The Blue Screen Of Death

Paul Tustain - Thu 17 Nov, 2005

"...Barely 1% of the world's gold buyers actually own the gold they buy. The rest are merely protecting the global banking system. Yes, really - read on..."

When my last laptop stopped behaving itself the experts couldn't fix it. After a week of increasing desperation in the end there was only one way I could get it back to predictable behaviour...

I threw it out of a second floor window.

I knew my PC would follow the parabola of any object falling freely under the influence of gravity, which was exactly what happened. Natural laws prevailed, and they continued prevailing as the machine redistributed its carefully organised components into disorganised chaos shortly afterwards - as predicted by science's second law of thermodynamics.

This simple law of nature also predicts that when a system of any kind gets too complicated you have to pour in energy to maintain that complexity. Under its watchful eye all organised systems eventually break down, and become disorganised again.

Everything from a house to a human body...from a bag of sugar to a spaceship...obeys this law. Time always makes organised things turn back into formless mush. The best we can do is pump in increasing amounts of energy to hold off the inevitable decay for a while.

Which brings us - sadly - to economics.

The 21st century economy is a technical device. It is a designed system too, although it used not to be. Before WWI, nobody seriously tried to organise the forces of economics. Then Western economists realised capital flows could be organised and harnessed. They discovered that under the right circumstances, they could engineer an economic system to benefit most people.

This has had an amazing result. Those of us living in the West today have become the wealthiest people ever. Nevertheless, the natural laws of science and economics will win out. There is absolutely no doubt this cleverly organised and beneficial economic system will fail; no doubt whatsoever.

The only question is, when?

My old computer, stuffed full of files and data, reacted to its increasing complexity by giving me a series of error messages. It started with "Disk read checksum error". Then it went through "Please consult your system administrator" - by which I think it was optimistically referring to me. And finally it offered what computer people call the "Blue screen of death", just before its short and violent final journey.

In much the same way there are ominous error messages coming out of the western economies today. In the US alone, every one of 100 million families annually spends $5,000 too much on imported goods. In Britain, household debt now totals 150% of post-tax income. Australia's trade deficit has reached 7% of GDP.

Our central bankers call these numbers "imbalances". But they are the error messages - like my computer's checksum - which nobody knows how to fix. So everyone continues to look the other way, while government spending and household debt explode, especially in the Anglo-Saxon economies of the world.

But the second law of thermodynamics is patient. It tolerates disequilibrium while you pump in energy - knowing that the energy is finite, and that it will win out. I was reminded by my failing computer how important it is to have a backup strategy - and not only for laptops.

Should the global economy break down, the most reliable backup strategy is gold. The trouble is, a highly complex system has developed in the gold market too. And it is not a system which serves your purpose.

When I first decided, several years ago, to back up my finances with gold, I wanted to buy a long-term secure bullion reserve. I wasn't interested in short-term speculation or relying on the complex clearing systems which underpin the options and futures markets. They aren't sufficiently reliable over a decade or two.

No, I wanted to own gold outright and not worry about it. Yet on top of a potentially nasty storage problem, the retail gold market demanded 4-6% dealing spreads - much too high.

This is a consequence of the delivery problem. Professional dealers will only buy bullion from you on narrow spreads if the bars are of standard size - fully 400 troy ounces and worth $188,000 at today's prices. The bars must also have been stored and shipped exclusively by recognised professional bullion market participants, ever since their manufacture.

But how many private buyers will be dealing in $188,000? And how many private individuals can deal with a professional vault where vaulting agreements cost a minimum of $1,000 a month?

Because of this I had to deal with the banks. It took ten weeks to complete the set-up of an account in Switzerland - and even then it cost me a 2% spread to buy 'unallocated' gold. And I still had to pay 0.5% in annual management!

Now, I want to rely absolutely on this gold reserve - my back up. So I decided to find out what this 'unallocated' gold is all about. Get ready to be surprised.

When a bank sells you unallocated gold, you become the bank's creditor. It owes you the gold in other words, and you do not own the asset you've bought. The gold is only available to you if the bank remains solvent.

What if your bank doesn't remain solvent? The regulators require the banks to hold a percentage of their liabilities in highly marketable and liquid assets, things that can be turned into cash quickly during times of crisis. This is called the "liquidity reserve", and it's there to protect the bank from a cash shortage - caused, for instance, by a breakdown in global finances that gold buyers might hope to survive.

Physical gold bars are good assets for a bank to hold as liquidity reserves - especially as they tend to rise in value when there are crises. They turn easily into cash. And while gold is held, unallocated to customers, the regulators allow it to be considered a part of a bank's reserve. This makes unallocated gold an attractive way for the bank to maintain its regulated liquidity reserve. In short, you have paid for your gold, and the bank can use your money all the while. Yet it must sell its gold - your gold, in fact - in the event of a crisis, to keep the bank liquid!

So your unallocated gold would be ditched if the bank were badly in need of cash. It has no choice in the matter; liquid reserves and other near-cash assets are there to protect the bank's general creditors - all of whom, including you, would receive a proportionate share of whatever money is raised from the sale of these and other bank assets if the bank were to go under.

If that did happen, unallocated gold owners would be in a bad position. The bank's usually small gold reserve would be diluted by its non-performing bond portfolios and other assets. Moreover, the last line of defence - deposit protection, which is a mainstay of banking confidence in the West - does not generally apply on bullion debts. Deposit protection is there to raise confidence in the national currency.

So unallocated gold actually offers LESS protection from bank failure than a cash deposit!

Allocated gold is different, of course. You become the outright owner of gold and you are no longer a creditor. Your allocated gold is your property and it cannot be used as the bank's reserve. But this explains why banks usually charge nothing for 'unallocated' storage against a chunky 1.5% per annum for 'allocated' storage. And as a result, professionals in the bullion market reckon that less than 1% of gold traded within financial markets is ever allocated as customer property.

Yes, the huge majority of today's gold buyers are - probably unwittingly - acquiring a personal financial backup in a way which protects everyone else in front of them.


Paul Tustain
for The Daily Reckoning