One of the things I often do with this blog is to attempt to decipher some of the tougher concepts expressed by Another and FOA. I try to get into their heads and figure out what they really meant so that I can rephrase it in a way that (to me at least) is easier to understand. This is one of those posts.
The following question came to me via email from "Solitary Monk" who took his name from a comment left by Woland referring to the fact that he had "preserved our 'Library of Alexandria' from destruction" with the AFTER (THOUGHTS!) archive. Another contribution from SM was the "threshold levels of understanding" concept which first appeared in this post and seems to be more relevant with each passing day:
I think that there are "threshold levels of understanding" required to 1) buy, 2) hold until the transition begins, and 3) hold through the transition. Each requires a greater level of understanding. I can see from your writings that you know some people will make it through 1) and 2), but not 3). I've been working for a long time to prepare myself to get through 3). Your blog posts are one way to help with that.
Even though he has not commented on the blog, Solitary Monk has been on the Gold Trail since 1998 (15 years now) and he obviously enjoys quiet contemplation followed by insightful emails which he leaves up to me to decide whether or not to use them on the blog. So I figured I'd go ahead and answer his email with a post. I'm sure he won't mind. ;D His words are in red, FOA is in blue and I am in black:
Great question for a post! "Will be called in" tells me that the lender is calling in the loan to force immediate repayment, or in the impossibility of repayment, perhaps restructuring the terms of repayment. Yes, the loans were denominated in gold ounces, that is to say that one troy ounce of gold (XAU) was the unit of account. But what was actually lent was dollars, and what must be paid back in extremis is dollars. It is a basic principle that you cannot force repayment of a physical item, just like the tractor analogy with the shuttered tractor factory. Suppose a mine is destroyed by collapse or landslide, or it simply goes bankrupt. Which brings us to who most of these gold-denominated debtors were.
It was mostly the mines. The second largest group was hedge funds. But most of these loans are closed out now, while they were very common when FOA wrote the above. Even so, I think this "euro conversion" is worth exploring because it may still be applicable to the LBMA paper gold market, at least to its European customers. ;D
The loans were from the BBs to the mines and the hedgefunds, and, on a much smaller scale, to the gold fabricators and industrial users. But in order to resell these notes to the East and to Oil who like their physical, the CBs stood behind them with their gold leases to the BBs. That guarantee gave the paper the credibility it needed for buyers who actually wanted the physical from the mines. A lot of those CB leases have been unwound now as well, although some do remain on the books. So those could certainly be restructured with euro as the ultimate payment instead of dollars.
Imagine we have the collapse of the paper gold market and the BBs still owe X tonnes to the CBs. In extremis, they can only pay back those loans at the cash equivalent of the price of gold. But they were the ones who set that price of gold in their now-failed paper gold market. Do you think they can get away with paying back the CBs at the defunct low price of $200/oz. now that their market has failed to deliver?
I don't think so. I think the CBs would reestablish a physical-only market pretty quickly and that market would establish the cash price at which the BBs could retire their obligation to the CBs. Meanwhile, the dollar would be collapsing which, in reality, means an extreme shortage of dollars. No matter how many dollars the BBs could get a hold of, the FPOG (Freegold price of gold) would be outrunning them, making repayment impossible and restructure or default the only remaining options. And with their creditor being their new overlord, restructure becomes the only option if they want to keep operating.
So how is this good for the euro and bad for the dollar? Well, if you need dollars to buy something or service a debt, this is usage demand, and this adds strength to the dollar, no? Think of poor countries with IMF loans, and the effect of having oil and other commodities priced in dollars. These are both dollar-positive, are they not? And so through conversion, dollar demand is reduced while supply remains, which will be dollar-negative and euro-positive as the outward flow of dollars (from the US) turns inward.
This will also be good for the BBs, because euro will be in plentiful supply while dollars will be in short supply (which is the case when a currency is collapsing in value), and gold will be stable in euros while it is anything but stable in dollars. And the UoA for the loans is gold ounces, so that means the amount owed will be stable in euro while it was previously skyrocketing in scarce dollars. A win-win for everyone involved. Well, almost everyone. ;D
With convertibility gone, "this "paper gold item" may lose it's "integrity from oil" by way of "competition" from a new reserve currency [that offers the reestablishment of credible convertibility]." Does that first sentence make more sense now?
"In that day, "paper gold" will rush to become "physical gold"..." This part is pretty self-explanatory.
"...as "dollar gold contracts" rush to become "Euro gold contracts"." Just like I said above, if you are either party (creditor or debtor), you would rather have your loan payable in extremis in a stable, knowable amount than a crazily rising, impossible to achieve amount, no?
And, once again, all of these dollar-denominated trading accounts outside of the US do require actual Realdollars (US base money, either cash or liabilities tied directly to the Fed or through a US bank with an account at the Fed) for clearing, even if not for every single transaction. This principle lends strength to the flow that can be described as Realdollars heading outward from the US while real goods and services head inward, aka the trade deficit. So the conversion of this need for dollars to, instead, a need for euros for clearing, will contribute to the reversal of that flow I just described.
Think of every transaction as one side being the traded commodity and the other side being the money. Even in currency trading, one currency is the traded commodity and the other is the money. Today, the USD is the "money" (or the denominator) in most of the global markets. This requires real US dollars for clearing. So imagine the simple change of using a different money, and what impact that change will have on the flow I described above. It will make the current glut of homeless dollars want to "go home" as FOA said.
Here's a short paragraph I found in a tutorial that explains how the dollar is the main axis of most transactions today. This adds demand for dollars everywhere in the world:
In EUR-USD, the first currency which is Euro is the commodity and the second currency which is USD is the money. When you buy EUR-USD, in fact you pay USD to buy Euro. No matter in what currency your forex trading account is. You can have a trading account in USD, GBP, CAD or any other currency. When you want to buy EUR-USD, your broker changes your trading account capital into USD and then pays that USD to buy Euro. This is how it works. Any trade in forex market has to be done through USD. US dollar is the main currency and is the axis of all transactions in the forex market. Any currency pair that you buy or sell has to be done through USD. However, all of these process will be done automatically and you just need to click on the buy or sell buttons.
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Let's look at that last sentence a different way:
After that guess who will be waiting with a brand new hard world reserve currency, ready made for converting dollar gold liabilities/credits into Euro gold liabilities/credits!
As the paper gold market fails, the derivatives backing the BB's gold-ounce-denominated liabilities will fail to be able to bring in (buy) the metal required for redemption. Say the paper market stops trading at $250 per ounce. There will be ounce-denominated liabilities that still exist, and they can now be settled for $250 instead of a real ounce because, like I said, in extremis you cannot force repayment of a physical item. But will they all be closed out in exchange for USD250? Perhaps not.
Here's a better alternative for everyone involved. Remember that if repayment becomes impossible, then the alternatives are restructuring or default. And if the banks want to keep operating in the new system, restructuring becomes the only option. So, even as the paper market dies at $250 per ounce, the real price of physical gold will be much higher, and the operators of the new system know this. So perhaps they would rather not let the BBs cash everyone in a currency that gold is running away from when they could be cashed out in a currency that is "strong" (stable) in physical gold.
The new gold price in dollar terms will be soaring as the USG is printing like mad, but the euro price for an ounce will be stable. So even in the time it takes to cash everyone out in dollars, the amount of real gold each cashed-out customer could buy on the physical market is diminishing quickly. That's what happens when a currency collapses/hyperinflates. On the other hand, you could lock in everyone's physical Freegold purchasing power on a moment's notice by converting all of those USD250 liabilities into EUR liabilities at the going exchange rate of that moment.
Think of it like this: The moment the paper market stops trading, physical gold is now $55,000 and you have 220 "ounces" in your BB trading account. Each of those "ounces" is only worth $250 now. If you could get that cash fast enough, you could buy one single ounce on the new physical market. But it takes time for them to cash everyone out and for everyone to go buy that physical. And during that time, the dollar is collapsing. So your physical gold-denominated purchasing power is going to decline rapidly from a single ounce, to 3/4 of an ounce, to half an ounce and so on.
If, on the other hand, the BIS/ECB and the BBs agreed to do the euro conversion, there would be no rush. You (as a BB customer) would still only get a single ounce of physical for your 220 "ounces" of BB credits, but at least you would now be locked into that full ounce and the BBs could cash everyone out at a more leisurely pace since I'm sure there will be plenty more pressing concerns at that moment.
How could this conversion be facilitated by the ECB? Easy! Print the new euro for the banks in exchange for their derivative "assets" which are mostly dollar-denominated. The next step, I guess, would be to unwind and liquidate the derivatives. The banks are getting a great deal here, so the ECB could easily instruct them to liquidate them on behalf of the ECB and return the proceeds in EUR. This would put further downward pressure on the dollar and upward pressure on the euro.
Of course there would be some loss and the result would be a net-increase in euro base money. But the ECB could easily mop that up with a small sale of Eurosystem gold. Like I said, I have no idea what the actual stock of these BB ounce-denominated credits is, but let's say it's 10,000 "tonnes". Divide that by 220 and you get 45 tonnes, and let's say the derivative loss is 50% from the time of the euro conversion until liquidation. Divide 45 tonnes by 2 and the Eurosystem would have to sell about 23 tonnes to mop up the extra euro that were created by the conversion.
Today the Eurosystem has about 10,800 tonnes, so the cost of the conversion would be about 0.2% of its gold, wholly absorbed in real terms by the revaluation.
I think I basically explained this one above. But he does say "limited gold delivery" is an option in addition to Euro cash. "Limited gold delivery" would mean paying off the BB liabilities in ounces rather than euro at the new Freegold rate, so in my back-of-the-envelope calculation above, that would mean 45 tonnes, half of which could hopefully be recouped by the liquidation of (what was previously) 10,000 "tonnes" of correlated derivatives. So it's essentially the same thing.
The ECB moved to block any further erosion of the Euroland position. [This was written just after the Washington Agreement. I think that is what this refers to but I’m not sure.] Most certainly, all world gold contracts denominated in dollars [denominated in dollars???????????????] would have gravitated towards Euro conversion to best advantage the EMCB gold stocks. Indeed, in a brilliant move they have blocked that escape and doomed the dollar gold market to collapse from non delivery. The ECB can now effectively support its gold commitments thru either bullion allocation or Euro settlement. By marking to the market their gold reserves they will contrast the advantage of a dollar gold market collapse no matter what form it takes. Weather discounting of paper gold from non delivery as derivatives are sold in mass (plunging dollar gold price) or a complete run for delivery (what we are seeing now) that leaves 95% of the market shut down and still holding paper demands ( paper gold priced in the many thousands. prior to lock up), the Euro will gain reserve backing.
Any currency pair that you buy or sell has to be done through USD. However, all of these process will be done automatically and you just need to click on the buy or sell buttons.
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Euroland gold notes at the official gold price, "in EUROS"! They can do this because their currency holds exchange reserves in gold that adds value as gold rises. The extra Euros printed to supply this demand will only fill the dollar void and be represented with gold reserves. When the dollar "paper" price starts it's "final" dive into the pits by discounting it's present credibility, it will drag every contract holder with it. This risk is real and will fuel the drive that demands a new Euroland physical marketplace.
Perhaps the LBMA will fail to deliver on demand at $1,200, or $907 instead of $250, and that becomes the settlement price. Say it happens at $1,200 and the revaluation takes it to $55K in real terms. If you thought you had 46 ounces, you'll be cashed out at about 1 ounce. So why would the ECB want to do this rather than letting all Euroland paper gold holders suffer the fate of the dollar? Well, gold is to be an important part of the new system, yes? Need I say more?
Sure! Perhaps the "gold in hiding" period will be less than a day, at least in Euroland! ;D
Let's see; you have a gold loan on the books, physical supply dries up forcing a premium on metal over contract gold, the contract and futures markets freeze up and your asset in the form of loan paper is worth zero. Then the ECB in conjunction with the Euro faction of the BIS offers to restate the now worthless gold loans into Euro denominations and you are going to walk? Where? To the US?
In this context, the next reserve system is saving a portion of assets that were already destroyed by US special interest. US policy destroyed before the fact as much as the US printing presses destroyed the dollar gold ratios in 71. Think again, my friend.
Again, no question came with this quote, so I'll just make a comment. I think it is unlikely that the paper gold market will trade all the way to zero. Trading will have to be halted at some point and cash settlment executed to wind it all down. We obviously don't know when or at what price this will occur. But there are three main exchange rates that will come into play here.
The first is the $POG at which trading is halted. The second is the EUR-USD exchange rate at the time of any euro conversion of Euroland-based claims. And the third is the new Freegold (revalued) price of physical in euros. We could play with various guesses here and see how you Eurolander paper gold players will fare versus the ones elsewhere who'll be left dangling with dollars. But if we just use my back-of-the-envelope calculations above, you Europeans could get somewhere between 1/40th and 1/220th of what you thought you had, as opposed to getting close to zero. Not so great either way, which is why it's best to stick with physical, even in Europe! ;D
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A process is in the works to change our dollar / gold relationship again, after derivatives were inflated beyond use. Now, even the price of gold can no longer be captured on a par basis between derivative gold paper and real physical gold as the preceived value of gold is soaring. Once a super currency inflation breeds super price inflation; the derivative markets will begin to fail their hedge purpose and their trading value. These asset themselves will become the real risk.
Dollar supporters have no choice but to "NET OUT" at even any derivative hedge that may risk the system. That is, "Net Out" in a way that completely voids their risk transferring purpose as they are settled in dollar cash "no matter what effect inflation is having on the currency's value or your other dollar assets! Remember, the financial world today turns on dollar assets that are hedged; not just pure bare holdings! Block the hedge markets from performing and the dollar itself is unseated.
Make no mistake, every official rule and regulation ever written for currency crisis management involves not only currency profile assets, but also gold profile assets. With this concept in grasp; it's easy to see, with gold derivatives so widely used in current dollar support functions today, why they will be impacted as part of the paper mass.
Modern derivative usage involves gold derivatives and a new evolving crisis policy management will function somewhat the same as in 1971. It will arrive as some "net out" policy directive and universally abrogate all gold delivery options as part of the package. Any gold derivative that is used to support dollar currency exchange rates will be reworked to implement cash settlement against all claims for international currency derivatives written for gold.
It seems to me like he's talking about gold derivatives used to hedge non-gold investments, perhaps even bonds whose value is tied to interest rates, as it has long been assumed that gold moves in the opposite direction. If you buy a bunch of Treasury bonds at today's low interest rates (which supports the dollar exchange rate like when China buys Treasuries), you might be worried that interest rates could rise destroying the present value of your bonds. If that were to happen, you'd expect gold to rise, so you might hedge your large position in bonds with gold derivatives like COMEX futures options or something with a low cost and a high payout if the low-probability event happens.
The problem is that those hedges can only perform like an FDIC sticker that gives you confidence in your position, but cannot perform in real terms if what you worry about actually happens.
Is it no wonder that Euro Banks have no fear from writing short gold paper. Because the entire Euro money profile is in the background for them. Running in parallel to and not in conjunction with the current dollar system. Any Fed policy that must break the risk transferring dynamic of derivatives, to protect our US banks, will open the door to the ECB's dumping IMF protocols and using the Euro alone as their sole reserve currency. This will immediately shift all dollar derivative plays onto the market, dynamically devaluing our dollar in the process. The ECB would then be cashing out holders of their gold loans in Euros as dollar physical gold prices spike and paper gold prices plunge.
I guess the "IMF protocols" must be at least part of the reason that dollars are the axis of most transactions today. So what he's saying is that if the Fed is forced to do anything that jeopardizes the hedging functionality of the derivative structure, the ECB will be forced to abandon this protocol and allow its banks to start using euros as the axis of transactions. And if this happens, then it would cause the unwinding and liquidation of all dollar derivatives as the banks frantically scramble to switch them to euros. As I already mentioned above, this would not only put downward pressure on the dollar, sending dollars "home", but it would do so "dynamically" as FOA so brilliantly put it.
Higher still; we climb
Of course, the big difference is that Euroland will encourage a physical only market price that, in turn, also floats Euro gold values to the sky. All in an well balanced effort to replace the massive dollar asset base it lost. In this; the Euro will become the first currency block that functions as a local reserve, yet under scores its image with huge non- monetary gold assets. Is it no wonder that EuroLand citizens will be buying gold as much for its prospects to rise as for its ability to be a wealth savings. In this it will hedge the future remains of a dollar failure and its impact on the world system.
If Mr. Huge EuroLand bank owes the ECB system gold worth 100 million in current gold deals; [why does the bank owe these to the ECB system?] with each 1,000 euro rise in gold he finds himself able to settle in less received physical gold. In a true "cashed out" transition of currency reserve hedges, each ounce of contracted gold owed could be reduced many times. Every player in the gold system, that is caught with their pants down, will rush to be a part of any Euro workout. Indeed, for every major player that was long the gold loan system, for the purpose of buying gold, cash outs in Euros will offer the only return. Official players in the oil sector would eventually be receiving American gold (but that is Another story).
SM asked why the bank would owe gold to the ECB system. This would be a bullion bank that had leased gold from one of the Eurosystem CBs. As I mentioned earlier, there are probably less of these leases outstanding today than there were when FOA wrote that, but we can't know for sure since they removed the lease cap from the 2009 WAG renewal.
And here, in this last paragraph, he makes it clear that "any Euro workout," any "cashouts in Euros will offer the only return." It won't be a great return, because you will have missed out on a once-in-a-thousand-years revaluation and the opportunity of a lifetime, but it will still be better than holding a "dollar gold contract" while the dollar circles the drain. ;D