Continued from part I: we look at another financial book that we feel is of great relevance to investors today. In part I we put the book in context and then began a detailed look at what Ferdinand Lips deemed as key reasons for a 20 year bear market in the gold price. We continue this articulation from Herr Lips, starting with the role of the Bullion and Investment Banks.Enter the bullion banks
The major bullion banks then enter the fray to apparently compound the effects of the central bank activity. With their enthusiasm to borrow leased gold from the central banks, the bullion banks made spectacular sums of money by executing a 'Gold Carry Trade'. The bullion banks borrowed gold at a 1% lease rate, sold this gold (thereby putting more selling pressure on the market) and invested the proceeds in US Treasuries at a 5% yield.
Beyond the attraction of the Gold Carry Trade, the bullion banks had also discovered ways for gold to apparently achieve a yield. This involved gold forwards and loans, and they sold the idea to owners of above-ground gold and owners of gold ounces yet to be extracted. Holders of gold bullion (eg - central banks) would loan their asset for 1-2% a year, and this gold would be lent to gold miners, providing them with cheap credit at below market rates at 3-4% a year. The miners would then sell this gold on the spot or forward market to realise the value and use the sales proceeds. This chain apparently offered something for everyone, but soon a prudent hedging mechanism exploded into a "speculation machine". It all depended on a lower and lower gold price though.
"Investment bankers, encouraged by their lucrative profit centre, lost no time and lost no bearish argument to build up their clientele steadily and aggressively… What neither the central banks or gold mining companies realised at first was that this activity turned into a vicious circle contributing to lower and lower gold prices. So, if somebody wanted to manipulate the gold market, he only had to convince the central banks to lend more and the mines to hedge more. Then they could sit back and watch their income from fees grow. That they were undermining the gold price in the process did not concern them".
Herr Lips found that it made no sense to loan gold at such ridiculously low rates and then risk losing it in an exercise that contributing to the asset losing value. A dynamic was building, aided by newly alerted speculators and hedge funds who had identified the reasons for the gold price weakness, that allowed the price of gold to be depressed for years yet had nothing to do with supply or demand in the physical market. We are informed that the biggest overhang on the market was from central bank lending not from actual sales. The greater the bearish sentiment regarding the gold price, the more confident the speculators and beneficiaries from the short side became.Gold mines develop an addiction
Whilst Herr Lips has shown how this dynamic may not have been in the interests of the central banks, the mining industry had apparently developed an unhealthy addiction which was undermining the value of the very resource they extracted.
"The mining industry was, therefore, equally short sighted. They were selling what they had not dug up by borrowing the metal from central banks through bullion banks. Seduced by cheap loans, they started projects that would have been uneconomical under normal market circumstances. The more the gold price fell, the more difficult it became to remain profitable or to limit the size of their losses. Many companies, therefore, resorted to mining higher grade ores just to stay alive. They were selling the precious metal at the most unfavourable prices at the most inopportune time, thereby shortening the life of the mines. Also, exploration virtually stopped".
We are informed that the market had become so divorced from the fundamentals, and miners so over hedged in the pursuit of profits independent of gold mining, that once the gold price eventually and unsurprisingly rose, like a balloon having been held underwater, some miners hedge books caused them enormous loses. The price of their product had risen yet miners like Ashanti of Ghana and Cambior of Canada were victims of this price appreciation. Not only mine shareholders but gold producing countries felt this pain.
Within a discussion of a badly short-sighted mining industry Herr Lips provides the reader with a firm understanding of the importance of gold mining to gold producing countries that receive royalties from extraction. Notably some of the poorest nations on earth could have been earning greater incomes had the gold price been more naturally set at a higher level. In 1999 the WGC found that 30 of the 42 Heavily Indebted Poor Countries (HPIC) were gold producers, yet these had paradoxically been undermined by those offering a 'helping hand' such as the IMF and governments of some developed nations (often active sellers and lenders of gold into the aforementioned dynamic). Also worthy of careful attention is a detailed discussion with Professor Antal Fekete about the potentially questionable hedging and reporting practices of miners like Barrick, which we are told was not properly understood by the accounting profession which signed off on it.
Needless to say Herr Lips is not shy in expressing a subsequent opinion that the net losers from this dynamic were the miners, the mining shareholders, gold producing countries, central banks, along with employment generally, and the savers of the world. The beneficiaries are represented to be the bullion banks, the speculators that worked the short-side, and gold buyers. Readers might ask why demand from these encouraged buyer did not rebalance the supply demand balance, and this the price, but remember Mr Lips' assertion that the market was acting under a bounded rationality that prices would always remain weak, and likely get weaker.Switzerland in the Gold Wars
An account of the Gold Wars from a Swiss perspective was something new to us that Herr Lips also presented with great consideration and empathy.
We learn how gold rich Switzerland became a central target in the Gold Wars as it became ever more obviously sound and gilded in a world of debased fiat currencies. The Swiss Franc was superior to other money.
"The reason was quite simple: the Swiss Franc was 100% backed by gold, and therefore considered as good as gold".
After joining the IMF (a seller of gold and contributor to potential gold price manipulation) in 1992, the Swiss government and Swiss National Bank (SNB) "came to the surprising conclusion that, in today's world, a 40% reserve backing of its currency was no longer necessary. Under the IMF's Articles a currency being backed by, or linked to, gold is not permissible.
Herr Lips is firm in his stance that there was not a good reason for the Swiss to have joined the IMF, and "the reasons that were given to the electorate were simply not serious… Not one person may realise that it is Switzerland's political and economic suicide in slow motion". He cites disingenuous and illogical actions by duplicitous or duped Swiss politicians and central banks who had appeared to give up on gold's monetary role as well.
Switzerland had apparently fallen prey to masters of a new world order who were floating adrift of gold. If the Swiss could be persuaded to sell the majority of their gold, one of the last remaining national bullion stockpiles could be whittled down, and another strategic victory would have been achieved by those with interests to side-line gold forever from its apparently natural monetary role.
The reader is told of a concerning lack of public disclosure, and that ultimately Switzerland appears bullied out of its previously sound monetary habits. One must remember the historical backdrop of alleged complicity with the Nazi party for handling Nazi gold that Switzerland had found impossible to shrug off altogether (even if a range of independent observers found Switzerland's actions understandable if not wholly preferable - Winston Churchill and Harry Schultz among them) .
You may be thinking that this path towards a pure fiat currency fixed to nothing has continued with the SNB finally giving up on the integrity of the Swiss Franc in 2011, when it announced a peg to the Euro and the commitment to printing unlimited amounts of money to maintain this peg. Is this the final nail in the Swiss economic coffin? It's too early to tell, but it is interesting how many anecdotal reports fly around the City of London of regular and significant capital flows from Switzerland to apparently preferable havens, like Singapore.Final thoughts
Whilst it may be difficult to do justice to such a book that is held in such esteem, we hope we have not been entirely unsuccessful.
Herr Lips' writing is enjoyable, lively, rich and eloquent. His depth and breadth of the gold market was not far from unrivalled and it would seem the Austrian school lost a great contributor when he died in 2005. Gold Wars is an expression of his standing and is highly recommended by us. Just take a look at the bibliography to understand Lips' depth of knowledge and standing in the markets and banking systems he operated in.
We found interesting perspectives on, and dynamics observed within, the 20 year bear market in gold at ended in 2000. Within this we achieved deeper and more rounded appreciation for the role and nature of the mining industry, and how the practice of prudent hedging evolved to become a speculative endeavour with pernicious implications.
Perhaps most importantly we gained far greater understanding on what Gold Wars are, and how they can be identified. It appears that Switzerland may have been one of the final bulwarks to fall against the tides of corrupting fiat money.
This book is a vital part of any investor's collection and will likely prove most supplementary to your knowledge."The Gold War is nothing else than a Third World War. It is not only a most unnecessary but the most destructive of all wars. It should be stopped now".