Central Banks Lease Gold and Silver; Distorting Markets and Balance Sheets

Libertarian economist Milton Friedman once commented that the principal defect of gold and silver as monetary bases is? society spends resources extracting them out of the ground in order to store them—back in the ground—in central-bank vaults. But another libertarian-gone-mainstream, Alan Greenspan, saw another problem with precious metals—metals don’t generate interest income.

On July 24, 1998, Alan Greenspan—a former advocate of the gold dollar and opponent the Federal Reserve he now chaired—uttered one sentence that drew the ire of every goldbug on the face of the Earth: “Central banks stand ready to lease gold in increasing quantities should the price rise.” What made the goldbugs so mad? And what did Greenspan mean by “leasing” gold?

As far as Greenspan was concerned, Friedman’s issue with gold—it was expensive to mine—was somebody else’s problem. All Greenspan cared about as chairman of the Federal Reserve, was he had a lot of gold and silver in his vaults that wasn’t generating interest income. So under his watch, the Fed began increasing the amount of gold and silver leased to mining companies, as well as to other central banks and foreign governments.

Direct Leasing

The most basic form of precious-metal leasing involves central banks such as the Fed taking their gold or silver to an intermediary institution known as a “bullion bank.” Major firms such as Bank of America, Barclays, Citigroup, Goldman Sachs, JP Morgan Chase, and UBS all operate as bullion banks.

Typically, the bullion banks might pay a 1% interest rate on the gold or silver, with the promise to return it at a specified date. The bullion bank then takes the precious metal and sells it on the open market, using the proceeds to buy Treasury bonds for a 3-4% net return.

But what if the precious metal rises in price and the bullion bank has to pay more for the gold or silver it returns than it received for the gold or silver that it borrowed? To address this concern, bullion banks use the futures market to lock in a price and delivery date of the necessary gold or silver. This cuts into their profit margins but takes all of the risk out. A 1-2% net return with zero risk is a great deal for them. As for the metal lender, a 1% return is better than the 0% return gold and silver earn in underground bank vaults. It’s a win-win for the central bank and the bullion bank—but some argue individual investors lose.

Critics of metal leasing say, because gold and silver leasing artificially increases the supply of the precious metals for industrial, commercial, and investment uses, thus holding down the prices of the commodities. Central banks and the bullion banks are insensitive to the price of gold or silver—profits are locked in and guaranteed—so this distorts the real supply and demand relationship between buyers and sellers.

But could it be that holding down the price of precious metals is not just a side effect, but the intended effect of leasing? After all, just reconsider Greenspan’s words: “Central banks stand ready to lease gold in increasing quantities should the price rise.” It’s quite possible that, in the absence of gold leasing, government fiat currencies would appear virtually worthless as they rapidly depreciate against gold.

Gold and Silver Swaps

Even more insidious is the action of “swapping,” which is most commonly performed with gold. Essentially, two central banks literally swap hordes of gold—with the objective of doing nothing more than muddying the accounting waters.

A second type of gold swap involves only one central bank’s gold reserves, which are lent for currency to another central bank. The real problem with this tactic is the banks consider these swaps to be “collateralized loans,” and thus they don’t appear on their balance sheets. No one knows for sure just how much gold and silver the Fed and other central banks have lent to each other this way.

In fact, the situation is getting so bad that the International Monetary Fund (IMF) is actually beginning to take gold swapping seriously. The IMF has recommended that these types of swaps be recorded on the balance sheets of central banks, and the rule could become mandatory by 2009.

Mining Companies

But central banks and the bullion banks aren’t the only bad guys in the precious-metal leasing story: Mining companies deserve a share of the blame, as well. Despite the near-sightedness of it, many of these companies participate in the leasing themselves by borrowing gold from the Fed or other central banks, selling it, and then later replacing it with new gold fresh from the mine.

Of course, considering gold leasing suppresses the price of gold, and generally, gold-mining companies benefit from higher gold prices, borrowing gold isn’t really in a mining company’s long-term interest—but since when has that stopped someone from making a short-term buck?

Is the End in Sight?

For all intents and purposes, silver leasing has come to an end. This happened because, finally, central banks were essentially out of silver. Most silver analysts expected this would result in a major bull market in silver, and while it did impact the market in a positive fashion, the price of silver has still been suppressed by a concentrated short position held four traders whom many analysts consider to be market manipulators.

Gold leasing, on the other hand, is still alive and well. But like silver leasing, it too must come to an end. The difference is when gold leasing is unwound, there won’t be a concentrated short position holding gold back. Many goldbug analysts predict gold could see $2,000 an ounce when central banks stop leasing gold.

The question is not if central banks will stop leasing gold—the question is merely when. But the real question is: Will you profit from it?