The Thoughts of Comrade Ching
Editor's note: This is an article out of the archives. It was first posted on "the Bear" in 2003. It was an insightful look into the future as you will discover.
Socrates was said to be the wisest of men because he was the first to realize his ignorance. Normally experts' write articles because they know something their public doesn't - in this case I am writing an article because I don't know something and perhaps my readers do.
Let me begin, not by telling you what it is that I don't know, but by recommending a book, Prosperity and Upheaval' by Herman van der Wee, which is a good but rather dry economic history of the post-WWII period down to 1980, or if you can't bear to read the whole thing, just section 9 on the gold standard.
This section contains two instructive episodes. The first is the designing of the Bretton Woods agreement in 1943. My views on John Maynard Keynes are largely unprintable. I will merely say that if Dante were writing the Divine Comedy today, he would undoubtedly have placed Maynard in one of the lower circles of hell for standing behind generations of politicians down to the present day, patting them on the back and saying not only are you justified in manipulating the economy against its natural tendencies, you are morally obliged to do so', despite the fact that he was undoubtedly intelligent enough to realize the dreadful consequences of his prescription.
Having said this, when called on to design a post-war monetary order, even someone as hopelessly addicted to government intervention as Keynes suggested a gold-backed currency Why? because he felt that this was the only way to establish an international central bank that transcended individual national interests.
As we see from cases such as the International Criminal Court, when it comes to accepting an international authority, the US is always delighted to do so, provided that the authority in question is an American authority.
Hence Keynes, after being assiduously courted by Harry Dexter White, saw his plan undermined, since White's superiors in the US Treasury didn't want a gold-backed international currency that rivaled the greenback. (Readers may know that White's triumph was short-lived and that he was in the process of being investigated as a Communist spy in 1948, when he had a well-timed fatal heart attack).
The second episode is the break-up of Bretton Woods in 1971 I will merely make two points here. Firstly, after WWII, the war-weakened economies of Europe and Japan were delighted to be pulled out of their holes by Uncle Sam, although once they got back on their feet, it became clear that the US had no plans to give up its status of the rich uncle/policeman who is above the law', even though by the early 1960s, the black market in gold was already signaling that the dollar was overvalued. As we all know, the US response was a central bank pool to suppress the gold price. [As an aside, let me say that I find it hard to understand why GATA has been ridiculed for suggesting covert manipulation of the gold price, when this went on openly from 1962-68].
The macroeconomic pressures that finally blew Bretton Woods apart in 1971 happened on the watch of Treasury Secretary, John B. Connally, Jr., a man known for his intransigence and xenophobia, who continued until the bitter end to regard requests from the international community for a devaluation of the dollar as nothing more than self-serving crying and whingeing, insisting that if the Germans, Brits, Japanese, etc. didn't like the then current dollar parities then they should revalue their own currencies.
Now, just as Jim Sinclair has given us the fictional figures of Dr. No and Hung Fat, let us propose Comrade Ching, who is an economist in Beijing (although he could also be somewhere else like Taipei). Jim Sinclair may well know exactly who Messrs. No and Fat are in real life, but Comrade Ching is purely a figment of my imagination.
Let us suppose that Comrade Ching receives a summons to Party Headquarters, is shown into a room with 20 Communist Party dignitaries and asked the question:
-Comrade Ching, you have been called here as an expert on modern economic history and monetary policy. What do your studies of the last fifty years tell you about the mentality of the Americans?
-Comrades, my studies have taught me three things:
Firstly, the Americans will only accept an international authority if they themselves are in charge of it.
Secondly, they will always oppose any international currency, whether gold or any other medium, which threatens the supremacy of the US dollar.
Thirdly, even after their exchange rate collapses under the weight of its own contradictions, they will refuse to accept any monetary system unless they are guaranteed a hegemonic position.
-Comrade Ching, you are no doubt aware that we have accumulated many dollars by flooding the United States with cheap goods. You must treat the following with complete confidentiality, but our satellites have detected many truckloads of trees going into the Federal Reserve buildings at the dead of night, and we suspect that these ministries of monetary policy are actually a façade for a massive and secret printing operation. We are afraid that the true value of our Yuan in these American dollars may be much higher than the official exchange rate suggests, and that if the dollar collapses and our peasants and workers find out that they are dollar millionaires, they will all want to go to Disneyland and discipline will break down. What do you recommend?
Comrade Ching replies.
-Comrades, I have given this much thought, and my conclusion is that the Americans have again placed themselves in an unsustainable situation while believing that they are strong and the rest of the world is weak. Sooner or later, the dollar will collapse against gold as it did in 1971, and when it does, we must be prepared to offer an alternative home to the capital of our friends especially those in the Middle East, who have been deeply offended by American saber-rattling. Until then, the Americans will continue to defend the dollar as they have always done, by selling gold. We must buy this gold with our paper dollars. But note, comrades, that the Americans have shown that they will defend gold to the death at $325. If gold goes above this, then the world will know that the dollar is collapsing.
Now, comrades, I draw your attention to a subtle point. Let us consider the value of our reserves in dollars and assume that if the dollar declines against a basket of currencies by 1%, then the gold price rises by 1% in dollar terms. Clearly, if we have less than half of our reserves in gold, as gold appreciates in dollar terms, the overall dollar value of our reserves will go down, since the loss on the dollar portion will be greater than the gain on the gold portion in dollar terms. If, instead, gold rises by 2% in dollar terms for every 1% decline in the dollar against a basket of goods, then we need only exchange one third of our dollars for gold for our reserves to maintain their overall dollar value as the dollar depreciates.
-But Comrade Ching, does gold appreciate by 1% when the dollar depreciates by 1%, or does it appreciate by 2%?
-Comrades, we have seen gold move from $275 to $320 as the Euro has moved from 85 cents to 99 cents. This suggests that at present the multiplier on the gold price is around 1. It may nevertheless rise to 2 since once it breaks through $325, since fears of uncompetitiveness will brake the rise of the Euro and it will not appreciate by as much as gold. It therefore seems that we should shift something more than a third and something less than a half of our dollar reserves into gold in order to ensure that these reserves maintain their value in dollar terms.
-Comrade Ching, what are your short-term policy recommendations?
-As I have explained, Comrades, once gold rises above $325, we may not be able to exchange very many of our paper dollars for gold. Unless we have shifted a substantial portion of our reserves into gold by that point, a rise in the price of gold will be against our interests, but once we have more than say 45% of our dollars in gold, we will gain from a rise in the gold price. We must therefore assist the Americans in keeping the price of gold below $325 until we have bought enough gold to ensure that our reserve position benefits from a rise in the gold price. The danger is that once the Americans perceive that we are close to our goal, they may even push up the price to prevent us from benefiting from a rise in the gold price, although history suggests that they are governed by pig-headed people who will resist a rise in the gold price to the bitter end. It is therefore very important to buy gold secretly so that the Americans do not know how much gold we really have and are not angered by our lack of faith in their currency into imposing trade sanctions.
Let's leave Comrade Ching and the Party Committee to their black tea. The point of introducing him was to present a simple conceptual model which explains why gold has slowly moved up, yet appears to have stalled repeatedly at $325 and backed off rather than blowing through since at this point, both fundamental buyers and sellers will both want to force the price of gold down, even though their motives are diametrically opposed (i.e. the buyers want to protect themselves against a collapse in the dollar, but still haven't accumulated a sufficiently large gold hedge, while the sellers want to maintain confidence in the dollar).
The model also includes a tipping point, an unstable equilibrium in terms of the percentage of reserves assigned to gold, at which point the dynamics of the market changes and a rise in the gold price starts to be in the interests of the buyer.
In this sense, Bill Murphy would be correct in assuming that sluggish gold price behavior to date does not rule out an explosive price move in the future. This is both encouraging and frustrating to gold bulls, since until the glorious day comes, gold will mark time, but it will not go down very much. Having said this, as it becomes clear that this is the game, no-one will dare to dump physical gold on the market as it will disappear into someone else's vault for good.
Hence, as it becomes clear that the physical supply is drying up, more and more of the price suppression will be attempted by the use of paper derivatives, which will be less and less effective. The buyers could dump physical on the market to force a major move down in the price, but this will become an increasingly high risk strategy since it will become harder to repurchase the dumped gold. This may explain what we have seen damped oscillation to the downside of a horizontal resistance at $325. I will speculate that the endgame will be sending Comex into tilt.
Since history shows that the American authorities always try and shift the goalposts in their own interests, it is likely that a huge purchase of nearest to expiry contracts on Comex plus a request for physical delivery will be met by Comex insisting on cash settlement. Placing this order may be the Asian buyers' way of signaling to speculators that the accumulation game is over and that large amounts of physical gold are no longer available for purchase within the United States sort of a judo strategy in which you use the weight and inertia of your opponent to throw him across the room.
Jim Sinclair has presented a conceptual model of rival speculators in an arm-wrestling competition Dr. No and Hung Fat trying to force e.g. J.P. Morgan to short cover its overextended derivative positions, and J. P. Morgan trying to force the gold price lower in the hope that Dr. No and Hung Fat have a stop loss on their portfolio which is triggered by a given fall in the gold price. In my model, you have end buyers who have a longer term strategy of simply getting out of dollars and know that if they force the price of gold higher before they have accumulated a sufficiently large amount then they will be overall losers from a rise in the gold price. Hence Dr. No and Hung Fat may well exist, although they are not proprietary speculators per se but brokers to a central bank disguised as speculators. He may protest that I am setting him up as a straw man, but so far the gold market seems to consist of major buyers who don't want to force the price, rather than speculators who do.
At the start of this article I stated that I was writing it because I don't know something that perhaps other readers do. What I don't know is this - how much gold have the Chinese (could be the Taiwanese or other Asian central banks with dollar reserves or a combination of these) accumulated since the 1999 low as a proportion of their dollar reserves. If we can answer this, then we may have the key to understanding when gold breaks through $325. All comments welcomed.
Socrates wishes to point out that he has no factual evidence for any assertions about the current/future behavior of the gold price made in the above article, and is merely an independent observer drawing his own subjective conclusions from publicly available information. He also wishes to state while this article may appear to carry anti-American sentiments, he remains a great admirer of the United States and wishes to see it remain a great, prosperous and free nation, even if he thinks that current US monetary policy will achieve the precise opposite.