This is the first in a new series I'll be returning
to occasionally. I have recently come across a number of fallacies relating
to the subject matter of this blog and my plan is to compile them and then
correct them one at a time.
1. Paper Gold is just like Paper Anything
This first fallacy aims to undermine a good deal of what Another and FOA
wrote about by claiming that the paper gold market has the same effect on
gold as any paper market has on its underlying commodity. This fallacy claims
that the same arguments made for an explosive revaluation of physical gold
could be made for anything else, therefore they must be wrong.
Commenter "ForLiberty" put it this way:
"This whole 'paper gold is holding the price
down' argument makes zero sense to me. It is just a logical nonsense. All
paper trades have two parties - bidup and biddown. A paper gold trade could have never taken place
if nobody wanted to short it. This is how all markets work. There are paper tomatoes sold too. Is there a conspiracy there
ForLiberty was apparently paraphrasing Martin Armstrong who wrote something remarkably similar:
"They argue that today gold is really paper gold,
and the market have multiplied that many times. They argue that the real gold
is only about 5 billion ounces. They then argue that the paper gold depresses
the price of gold and this is why it is not where it should be right now. All
this sound nice, however, you can make the same argument about anything
traded today from wheat to stocks and bonds given the derivative markets. Some see
conspiracy behind everything."
Is he correct? No he's not. Can we really make the same argument for anything
else? No we can't. The paper market for commodities is just as likely to
have a levitating effect as a suppressing one because it allows for financial
participation by those who have no need or ability to hold the actual
commodity. Gold is the only one that is unequivocally suppressed by
the existence of a paper market.
No conspiracy. The mere existence of a commodity-like paper market for gold
suppresses the price naturally, systemically. Long term systemic suppression
of gold is something totally separate and different from short term price
manipulation or distortion which can occur in any commodity or paper market.
Here's ANOTHER explaining that the BIS (primarily European central banks at the
time) not only anticipated that a paper gold market would lower the price of
gold, but that in the 1980s they supported the creation and expansion of this
market for that very purpose:
Date: Mon Feb 16 1998 14:40
ANOTHER (THOUGHTS!) ID#60253:
"The BIS leads the creation of a paper gold market that will lower
the world price of gold to the extent that it remains above
Guess what, it worked! Contrary to all expectations of oil shortages,
inflation, debt collapse and what have you, It Worked! But, there is one
The BIS and other various governments that developed this trade (notice I
didn't use conspiracy as it was good business, as the world gained a lot),
thought that the paper gold forward market would have allowed the gold
industry to expand production some five times over! Don't ask where they got
this, as they are the same people that bring us government finance and
In other places ANOTHER explains that we should not be upset with the CBs
because they were just buying us time. And later he explains what they were
buying time for—to make it to the launch of the euro. He also muses
about the fact that it's the Westerners playing in this new paper gold market
who are most upset about the low price. The physical buyers in the East see
it as a gift. But I digress.
Nobody is claiming there are more than 5 billion ounces of paper gold. In
fact, there is probably far more physical in the world than paper gold.
Enough physical gold to cover all of the paper a few times over perhaps. But
that doesn't matter, it is only the flow that
matters. It's the same with commodities that get produced and then consumed.
It's the flow between production and consumption where the price is
discovered in the paper markets. But gold doesn't get consumed at a rate
anywhere close to its next closest competitor. It just accumulates.
In commodities the paper market regulates the flow between the producers and
consumers, acting as a kind of a shock absorber against unexpected supply and
demand shocks. But gold is different because it just accumulates. There are
two main differences between gold and everything else. The first is that gold
just accumulates rather than getting consumed, so there is no reason for
there to ever be a supply side shock, even if all the mines suddenly stopped
producing. In fact, today we have a 60 year "supply overhang" in gold.
Nothing else comes close.
The second difference is that the vast majority of demand for gold is in
currency terms, not weight terms. This is not true for commodities. If you
need a ton of copper for a construction site, you need a ton of copper. That's
weight-denominated demand. But gold demand is overwhelmingly in currency
terms. If you need a tonne of gold, what you really
need is $50,000,000 worth of gold. It doesn't matter how much it weighs
because you're just going to stick it in a vault.
Having a paper market as a shock absorber for the gold market only has the
effect of keeping the price too low. My explanation for the LBMA survey
discrepancy is a perfect example.
Since gold is not consumed by consumers or industry the way corn, oil, copper
and grains are, and because it simply accumulates, supply shocks are not
economically critical. On the demand side, gold is apparently used as a
"safe haven currency". And we apparently had a demand shock of
around 7,575 tonnes in Q1 2011. The normal supply
for that period would have been around 700-1000 tonnes,
so the paper gold market acted as a shock absorber and absorbed that demand
shock by expanding. That way the price of gold only rose $30 in a quarter
with a demand shock of 10 times the normal physical supply flow.
But that wasn't really demand for 7,575 tonnes of
gold. It was demand for $337B worth of gold. Hypothetically, if the price of
gold had been $55,000/oz. in Q1 2011, that demand would still have been for
$337B worth of gold, the only difference being that the $337B demand could
have been supplied by only 190 tonnes (a mild 20%
increase in flow rather than an extreme 1,000% increase) and the price of
gold would therefore have barely felt a bump in the road, even without a
paper market shock absorber.
Therefore, having an elastic paper market shock absorber for gold is only
necessary if the price is too low, because there will always be plenty of
supply if the price is high enough (60 year supply overhang, remember?). At
today's price, having a paper market shock absorber is apparently necessary
to keep the gold market from blowing up.
It logically follows that it is the very existence of the paper gold market
which is keeping the price too low, because if you took it away, price alone
would have to regulate the flow. Take the paper market away from other
commodities and you simply remove the investor/speculator money in the middle
thereby exposing producers (and consumers) to unpleasant shocks.
We have no idea what the "stock" of paper gold is. The LBMA survey only gave us a glimpse of the flow (paper gold turnover) over a given
time period (Q1 2011) and in a given market (loco London spot, forwards, options
and swaps, with spot transactions being 90% of the reported trades). That
turnover was 2,700 "tonnes" of paper gold
per day with 64% of the LBMA members reporting. We only got a lucky
glimpse because the largest banks in the world (bullion banks like JP Morgan
Chase, Goldman Sachs, HSBC, Barclays, Deutsche Bank, Credit Suisse and UBS)
are lobbying for a technical rule change that will make their overall Basel
III compliance easier.