Orlin Grabbe - The Gold Market

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The Gold Market

by J. Orlin Grabbe

The Gold Market, Part 1 Gold in the international financial system. The London Gold Fixing.
The Gold Market, Part 2 Spot gold trading. The London Bullion Market Association.
The Gold Market, Part 3 Gold lease and libor rates. The forward price of gold. Gold swaps.
The Gold Market, Part 4 The World Trade Center bombing and the gold market. Gold futures. Exchange for physicals.
The Gold Market, Part 5 Gold FRAs. Gold interest-rate swaps. Gold interest-rate guarantees.
The Gold Market, Part 6 Gold options. Options as insurance contracts.

These articles are parts of a work in progress. ©1998-2000 J. Orlin Grabbe. All Rights Reserved.

The Gold Market

Part 1

by J. Orlin Grabbe

The gold market is a unique 24-hour-a-day market for the purchase or sale of one of history's longest-valued commodities. What gives the market its special character is the use of gold simultaneously as industrial commodity, as decoration (jewelry), and as a monetary asset. To understand the gold market, it is important to understand the latter function. Because gold has often formed a component of the local money supply, its history is intertwined with national and central bank politics.

Gold as Money

Gold is only one of many commodities that over the years have served as money--as a medium of exchange--in international trade and financial transactions. Such commodities have frequently varied. In many local communities (including nation-states), the most widely used commodity, or the product most traded with outsiders, has often functioned as money. In the Oregon territory from 1830 to 1840, for example, beaver skins were a customary medium of exchange. Then, as the population shifted from fur trapping to farming, wheat became the chief form of money, and from 1840 to 1848 promissory notes were made payable in so many bushels of wheat. Later, with the California gold discoveries in 1848, the Oregon legislature repealed the law making wheat legal tender, and proclaimed that thereafter only gold and silver were to be used to settle taxes and debts. For similar reasons, tobacco long served as the principal currency in Virginia. When the Virginia Company imported 150 "young and uncorrupt girls" as wives for the settlers in 1620 and 1621, the price per wife was initially 100 pounds of tobacco--later climbing to 150 pounds.

Only a few currencies, however, have had long-run durability as well as multi-territorial acceptability. Silver and gold are two of these. Roughly speaking, from the time of Columbus' discovery of America in 1492 to the California gold discovery in 1848, silver dominated in common circulation in America and Europe, while gold came into dominance following the Californian and Australian gold discoveries (see Chapter 8 in J. Laurence, The History of Bimetallism in the United States, D. Appleton and Company, 1901). Under the rule of the British Empire, the British pound sterling and the gold standard were adopted in much of the world. Toward the end of World War Two, the U.S. dollar and gold became the principal international reserve assets under the Bretton Woods agreement--a market position the U.S. dollar and gold have maintained despite the de facto dissolution of that system in the early 1970s.

The Post-WW2 Politics of Gold

Under the Bretton Woods Agreement forged at the Mt. Washington Hotel in Bretton Woods, New Hampshire in 1944, each member of the newly created International Monetary Fund (IMF) agreed to establish a par value for its currency, and to maintain the exchange rate for its currency within 1 percent of par value. In practice, since the principal reserve currency would be the U.S. dollar, this meant that other countries would peg their currencies to the U.S. dollar, and--once convertibility was restored--would buy and sell U.S. dollars to keep market exchange rates within the 1 percent band around par value. The United States, meanwhile, separately agreed to buy gold from or sell gold to foreign official monetary authorities at $35 per ounce in settlement of international financial transactions. The U.S. dollar was thus pegged to gold, and any other currency pegged to the dollar was indirectly pegged to gold at a price determined by its par value.

What does it mean to fix the price (the exchange value) of a currency or a commodity like gold? If no trading other than with official authorities is allowed (as when something is "inconvertible"), then fixing the price is easy. The central bank or exchange authority simply says the price is "X" and no one can say differently. If you want to trade gold for dollars, you have to deal with the central bank, and you have to trade at central bank prices. The central bank may in fact even refuse to trade with you, but it can still maintain the lawyerly notion that the exchange rate is "fixed." (Such a refusal, of course, will only lead to black market trading outside official channels.) If, however, free trade is allowed, fixing the price requires a great deal more. The price can be fixed only by altering either the supply of or the demand for the asset. For example, if you wanted to fix the price of gold at $35 per ounce, you could only do so by being willing and able to supply unlimited amounts of gold to the market to drive the price back down to $35 per ounce whenever there would otherwise be excess demand at that price, or to purchase unlimited amounts of gold from the market to drive the price back up to $35 per ounce whenever there would otherwise be excess supply at that price.

In order to peg the price of gold you would thus need two things: a large stock of gold to supply to the market whenever there is a tendency for the market price of gold to go up, and a large stock of dollars with which to purchase gold whenever there is a tendency for the market price of gold to go down. No problem. The U.S. had plenty of gold--about 60 percent of the world's stock. And, naturally, it also had plenty of dollars, which could be created with the stroke of a pen.

After the Bretton Woods Agreement, the price of gold remained uncontroversial for the next decade. But around 1960 the private market price of gold began to show a persistant tendency to rise above its official price of $35/ounce. So, in the fall of 1960, the United States joined with the central banks of the Common Market countries as well as with Great Britain and Switzerland to intervene in the private market for gold. If the private market price did not rise above $35 per ounce, it was felt, the Bretton Woods price was de facto the correct price, and in addition no one could complain if dollars were not exchangeable for gold. This coordinated intervention, which involved maintaining the gold price within a narrow range around $35 per ounce, became formalized a year later as the gold pool. Since London was the center of world gold trading, the pool was managed by the Bank of England, which intervened in the private market via the daily gold price fixing at N. M. Rothschild.

The London Gold Fixing

In its current form, the London gold price fixing takes place twice each business day, at 10:30 A.M. and 3:00 P.M. in the "fixing room" of the merchant banking firm of N. M. Rothschild. Five individuals, one each from five major gold-trading firms, are involved in the fixing. The firms represented are Mocatta & Goldsmid, a trading arm of Standard Chartered Bank; Sharps Pixley, a dealer owned by Deutsche Bank; N. M. Rothschild & Sons, whose representative acts as the auctioneer; Republic-Mase, a bullion subsidiary of Republic Bank; and Samuel Montagu, a merchant banking subsidiary of Midland Bank (owned by HSBC). Each representative at the fixing keeps an open phone line to his firm's trading room. Each trading room in turn has buy and sell orders, at various prices, from customers located all over the world. In addition, there are customers with no existing buy or sell orders who keep an open line to a trading room in touch with the fixing and who may decide to buy or sell depending on what price is announced. The N. M. Rothschild representative announces a price at which trading will begin. Each of the five individuals then confers with his trading room, and the trading room tallies up supply and demand--in terms of 400-ounce bars-- from orders originating around the world. In a few minutes, each firm has determined if it is a net buyer or seller of gold. If there is excess supply or demand a new price is announced, but no orders are filled until an equilibrium price is determined. The equilibrium price, at which supply equals demand, is referred to as the "fixing price." The A.M. and P.M. fixing prices are published daily in major newspapers.

Even though immediately before and after a fixing gold trading will continue at prices that may vary from the fixing price, the fixing price is an important benchmark in the gold market because much of the daily trading volume goes through at the fixing price. Hence some central banks value their gold at an average of daily fixing prices, and industrial customers often have contracts with their suppliers written in terms of the fixing price. Since a fixing price represents temporary equilibrium for a large volume of trading, it may be subject to less "noise" than are trading prices at other times of the day. Usually the equilibrium fixing price is found rapidly, but sometimes it takes twenty to thirty tries. Once in October 1979, with supply and demand fluctuating rapidly from moment to moment, the afternoon fixing in London lasted an hour and thirty-nine minutes.

The practice of fixing the gold price began in 1919. It continued until 1939, when the London gold market was closed as a result of war. The market was reopened in 1954. When the central bank gold pool began officially in 1961, the Bank of England--as agent for the pool--maintained an open phone line with N. M. Rothschild during the morning fixing (there was as yet no afternoon fixing). If it appeared that a fixing price would be established that was above $35.20 or below $34.80, the Bank of England (as agent) became a seller or buyer of gold in an amount sufficient to ensure that the fixing price remained within the prescribed bands.

Gold and European Union

While the gold pool held down the private market price of gold, gold politics took a new turn in the international arena. This was related to the fact that European countries, which had complained of a "dollar shortage" in the 1950s, where now complaining of a "dollar glut." They were accumulating too many dollar reserves. Although it was actually Germany that was running the greatest surplus and accumulating the most dollar reserves in the early 1960s, it was France under the leadership of Charles de Gaulle that made the most noise about it. During World War II, in conversations with Jean Monnet, de Gaulle had supported the notion of a united Europe--but a Europe, he insisted, under the leadership of France. After the war, France had opposed the American plan for German rearmament even in the context of European defense. France had been induced to agree, however, through Marshall Plan aid, which France was not inclined to refuse after it became embroiled in the Indo-China War. But now, in the 1960s, de Gaulle's vision of France as a leading world power led him to withdraw from NATO because NATO was a U.S.-dominated military alliance. It also led him to oppose Bretton Woods, because the international monetary system was organized with the U.S. dollar as a reserve currency.

In the early 1960s there was, however, no realistic alternative to the dollar as a reserve asset, if one wanted to keep reserves in a form that both would bear interest and could be traded internationally. Official dollar-reserve holders not only were made exempt from the interest ceilings of the Federal Reserve's Regulation Q for their deposits in New York but also began as a regular practice to hold dollars in the eurodollar market--a free market where interest rates found their own level. Prior to 1965, central banks were the largest suppliers of dollars to the euromarket. Thus dollar reserve holders received a competitive return on their dollar assets, and the United States gained no special benefit from the use of the dollar as a reserve asset.

Nevertheless, de Gaulle's stance on gold made domestic political sense, and in February 1965, in a well-publicized speech, he said: "We hold as necessary that international exchange be established . . . on an indisputable monetary base that does not carry the mark of any particular country. What base? In truth, one does not see how in this respect it can have any criterion, any standard, other than gold. Eh! Yes, gold, which does not change in nature, which is made indifferently into bars, ingots and coins, which does not have any nationality, which is held eternally and universally. . . ." By the "mark of any particular country" he had in mind the United States, which announced the Foreign Credit Restraint Program about a week later, in part as a direct response to de Gaulle's speech. France stepped up its purchases of gold from the U.S. Treasury and in June 1967, when the Arab-Israeli Six-Day War led to a large increase in the demand for gold, withdrew from the gold pool.

The Two-Tier System

Then in November 1967, the British pound sterling was devalued from its par value of $2.80 to $2.40. Those holding sterling reserves took a 14.3 percent capital loss in dollar terms. This raised the question of the exchange rate of the other reserve assets: if the dollar was to be devalued with respect to gold, a capital gain in dollar terms could be made by holding gold. Therefore demand for gold rose and, as it did, gold pool sales in the private market to hold down the price were so large that month that the U.S. Air Force made an emergency airlift of gold from Fort Knox to London, and the floor of the weighing room at the Bank of England collapsed from the accumulated tonnage of gold bars.

In March 1968, the effort to control the private market price of gold was abandoned. A two-tier system began: official transactions in gold were insulated from the free market price. Central banks would trade gold among themselves at $35 per ounce but would not trade with the private market. The private market could trade at the equilibrium market price and there would be no official intervention. The price immediately jumped to $43 per ounce, but by the end of 1969 it was back at $35. The two-tier system would be abandoned in November 1973, after the emergence of floating exchange rates and the de facto dissolution of the Bretton Woods agreement. By then the price had reached $100 per ounce.

When the gold pool was disbanded and the two-tier system began in March 1968, there was a two-week period during which the London gold market was forceably closed by British authorities. A number of important changes took place during those two weeks. South Africa as a country was the single largest supplier of gold and had for years marketed the sale of its gold through London, with the Bank of England acting as agent for the South African Reserve Bank. With the breakdown of the gold pool, South Africa was no longer assured of steady central bank demand, and--with the London market temporarily closed--the three major Swiss banks (Swiss Bank Corporation, Swiss Credit Bank, and Union Bank of Switzerland) formed their own gold pool and persuaded South Africa to market through Zurich.

In 1972, the second major country supplier of gold, the Soviet Union, also began to market through Zurich. In 1921, V. I. Lenin had written, "sell [gold] at the highest price, buy goods with it at the lowest price." Since the Soviet ruble was not convertible, the Soviet Union used gold sales as one major source of its earnings of Western currencies, and in the 1950s and 1960s sold gold through the Moscow Narodny in London (a bank that had also provided dollar cover for the Soviets during the early days of the Cold War). In Zurich, the Soviet Union dealt gold via the Wozchod Handelsbank, a subsidiary of the Soviet Foreign Trade Bank, the Vneshtorgbank. (In March 1985, the Soviet Union announced that the Wozchod would be closed because of gold-trading losses and would be replaced with a branch office of the Vneshtorgbank. The branch office, unlike the Wozchod, would not be required to publish information concerning operations.)

London, in order to stay competitive, subsequently turned itself more into a gold-trading center than a distribution center. When the London market reopened in March 1968 after the two-week "holiday," a second daily fixing (the 3:00 P.M. fixing) was added in order to overlap with U.S. trading hours, and the fixing price was switched to U.S. dollar terms from pound sterling terms. But by the 1980s, London's new role as a trading center had begun to be challenged by the Comex gold futures market in New York.

The SDR as "Paper Gold"

During the early years of the gold pool, it came to be believed that there was a deficiency of international reserves and that more reserves had to be created by legal fiat to enable reserve-holders to diversify out of the U.S. dollar and gold. In retrospect, this was a curious view of the world. The form in which reserves are held will ultimately always be determined on the basis of international competition. People will hold their wealth in the form of a particular asset only if they want to. If they do not have an economic incentive to desire a particular asset, no legal document will alter that fact. A particular currency will be attractive as a reserve asset if these four criteria exist: (1) an absence of exchange controls so people can spend, transfer, or exchange their reserves denominated in that currency when and where they want them; (2) an absence of applicable credit controls and taxes that would prevent assets denominated in the currency from bearing a competitive rate of return relative to other available assets; (3) political stability, in the sense that there is a lack of substantial risk that points (1) and (2) will change within or between government regimes; (4) a currency that is in sufficient use internationally to limit the costs of making transactions. These four points explain why, for example, the Swiss but not the French franc has been traditionally used as an international reserve asset.

Many felt that formal agreement on a new international reserve asset was nevertheless needed, if only to reduce political tension. And while France wanted to replace the dollar as a reserve asset, other nations were looking instead for a replacement for gold. The decision was made by the Group of Ten (ten OECD nations with most of the voting rights in the IMF) to create an artificial reserve asset that would be traded among central banks in settlement of reserves. The asset would be kept on the books of the IMF and would be called a Special Drawing Right (SDR). In fact it was a new reserve asset, a type of artificial or "paper gold," but it was called a drawing right by concession to the French, who did not want it called a reserve asset.

The SDR was approved in July 1969, and the first "allocation" (creation) of SDRs was made in January l970. Overnight, countries gained more reserves at the IMF, because the IMF added new numbers to its accounts and called these numbers SDRs. The timing of the allocation was especially maladroit. In the previous four years the United States had been in the process of financing the Great Society domestic social programs of the Johnson administration as well as a war in Vietnam, and the world was being flooded with more reserves than it wanted at the going price of dollars for deutschemarks, yen, or gold. In the 1965 Economic Report of the President, Johnson wrote, in reference to his Great Society Program and the Vietnam War: "The Federal Reserve must be free to accommodate the expansion in 1965 and the years beyond 1965." U.S. money supply (M1) growth, which had averaged 2.2 percent per year during the 1950s, inched upward slightly during the Kennedy years (2.9 percent per year for 1961- 1963) but changed materially under the Johnson administration. The growth rate of M1 averaged 4.6 percent per year over 1964-1967, then rose to 7.7 percent in 1968. Under the Nixon administration that followed, money growth initially slowed to 3.2 percent in 1969 and 5.2 percent in 1970, then accelerated to 7.1 percent for 1971-1973. The latter three years would encompass the breakdown of Bretton Woods, and would also have a material effect on the price of gold.

How Foreign Exchange Intervention Affects the Money Supply

In order to succeed, a regime of fixed exchange rates (and under Bretton Woods, rates for the major currencies were fixed in terms of their par values, which could not be casually altered) requires coordinated economic policies, particularly monetary policies. If two different currencies trade at a fixed exchange rate and one currency is undervalued with respect to the other, the undervalued currency will be in excess demand. By the end of the 1960s both the deutschemark and the yen had become undervalued with respect to the U.S. dollar. Therefore the countries concerned (Germany and Japan) had two choices: either increase the supplies of their currencies to meet the excess demand or adjust the par values of their currencies upward enough to eliminate the excess demand.

As long as either country intervened in the market to maintain the par value of its currency with respect to the U.S. dollar, an increased supply of the domestic currency would take place automatically. To see why this is so, take the case of Germany. In order to keep the DM from increasing in value with respect to the U.S. dollar, the Bundesbank would have to intervene in the foreign exchange market to buy dollars. It would buy dollars by selling DM. The operation would increase the supply of DM in the market, driving down DM's relative value, and increase the demand for the dollar, driving up the dollar's relative value.

Any time the central bank intervenes in any market to buy or sell something, it potentially changes the domestic money supply. If the central bank buys foreign exchange, it does so by writing a check on itself--by giving credit to the seller. Central bank assets go up: the central bank now owns the foreign exchange. But central bank liabilities go up also, since the check represents a central bank liability. The seller of the foreign exchange or other asset will deposit the central bank's check, in payment for the value of the assets, in an account at a commercial bank. The commercial bank will in turn deposit the check in its account at the central bank. The commercial bank will now have more reserves, in the form of a deposit at the central bank. The bank can use the reserves to make more loans, and the money supply will expand by a multiple of the initial reserve increase.

Is there anything the German authorities can do to prevent the money- supply increase? Essentially not, as long as they attempt to maintain the fixed exchange rate. There is, however, an operation referred to as sterilization. Sterilization refers to the practice of offsetting any impact on the monetary base caused by foreign exchange intervention, by making reverse transactions in terms of domestic assets (such as government bonds). For example, if the money base went up by DM4 billion because the central bank bought dollars in the foreign exchange market, a sterilization operation would involve selling DM4 billion worth of domestic assets to reduce central bank liabilities by an equal and offsetting amount. If the Bundesbank sold domestic assets, these would be paid for by checks drawn on the commercial banking system and reserves would disappear as the commercial banks' checking accounts were debited at the central bank.

However, the Bundesbank could not simultaneously engage in complete sterilization (a complete offset) and also maintain the fixed exchange rate. If there was no change in the supply of DM, the DM would continue to be undervalued with respect to the dollar, and foreign exchange traders would continue to exchange dollars for DM. During the course of 1971, the Bundesbank intervened so much that the German high-powered money base would have increased by 42 percent from foreign exchange intervention alone. About half this increase was offset by sterilization, but, even so, the increase in the money base--and eventually the money supply--by more than 20 percent in one year was enormous by German standards. The breakdown of the Bretton Woods system began that year.

The Breakdown of Bretton Woods

It came about this way. From the end of World War II to about 1965, U.S. domestic monetary and fiscal policies were conducted in such a way as to be noninflationary. As world trade expanded during this period, the relative importance of Germany and Japan grew, so that by the end of the 1960s it was unreasonable to expect any system of international finance to endure without a consensus at least among the United States, Germany, and Japan. But after 1965, U.S. economic policy began to conflict with policies desired by Germany and Japan. In particular, the United States began a strong expansion, and moderate inflation, as a result of the Vietnam War and the Great Society program.

When it became obvious that the DM and yen were undervalued with respect to the dollar, the United States urged these two nations to revalue their currencies upward. Germany and Japan argued that the United States should revise its economic policy to be consistent with those in Germany and Japan as well as with previous U.S. policy. They wanted the United States to curb money- supply growth, tighten credit, and cut government spending. In the ensuing stalemate, the U.S. policy essentially followed the recommendations of a task force chaired by Gottfried Haberler. This was a policy of officially doing nothing and was commonly referred to as a policy of "benign neglect." If Germany and Japan chose to intervene to maintain their chosen par values, so be it. They would be allowed to accumulate dollar reserves until such time as they decided to change the par values of their currencies. That was the only alternative if the United States would not willingly change its policy. It was clearly understood at the time that a unilateral action on the part of the United States to devalue the dollar by increasing the dollar price of gold would be matched by similar European devaluations.

In April 1971, the Bundesbank took in $3 billion through foreign exchange intervention. On May 4 it took in $1 billion in the course of the day. On May 5 the Bundesbank took in $1 billion during the first hour of trading, then suspended intervention in the foreign exchange market. The DM was allowed to float upward. On August 15 the U.S. president, Nixon, suspended the convertibility of the dollar into gold and announced a 10 percent tax on imports. The tax was temporary and was intended to signal the magnitude by which the United States thought the par values of the major European and Japanese currencies should be changed.

An attempt was made to keep the Bretton Woods system going by a revised agreement, the Smithsonian agreement, reached at the Smithsonian Institution in Washington on December 17-18, 1971. Called by President Nixon "the most important monetary agreement in the history of the world," it lasted only slightly more than a year, but beyond the 1972 U.S. presidential election. At the Smithsonian Institution the Group of Ten agreed on a realignment of currencies, an increase in the official price of gold to $38 per ounce, and expanded exchange rate bands of 2.25 percent around their new par values.

Over the period February 5-9, 1973, history repeated itself, with the Bundesbank taking in $5 billion in foreign exchange intervention. On February 12, exchange markets were closed in Europe and Japan, and the United States announced a 10 percent devaluation of the dollar. European countries and Japan allowed their currencies to float and, over the next month, a de facto regime of floating exchange rates began. The floating rate system has persisted to the present, with none of the five most widely traded currencies (the dollar, the DM, the British pound, the Japanese yen, the Swiss franc) in any way officially fixed in exchange value with respect to the others. (Briefly, from October 1990 to September 1992, the DM and the British pound were nominally linked in the Exchange Rate Mechanism of the European Monetary System.) With the breakdown of Bretton Woods, there began a slow dismantling of the array of controls that had been erected in its name. This included gold.

As part of the Jamaica agreement in 1976 (which ludicrously proclaimed a "New International Economic Order"), IMF members agreed to demote the role of gold. But few central banks subsequently followed up this agreement in practice. One associated change that did come about, however, affected the private gold market in the United States. On January 2, 1975, after forty years of prohibition, U.S. citizens were allowed to purchase gold bullion legally. The Comex in New York subsequently became an important center for the trading of gold futures.

Part 2

This article appeared in Laissez Faire City Times, Vol 2, No 16.
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