ensure that it doesn't overextend itself by emitting more liabilities (claims against itself) than it can balance against its own assets (its claims upon others).

At the central banking level, like the ECB, institutional liabilities largely take the form of issuance of currency and deposits held at the CB on behalf of commercial banks (such as those to meet reserve requirements and to facilitate check-clearing between institutions). These liabilities are denominated in its own domestic monetary unit (i.e., the euro.)

The assets to balance against these liabilities are largely in form of euro-denominated claims on commercial credit/banking institutions. As these claims are often collateralized by government bonds, at the very end of the rope it is fair to say a large portion of assets held by the central bank take the form of government bonds even though they were (largely) acquired indirectly through typical financing operations to extend credit (liquidity) to the commercial banks.

Euro-denominated claims (assets) are suitable for offsetting euro-denominated liabilities, but they do NOTHING in regard to your rare "rainy day" when it is found necessary to defend the euro's stature against its foreign peers. For that purpose a central bank needs to have either gold (which is a universal asset) and/or a net (positive) position in foreign currency assets, IMF SDR's and other assets denominated in "reserve currency" units, meaning mostly the US dollar, the pound, the yen, and (outside the Eurozone) the euro. It is this combination of gold and net foreign currency assets that constitute the official "reserves" of any central bank.

The proportion of RESERVE assets among the central bank's TOTAL assets is usually a judgement call. Generally, the more unstable or insecure a central bank deems its national government and economy to be on the world stage, the larger the proportion of assets it will hold in the form of reserves. (Recall the expansion of reserves among Asian countries following the 1997 Asian Contagion crisis.)

And regarding the make-up of the reserve assets specifically, it is ultimately a central bank's own internal management decision that determines what proportion of reserves are in the form of gold versus foreign currency. Of course, there is often a political component as well, such as "good will" or crude attempts at bilateral exchange rate intervention -- akin to playing pick-up-sticks while wearing oven mitts.

Historically, official reserves were ONLY gold. But through the Bretton Woods experiment we evolved into what we have today. Wikipedia describes this transition succinctly:

Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From 1944-1968, the US dollar was convertible into gold through the Federal Reserve System, but after 1968 only central banks could convert dollars into gold from official gold reserves, and after 1973 no individual or institution could convert US dollars into gold from official gold reserves. Since 1973, no major currencies have been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can function as official international reserves.

In a flexible exchange rate system, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank (since it prints the money or fiat currency as IOUs). This action can stabilize the value of the domestic currency.

Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates.

Excess reserves

Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations, however, other government funds that are counted as liquid assets that can be applied to liabilities in times of crisis include stabilization funds, otherwise known as sovereign wealth funds. If those were included, Norway and Persian Gulf States would rank higher on these lists, and UAE's $1.3 trillion Abu Dhabi Investment Authority would be second after China. Singapore also has significant government funds including Temasek Holdings and GIC. India is also planning to create its own investment firm from its foreign exchange reserves.

Recall Lamfalussy's 1969 speech above. In the decade from 1958-1968, the gold proportion of the make-up of all international reserves DECLINED from 66% --> 51%. Remember? And there was another interesting thing Lamfalussy said about reserves that matches what wikipedia says (above):

Wikipedia: Foreign exchange reserves are important indicators of ability to repay foreign debt...

Lamfalussy (1969) at the IMF: "The IMF definition [of "international liquidity"] has the additional merit of limiting the concept of international liquidity to the amount of reserves over which the monetary authorities of a country have unconditional and immediate command. This is not without importance in a era dominated by vast and swift movements of capital, when speculative attitudes are strongly influenced by the confidence (or lack of confidence) one can have in the ability of the national authorities to settle their debts immediately and unconditionally. On this point I published a recent article in the December 1968 number of the “Recherche 5 Economiques de Louvain”."

So now that we understand how central banks define their reserves, similar to "2. Funds set aside for emergencies or other future needs", also "international liquidity", lets take a look at the actual make-up of the Eurosystem's present official reserves.


On the asset side of the statement, lines 1 and 2 are the reserves. So we have:

1. Gold - €352,092,000,000
2. Foreign currency claims outside the Eurozone - €232,639,000,000

Adding them we see that the Eurosystem has total reserves of €584,731,000,000 as of July 2, 2010. Considering that €352 billion of that is gold, we can say that the gold proportion of the Eurosystem's reserves is presently 60% (60.21% to be more precise).

Next, let's do the same calculation on the Eurosystems FIRST ConFinStat and compare the two.


Assets (as at January 1, 1999):

1. Gold - €99,598,000,000
2. Foreign currency claims outside the Eurozone - €230,342,000,000

Total reserves at ECB MTM concept innauguration - €329,940,000,000
Gold proportion of the Eurosystem's reserves on Jan. 1, 1999 - 30% (30.19% if you insist).

Conclusion (And isn't it an interesting one?): During the last decade of the Bretton Woods "experiment", 1958-1968, gold failed to produce new international liquidity and fell from 66% --> 51% as a proportion of international reserves. But during the FIRST decade of the Freegold (ECB MTM FLOATING gold price) "experiment", gold has risen from 30% --> 60% of the Eurosystem's (international liquidity) reserves!

Think on this one for a while. It deserves at least that.

1958-1968 - 66% --> 51%
1999-2010 - 30% --> 60%

And where do you think it might be going?

1999-->2010-->201_ - 30% --> 60% --> 9_%?

To be fair, we should also look at that same gold evolution from a weight perspective (the opposite of the ECB MTM Freegold floating gold price perspective).

The official gold used in Lamfalussy's statistics totalled 33,769 metric tonnes in 1958 and 34,569 tonnes in 1968. And the Eurosystem's total official gold was 12,576 tonnes on Jan. 1, 1999, and today it is 10,833 tonnes. Note that these weights are not from the WGC or Wikipedia. They are directly from official financial statements.

So we can now see that, measured by weight alone, gold reserves ROSE by 800 tonnes from 1958 to 1968, while, at the same time, falling as a proportion of total reserves. Also, measured by weight alone, the Eurosystem's gold reserves actually FELL by 1,743 tonnes from 1999 to 2010, while, at the same time, RISING as a proportion of total reserves.

Again, please think about this for a while.

1958-1968 - UP 800 m/t; DOWN in relevance 66% --> 51%
1999-2010 - DOWN 1,743 m/t; UP in relevance 30% --> 60%

(Of course these weight changes are "net" over the entire decade. In the case of 1958-68 the official gold hoard actually spiked to 35,725 tonnes in 1963, up 1,956 tonnes, and then plunged 1,156 tonnes from '63 to '68 thanks to the misguided "interventions" of the London Gold Pool. Likewise, the Eurosystem actually sold more than 1,743 tonnes during the last decade, but this was offset by the small gold additions to the consolidated statement as the newer group of euro-member nations came on board as part of the Eurosystem. So 1,743 was the net change.)

And while we are on the subject of "gold sales", I'd like to briefly comment on the recent "hot topic" of the BIS gold swap. I have read myriad speculation on this gold swap with the BIS. But the one I give the most credence to belongs to Randal Strauss over at USAGold.com: "News & Views", as it relates directly to this post. Randy says,

"...throughout this entire crisis it has been the commercial banks which are highly stressed and in need of liquidity, NOT the central banks. (The CBs already have ample fire-power to create domestic liquidity at will or to access forex liquidity through preexisting bilateral loan agreements with their peers.)

...the more rational conclusion to the slender body of evidence is simply the continuing need/desire for forex liquidity on the part of the profoundly stressed commercial banks. In an effort to make the most out of the unallocated gold deposits managed by their various bullion banking departments, it takes no stretch of the imagination to see these employed in every manner of conceivable derivative utilization, with swaps ranking high among them in this current economic environment. But with so many of their commercial peers swimming in the same soup, it does not take terribly deep thinking to fathom how or why the BIS would emerge as a principle counterparty.

As the bullion banks are casting derivatives of their unallocated gold deposits time and again into the thusly-polluted waters of the market (note to self: never commit your physical gold to an unallocated account at a bank!) the central banks of the world who adhere to mark-to-market accounting principles can become understandably dismayed that the commercial banks, poised along the shoreline with their garbage, are creating a superficial blight upon the market’s perception of and confidence in this most important of all reserve assets — gold. It is no surprise, therefore, that the BIS would emerge — as a sort of vacuum sweeper — to suck up a goodly quantity of these filthy commercial derivatives and thereby working to clean up the gold market by taking the corresponding tonnage out of commercial circulation (even if only a temporary step), removing it for the time being from risk of any further derivatization and fractionalization.

As a bit of corroborating evidence, I would again point out that the European’s quarterly MTM revaluations on June 30 took place in a distinctly favorable environment — with gold prices residing near record high levels, thus allowing the gold portion of the European central banks’ reserves to strengthen the books at this critical juncture with a chart-topping €65.4 billion quarterly gain. Subsequently, the July 1st price drop was of no account — a nice physical buying opportunity for the rest of us ahead of future quarterly advances in the status and value of gold."

The only thing I would add to Randy's excellent analysis is that, to me, it doesn't really matter who or why. What is obvious is that THE most important kind of liquidity, "international liquidity", foreign liquidity, external liquidity, the hardest "liquidity" to round up, was desperately needed by someone. So they swapped one reserve for another, with the promise of getting it back, placing their gold in probably the safest hands in the world when considering a future dramatic Freegold revaluation. To me, this is evidence that the transition is near.

Reserves, wealth, "that which you cannot print", "that which is tradable outside your zone", "that which is hard, not easy, to get"... this is exactly what the system needs right now in VOLUME!!! And the CB's can no longer provide it. They are pushing on strings! So someone went to the ultimate bank with the ultimate asset, gold, and got themselves some of the ultimate liquidity, "international liquidity". And because debt is collapsing, CB printing is failing to provide this ultimate liquidity. The BIS gold swap is FRESH EVIDENCE that only gold can provide what the global system desperately needs today!

Summary

I started this long post stating that there is a new and unique opportunity directly in front of us, greater than any before. And that it is there for all with eyes to see. And then I went on to explore the seemingly amorphous definitions of three words that are key to understanding why this opportunity is as real, and as big, as ANOTHER said it was. So I guess now that you are probably as tired of reading as I am of writing, I should wrap this post up by using these words in a sentence (or three) so that we can flex our new, deeper understanding.

What the world needs now, other than love sweet love, is recapitalization through true, international liquidity. The kind that can only come from the MTM revaluation of true reserves. And when I say needs, I am talking about the kind of need that is a constant, not a variable. In other words, it is a fixed need that all other variables must, will and do conform to, one way or another, manipulated or not.

Today we can observe, as the ZH Taylor piece above does, that the real world is undergoing recapitalization through austerity and savings, the old fashioned way. And the commercial banking system is recapitalizing the newfangled way, by taking on unlimited debt liquidity and leveraging it to look good on the surface. And the central banks are prepared for whatever comes. As their dollar foreign reserves go up in smoke, their gold reserves will more than replace any lost value. And as this happens, that gold percentage will rise from 30% to 65% to 90+%.

Any time during 2004, 2005 or 2006 would have been a financially beneficial time to consolidate your perceived reserves held in home equity. But if you happened to sell your house and become a renter in late 2006 or early 2007, you got really lucky! Well, it's now "2007" for paper wealth. Time to consolidate that percieved value, before it goes the way of your old home equity. And for those of you that think a better time is yet to come, just look at any 10-year gold chart.

Now obviously I haven't connected ALL the dots for you in this post. But they are there... and self-discovery is a wonderful feeling. Recapitalization, international liquidity and reserves all relate very closely to gold when properly defined. Herein lies an epiphany worth discovering.

As ANOTHER and FOA taught us, a time of systemic transition is completely wrong for trading on technicals. Instead, it is the PERFECT time to consolidate on fundamentals, then sit back and wait. The reward, as ANOTHER put it, will be enough for one's lifetime. And what is gold? Oh yeah, it's the ultimate wealth consolidator.

Sincerely,
FOFOA