Gold “Monetized” Honestly vs. Dishonestly

We have the opportunity today for a wonderful monetary lesson. Two contrasting news items highlight two diametrically opposed uses of gold — one honest and openly-monetary, the other dishonest and destructive of not only gold’s monetary purpose, but the very economic fabric of society. (Both came to my attention via Ed Steer’s “Gold and Silver Daily” bulletin, so thanks, Ed!)

In the first item, we see that India’s regular folk are increasingly using gold as collateral for personal loans:

More than Rs 50,000 crore worth of gold is likely to be pledged this year to procure loans in a rapidly expanding gold loan market, allowing India’s favourite hoarded asset to re-enter financial markets and provide a boost to the economy.

Remember, the real wealth is the collateral in any loan transaction — not necessarily what the loan is denominated in (which will simply be the prevailing currency or whatever form immediate payment/settlement is owed to the third party by the borrower).   Note that using gold as collateral for loans is a totally different philosophy from what we’re accustomed to here in the West; one does not simply sell the gold, because one expects it to rise in value (or at least, retain its value relative to fiat).  Duh!

In the West, people are ignorantly selling their gold in droves to procure ready cash to pay their bills amidst the “Great Recession” (which is really a depression).    Ads and opportunities to sell gold must outnumber those to buy by something like 10 to 1 (we’ve commented on this before as indicative of the ABSENCE of a gold bubble).

By contrast, in India, despite the lack of a formal inclusion of gold into the monetary system, gold is already being treated as the fundamental money in society, as revealed by these loan arrangements.    One way to put it is that the Indians are monetizing gold (as Americans are), but they are doing it honestly/smartly: not by selling it, but by borrowing mere fiat currency against it.

So now we have a “good” in this hierarchy (the Indians with their gold-collateral loans) and the “bad” (ignorant Americans simply selling off the family heirlooms)… is there an “ugly”?  Why yes, there is.

Simultaneous to the above, there have been some raised eyebrows about negative lease rates on gold in the European money markets.   Normally, when gold is lent out in these markets, the lender charges interest (in fiat money terms, i.e., dollars or euros) on that gold loan.   That has reversed: essentially the gold lenders are paying borrowers, in a Don Rickles-esque “take my gold, please” gesture.

Needless to say, this is highly abnormal — so what’s going on here?

John Dizard of the FT (via GATA) explains (emphasis us):

The partnership between the Federal Reserve and European Central Bank to provide hundreds of billions of relatively low-cost dollars for euro-area banks should have relieved the pressure to come up with greenbacks. Yet gold market people say European commercial banks are being driven to lend gold for dollars at negative interest rates just to raise some extra cash for a few weeks. There’s not a lot of transparency about where the banks are getting the gold they are lending out, but it could be lent to them by either their national central banks or by gold exchange-traded funds.

So what we see here is another way of “monetizing” gold.  But it’s a corrupt,  mirror-image version of what the Indians are doing (and it’s not merely stupid, like Americans selling off their gold at retail).  Basically, the big entities are lending out gold secretly, and actually dumping it on the market at negative lease rates (“we’ll PAY you to take our gold — how could you refuse?”).

This both suppresses the market AND (more importantly) diverts momentum away from openly from using gold as monetary collateral — which could be done on a greater, more official scale than what the Indian public is doing.  (Note that you could just as well borrow any other asset and sell it to raise cash; so in this case, the gold is being treated not as money, but as a generic commodity that happens to have an readily-available market price).

By contrast, were these banks getting above-the-board, collateralized gold loans with THEIR OWN gold (as if they have any), gold’s primary monetary role would be obvious.   The next short step would then be pricing the gold appropriately vs. fiat; e.g. a 20% gold collateral backing (as discussed by some recently in the case of Italy) would imply gold is undervalued in terms of fiat by 5x. If that were recognized publicly, it would be bedlam for fiat money, very quickly.

A further consequence of this leasing is that you have essentially short-selling (borrowing something to sell it — but you have to buy it back later and return it to the lender).  Because the gold is almost certainly borrowed from central banks (or ETFs like GLD)  — commercial banks don’t just keep capital around in the form of gold — it will have to be returned.  This may require buying at a higher price later, which would be disastrous. Thus, this will all increase instability.

So here we have a triple-whammy of officialdom denigrating/hiding gold’s monetary role, suppressing the market with short sales, and planting the seeds for a further “liquidity crisis” (and gold price spike) shortly down the road when this borrowed gold must be returned.

Luckily, those following along at home don’t need to wait for a public “fessing up” about gold’s true role: you can already follow the lead of those shrewd Indians and hold your primary wealth in the very form being denied by the big banksters.