The full-scale attack on gold by global central banks officially began with the provision of swap lines by the Bank of England and the European Central Bank (ECB) to the US Federal Reserve in the days following the rescue of Bear Stearns. In effect, the emergency provision of liquidity to the financial system has been aimed at reinflating the US economy by creating exactly the same kind of unnecessary and irresponsible lending that caused the latest mess.

There are necessarily two elements to this story that must be understood separately: first, the need to preserve the US status quo as is being suggested by the world’s central banks, and second, the mechanisms aimed at restoring the purchasing power of fiat currencies – in effect pushing gold off its perch.

As I have written in recent articles, the death of the US dollar (see The dead dollar sketch Asia Times Online, March 4, 2008) as the global reserve currency elicited a search for suitable alternatives, with the putative contender the euro being dismissed pretty much out of hand by most people (see Euro-trash Asia Times Online, March 11, 2008).

Into this vacuum, investors globally found that the sole store of purchasing power was something of value that central bankers couldn’t manipulate for their own dirty ends, namely gold. That created a huge problem of sorts for the global economy, because a collapse of faith in fiat currencies – so called because their value rests entirely on a stated nominal denomination rather than any notion of intrinsic purchasing power – also means the unwinding of the global financial system. Simple translation: these central bankers would no longer have any power through their inane market policies to wreak destruction willy-nilly.

A secondary and perhaps more lethal result of investors flocking to a fixed-value currency like gold would be to reduce the velocity of the global financial system to essentially zero as gold doesn’t lend itself to value manipulation.

In the finance-based economy of the US and Britain, if not the rest of Europe, this collapse in monetary system velocity would be the equivalent of a thousand bank runs: simultaneously. This was the key stake that the US was playing for, ie to avoid a complete destruction of risk-taking in the economy that would in turn paralyze the unreal economy of excessive consumption that underpinned it.

What did Europe have to fear from all this – after all, wouldn’t the destruction of the US system of capitalism provide a boost for its own alternate method, namely market socialism? Why then should the ECB and others help the Fed instead of letting it slide to its own doom?

The answer is that no one really wants to live in Europe, not even the Europeans: thanks in equal part to the stupidly high tax rates and low economic dynamism prevalent in these economies. These explain the low birth rates across the continent, which have pushed most countries (eg Italy, Spain, Germany as well as all the Scandinavian countries) into sub-replacement demographic trends.

Simply put, as a bunch of old people sitting around like the Japanese, the folks in Europe need the US consumer to continue buying their ridiculously expensive goods because they couldn’t really do much of it themselves. This is also the reason that the Bank of Japan has been anxious to support the policies of the US Fed, even when it hasn’t been asked for any explicit support. The exporters’ lobby in Japan has been screaming blue murder ever since the Japanese yen slid below 120 to the US dollar for its spin-off effects on the rest of the economy.

The second reason for the ECB (and the Bank of Japan) to want to help the US Fed, as I referred to in the previously cited article, was the simple fact that European banks (and their Japanese counterparts) held most of the subprime junk originated in the US.
The reason for them to purchase these US assets was the paucity of domestic assets due to the lack of intrinsic consumption in most European economies, which in turn reduced the opportunity for banks to lend. European banks had and still have more to lose from the collapse of the US financial system than even the US banks. In effect, the ECB wasn’t trying to save the US; it was actually trying to save Europe when it offered to help the Fed.

Mechanism to reinstate the US dollar

Have you heard of the alcoholic who promised you that the best cure for his hangover was to drink a bit more alcohol? This is the same position of the US economy today, where the Fed is bravely attempting to reinflate the economy and in effect create the same spiral that contributed to the most recent market eruptions. What I wrote last year in “Cracks” in credit (Asia Times Online, August 25, 2007) has certainly come to pass, as the increasingly aggressive behavior of the central bankers shows.

As most goods have seen their prices rise in US dollar terms, the best way out for global central bankers is to inflate the value of the dollar again. This in turn reduces demand for gold. Now, if the US actually makes anything useful, central banks could act in concert to increase the demand for that widget, and in turn boost the US economy.

Unfortunately, the US doesn’t really make anything anymore, except lousy cars and delayed airplanes. What it does create a lot of is, in contrast, something that requires a leap of faith – namely financial risk. The description of the US economy as a giant stack of people selling inflated housing to each other, while simplistic and slightly exaggerated, isn’t too far off the truth. This financial risk though needs to be parlayed to the rest of the world so that US consumers can buy real goods such as washing machines made in South Korea and toasters made in China.

The mechanism to kill off gold as a viable substitute for the US dollar rests essentially on taking a number of steps that are designed to reassert the primacy of financial risk in portfolios. Remember that most of the world’s openly traded gold is owned by the likes of pension funds through their alternate investment arms in a choice that vastly irritates central banks for reasons I mentioned above.

Following the rescue of Bear Stearns and opening up its balance sheet to all comers, the Fed has effectively underwritten the biggest parts of the US financial system. Investors looking at these banks and other institutions are now confronted with a simple paradigm of an asset that has fallen a long way from its highs of last year, but will never reach nil value because the Fed stands in the way to catch a falling knife. This is what I call moral hazard – unintended insurance of risky activities by people who really should know better.

Thus, when Lehman announced a share issue on Monday, March 31, it was rapidly oversubscribed because, ignoring the fears of a mere two weeks ago, no one really expects another US investment bank to go bust again. The equity subscription to Lehman also opens the floodgates for credit investors to come running back to the financial sector where credit spreads have dramatically tightened to highlight the reduced bankruptcy risks. Don’t forget also that with the increased capital at their disposal, US investment and commercial banks will be indulging in a new bout of financial asset purchases aimed at restoring their profitability.

Increased demand for assets such as equities and credit diminishes the demand for alternate assets such as gold. A return of confidence in the US dollar takes the sheen off the prices of commodities, and helps engineer a slow increase in the purchasing power of the US dollar.

At least, that’s the theory.

Where it will fail

So far so good – but try as they may, the fact of the matter is that the rest of the world will find it difficult to buy any US financial asset that isn’t implicitly or explicitly guaranteed by the US government. In turn, increasing the amount of financial guarantees could well imperil the credit standing of the US government itself, which is already stretched from years of fiscal mismanagement and budgetary blowouts.

That is what virtually ensures that the US economy will go down the same path as Japan, ie as growth prospects diminish, the chances of attracting new immigrants goes down and with it the potential for generating further consumption in the economy. As de-leveraging and de-consumption bite hard, the US will find that its inability to actually make things will stand in the way of any economic revival.

When that happens, I rather suspect that the world will not want to own any US financial risk, thereby starting the cycle of last year all over again. The economy, in effect, will have to suffer from a Chinese death by a hundred cuts.

So where does this leave gold? Not in a good position for the immediate future, I am afraid. As the world tries to reinflate and stock market enthusiasm once again blinds all investors, it is but natural for gold and other precious metals to suffer. The fact that, rather than any meaningful economic improvement, it is the machinations of central banks that caused this slide will come as cold comfort for gold bugs.