October 21, 1999. The Euro Area: A New Monetary Colossus

The 11 nations of the Euro Area have a total population of 290 million and a combined annual GDP of almost $7 trillion, comparing quite favorably in size to the United States with a population of 270 million and a GDP of $8.5 trillion. Impressive as these numbers are, they pale beside the monetary numbers. Source: IMF, International Financial Statistics, October 1999 (most figures for end of June 1999).

With over 400 million ounces (12,560 metric tons) of gold reserves, the EA has almost 1.4 ounces per person compared to 262 million ounces (8150 tons) equating to just under 1 ounce per person for the U. S. More importantly, with the equivalent of around $1350 of cash currency per person in circulation compared to more than $2000 for each American, the EA could provide a 40% gold cover for its currency outstanding (i.e., the combined total of all 11 national currencies outstanding) at less than $400/oz. The U.S., as I have noted before, would need a gold price in excess of $800/oz. to do the same thing. Total U.S. foreign exchange reserves are some $30 billion; those of the EA over $220 billion. And with a 1998 positive balance on goods and services in excess of $120 billion, the EA is running trade surpluses almost as impressive as U.S. trade deficits.

The implications of these numbers are huge, particularly for anyone contemplating any sort of currency competition, let alone a possible currency war, between the Euro Area and the United States. What makes them even more frightening from the American perspective is the fact that Euro currency itself does not yet exist but must be introduced by January 1, 2002.

One of the most intriguing questions about the U.S. dollar, or more precisely the 550 billion of them circulating in the world, is: where are they? No one really knows, but it seems almost certain that a great many of them circulate outside the country in parts of the world where the local currency is unreliable. Something of the same phenomenon is seen with the German mark, of which there are the equivalent of almost 1675 Euros (approx. US$ 1800) for every German, and even more spectacularly with the Swiss franc (over 4500 (approx. US$ 3000) per citizen, for each of whom Switzerland also has gold reserves equal to almost 11.75 ounces before the currently proposed gold sales). On the other hand, Belgium, France, Italy and the Netherlands, taken together, have currency outstanding equal to about 1000 Euros (approx. US$1100) per citizen.

The problem with a currency held in large quantities outside its country of issuance, where it is legal tender, is its potential for causing destabilizing inflation in its home country should a large amount of it be repatriated suddenly, as might be caused for example by a sudden loss of confidence. Indeed, just this problem led to some discussion in Congress a few years ago about creating two dollars, one to circulate internally and one externally. The problem with such an idea, of course, is that even serious discussion of it can trigger the very consequences it seeks to forestall.

In this context, the planned issuance of Euro notes and associated elimination of national currencies, particularly the German mark, should hold some potential concern for the EMU. What is more, and even more importantly, the new Euro currency will have to earn and secure acceptance by citizens of the Euro Area. But look at the numbers. It is well within the realm of possibility: (1) to back the new Euro currency with a 40% gold cover, whether it is actually redeemable or not; and (2) to mop up all excess German marks and other EA national currencies circulating externally with EA dollar forex reserves. Indeed, what other use will there be for the bulk of these reserves? If the United States can get along with its gold and $30 billion of forex reserves, surely the EA -- with more gold as well as balance of payments surpluses -- can do the same. And however attached EA citizens may be to their old national currencies, a new Euro currency -- backed by gold -- might command not only monetary allegiance ("a Euro as good as gold") but also greater allegiance to the whole concept of a United States of Europe.

October 20, 1999. The Coming Currency War: Europe Prepares

The European Economic and Monetary Union (EMU) has evolved in three stages from the European Economic Community (EEC), established in 1958. The first stage of monetary union, starting in 1990, involved free movement of capital, cooperation among central banks, utilization of the European currency unit (ECU), and increased economic harmonization among the member states of the European Union (EU). Stage two, based on the 1992 Maastricht Treaty, began with the creation of the European Monetary Institute (EMI), and involved further economic convergence and monetary coordination, including a prohibition on monetary financing of governments by central banks. The European Central Bank (ECB), established June 1, 1998, succeeded the EMI. The third stage commenced January 1, 1999, with the launch of the Euro as the common currency for the 11 participating nations (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain), known as the Euro Area (EA). A new exchange rate mechanism (ERM II) also became effective for the four EU countries (Denmark, Greece, Sweden and United Kingdom) not joining the initial EMU.

On January 1, 1999, based on then existing exchange rates, Euro conversion rates for the national currencies of the 11 EA countries were irrevocably fixed, and the ECB together with the central banks of these countries began conducting a single monetary policy for the EA. The Euro is the legal currency of the EA and was set at one ECU, which it replaced. However, the Euro is not yet a circulating medium, there being no Euro notes or coins. The national currencies and coins of the EA countries will continue as the circulating medium, at their fixed conversion rates, until January 1, 2002, when they will be replaced with Euro notes and coins. Today, then, the Euro remains solely a transactional and accounting currency, a digital currency with no physical expression.

The EMU traces its roots to a 1961 article by Robert A. Mundell, then chief economist at the IMF, outlining a theory of optimal currency areas. In awarding the 1999 Nobel Prize for Economics to Professor Mundell, the Royal Swedish Academy of Sciences expressly cited his work in the field of "monetary dynamics and optimum currency areas." Professor Mundell is widely regarded as the driving intellectual force behind the Euro, which according to The Wall Street Journal (Oct. 14, 1999, page A2), "he believes...will eventually challenge the dollar for global dominance." He is also one of the few modern economists with a favorable view of the gold standard. Thus, reflecting the attitude of many academics, Keynesians and other liberals toward his Nobel, The Boston Globe (October 14, 1999, page C1) wrote: "Mundell's long years during the 1970s and 1980s as a shadowy expositor of 'supply-side' economics and an enthusiast of the gold standard, were overlooked by the prize committee -- or ignored."

Professor Mundell has on occasion observed that an optimum currency area is not that much different from a group of free market countries on a gold standard with fixed exchange rates between them. He has also recognized the political reality that the United States is unlikely to support any reform of the international monetary system while the present one remains so beneficial to it. In refusing to take his work as a whole, his detractors are unlikely to be prepared for the currency war to come. For those interested in pursuing further study of Professor Mundell's ideas, there is a link to his website at my Recommended Links. I particularly recommend a 1997 lecture he gave at St. Vincent College, Letrobe, PA, entitled "The International Monetary System in the 21st Century: Could Gold Make a Comeback?" (

In a 1990 article reprinted (excerpts) by The Wall Street Journal (Oct. 14, 1999, page A26), Professor Mundell concluded with these paragraphs:

In the days of the Cold War, national security took priority over monetary systems. But in the post-Cold War era there is likely to be both less opposition and more to gain from a stable international currency. The emerging multi-polar world has in many respects more in common with the patterns of world power in the heyday of the gold standard than with the recent bi-polar past. It presents a better opportunity to create a world central bank with a stable international currency than at any previous time in history. There is no reason why the gold stocks held by governments and central banks should not be utilized to create an international money.

There are numerous options. A trillion-dollar central bank, producing its own currency, backed by gold and foreign exchange reserves (and, if necessary, other convertible currencies) could be made the central institution around which a stable international monetary system could be erected.

October 14, 1999. The Coming Currency War: Roots

Like most of the great macroeconomic and geopolitical events of the twentieth century, the roots of the coming currency war spring from what was called "The Great War" until its dislocations spawned a second. Largely as a result of Anglo-American monetary bungling, the classical gold standard became a casualty of the First World War although it was not finally laid to rest until the World Economic Conference held in London in early 1933. The story of the London Conference is most authoritatively told in The Money Muddle by James P. Warburg, chief currency advisor to the American delegation, scion of the German banking family, and son of Paul Warburg, first chairman of the Federal Reserve System and generally regarded as its father, who, once when asked if it were true, replied that he didn't know, "but judging from the number of men who claim the honor, all I can say is that its mother must have been a most immoral woman."

Paul Warburg's term as Fed chairman expired in 1918, and in the anti-German atmosphere of the day, President Wilson felt unable to reappoint him and he returned to private banking. In March 1929, he issued a public warning of the crash and depression to come, noting that by not raising interest rates the Fed had chosen "to leave the gamblers in control until a crash will bring speculation to an end." Vilified for trying to sabotage American prosperity, he put his own family's finances on a course that took them through the ensuing financial calamity far better than many other wealthy families.

Britain returned to gold in 1925 at the pre-war parity because, as one banker said, Winston Churchill, then Chancellor of the Exchequer, thought that to do otherwise was to cheat your creditors. However Britain did not return to the classical gold standard but to a bastardized version -- the gold exchange standard -- under which not only gold but also currencies convertible into gold were counted as reserves. Since these currencies themselves were backed only by fractional gold reserves, the gold exchange standard yielded more credit from less gold and allowed (temporarily, at least) devaluation to be avoided. But in the financial maelstrom that soon unfolded, this system could not hold, and Britain was forced to suspend gold payments again in 1931. That took the Sterling countries off gold, and several Scandinavian countries with close economic ties to Britain were forced to follow.

Franklin Roosevelt took office in March 1933, and shortly thereafter declared a national bank holiday and initiated a series of actions, including an embargo on gold shipments abroad, that ultimately led to nationalizing the gold supply. He also enlisted "Jimmy" Warburg, whose father had died the previous year, as his principal currency advisor. In a nutshell, Jimmy Warburg advised that the United States should seek restoration of a modernized international gold standard as soon as practicable, and should publicly state its intentions in this regard, including, if and to the extent necessary, devaluation of the dollar. He vigorously opposed all the schemes then being proposed to Roosevelt by others to "debauch" the dollar, particularly the notion of a "commodity dollar" under which the gold parity of the dollar would be allowed to fluctuate to maintain a constant purchasing power expressed in some sort of price index.

Thus when the London Conference began, there were three distinct groups: the Americans, whose chief delegate was Cordell Hull; the Sterling Bloc led by the British and Ramsay MacDonald; and the Gold Bloc, which were the countries still on the gold standard. Led by the French, they also included Belgium, Holland, Italy and Switzerland. These countries not only wanted to stay on gold, but to do so at their existing parities.

As he left for the London Conference, Jimmy Warburg believed that his approach had Roosevelt's support. Then, after being cabled to Washington, the first tentative agreements of the conference along these lines were rejected. More negotiations and more cables led to only one conclusion: FDR had determined instead to follow another route, later described by Jimmy Warburg in his autobiography as "monetary experimentation, deliberate inflation [and] economic nationalism." It soon led to his resignation from Roosevelt's inner circle and his publication of The Money Muddle (see Reading List). The London Conference ended in disarray and outrage at the American position, and the world sailed into uncharted monetary waters.

Allied with the Gold Bloc was the Bank for International Settlements. The BIS, generally regarded today as the central bank for central banks, was formed under international treaty in 1929 to facilitate payment of German war reparations. The United States declined to join, and the 15% of the shares allocated to the Fed were floated publicly and now trade on the Swiss Exchange. The BIS holds gold reserves of about 200 metric tons and continues to this day to keep its accounts in Swiss gold francs of the 1929 parity.

The Weimar Republic had survived the hyperinflation of 1923 that makes Germans today the world's leading proponents of sound money. But the inflationary experience was an important contributing cause to the rise of Hitler, who assumed the German chancellorship in January 1933. All along the Allied powers continued to insist on payment of war reparations, something Germany could not do except by selling bonds -- ultimately repudiated -- to foreign investors.

World War II shoved to the sidelines further consideration of the international monetary structure until the 1944 conference at Bretton Woods, N.H. It was almost exclusively a British and American show. Neither France nor the other nations of the old Gold Bloc were then in any position to challenge the Anglo-American design. Twenty years later, however, French demands to redeem dollars for gold at the fixed rate of $35/oz. would be an important factor finally leading to President Nixon's closing of the gold window in 1971.

Thus, by the unilateral action of another American president, the world was again pushed onto unknown monetary terrain: unlimited paper currency and floating exchange rates, with the paper of the dominant power, the United States, serving as the "key" reserve currency. After a decade of severe inflation almost around the world and another decade of trying to rein it in with high interest rates, a decade of apparent monetary stability has produced in the United States and Europe the greatest credit and stock market boom that the world has ever seen, in Japan a boom turned to bust, and in many smaller nations, whose paper is at the uncontrolled mercy foreign exchange speculators, assorted economic crises ranging from merely serious to dire.

What is different now from 1933, 1944 or 1971, is that the Gold Bloc, reconstituted under the banner of the Euro and with Germany on board, has prepared itself to challenge Anglo-American hegemony over the international financial system.

October 12, 1999. Real Gold, Paper Gold and Fool's Gold: The Pathology of Inflation

There was a time when, as someone recently said, everybody and his cat knew the difference between real gold and paper gold. But today's kool cats, if they own gold at all (which few do), are too smart to pay storage or insurance on allocated gold, too sophisticated to tie up funds in stodgy old coins or bullion bars with no yield, and too greedy to forswear the allure of maximum leverage. Gold investors, on the other hand, know gold first and foremost as a portfolio anchor to windward, a shelter in a monetary storm. Ashanti and Cambior are examples of apparently good hooks that dragged badly at the first stormy blasts. Why?

The nub of the problem is to recognize that while the line between real gold and paper gold is quite clear, the line between paper gold and fool's gold can be a moving target. Paper gold is all paper instruments credibly repayable in, or otherwise linked to, gold. Fool's gold is paper gold that lacks credibility. Typical examples include unallocated gold in unsound banks, options or futures on gold from parties that may not be able to deliver, and mining shares in companies whose ore deposits or finances are questionable.

To appreciate the potential force of the coming monetary storm, a basic understanding of gold, gold banking, inflation and deflation is essential. Forget the CPI and other such price indices. They are generally lagging indicators of prices in certain sectors of the economy. What is more, the CPI is now subject to so many "adjustments" that its usefulness except perhaps as a tool to reduce government expenses tied to it (e.g., Social Security payments) is suspect. Forget, too, most blather about whether gold does better in an inflation or a deflation. Gold is insurance against severe currency or credit destruction, whether its precipitating cause be inflation or deflation. Inflation and deflation are, respectively, expanding and contracting credit relative to some reliable measure of money. Historically, the monetary measure was gold, which does not do well in periods of controlled or hidden inflation precisely because more credit can be built on less gold without arousing widespread public alarm. Measuring inflation today is difficult because what passes for money -- unlimited paper currency -- is itself so intermingled with credit as to make the two virtually indistinguishable. A money market fund is nothing really but short-term credit obligations aggregated to look like what was once a bank account backed (in a sound bank) by a 40% reserve in gold coin or bullion resting in the vault.

Measuring the amount of real money in the world is no more difficult today than a century ago. It is the total above-ground physical gold stock, now somewhere around 120,000 metric tons (excluding the double-counting of gold leased by central banks but still on their balance sheets). Going off the classical gold standard and the quasi-gold standards that followed has not change gold's inherent nature as real, permanent, natural money. What it has done, besides changing for a time at least general public perceptions about gold, is to reduce to a small but elite group (international financial institutions like the BIS and IMF, national central banks, bullion banks and their customers, and the gold markets themselves) that portion of the international currency/credit structure directly tied to gold.

The short gold position created by the bullion banks with leased gold mostly from the central banks is a fractional reserve position. This physical gold sold short must at some point be replaced, either by purchase in the market or new production. Be this short position 6000 metric tons, 10,000 tons or higher, it is a significant multiple of annual new production of around 2500 tons. Some portion of this short position represents forward sales by gold mining companies; the remainder is largely borrowed gold used in the so-called carry trade. Accordingly, counting forward sales by gold mining companies as existing gold (which they really aren't) and assuming these contracts cover approximately half of the total short position (as good a guess as any), the gold banks are operating with fractional reserves not far from the minimum safe level of 40% sanctioned by historic experience. Half the physical gold they owe to their lessors must be obtained on the market. What is more, the other half is not really in the vault. It is underground, but in an ore deposit, where it must be dug out, processed and refined before it can be delivered.

On top of this shaky reserve position, the bullion banks have created gold derivatives, principally options and futures. Cambior's hedge book shows how the gold banks have created options for gold in amounts that far exceed the amounts already sold forward by producers. What is more, they have done so primarily in the over-the-counter market out of public view. The gold banks' exposures particularly as they relate to the gold mining industry are detailed in an excellent article by John Hathaway of the Tocqueville Gold Fund entitled Simple Math & Common Sense: A $66 Billion Problem (

All that is reported about the activities of the London Bullion Market Association is its monthly average daily clearing volume, a figure that will be quite interesting to watch in the months to come. The LBMA dwarfs the two best-known public markets, the COMEX and the TOCOM, which though smaller are more transparent. They offer gold futures contracts where open interest now exceeds warehouse stocks by multiples of 20 or more. On the COMEX open interest is north of 600 tons (200,000 contracts x 100 / 31250 = 622) against warehouse stocks of some 30 tons. On the TOCOM, where the percentage of coverage appears even lower, open interest has very recently shrunk from over 500 tons to 400 tons on October 7. Fear, perhaps, is hitting the TOCOM a bit before it hits New York.

As I have discussed before, TOCOM futures, which are priced in yen, are in backwardation. The degree of backwardation, however, is more than accounted for by interest rate differentials between the dollar (in which gold is almost universally priced internationally) and the yen. In other words, the implied yen forward rate is not what the difference between gold lease rates and yen interest rates would suggest, but less (i.e., a smaller negative percent or discount) than on dollar/yen futures. However, as a result of the backwardation, open interest on the TOCOM is mostly in the further out months, although this too may be beginning to shift.

The COMEX also offers options on futures contracts, where the call open interest at strike prices between $310/oz. and $335/oz. running from November to February exceeds 500,000 contracts, representing futures on another 1500+ tons. Including options, the two public futures markets could be asked to deliver about one full year's production within a year, mostly in December and next spring. This potential obligation has been assumed on the erroneous assumption that because gold is just another commodity, there is no possibility of ever having to make actual delivery of the total outstanding open interest. Another quick $60 on the gold price, all the options will be well in the money, and futures on gold will almost certainly be fool's gold.

But what is most alarming about the strained condition of the gold banks is the larger world financial picture of which they are a small but very important part. At the macroeconomic level, not only are there eye-popping figures on credit creation, derivative exposures and stock market valuations, but the potential collapse last year of a single hedge fund, Long Term Capital Management, threatened sufficiently dire consequences for the entire international financial system to warrant a bailout orchestrated by the Fed and backed by three discount rate cuts. Determining what paper gold is credible and what isn't is difficult enough under ordinary circumstances. Far harder, and in extraordinary times much more crucial, is gauging external factors -- macroeconomic, geopolitical, cultural, whatever -- that paper gold and even real gold may have to survive.

The bullion banks and their customers were not caught wrong-footed by a free gold market. They were caught out of position by the first attack in a monetary war they they didn't expect and on terrain that they thought they controlled. The full story of how Anglo-American manipulation of the gold market led to a counterattack by the European central banks is yet to be told, but Ashanti, Cambior, and their shareholders are among the first victims. Before the gathering monetary storm is over, there will be many more casualties, caught in the cross-fire as nations fight a currency war the likes of which the world has never seen. Governments who try to wage this war with the weapons of old -- forex interventions, interest rate changes, currency controls, gold restrictions, competitive devaluations, etc. -- are likely to be overwhelmed by the very free market principles which they have recently preached if not always followed. For in a truly free market for money, one with no legal tender laws, gold wins.

In the United States, the legal and cultural settings are vastly different from the 1930's or 1970's. As a matter of law at least, gold is in a free market, hugely complicating the legal basis for any effort at confiscation. Trust in government officials, starting with the President, has never been lower. So turned off to their government are Americans that nearly half the eligible voters no longer participate. So offended are they by the shenanigans of the two major parties that third party or otherwise apparently independent candidates arouse astonishing levels of interest and support. And then there is the internet, giving freedom of speech and debate rein to affect public policy as never before while at the same time braking the power of the mass media. What is more, the internet is now as international as gold, giving gold bugs worldwide their own web in which to catch miscreant officials and expose official scams.

So-called "gold clauses" were a standard feature of many private contracts from the "greenback era" of the Civil War to the midst of the Great Depression, when the monetary measures of the New Deal made them invalid by government fiat. Thus fell at a blow supposedly certain protection against the gold devaluation of the dollar, catching off-base the most prudent and best-advised lenders of their era. For ordinary American citizens in that particular financial cataclysm, mining shares proved a much better refuge than physical gold or gold dollars, ownership of which was made illegal on the ridiculous theory that government gave gold its value by making it money.

So too, in 1971 not even an international treaty, the Bretton Woods Agreements, could protect those nations who had placed their reserves in U.S. dollars from a second unilateral gold devaluation by the United States. Only the French, by redeeming dollars in gold "avant le déluge," gained a partial measure of protection. The monetary history of the twentieth century, for both individual nations and the world at large, is a story of swift and devastating discontinuities, not a linear progression of events.

Today the evidence points to an impending conjunction of macroeconomic and geopolitical events that will almost certainly sweep from the scene the entire monetary and credit structure erected on floating exchange rates with the U.S. dollar as the key reserve currency. This lopsided international structure -- imposed by and so favorable to the United States that it has for years run balance of payments deficits of truly gargantuan proportions -- is hopelessly dysfunctional, often placing smaller economies at the mercy of forex market speculators. As this structure disintegrates, gold will retake its accustomed place at the heart of the world monetary order not so much by official choice as by international necessity enforced by free market principles that will be virtually impossible for free governments at least to resist.

To ask at what price gold is to misunderstand both the problem and gold. No one could foresee in 1929 that gold, then $20.67/oz., would be $35/oz. in 1934? Similarly, no one could could tell in 1971 that gold, then $35/oz., would rise as high as $800/oz. within a decade? What a few could and did predict in the months and years immediately preceding these devaluations was that the world would soon be forced to confront the effects of then unprecedented credit inflation built with far too little regard for the underlying amount of gold available to support it. What they also could and did predict was that the existing dollar/gold exchange rate (or price) was too low and would have to rise substantially to offset what would otherwise be devastating credit deflations. As they say, history repeats though never in quite the same way.

Eight years ago in The Golden Sextant I discussed the problem of setting a new official gold price in the context of an orderly return to an international gold standard. Today 40% gold cover for U.S. currency in circulation would require a gold price over $800/oz., almost twice the number of eight years ago. Yet we are constantly told that this is the decade when inflation was vanquished. When gold was at $800/oz., in January 1980, one ounce would buy the Dow Jones Industrial Average, as it would have in 1932 if it had been fixed at $35/oz. two years sooner. If you must guess a future gold price, ask yourself what will be the price when next one ounce, two or even three will buy the Dow.

Eight years ago I also held little hope of an orderly return to a gold-linked dollar. By then American officials of both political parties and all three branches of government had decreed by their actions over many years that any formal return to gold would come, if at all, only under almost unimaginable crisis conditions, when the golden lifeboat is the only lifeboat. What historians may call "The Great Gold Scandal" and Americans may call "Moneygate" did not begin just a few years ago only to surface with the Bank of England's gold sales. It began in 1971 when President Nixon closed the gold window and for the first time in U.S. history cut the dollar free from any meaningful link to gold. Compared to what is coming, Watergate was a bagatelle.

It is no accident that Moneygate began with the first President to be driven from office and will likely end with the first in this century to be impeached. Scandal -- indeed, the most egregious breaches of public and private trusts -- are part of the pathology of all great inflations, a pathology not unlike that of the drunk or the addict. Nowhere is this pathology better described than in today's addition to my Reading List: Fiat Money Inflation in France by Andrew Dickson White, founder and first president of Cornell University. This essay, written in 1876 and read by its author to members of the House and Senate in connection with the debate over returning to the gold standard after the Civil War, tells the story of the French assignats of the 1790's. This great paper money inflation, originating in the French Revolution, ended "in the complete financial, moral and political prostration of France -- a prostration from which only a Napoleon could raise it."

The tragedy for today's America is not just that the looming monetary shipwreck could have been avoided by more honest policy decisions, but that it would have been if mostly well-intentioned but misguided officials had stuck to the letter and spirit of the monetary provisions of the Constitution. Its framers knew when they met in Philadelphia in the hot summer of 1787 what the French were about to prove to themselves the hard way despite their inflationary experience seventy years before in John Law's Mississippi Bubble.

Nobody can predict with certainty or in detail the consequences of a 100-year storm, be it financial and monetary or meteorological. Gold will more than survive; it will prevail as it always has. Gold mines will prosper though certain mine owners may fail. With clear thinking, preparation, nerve and luck, gold investors will survive; some may even prosper. As for the nation, let's hope that aided by their ability to speak directly with each other on the internet, exercising their good judgment and common sense, the American people will demand for themselves, their children and their Constitution -- as is their right in accordance with its exact terms -- early passage on the golden lifeboat.

October 7, 1999. Cambior's Hedge Book: Incroyable! Un dommage aussi

The current big worry in the gold mining business is rock bursts, not underground but right in the executive suite. Hedge books are blowing up. Ashanti and Cambior are the most visible examples, the share price of each having been more than cut in half in the past two days due to major losses in their hedging programs. Cambior's press release of yesterday holds such unsettling implications for the gold market that I cannot let it pass without comment.

Cambior is a medium-sized gold producer based in Montreal. It expects to produce 630,000 ounces of gold in 1999 at an average cash cost of US$215/oz., and 700,000 ounces in each of the following three years at an average cost of $200/oz. Over the past ten years it has operated a hedging program that it says has produced an average premium of $57/oz. over the spot price. While it has experienced some operating problems in recent years, its management is generally quite well-regarded in the mining community, and its shares have heretofore frequently appeared in the reported holdings of many gold mutual funds.

Its financial report for the second quarter included the following: "As of June 30, 1999, the gold hedging program had positions ensuring an average price of $350 per ounce for 1.3 million ounces. This program assures full coverage of the remaining gold production for 1999 at $364 per ounce and 80% of the production exposure for 2000 at $322 per ounce."

Yesterday it reported that as of September 30, 1999, it had sold forward 2.67 million ounces at an average price of $318/oz., and had also sold call options for 1.9 million ounces at an average price of $315/oz. What is even more astonishing is the breakdown of these positions. Forward sales are: 159,000 ounces at $335/oz. for the rest of 1999; 642,000 ounces at $298/oz. for 2000; 640,000 ounces at $292/oz. for 2001; and 597,000 ounces at $292/oz. for 2002, with smaller amounts running out to 2007. But the real killer is the call options: 921,000 ounces at $287/oz. maturing before the end of 1999; 299,000 ounces at $323/oz. in 2000; 382,000 ounces at $352/oz. in 2001; and 303,000 ounces at $348/oz. in 2002. Taking the current year, Cambior has already sold forward the rest of its production (630,000/4 = 157,500) and is now naked on call options some $30 in the money for an amount of gold almost equal to one and one-half years of production -- production that itself has already been sold forward.

You may ask, "How the [fill in the blank] could this happen?" There is a hint in the press release: "The counterparties to these hedging contracts consist of international banks and financial institutions, principally lenders in the Revolving Credit Facility." And sure enough, the report for the second quarter reveals that Cambior has a $250 million five-year Revolving Credit Facility with the first scheduled repayment of $54 million due in 2001.

The use of put and call options was discussed in my commentary of September 11, 1999, Gold Banking and Mining Finance: Elements of Risk. For mining companies, the hedge is really the purchase of the put option. In the declining gold market of recent years, these purchases were generally financed by writing (selling) call options, often in a ratio of 2:1 since sale of two call options would typically finance purchase of one put option. Particularly in the negative atmosphere following the Bank of England's announcement of its planned gold sales, there were many reports of bullion bankers "suggesting" to gold mining companies the advisability of additional puts to protect credit lines. For already strapped mining companies, purchasing meaningful puts meant writing calls at strike prices near or below $300/oz., an obviously risky strategy.

There is another problem with options that those not familiar with them often overlook: volatility premiums. The more volatile the market, the higher the premium on an option. Because markets tend to tank more rapidly than they rise, puts are often relatively more expensive than calls. But in a sharply rising market, particularly one suggestive of a short squeeze, volatility premiums can shoot through the roof, which is what is happening now in gold call options, both over-the-counter and publicly traded. What is more, the mathematical models (delta hedging, Black-Scholes, etc.) that are designed to control risk tend to breakdown in these circumstances due to liquidity constraints.

Several points emerge from this picture: (1) both Cambior and its bankers face a serious financial problem, and one that will grow a lot worse should the gold price continue to rise; (2) if Cambior's hedge book is at all representative of many others, as many well-informed observers suspect, there is a far larger systemic problem, and one that will grow exponentially with further increases in the gold price; (3) quite apart from the mining business, if the Cambior and Ashanti examples are at all representative of current gold banking practices in general, the over-the-counter gold derivatives market is almost certainly in far more parlous condition than all but a very few imagined; and (4) by extension, all paper gold must now be deemed suspect. In all candor, when I suggested in my last essay that we might see a gold banking panic in which gold would go to $1000 bid, none offered, I knew intellectually that it could happen, but I did not really envisage it as an imminent possibility. Cambior's hedge book, c'est incroyable. J'ai peur de ce qui se passera.

Mais c'est un dommage aussi. Tout le monde sait que j'aime bien le Québec et les Québécois. It gives me no pleasure at all to write critically of Cambior, particularly since the problem it faces is not so much of its own making as it is the work of powerful people bent on other agendas having nothing to do with fair play, free markets, hard work, or any other virtues for which Quebeckers are justly known. Indeed, it is to Cambior's credit that management faced up to the problem and put out a detailed, factual press release.

Free advice is worth what you pay for it. But were I directing Cambior's affairs, I would have my lawyers hard at work. In particular, I would ask them if the Lac Minerals/International Corona case -- a legendary battle in the annals of Canadian mining -- might have application here. That case, arising out of the famous Hemlo discovery, established that a senior mining company in negotiations with a junior over a prospective property owes a fiduciary duty to the junior not to take any undue or improper advantage of the relationship. Doesn't this principle suggest that an international bullion bank dealing with a relatively small gold mining company owes it a fiduciary duty of full disclosure of all material facts relating to a proposed loan transaction and associated hedging? If so, does it then follow that the bank, if it had any knowledge thereof, must disclose any facts relating to the manipulation of the gold market by itself or others? My lawyers would probably tell me that the arguments could be made, but that it would be hard to prove knowledge of manipulation. Smiling like the Cheshire cat, I would then suggest they talk to Bill Murphy at GATA. And forsaking the finesse of les Habitants for the bad habits of the Bruins de Boston, I would get ready to take off the gloves.

October 5, 1999. Gold Certificates: Potential Wild Card

Several readers of my commentary dated September 16, 1999, on Gold Leasing by Central Banks: Reaching the Limits raised the issue of gold certificates as potential additions to the amount of leased gold. Most of the major bullion banks offer gold certificate programs as an alternative method of purchasing gold. So-called "unallocated" gold certificates are essentially gold deposits, which is to say that the gold purchased by the customer is held for his account but title to the gold remains with the bank. It is a banking relationship in which the customer, in this case a private person or entity rather than a central bank, is a creditor of the bullion bank, which is then free to lease out the gold covered by the certificate. There are also gold certificate programs in which the gold is held in allocated, segregated or identified accounts, in which event title to the gold rests with the customer, the relationship created is a bailment, and the gold is neither carried on the bank's balance sheet nor available for leasing. These accounts offer the customer greater security but also typically incur higher storage and insurance charges and of course do not pay any interest.

I did not discuss unallocated gold certificate programs in my earlier commentary for two reasons. First, I had not seen any informed guesses as to the total amounts of leased gold that might be involved. Second, most of the major bullion banks that operate these programs are not only the same banks to which the central banks lend gold, but also these bullion banks are major commercial banks as well and thus fall under the regulatory jurisdiction of their home central banks. Accordingly, it was my view that in assessing the risk of leasing their own gold to the bullion banks, the central banks would give due weight to any additional gold these banks were obtaining from unallocated gold certificate programs.

In the past week I have seen apparently informed estimates suggesting that there may be up to 2000 tons of leased gold arising out of unallocated gold certificate programs. If these estimates are close to correct, it introduces a potential wild card into the current market environment. Central banks worry not just about their gold out on lease but even more about the larger banking system itself. No central bank would lightly push a major bank into default. Private depositors, on the other hand, worry principally about themselves. Should they begin to doubt the soundness of their bullion bankers, they could start an old-fashioned bank panic in the blink of an eye.