One question which I haven't yet addressed is why central banks would bother with gold's exchange rate in the first place. Here's why: Because gold is money, it is one of the yardsticks by which the world's currencies - and the central banks which manage them - are measured. When gold's exchange rate is low relative to the dollar and euro, central banks appear to be doing a good job of keeping inflation down and the value of their fiat currencies up. So part of the central banks' motivation has no doubt been to keep exchange rates at favorable levels – by keeping gold undervalued – thus making their currencies and themselves look good.
As for why central bank manipulation of gold's exchange rate portends a dramatic spike in gold's exchange rate, let's revisit Chapter eight's brief explanation of how central banks lend their gold to private sector bullion banks, which then sell it on the open market. Because the bullion banks have promised to eventually return the borrowed gold to the central banks, they, in effect are "short" gold. That is, at some point in the future they are obligated to buy gold in order to repay to the central banks. The bullion banks thus benefit when gold is available at a low exchange rate, and are hurt, potentially very seriously, when gold rises.
By the end of 2002, I estimate that the amount of gold that central banks had loaned out was at least 12,000 tonnes, or about 385.8 million ounces. That's almost five times the world's annual gold production, worth about $160 billion. If the banks have borrowed this gold at an average of $350 ($11.25gg), and gold rises to $400 ($12.86/gg) (leaving the euro out of this equation for simplicity), the bullion banks are looking at a loss of $50 times 385.8 million ounces, or $19 billion. If the banks borrowed at $300 ($9.64/gg) on average, they're facing a potential loss of $38 billion, more than enough to bankrupt some of the more aggressive players.
As the cost of acquiring gold begins to rise, the bullion banks might be tempted to cut their losses by covering their shorts (i.e. buying back their gold) en mass. In the stock market this is known as a short squeeze, and it often results in a buying panic, in which everyone heads for the exits at once, sending the price of the security in question through the roof. For the bullion banks the short squeeze is a terrifying prospect because of the potential losses they might incur. For the central banks, a short squeeze in gold is equally terrifying because the result will be, in effect, a massive devaluation of their currencies versus gold, potentially undermining the monetary status quo they try so hard to maintain.
In any event, the failure of one or more bullion banks (remember, these are among the world's biggest financial institutions) might threaten the entire global financial system, a prospect that no doubt has central bankers shaking in their boots.
Viewed this way, the recent gyrations in the gold market make perfect sense. When free individuals, observing the debasement of the world's fiat currencies, begin to bid up the exchange rate of the one money that's immune from debasement, the bullion banks run to Washington (or Paris or London) for a bailout, and the central banks oblige by pushing gold back down. But the game is just about up. The bullion banks' short positions have reached unmanageable proportions, and gold's exchange rate is surging into the danger zone. A short squeeze is coming, and for the world's central banks (and bullion banks' shareholders) it will be a disaster. But for those who value and understand gold's enduring role as money, it will be a classic case of poetic justice.