Marc Chandler: Reverse Alchemy

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At the turn of the century, American writer Frank Norris wrote a best-selling novel,

The Pit

, about a Chicago speculator trying to corner the wheat market. Although the protagonist managed to do so for a time, the market was bigger and soon left him in ruin.

From time to time, producers, and even sovereigns, have joined efforts to control a market.


, as we all know, is a cartel of oil producers trying to control output to determine its price. In some ways, this is what central bankers have been doing for years with


. Due to a general prejudice, some would say a popular fetish, gold has been given a significance that far outstrips its intrinsic value. And now it increasingly seems as if many officials may be gradually acting to remove gold's special status.

There has long been a vocal segment of market participants who believe that the price of gold is a significant gauge of inflation expectations and a useful guide in setting monetary policy.

Federal Reserve Chairman Alan Greenspan

is perhaps the most visible believer in gold's extraordinary power. Over the years, if not centuries, sovereigns, which in the modern era delegated the responsibility to central banks, have accumulated the equivalent of about 10 years' worth of current mine production of gold. At the end of the 1997 first quarter, the world's central banks and their agents, like the

Bank for International Settlements

, owned about 34,100 tons of gold. This is roughly 28% of all the gold that has ever been mined, which is nearly the same share officials owned on the eve of WWI.

Official gold holdings have been relatively stable in the 33,000- to 35,000-ton range for nearly three decades. This stockpile was not really considered part of the supply of gold because it was largely kept off the market. By restricting the effective supply of gold, central banks have kept its price artificially high.

The price of a good tends to have some relationship with the cost of production. Usually economists argue that in a free market, all things being equal, competition will drive the price of a commodity toward the marginal cost of production. Canada is currently the low-cost producer of gold. Its average cost of production is about $222 an ounce. The U.S. follows closely, mining gold at an average price of about $237 an ounce. Industry estimates suggest that the average cost of production in South Africa and Australia is almost $300 an ounce. Former

Federal Reserve Governor Wayne Angell

, a longtime advocate of using the price of gold as a guide to monetary policy, was recently quoted forecasting a decline in the price of gold to $222, or roughly the marginal cost of production.

It is true that as a reserve asset, gold is unique because it is the only such asset that is not at the same time someone else's liability. For example, a U.S. Treasury bond held as part of the reserves of the

Bank of Japan

is obviously a liability of the U.S. government. However, governments stockpile other metals and minerals, like nickel, copper, and of course, oil, which also do not represent someone else's liability. In fact, sometimes these are referred to as strategic reserves. Gold (and in the past, silver) are considered part of monetary reserves, for reasons that seem to have more to do with tradition than economics.

Recent developments give hope that the official gold cartel is weakening. The pressure is coming from a number of sources, but the underlying force is the desire to more efficiently mobilize reserves. There is a clear and significant opportunity cost of using gold as a reserve asset. Gold does not generate an income stream and even when central banks loan out the gold, as they are increasingly doing, they receive a yield far below other potential reserve assets like government bonds. Currently, a one-year gold loan generates a yield of about 2% compared with about 5.5% yield on a U.S. one-year T-bill.


Reserve Bank of Australia

recently confirmed it sold 167 ton of gold or nearly 70% of its gold holdings for the specific purposes of improving the return on its reserves. It bought G3 bonds. Argentina recently confirmed it sold the bulk of its gold reserves in the first half of 1997 and invested the proceeds in bonds. Switzerland, one of the last countries to back a portion of its currency with gold, has decided to reduce that backing from 40% to 25% and pending a referendum next year, may sell as much as 440 tons of its gold reserves to establish a humanitarian fund. The


has confirmed a more extensive gold lending program than the market had previously thought likely.

There is an ongoing debate about how much gold the

European Central Bank

(ECB) will have when it is officially established in 1999. At first, many market participants had thought to underscore its credibility the ECB would hold as much as 40% of its reserves in gold. Now, market talk suggests much less, perhaps as little as 10%. Asian central banks, including the Bank of Japan, hold about 40% of the world's foreign exchange reserves, but only about 9% of the official gold reserves. When many of the emerging Asian countries rebuild their reserves that have been run down in the current crisis, there is little chance that they will choose gold over U.S. Treasuries.

As global trade has increased, there is a need for greater reserves. Gold's share of central bank reserves has fallen from 46% in 1986 to 20% in 1996, according to the

International Bank Credit Analyst

. If world trade continues to expand, this trend is likely to continue.

The point here is not so much to forecast the price of gold, but to suggest that the nature of gold may be changing. In the past it has been a medium of exchange and a store of value. It has long ceased to be a medium of exchange, especially where developed financial systems exist. While many countries do issue gold coins, they are for the most part collectors' items and not used for the purchase of goods and services. Some countries also issue silver and platinum coins, but that doesn't make these metals a true medium of exchange. Gold may still be a store of value, but then surely are other metals and minerals, like silver, platinum, diamonds and famous works of art, for that matter. That gold may be a superior store of value is a hypothesis that requires a competitive market to determine, which is not possible when central banks control the effective supply and therefore the price.

In an age when money moves rapidly around the world as electronic blips on a computer screen, gold is an awkward and bulky form. At a time when people are being asked to pay more taxes and receive less benefits from their governments, it seems unreasonable for monetary officials to squander their countries' wealth by holding vast sums of noninterest-bearing gold.



had a point. He once suggested that after the socialist revolution, all the world's gold should be melted down and recast to make public lavatories. Let's hope we don't have to wait that long for gold to become a commodity and not have its value regulated by bureaucrats sitting in their monetary castles.

Marc Chandler is vice president and senior currency strategist at Deutsche Morgan Grenfell. The views expressed in this column, which is original to, are those of Mr. Chandler, and do not necessarily represent those of DMG. His column appears on Wednesdays in