Guest Post: The Gold Market, Part 1

Education has been an important part of my journey through economics in recent years. I’ve experienced it was hard to find oriented material for what I was looking for. If you have all the time in the world you can read hundreds of books and probably you will come across the topics you were specifically interested in, but most people don’t have all the time in the world.

A few essay’s were of great use to me. One of them I will publish on this site in five parts, it was written by James Orlin Grabbe in the late nineties. It covers the history of gold, its function in the economy, futures trading, the London gold fix, gold leasing, gold forwards, gold swaps, gold forward rate agreements (FRA), gold interest rate guarantees (IRG) an options trading. It’s outdated but it provides proper basic knowledge of gold trading. For more recent information look in the side bar of this site under de header “Online Education", where I will make a list of additional essay’s. I have not changed, added or deleted one word of Grabbe’s writings.

Written by James Orlin Grabbe

The Gold Market

Part 1

The gold market is a unique 24-hour-a-day market for the purchase or sale of one of history’s longest-valued commodities. What gives the market its special character is the use of gold simultaneously as industrial commodity, as decoration (jewelry), and as a monetary asset. To understand the gold market, it is important to understand the latter function. Because gold has often formed a component of the local money supply, its history is intertwined with national and central bank politics.

Gold as Money

Gold is only one of many commodities that over the years have served as money — as a medium of exchange — in international trade and financial transactions. Such commodities have frequently varied. In many local communities (including nation-states), the most widely used commodity, or the product most traded with outsiders, has often functioned as money. In the Oregon territory from 1830 to 1840, for example, beaver skins were a customary medium of exchange. Then, as the population shifted from fur trapping to farming, wheat became the chief form of money, and from 1840 to 1848 promissory notes were made payable in so many bushels of wheat. Later, with the California gold discoveries in 1848, the Oregon legislature repealed the law making wheat legal tender, and proclaimed that thereafter only gold and silver were to be used to settle taxes and debts. For similar reasons, tobacco long served as the principal currency in Virginia. When the Virginia Company imported 150 “young and uncorrupt girls" as wives for the settlers in 1620 and 1621, the price per wife was initially 100 pounds of tobacco — later climbing to 150 pounds.

Only a few currencies, however, have had long-run durability as well as multi-territorial acceptability. Silver and gold are two of these. Roughly speaking, from the time of Columbus’ discovery of America in 1492 to the California gold discovery in 1848, silver dominated in common circulation in America and Europe, while gold came into dominance following the Californian and Australian gold discoveries (see Chapter 8 in J. Laurence, The History of Bimetallism in the United States, D. Appleton and Company, 1901). Under the rule of the British Empire, the British pound sterling and the gold standard were adopted in much of the world. Toward the end of World War Two, the U.S. dollar and gold became the principal international reserve assets under the Bretton Woods agreement — a market position the U.S. dollar and gold have maintained despite the de facto dissolution of that system in the early 1970s.

The Post-WW2 Politics of Gold

Under the Bretton Woods Agreement forged at the Mt. Washington Hotel in Bretton Woods, New Hampshire in 1944, each member of the newly created International Monetary Fund (IMF) agreed to establish a par value for its currency, and to maintain the exchange rate for its currency within 1 percent of par value. In practice, since the principal reserve currency would be the U.S. dollar, this meant that other countries would peg their currencies to the U.S. dollar, and–once convertibility was restored–would buy and sell U.S. dollars to keep market exchange rates within the 1 percent band around par value. The United States, meanwhile, separately agreed to buy gold from or sell gold to foreign official monetary authorities at $35 per ounce in settlement of international financial transactions. The U.S. dollar was thus pegged to gold, and any other currency pegged to the dollar was indirectly pegged to gold at a price determined by its par value.

What does it mean to fix the price (the exchange value) of a currency or a commodity like gold? If no trading other than with official authorities is allowed (as when something is “inconvertible"), then fixing the price is easy. The central bank or exchange authority simply says the price is “X" and no one can say differently. If you want to trade gold for dollars, you have to deal with the central bank, and you have to trade at central bank prices. The central bank may in fact even refuse to trade with you, but it can still maintain the lawyerly notion that the exchange rate is “fixed." (Such a refusal, of course, will only lead to black market trading outside official channels.) If, however, free trade is allowed, fixing the price requires a great deal more. The price can be fixed only by altering either the supply of or the demand for the asset. For example, if you wanted to fix the price of gold at $35 per ounce, you could only do so by being willing and able to supply unlimited amounts of gold to the market to drive the price back down to $35 per ounce whenever there would otherwise be excess demand at that price, or to purchase unlimited amounts of gold from the market to drive the price back up to $35 per ounce whenever there would otherwise be excess supply at that price.

In order to peg the price of gold you would thus need two things: a large stock of gold to supply to the market whenever there is a tendency for the market price of gold to go up, and a large stock of dollars with which to purchase gold whenever there is a tendency for the market price of gold to go down. No problem. The U.S. had plenty of gold — about 60 percent of the world’s stock. And, naturally, it also had plenty of dollars, which could be created with the stroke of a pen.

After the Bretton Woods Agreement, the price of gold remained uncontroversial for the next decade. But around 1960 the private market price of gold began to show a persistant tendency to rise above its official price of $35/ounce. So, in the fall of 1960, the United States joined with the central banks of the Common Market countries as well as with Great Britain and Switzerland to intervene in the private market for gold. If the private market price did not rise above $35 per ounce, it was felt, the Bretton Woods price was de facto the correct price, and in addition no one could complain if dollars were not exchangeable for gold. This coordinated intervention, which involved maintaining the gold price within a narrow range around $35 per ounce, became formalized a year later as the gold pool. Since London was the center of world gold trading, the pool was managed by the Bank of England, which intervened in the private market via the daily gold price fixing at N. M. Rothschild.

The London Gold Fixing

In its current form, the London gold price fixing takes place twice each business day, at 10:30 A.M. and 3:00 P.M. in the “fixing room" of the merchant banking firm of N. M. Rothschild. Five individuals, one each from five major gold-trading firms, are involved in the fixing. The firms represented are Mocatta & Goldsmid, a trading arm of Standard Chartered Bank; Sharps Pixley, a dealer owned by Deutsche Bank; N. M. Rothschild & Sons, whose representative acts as the auctioneer; Republic-Mase, a bullion subsidiary of Republic Bank; and Samuel Montagu, a merchant banking subsidiary of Midland Bank (owned by HSBC). Each representative at the fixing keeps an open phone line to his firm’s trading room. Each trading room in turn has buy and sell orders, at various prices, from customers located all over the world. In addition, there are customers with no existing buy or sell orders who keep an open line to a trading room in touch with the fixing and who may decide to buy or sell depending on what price is announced. The N. M. Rothschild representative announces a price at which trading will begin. Each of the five individuals then confers with his trading room, and the trading room tallies up supply and demand — in terms of 400-ounce bars — from orders originating around the world. In a few minutes, each firm has determined if it is a net buyer or seller of gold. If there is excess supply or demand a new price is announced, but no orders are filled until an equilibrium price is determined. The equilibrium price, at which supply equals demand, is referred to as the “fixing price." The A.M. and P.M. fixing prices are published daily in major newspapers.

Even though immediately before and after a fixing gold trading will continue at prices that may vary from the fixing price, the fixing price is an important benchmark in the gold market because much of the daily trading volume goes through at the fixing price. Hence some central banks value their gold at an average of daily fixing prices, and industrial customers often have contracts with their suppliers written in terms of the fixing price. Since a fixing price represents temporary equilibrium for a large volume of trading, it may be subject to less “noise" than are trading prices at other times of the day. Usually the equilibrium fixing price is found rapidly, but sometimes it takes twenty to thirty tries. Once in October 1979, with supply and demand fluctuating rapidly from moment to moment, the afternoon fixing in London lasted an hour and thirty-nine minutes.

The practice of fixing the gold price began in 1919. It continued until 1939, when the London gold market was closed as a result of war. The market was reopened in 1954. When the central bank gold pool began officially in 1961, the Bank of England — as agent for the pool — maintained an open phone line with N. M. Rothschild during the morning fixing (there was as yet no afternoon fixing). If it appeared that a fixing price would be established that was above $35.20 or below $34.80, the Bank of England (as agent) became a seller or buyer of gold in an amount sufficient to ensure that the fixing price remained within the prescribed bands.

Gold and European Union

While the gold pool held down the private market price of gold, gold politics took a new turn in the international arena. This was related to the fact that European countries, which had complained of a “dollar shortage" in the 1950s, where now complaining of a “dollar glut." They were accumulating too many dollar reserves. Although it was actually Germany that was running the greatest surplus and accumulating the most dollar reserves in the early 1960s, it was France under the leadership of Charles de Gaulle that made the most noise about it. During World War II, in conversations with Jean Monnet, de Gaulle had supported the notion of a united Europe — but a Europe, he insisted, under the leadership of France. After the war, France had opposed the American plan for German rearmament even in the context of European defense. France had been induced to agree, however, through Marshall Plan aid, which France was not inclined to refuse after it became embroiled in the Indo-China War. But now, in the 1960s, de Gaulle’s vision of France as a leading world power led him to withdraw from NATO because NATO was a U.S.-dominated military alliance. It also led him to oppose Bretton Woods, because the international monetary system was organized with the U.S. dollar as a reserve currency.

In the early 1960s there was, however, no realistic alternative to the dollar as a reserve asset, if one wanted to keep reserves in a form that both would bear interest and could be traded internationally. Official dollar-reserve holders not only were made exempt from the interest ceilings of the Federal Reserve’s Regulation Q for their deposits in New York but also began as a regular practice to hold dollars in the eurodollar market — a free market where interest rates found their own level. Prior to 1965, central banks were the largest suppliers of dollars to the euromarket. Thus dollar reserve holders received a competitive return on their dollar assets, and the United States gained no special benefit from the use of the dollar as a reserve asset.

Nevertheless, de Gaulle’s stance on gold made domestic political sense, and in February 1965, in a well-publicized speech, he said: “We hold as necessary that international exchange be established . . . on an indisputable monetary base that does not carry the mark of any particular country. What base? In truth, one does not see how in this respect it can have any criterion, any standard, other than gold. Eh! Yes, gold, which does not change in nature, which is made indifferently into bars, ingots and coins, which does not have any nationality, which is held eternally and universally. . . ." By the “mark of any particular country" he had in mind the United States, which announced the Foreign Credit Restraint Program about a week later, in part as a direct response to de Gaulle’s speech. France stepped up its purchases of gold from the U.S. Treasury and in June 1967, when the Arab-Israeli Six-Day War led to a large increase in the demand for gold, withdrew from the gold pool.

The Two-Tier System

Then in November 1967, the British pound sterling was devalued from its par value of $2.80 to $2.40. Those holding sterling reserves took a 14.3 percent capital loss in dollar terms. This raised the question of the exchange rate of the other reserve assets: if the dollar was to be devalued with respect to gold, a capital gain in dollar terms could be made by holding gold. Therefore demand for gold rose and, as it did, gold pool sales in the private market to hold down the price were so large that month that the U.S. Air Force made an emergency airlift of gold from Fort Knox to London, and the floor of the weighing room at the Bank of England collapsed from the accumulated tonnage of gold bars.

In March 1968, the effort to control the private market price of gold was abandoned. A two-tier system began: official transactions in gold were insulated from the free market price. Central banks would trade gold among themselves at $35 per ounce but would not trade with the private market. The private market could trade at the equilibrium market price and there would be no official intervention. The price immediately jumped to $43 per ounce, but by the end of 1969 it was back at $35. The two-tier system would be abandoned in November 1973, after the emergence of floating exchange rates and the de facto dissolution of the Bretton Woods agreement. By then the price had reached $100 per ounce.

When the gold pool was disbanded and the two-tier system began in March 1968, there was a two-week period during which the London gold market was forceably closed by British authorities. A number of important changes took place during those two weeks. South Africa as a country was the single largest supplier of gold and had for years marketed the sale of its gold through London, with the Bank of England acting as agent for the South African Reserve Bank. With the breakdown of the gold pool, South Africa was no longer assured of steady central bank demand, and — with the London market temporarily closed — the three major Swiss banks (Swiss Bank Corporation, Swiss Credit Bank, and Union Bank of Switzerland) formed their own gold pool and persuaded South Africa to market through Zurich.

In 1972, the second major country supplier of gold, the Soviet Union, also began to market through Zurich. In 1921, V. I. Lenin had written, “sell [gold] at the highest price, buy goods with it at the lowest price." Since the Soviet ruble was not convertible, the Soviet Union used gold sales as one major source of its earnings of Western currencies, and in the 1950s and 1960s sold gold through the Moscow Narodny in London (a bank that had also provided dollar cover for the Soviets during the early days of the Cold War). In Zurich, the Soviet Union dealt gold via the Wozchod Handelsbank, a subsidiary of the Soviet Foreign Trade Bank, the Vneshtorgbank. (In March 1985, the Soviet Union announced that the Wozchod would be closed because of gold-trading losses and would be replaced with a branch office of the Vneshtorgbank. The branch office, unlike the Wozchod, would not be required to publish information concerning operations.)

London, in order to stay competitive, subsequently turned itself more into a gold-trading center than a distribution center. When the London market reopened in March 1968 after the two-week “holiday," a second daily fixing (the 3:00 P.M. fixing) was added in order to overlap with U.S. trading hours, and the fixing price was switched to U.S. dollar terms from pound sterling terms. But by the 1980s, London’s new role as a trading center had begun to be challenged by the Comex gold futures market in New York.

The SDR as “Paper Gold"

During the early years of the gold pool, it came to be believed that there was a deficiency of international reserves and that more reserves had to be created by legal fiat to enable reserve-holders to diversify out of the U.S. dollar and gold. In retrospect, this was a curious view of the world. The form in which reserves are held will ultimately always be determined on the basis of international competition. People will hold their wealth in the form of a particular asset only if they want to. If they do not have an economic incentive to desire a particular asset, no legal document will alter that fact. A particular currency will be attractive as a reserve asset if these four criteria exist: (1) an absence of exchange controls so people can spend, transfer, or exchange their reserves denominated in that currency when and where they want them; (2) an absence of applicable credit controls and taxes that would prevent assets denominated in the currency from bearing a competitive rate of return relative to other available assets; (3) political stability, in the sense that there is a lack of substantial risk that points (1) and (2) will change within or between government regimes; (4) a currency that is in sufficient use internationally to limit the costs of making transactions. These four points explain why, for example, the Swiss but not the French franc has been traditionally used as an international reserve asset.

Many felt that formal agreement on a new international reserve asset was nevertheless needed, if only to reduce political tension. And while France wanted to replace the dollar as a reserve asset, other nations were looking instead for a replacement for gold. The decision was made by the Group of Ten (ten OECD nations with most of the voting rights in the IMF) to create an artificial reserve asset that would be traded among central banks in settlement of reserves. The asset would be kept on the books of the IMF and would be called a Special Drawing Right (SDR). In fact it was a new reserve asset, a type of artificial or “paper gold," but it was called a drawing right by concession to the French, who did not want it called a reserve asset.

The SDR was approved in July 1969, and the first “allocation" (creation) of SDRs was made in January l970. Overnight, countries gained more reserves at the IMF, because the IMF added new numbers to its accounts and called these numbers SDRs. The timing of the allocation was especially maladroit. In the previous four years the United States had been in the process of financing the Great Society domestic social programs of the Johnson administration as well as a war in Vietnam, and the world was being flooded with more reserves than it wanted at the going price of dollars for deutschemarks, yen, or gold. In the 1965 Economic Report of the President, Johnson wrote, in reference to his Great Society Program and the Vietnam War: “The Federal Reserve must be free to accommodate the expansion in 1965 and the years beyond 1965." U.S. money supply (M1) growth, which had averaged 2.2 percent per year during the 1950s, inched upward slightly during the Kennedy years (2.9 percent per year for 1961- 1963) but changed materially under the Johnson administration. The growth rate of M1 averaged 4.6 percent per year over 1964-1967, then rose to 7.7 percent in 1968. Under the Nixon administration that followed, money growth initially slowed to 3.2 percent in 1969 and 5.2 percent in 1970, then accelerated to 7.1 percent for 1971-1973. The latter three years would encompass the breakdown of Bretton Woods, and would also have a material effect on the price of gold.

James Orlin Grabbe