By Charles Hugh Smith, OFTWOMINDS
The ramifications of Google’s decision to leave China are deep: China’s leadership, be careful what you wish for.

I have been a student of China for 40 years. Alas, no, I did not learn Mandarin. When I started reading about China in 1969, and taking university courses on its culture and history in 1972, the Cultural Revolution was in full swing. The People’s Republic was locked down; other than a trickle of black-market trading with Hong Kong, nobody was allowed in or out. No young person today, Chinese or American, can even imagine conditions in that distant, bleak time.

In essence, China’s leadership sacrificed two generations in the Cultural Revolution. It imprisoned, tortured, killed, banished, placed under house arrest, etc., the most experienced leaders of its society below the secretive high reaches of the CCP (Chinese Communist Party) and Mao’s inner circle.

Due to our large number of Chinese friends, we know several utterly harmless, apolitical men who were imprisoned during the Cultural Revolution. One was actually an officer in the People’s Liberation Army. Yes, even the military was purged.

By destroying its educational system, China also sacrificed the upcoming generation. Though few ever voice it, there remains a deep bitterness amongst those who were denied an education and thus a foothold in a better life. After the madness of the Cultural Revolution finally ended with the death of Mao and the coup deposing The Gang of Four (circa 1976-77), then the generation of youth who came of age in Deng’s era of reform starting in 1978 were awarded opportunities lost to their older peers.

I preface my entry with this brief history to show how far China has come in the past 30 years. The young people we know (teens and 20-somethings) show little to no awareness (or interest) in the Cultural Revolution. This is understandable; that era might as well be ancient history to youth concerned with getting their place at the exciting banquet of opportunities now available.

China remains a velvet-gloved dictatorship. If you work within the boundaries set for acceptable behavior and thinking, you will be left alone or perhaps followed /tracked but not openly harrassed. But if you step over that boundary by embarrassing the Central State, by questioning its authority or its prosecution of policy and laws, then you will disappear or be driven into exile.

Chinese Dissident Lawyer Convicted of Subversion The whereabouts of Gao Zhisheng, who had carved out an international reputation for taking on controversial legal cases, such as government land seizures, has been the subject of intense speculation since he disappeared last year.

In essence, Google questioned the status quo too directly, and so it has been silenced by being driven into exile. To do anything other than exile Google would have caused the Central Government to lose face, which is a humiliation which must not be allowed.

There are two keys to understanding the nuances and apparent contradictions in Chinese policy and actions. One is the absolute importance of “face.” Face must be saved; any perceived slight or humiliation will be countered forcefully lest face be lost. This is a pan-Asian cultural trait which Westerners often fail to understand in full measure. If you don’t understand “face” then you will fail to understand Asia.

General Douglas MacArthur’s nuanced arrangements for the unconditional surrender of Japan in World War II provide a good example. Many felt that Japan’s Emperor should be hung as a war criminal, and indeed it seems Emperor Hirohito expected this himself. But MacArthur felt that might unleash an unwelcome turmoil in Japan, right when the U.S. was fending off Soviet demands for the northern half of Japan (due to their extraordinary efforts in the the last week of the war, when they formally declared war on Japan).

So instead he had the Emperor address the Japanese people in a radio broadcast. The citizenry had never heard their Emperor’s voice before, and so this simple act was a revelation of vast consequence. Next, MacArthur released one photo of himself standing next to the diminutive, formally attired Emperor. MacArthur was a tall man, and he wore his U.S. Army uniform (not dress uniform) and a grave expression.

The message was clear to the Japanese people: MacArthur was in charge but had avoided humiliating their Emperor. The occupation of Japan, a fantical enemy which had fully embraced mass-suicide attacks on U.S. ships and troops, went smoothly.

The point is that being challenged by an American tech company raised the issue of face for the Chinese Central Government. To “lose” a confrontation with Google was simply not possible for the leadership; to do anything but “win” by forcing Google to “obey the law” (which is a relative term in China) would be to lose face.

So Google predestined the outcome by going public.

Alternatively, if Google had gone privately, hat in hand, to “friendly” fixers in the top rungs of the CCP or Central Government, the outcome might have been different.

But perhaps not, because China’s leadership is making it clear that it wants a Chinternet, not the Internet, within its borders. The Central Government has erected, at vast expense, a Great Firewall of thousands of technicians who monitor and selectively block or impede thousands of sites–even down to my architect-friend’s Chinese-language version of his entirely harmless and apolitical architecture site.

China is blocking any coverage of Google’s banishment except for official sources.Is there any clearer way to stress that all communication within China proceeds at the Central Government’s pleasure?

I often note that if you don’t have sources within local government, then you know nothing about China. In cases such as Google, the Great Firewall, exchange rates, or closing down the country to battle SARS, then the Central Government does wield extraordinary powers. Yet in the actual lived experience of doing business, all the action is local.

Thus the Central Government issues various environmental statutes, but how, when and where they are actually enforced is entirely a local matter. Ditto for food safety, development, lending, land stolen from peasants, etc. etc. etc.

Thus when Westerners go to China and end up in fancy restaurants drinking with locals, or being ushered into Central Government offices, their grasp of China on the ground is mostly illusory. Let me repeat: if you don’t have sources within local government, then you know nothing about China.

I will illustrate with one example of dozens known to me personally (yes, from sources in local government). A multinational pharmaceutical company opened a large, costly plant in China to manufacture medications for the Chinese market. Within weeks, reports trickled in that the medications didn’t work and Chinese consumers were angry. It turned out that local entrepreneurs had begun shipping sugar pills in the exact containers used by the pharmaceutical giant–worthless counterfeit pills, identical in shape, size, feel, and packaging, were being shipped all over China.

The pharmaceutical giant closed the plant. What choice did they have?

This was of course hushed up; only the local government and the managers knew the truth.

The pharmaceutical giant had learned a painful but important lesson: not only can you prosper without doing in business in China, your business in China will fail if your products can be counterfeited, pirated or copied. Your recourse is zero.

China is organized at the Central State and local government levels around building China, Inc. To the degree that Western and other Asian firms can help build China, Inc., then they are encouraged to set up shop and invest their billions. To the degree they challenge China, Inc. or the Central Government, they are unwelcome and will be cut off at the knees, either openly or via subversion.

What Google is announcing to the world is profound: you can stop doing business in China and prosper. The notion that “you have to be in China or you’re doomed” has been upended. There are plenty of other markets, and Western firms are learning (if they haven’t already learned from painful experience) that their capital and trade secrets are there to serve China, Inc. Once the knowledge is in Chinese firms’ hands, then the Westerners are either junior partners or left in the dust of piracy.

Google is simply the highest-profile company to publicly say, Take This Dictatorship and Shove It. Yes, they still hope to sell their Android phones and advert services, and perhaps they will do well in these other ventures–if they establish strong local partners with access to the Powers That Be.

But in its push to construct a Chinternet free of troublesome Western-controlled information and ideas, China’s leadership should be careful what they wish for. Establishing a simulacrum Internet is akin to establishing a simulacrum of free-market capitalism; the consequences of a system built on obfuscation, manipulated “news” and statistics, cronyism, and what amounts to fraud and corruption are not controllable.

As we in the U.S. are learning to our own sorrow, any system (financial or otherwise) built on obfuscation, manipulated “news” and statistics, cronyism, fraud and corruption cannot endure. Truth will out, eventually, and those who have maintained power via propaganda and lies will find manipulation has its limits.

Oh, which reminds me: the Federal Reserve meets today, and the propaganda machine is going full throttle.

Here are some recent articles on China, and my long report from 2006 for background: China: An Interim Report: Its Economy, Ecology and Future

China Accounting Shift Narrows Deficit

China Hears Foreign Firm Complaints

Latest Gathering Sees Lively Debate Spotlight on leaders exposes tensions between people seeking more openness in government and tradition of secrecy

Chinese Censorship of Google Issue Betrays Concerns

Google Is Poised to Close China Site Expected Move by Search Engine Would Reduce Foreign Presence in World’s Largest Web Market

China remained a net seller of Treasurys its holdings falling $5.8 billion to $889.0 billion in January, following net sales of over $34 billion in December

Why China Can’t Cool Its Overheated Real Estate Boom

Here are a few titles on China that may be of interest:

China: Fragile Superpower: How China’s Internal Politics Could Derail Its Peaceful Rise

The River Runs Black: The Environmental Challenge To China’s Future
by Elizabeth C. Economy

The Future of Life
by E. O. Wilson

The Rape of Nanking: The Forgotten Holocaust of World War II

Mao’s War against Nature : Politics and the Environment in Revolutionary China
by Judith Shapiro

China’s New Rulers: The Secret Files
by Andrew J. Nathan and Bruce Gilley

China Wakes : The Struggle for the Soul of a Rising Power
by Nicolas D. Kristof

River Town: Two Years on the Yangtze by Peter Hessler

The River at the Center of the World : A Journey Up the Yangtze, and Back in Chinese Time
by Simon Winchester

The Good Women of China : Hidden Voices by Xinren Xue

Wild Swans : Three Daughters of China
by Jung Chang

Hungry Ghosts: Mao’s Secret Famine
by Jasper Becker

Mao: The Unknown Story by Jung Chang

The Private Life of Chairman Mao
by Li Zhi-Sui

The Great Wall and the Empty Fortress: China’s Search for Security
by Andrew J. Nathan

China Dawn: The Story of a Technology and Business Revolution
by David Scheff

Streetlife China
by Michael Dutton

China’s New Order: Society, Politics, and Economy in Transition by Hui Wang

Red Sorrow: A Memoir
by Nanchu

The Dragon Syndicates: The Global Phenomenon of the Triads

The China Dream: The Quest for the Last Great Untapped Market on Earth by Joe Studwell

If you haven’t visited the forum, here’s a place to start. Click on the link below and then select “new posts.” You’ll get to see what other oftwominds.com readers and contributors are discussing/sharing.

DailyJava.net is now open for aggregating our collective intelligence.

Order Survival+: Structuring Prosperity for Yourself and the Nation and/or Survival+ The Primer from your local bookseller or from amazon.com or in ebook and Kindle formats.A 20% discount is available from the publisher.

Of Two Minds is now available via Kindle: Of Two Minds blog-Kindle

Go to my main site at www.oftwominds.com/blog.html
for the full posts and archives.

More articles from Charles Hugh Smith….

By Chris Carey, Bailout Sleuth

Sen. Chris Dodd (D-Conn.) revealed his long-anticipated financial reform bill Monday, which he said would provide a better regulatory framework than the existing system that has grown “hopelessly inadequate” in the wake of the financial crisis.

The bill, Dodd said, would prevent a future bailout by providing a mechanism for the government to shut down failing institutions that are threatening the economy through either bankruptcy or resolution

“Never again should the American taxpayer be asked to write a check because of an implicit guarantee that the federal government will bailout a company when it collapses if it threatens the stability of the economy as a whole,” Dodd said.

The bill would also discourage institutions from becoming “too big to fail” through more stringent capital requirements and improved supervisory protections.

The bill creates a consumer watchdog agency would be housed within the Federal Reserve. Dodd said the agency would be wholly independent, with its own budget and a presidentially-appointed director. It also establishes a systemic risk council tasked with monitoring the financial system for activities that could contribute to a future crisis.

Other provisions promote whistle blowing at the Securities and Exchange Commission, enhance accountability for credit rating agencies and make the head of the Federal Reserve Bank of New York a presidentially-appointed position.

Though Dodd introduced the bill alone and did not receive the bipartisan support he had hoped for, he emphasized contributions made by Republican Sens. Richard Shelby of Alabama, Bob Corker of Tennessee and Judd Gregg of New Hampshire.

Markup of the bill is scheduled to begin next week.

More articles from the Bailout Sleuth….

Research Recap submits:

Loss severities on distressed U.S. residential mortgage loans are likely to rise this year as several key government support programs expire, according to Fitch Ratings.

Low mortgage rates, homebuyer tax credits and government directed loan-modification programs have led to an improvement in home prices and loss severities since second quarter-2009. But the expiration in the coming months of both the homebuyer tax credit and the Federal Reserve’s $1.25 trillion MBS purchase program will increase negative pressure on home prices and loss severities, according to Senior Director Grant Bailey.

Read more…. »

The fine print in the sweeping overhaul of the U.S. financial system proposed by Sen. Christopher Dodd reveals loopholes, ambiguities and unanswered questions about some key players – among them a new consumer protection bureau, credit-rating companies and payday lenders.

Dodd, the Connecticut Democrat who chairs the Senate Banking Committee, unveiled his draft legislation on Monday. His plan’s details suggest his struggle to balance the conflicting demands of Republicans and the financial industry lobbyists, who oppose an independent new consumer agency, and Democrats, many of whom question whether Dodd has gone far enough.

Dodd has stressed the reach of his blueprint, especially noting the importance of a new independent consumer watchdog to write rules for products such as mortgages and credit cards. “This crisis started when people were given mortgages they didn’t understand and could never afford,” said Dodd. “If there was a watchdog on duty, it didn’t bark.”

Still, the legislation would impose significant limits on the autonomy of the new watchdog. It would establish a Financial Stability Oversight Council of nine members, all but one of whom would be existing financial regulators such as the Treasury Secretary and Comptroller of the Currency, which oversees national banks.

Just one member of the Council would have the power to delay the bureau’s suggested regulations, and six would be needed to override them. Council members could block any bureau recommendation they feel threatens the stability of the banking system.

Even before it crafted a rule, the consumer bureau would be required to consult with other financial regulators about whether the rule would be consistent with the objectives of those existing agencies, some of which have been accused of being lax in the lead-up to the financial crisis. The bureau also would have to consult with the Federal Trade Commission before imposing any regulations.

Nor would the consumer bureau be allowed to examine the books of any lender without first coordinating with other federal and state bank examiners so that they all go on the same day – a measure intended to reduce the regulatory burden on lenders.

In addition, the new bureau would have to rely as much as possible on existing documents of the financial institutions it oversees and could not dictate that they use any specific technology to aid the bureau in monitoring.

The consumer bureau would be housed in the Federal Reserve. While Dodd said the Fed wouldn’t have “one iota” of authority over the bureau – and would basically be renting office space – the bill provides for the presidents of the regional Fed banks to recommend at least six members to the bureau’s advisory board.

Much of the bill addresses what the consumer bureau would not be able to do. For instance, the bureau could not declare a lending practice “unlawful” simply because it is deemed unfair. To be illegal, the practice must be “likely to cause substantial injury to consumers, which is not reasonably avoidable by consumers.”

It’s also unclear exactly which lenders the bureau could regulate. Take, for example, payday lenders, which offer short-term, high interest loans.

Dodd’s bill does not actually mention the word “payday.” Yet Dodd’s 11-page summary of the bill does. The summary says a new consumer protection bureau housed within the Fed will have the authority to examine and enforce regulations for “large payday lenders.” But “large” is not defined.

“It’s not clear what ‘large’ means,” states the “Payday Pundit,” a blog of the industry trade group, the Community Financial Services Association. “I will try to seek clarification over the next few days.”

Another payday industry lobbyist told the Investigative Fund that he believes Dodd intends for the consumer protection bureau to determine what “large” means.

As the Investigative Fund has reported, the industry spent about as much as JP Morgan & Co. last year on lobbying alone, and is engaged in an aggressive campaign to resist being ruled by Washington.

Payday lenders were not explicitly mentioned in the approved House version of financial reform either. Amid uncertainty, the bill’s author, financial services committee chair Barney Frank (D-Mass), quickly dispatched a letter to his colleagues saying the new consumer agency would have authority over them.

Separately, Dodd’s bill targets the nation’s top credit rating companies, such as Standard & Poor’s and Moody’s.

As the Investigative Fund reported in a three-part series last year, the raters have long dodged regulation using the First Amendment as a shield. But now, the raters are at the center of the financial crisis. They awarded inflated grades to investments–including ones they allegedly helped create–that ultimately unraveled the economy.

Dodd’s bill calls for a new credit rating overseer within the Securities and Exchange Commission, which will have the authority to fine – or even de-register – the companies for repeated mistakes. The bill also would require ratings analysts to pass qualifying exams and receive relevant education.

But in certain ways, Dodd doesn’t appear to have been as forceful with the raters as Frank was last year. Whereas Frank would remove most, if not all, requirements that investors and banks rely on credit ratings, Dodd called for a Government Accountability Office study of this step. Meanwhile, his bill would direct regulators to remove whatever statutory references to credit ratings that they see as unnecessary. Again, however, it’s unclear exactly what that wording means.

Dodd, like Frank, provided investors the first explicit right to sue the rating companies. But Frank’s bill set forth a seemingly easier standard for suing the raters.

Ultimately, Dodd’s measures, clear and ambiguous alike, face an uncertain future. They are subject to change as the full banking committee takes up amendments to the bill next week.

Read more….

What do Enron, Greece and Lehman Brothers have in common?

The world is about to find out.

The latest disturbing news to crawl out from under a rock this weekend was that Lehman’s used offshore accounting gimmicks to mislead the world about its financial problems. This was the conclusion reached by Anton Valukas, a Chicago prosecutor and fraud expert and contained in his 2,200-page report. He was commissioned by the bankruptcy court to pore over millions of documents to get to the bottom of the biggest bankruptcy in U.S. history involving US$613 billion in debts.

Among his findings and opinions:

• Valukas believes that Lehman executives were involved in “balance sheet manipulation” in order to shift tens of billions of dollars of bad assets off its books.

• The shift was done, as was the case with Greece, using the repo market or an eyebrow-raising buy-sell arrangement.

• Valukas said Ernst & Young, Lehman’s auditors, did not “question and challenge improper or inadequate disclosures” in the firm’s professed results.

• Lehman could not get their offshore gimmick “papered” (which means a legal opinion approving the maneuver) by any credible American law firm so they shopped around and used Linklaters, a legal shop in London, he alleged.

• The New York Federal Reserve Bank, run at the time by Timothy Geithner (now U.S. Treasury Secretary), imposed no restraints on Lehman even though the firm failed to pass several smell tests conducted by Fed staff, alleged Valukas.

• Valukas said he questioned Lehman executives in the past few months and they said full and complete information was disclosed to government agencies (stock markets, SEC, the Fed) about the repo transactions and the governments never raised objections nor did they demand corrective action.

The report raises questions. Were the market’s “cops” then the same people who are still in charge and advising Obama and Congress? Did they have any inkling of trouble or not?
If regulators knew, why didn’t they do something? If they knew, why didn’t they force disclosure to the investing public?

Conversely, if they were not told the truth, then why haven’t charges been laid?

The revelations may take down some very prominent people, send a few others to jail and explain why the former administration refused to bail out Lehman Brothers.

Read more….

"The bill clamps down on conflicts of interest at the Federal Reserve, making the head of the New York Fed, for example, a position appointed by the president of the United States and not hand-picked by the very bankers the New York Fed is responsible for regulating," the Connecticut Democrat told reporters as he unveiled his bill. // Critics said the proposed governance change could weaken the central bank's independence. – Reuters¹

Well duh.  As we noted in, among other places, Doom's introduction to our recent Jesse / Ives Smith re-post, the NY Fed is actually pretty independent from the Fed Board itself, and within its present configuration with the great banks of Wall Street has about as much independence from Washington as Florence did from the papacy during the 16th Century.

IMHO even granting the Fed supervision over the Second District would be an improvement

LATER: Obama's FDR moment seems to be turning into his Andrew Jackson moment,⁶ if he's got the will.  Just the prospect of the first real regulation of Wall Street's IBs in decades will inevitably turn Dodd's proposal into a Superbowl of financial lobbyists.  Meanwhile, the Daily Bell has an article² on the Joseph Stiglitz Fed criticisms which has some nice things to say about the web.

The Fed is in such bad odor because the Internet has exposed its conflicted inner workings to people throughout the United States for years. Viewers, however, likely did not take the Internet's presentations seriously for a long time. But the advent of the financial crisis has changed this perception. By now, even, many may have found the Internet-based free-market interpretations of the Fed's mechanisms more compelling than the dry-as-dust socialist perspectives offered in manifold university textbooks or distributed plentifully by the Federal government and the Fed itself.

The WSJ actually asserts³ that "[t]he biggest winner in Mr. Dodd's bill appears to be the central bank." Murdoch's gang is ignoring the US appointment of the NY Fed Pres under the proposal so hard they might as well be staring straight at it.  The story's first paragraph is pretty ironic since up to now those same big banks were hardly being overseen at all.

WASHINGTON—U.S. Senate legislation aimed at overhauling regulation of finance would cost large banks billions of dollars, prevent them from taking certain risks and create a new regulatory infrastructure to oversee their activities.

Financial blogger Jr Deputy Accountant (JDA — great handle ) doesn't appear to agree with me.⁴ And Igor points out that I wasn't even the first up on this story with the "D" word.  Don't miss JDA's just-released post "Chris Dodd Taps the Fed's Secret Backdoor."

Notice you didn't hear a peep out of the NY Fed when a handful of clever Fed Presidents were campaigning to keep the Fed "independent" and free from political interference. JDA will ignore the fact that they gave that up about 18 months ago when they pledged whatever it takes to prop up everyone except Lehman Brothers as this is not about arguing over whether or not they are actually independent but criminalizing the NY Fed. Duh.

… and the plot thickens; this⁵ just in from Salon.

The Financial Times' Tom Braithwaite dropped this intriguing bomb:

The new proposal would bar appointments of Wall Street bankers as directors at the New York Fed.

I hadn't seen this news elsewhere, and it took a little digging to find the relevant text in the bill. And having done so, it's unclear that the bill specifies exactly what the FT is reporting.
…

Under the Dodd bill all class A and B directors will be appointed by the Board of Governors of the Federal Reserve System. …

—————–

[1]: "President would tap NY Fed chief under Dodd bill", Reuters, March 16, 2010.

[2]: "Nobel Winner Stiglitz Calls Fed Corrupt", Daily Bell, March 16, 2010.

[3]: "U.S. bill takes aim at banks", by Corey Boles and Michael R. Crittenden, Wall Street Journal, March 16, 2010.

[4]: "Chris Dodd's Last Land Mine: Transforming the Fed and Screwing the Consumer", Jr Deputy Accountant, March 15, 2010.

[5]: "Getting the bankers out of the Fed: See ya later, Jamie Dimon. Under the Dodd bill, bankers will no longer be able to choose their own supervisors", by Andrew Leonard, Salon, March 16, 2010.

[6]: "Dodd Targets Banker Influence Over New York Fed", by Alain Sherter, BNET, March 15, 2010.

Although the Fed was founded nearly a century ago, disputes over who controls the nation’s money supply and credit date back to the founding of the U.S., and certainly to the creation of the First Bank of the United States by Alexander Hamilton in 1791. Southern planters and businessmen vied for influence with mostly Northern, urban financial interests. New York bankers later helped sink the First Bank, largely for competitive reasons, culminating in President Andrew Jackson’s move in the 1830s to yank the charter of of the Second Bank of the U.S.

Flash forward to 1913. The Federal Reserve Act, which established the Fed system, cemented banks’ power, especially that of large New York institutions. It shunted aside concerns over the availability of credit for farmers and instead focused on meeting the needs of financial firms, including creation of a more flexible currency. In an important shift, the bill also transferred chief responsibility for stopping financial crises from New York banks to the newly created reserve institutions; that liberated banks to focus on more profitable endeavors.

Read more….

Here’s a brief summary of the financial reform bill proposed by Senator Dodd:

• Consumers: A consumer-protection division would be created within the Federal Reserve, with the ability to write new rules governing the way companies offer financial products such as mortgages and credit cards. It would have authority over any bank with more than $10 billion of assets, and certain nonbank lenders.
• Banks: The Fed would oversee bank holding companies with more than $50 billion of assets. Regulators would have the discretion to force banks to reduce their risk or halt certain speculative trading practices.
• Failing companies: The government would be able to seize and break up large failing financial companies. Big companies would have to pay into a $50 billion fund to finance the dissolution of a failing firm.
• Systemic risk: A new council of regulators would be created to monitor broader risks to the economy. The council could strongly urge individual agencies to take specific actions to curb risk.
• Corporate governance: The Securities and Exchange Commission would have authority to write rules giving proxy access to shareholders who own a certain amount of stock. Shareholders would have a nonbinding vote on compensation packages for top executives.
• Hedge funds: Large funds would have to register with the government.

On the surface I don’t think it’s bad. I don’t know much about the details.

I really like the consumer protection part, because a lot of credit card and consumer lending has gotten completely out of control. Will the new regulation result in 20% down payments for houses again? I doubt it. Why would the new regulation result in 20% down payments when the government, via the FHA, is encouraging 3.5% down payments?

I think having a systemic risk regulator is a good idea. I am skeptical about its ability to prevent future financial crises, though. After all, didn’t the Fed completely look the other way during the buildup of the housing bubble? When everybody’s getting rich, nobody wants to step in and stop the party. I don’t see how this changes that innate human tendency.

Read more….

” It should come as no surprise that Whitney thinks banks are not prepared for home prices to go lower and that, after the Federal Reserve’s scheduled exit from the mortgage backed securities market in just two weeks, there will be a “material” correction there.”

Read more….

Zero Hedge

GATA’s Adrian Douglas has done a tremendous job of combing through dozens of hundred-plus page FOMC transcripts, and has compiled numerous quotes by assorted FOMC-related personnel, including former Chairman Greenspan, which provides yet another piece of evidence, demonstrating the persistence of the Fed’s gold price suppression scheme. As Douglas puts it: “My thinking was that if an organization is so inept at covering up that
detailed transcripts were retained, then perhaps it is also inept at
completely redacting sensitive and incriminating information. What I
found is quite astounding and serves as documented evidence by the
Federal Reserve itself that it manipulates the gold market.” We present the relevant quotes dug up by Douglas, whom we applaud for his effort, together with his very relevant commentary, which once again exposes the Fed’s covert gold price suppression intentions.

In the March 21, 1978, FOMC meeting —

http://www.federalreserve.gov/monetarypolicy/files/FOMC19780321meeting.p…

– the following exchange took place.

* * *

CHAIRMAN MILLER. The Treasury has severe reservations about it.
Originally, two weeks ago, they were taking the position that they
would not be in favor of it — that it raised too many problems for
them. Since then I think they have become a little more open-minded
about it. However, I think the first avenue is apt to be the sale of
gold. Sales of gold were under consideration and were deferred partly
because of the French elections, which are now over. So I think it’s
likely that the Treasury will start a program of selling gold, which I
personally would favor. There are a lot of advantages in using gold
because at least then we don’t end up with debt and the currency risks
that go with it. So I think that’s an avenue that should be pursued.
There has been a discussion about the level of gold sales that are
possible — what the market can absorb and that sort of thing. Henry
can correct me, but I believe the Treasury feels that they could sell
about 300,000 ounces a month.

MR. WALLICH. That would be a very moderate amount — something like
less than 60 million. And bear in mind that unless they can develop a
means of selling the gold for foreign currency in a way that doesn’t
cause holders of dollars to buy that foreign currency in order to buy
the gold, it could be completely counterproductive. Then there isn’t
going to be much of a net effect. There is some because, after all, we
are importers of gold, which may reduce the imports of gold and may
make the trade balance look a little better. There is some portfolio
shift when there is gold in portfolios instead of dollars, so I
wouldn’t say it’s without effect, but there are lots of qualifications
on the possible success.

CHAIRMAN MILLER. The nice thing about this problem is that it’s
surrounded by dilemmas! Everything you do has an adverse effect on
something else. Nothing is ideal. I might add that we live in a
situation where the market is very realistic, very factual. That’s why
the possibility that gold would be sold caused the gold price to drop
by $5. You don’t have to sell gold; you just have to breathe [that you
may] one day.

* * *

The last sentence by Chairman William Miller (Fed chairman in 1978
and 1979) telling the FOMC that the gold market can be manipulated by
propaganda is very significant. This would certainly make Joseph
Goebbels proud. This manipulative deception has been played out time
and time again since then. This is why official gold sales are always
announced in advance and the announcements are repeated many times, as
happened with the International Monetary Fund’s gold sales.

At the FOMC meeting of July 9, 1980 –

http://www.federalreserve.gov/monetarypolicy/files/FOMC19800709meeting.p…

– the following discussion took place.

* * *

MR. BAUGHMAN. Is it considered a political no-no to sell gold in the current environment?

CHAIRMAN VOLCKER. Oh, I don’t think so, necessarily. I don’t think
it’s a political problem in the sense that you may be suggesting. It’s
a question of whether it’s very useful or desirable at this stage. [If
we sold gold] we’d have to do it alone; I think that’s pretty clear. It
isn’t anything that’s ruled out a-priori, but it’s a practical matter
of whether it’s a good idea.

MR. BAUGHMAN. Well, it’s between selling assets and borrowing money. That seems to me the significant difference.

VICE CHAIRMAN SOLOMON. The psychology, Ernie, is that [selling gold]
seems to be much more effective if it’s a component of an overall
package of forceful measures than if it is done by itself. In the
present climate it would look like a major act of weakness. And that
might spur some additional dollar selling unless we did it on an
enormously massive scale, not just the levels that we have before. On
the other hand, if the situation gets to a point where once again we
have to begin thinking carefully of a package, then along with some
monetary policy measures it would be appropriate and add to the
effectiveness — this is my own personal feeling — to do some
substantial gold selling. And in that situation I think the Congress
would understand that. We’d have less of a political problem also. So I
think both factors operate.

CHAIRMAN VOLCKER. I should say, in connection with the political
problem, that I don’t think there are any great political constraints
so far as the thinking in the Administration is concerned. There are
politicians who would make a noise that would reflect upon the
credibility of the action. If we sell some gold and then immediately
get some congressional opposition, the market would say: “Well, they’re
not going to sell very much because there’s too much opposition.” And,
therefore, it might not be very productive in terms of the impact we’d
want to achieve.

MR. BAUGHMAN. There would be some grassroots opposition to it. I can report that, but I don’t have any impression. …

CHAIRMAN VOLCKER. Perhaps I spoke a little misleadingly because that
kind of opposition, I think, does reflect on the credibility of the
action. It raises questions about whether it could be sustained and
what the [total] amount would be and whether it’s really an accepted
technique or not, even though in some sense I think it’s not a
political deal for the Administration except in terms of appraising
that reaction. I can’t quite see the Congress opposing it in a formal
sense but there would be a lot of noise by these limited groups. We
have to ratify these transactions.

MR. SCHULTZ. So moved.

* * *

What is noteworthy is the comment by Vice Chairman Solomon when he
says selling gold “seems to be much more effective if it’s a component
of an overall package of forceful measures than if it is done by
itself. In the present climate it would look like a major act of
weakness. And that might spur some additional dollar selling unless we
did it on an enormously massive scale, not just the levels that we have
before.”

This is without a doubt a proposal to undertake gold market
manipulation, and what’s more it is proposed to be on an “an enormously
massive scale.” This is not a discussion about selling gold based on a
motivation to maximize the profit from such sales. Furthermore, the
vice chairman admits to previous gold market intervention when he
recommends increased selling of gold that is “not just the levels that
we have before.”

What is shocking is the apparent cavalier approach to breaking the
law. Volcker says, “I should say, in connection with the political
problem, that I don’t think there are any great political constraints
so far as the thinking in the Administration is concerned. There are
politicians who would make a noise that would reflect upon the
credibility of the action. If we sell some gold and then immediately
get some congressional opposition. …”

Note that the proposal implies that gold sales would occur without the congressional approval required by law.

The “strong dollar policy” was concocted by Treasury Secretary
Robert Rubin in 1995. However, the mechanism by which such a policy
could be implemented in a supposedly free market was never explained.
GATA has long maintained that the policy involved the suppression of
the gold price. In December 1994 the following exchange took place at
the FOMC meeting –

http://www.federalreserve.gov/monetarypolicy/files/FOMC19941220meeting.p…

* * *

CHAIRMAN GREENSPAN. President Jordan.

MR. JORDAN. I think the main part of our problem right now is
inflation psychology. It certainly reflects the lack of a nominal
anchor. It suggests that it would be helpful to have a politically
supported mandate to attain and maintain a stable value of the dollar.
If somehow we could achieve the conditions of a true gold standard –
without gold but the steady purchasing power of money in the minds of
people — over time it would make some of these short-term things that
we go through a lot easier to deal with.”

* * *

Well, how about that? Achieving the conditions of a true gold
standard without gold? Does that sound like a confidence trick? The
last sentence of the FOMC minutes above here has been redacted. It
would be extremely interesting to know the full extent of the
discussion.

In response to a question posed by U.S. Rep. Ron Paul in testimony
before Congress in 2005, Fed Chairman Greenspan confirmed that this
financial wizardry has actually been implemented:

http://www.lewrockwell.com/paul/paul267.html

* * *

MR. GREENSPAN: So that the question is: Would there be any
advantage, at this particular stage, in going back to the gold
standard? And the answer is: I don’t think so, because we’re acting as
though we were there. Would it have been a question at least open in
1981, as you put it? And the answer is yes. Remember, the gold price
was $800 an ounce. We were dealing with extraordinary imbalances,
interest rates were up sharply, the system looked to be highly unstable
– and we needed to do something.

Now, we did something. The United States. … Paul Volcker, as you
may recall, in 1979 came into office and put a very severe clamp on the
expansion of credit, and that led to a long sequence of events here,
which we are benefiting from up to this date. So I think central
banking, I believe, has learned the dangers of fiat money, and I think,
as a consequence of that, we’ve behaved as though there are, indeed,
real reserves underneath the system.

* * *

The last sentence is exactly what Mr. Jordan was pondering in the
FOMC meeting of December 1994: How to have a gold standard without
using gold. Greenspan says the Fed “behaved as though there are,
indeed, real reserves underneath the system.”

I think it is safe to say there is some financial wizardry that is
apparent by implication. One either has real reserves or one doesn’t.
To behave as if there are when there are not is a confidence trick
doomed to fail at some stage.

In the FOMC meeting of Dec 22, 1992, the Fed governors reveled in
the fact that accounting errors in gold shipments could improve the
U.S. balance of trade numbers –

http://www.federalreserve.gov/monetarypolicy/files/FOMC19921222meeting.p…

* * *

CHAIRMAN GREENSPAN. Did I hear you correctly when you said that the
gold exports in October appear to have come from the coffers of the
Federal Reserve Bank of New York? Has anyone looked lately?

MR. TRUMAN. Well, I didn’t want to tell too many secrets in this temple!

VICE CHAIRMAN CORRIGAN. Obviously, we knew what happened to the gold, but I don’t think we knew what it did to exports.

MR. TRUMAN. What happens in the Census data is that the Federal
Reserve Bank of New York is treated as a foreign country. [Laughter]
And when a real foreign country takes some of the gold out of New York
and ships it abroad, it counts first as imports and then as exports.
However, the import side is not picked up in the Census data. So there
you get the export side of it.

MR. LAWARE. Great accounting!

MR. BOEHNE. Great confidence building!

MR. TRUMAN. That’s because you haven’t been filling out your import documents!

MR. ANGELL. Let me run this by again. You mean a country owns gold
and has it stored in the Federal Reserve Bank of New York and if they
ship it out, that’s an export?

MR. TRUMAN. And in the balance of payments accounts it also counts as an import, so it washes out.

CHAIRMAN GREENSPAN. The Federal Reserve Bank’s basement is a foreign
country. When they move it out of the basement into the United States,
it’s an import. Then, when they ship it out again, it’s an export.

MR. ANGELL. That makes sense!

MR. TRUMAN. And sometimes when they sell the gold, it might be sold
into the United States, so it should count as an import. It doesn’t
necessarily always show up as an export.

MR. BOEHNE. That really clarifies it!

MR. KELLEY. Does it have to get out of your vault at all in order to be considered an import and an export?

VICE CHAIRMAN CORRIGAN. Well, I’m not even going to try to answer
that. In this particular case I know what happened, so I think. …

* * *

The most intriguing part of this discussion is the question by
Kelley: “Does it have to get out of your vault at all in order to be
considered an import and an export?”

While there is no explanation of the thinking behind Kelley’s
question (it was probably redacted), it is reasonable to extrapolate
the inference that “ledger entries” for gold movements could be made to
the import or export accounts without any gold having been physically
moved.

At the May 18, 1993, FOMC meeting there was much discussion how gold
influences public attitudes toward inflation. There were discussions
about interfering in the gold market to change the public’s expectation
of inflation, and such postulated interference was even regarded as
amusing by the FOMC –

http://www.federalreserve.gov/monetarypolicy/files/FOMC19930518meeting.p…

* * *

MR. ANGELL. Here’s what I think would happen. I don’t think we
should increase interest rates by 300 basis points, but, if we did, I’m
quite certain the price of gold would immediately begin a [sharp],
quick [drop]. It would happen so fast you’d just have to go and watch
it on the screen. If we made a 100-basis-point increase in the Fed
funds rate, the price of gold surely would turn back down unless the
situation is worse than I anticipate. If we made a 50-basis-point
increase in the Fed funds rate, I don’t know what would happen to the
price of gold, but I’d sure like to find out! [Laughter]… People can
talk about gold’s price being due to what the Chinese are buying;
that’s the silliest nonsense that ever was. The price of gold is
largely determined by what people who do not have trust in fiat money
system want to use for an escape out of any currency, and they want to
gain security through owning gold. Now if annual gold production and
consumption amount to 2 percent of the world’s stock, a change of 10
percent in the amount produced or consumed is not going to change the
price very much. But attitudes about inflation will change it.”

* * *

Later in the same meeting Greenspan pursued this line of thinking:

* * *

ALAN GREENSPAN: I have one other issue I’d like to throw on the
table. I hesitate to do it, but let me tell you some of the issues that
are involved here. If we are dealing with psychology, then the
thermometers one uses to measure it have an effect. I was raising the
question on the side with Governor Mullins of what would happen if the
Treasury sold a little gold in this market. There’s an interesting
question here because if the gold price broke in that context, the
thermometer would not be just a measuring tool. It would basically
affect the underlying psychology. Now we don’t have the legal right to
sell gold but I’m just frankly curious about what people’s views are on
situations of this nature because something unusual is involved in
policy here. We’re not just going through the standard policy where the
money supply is expanding, the economy is expanding, and the Fed
tightens. This is a wholly different thing. Anyway, I’m most curious to
get your views in these various respects, so please don’t be afraid to
throw things out on the table.

* * *

Greenspan proposed that if the gold price could be significantly
depressed, then the public’s inflation expectations could be radically
altered.

In an FOMC meeting in January 1995 Virgil Mattingly, the Fed’s general counsel, said the following –

http://www.federalreserve.gov/monetarypolicy/files/FOMC19950201meeting.p…

* * *

MR. MATTINGLY. It’s pretty clear that these ESF [Exchange
Stabilization Fund] operations are authorized. I don’t think there is a
legal problem in terms of the authority. The statute is very broadly
worded in terms of words like “credit” — it has covered things like
the gold swaps — and it confers broad authority. Counsel at the White
House called the Treasury’s general counsel today and asked, “Are you
sure?” And the Treasury’s general counsel said, “I am sure.” Everyone
is satisfied that a legal issue is not involved, if that helps.

* * *

This comment suggests that the U.S. gold stock has been mobilized in
the market. When GATA urged U.S. Sen. Jim Bunning to pursue this matter
with Greenspan, Mattingly responded (http://www.gata.org/node/1181):

“These inquiries focus primarily on a statement attributed to me
that appears on Page 69 of the published transcript of the January
31-February 1, 1995, FOMC meeting to the effect that the Exchange
Stabilization Fund (ESF) has engaged in ‘gold swaps.’ Given the passage
of time, some six years, I have no clear recollection of exactly what I
said that day but I can confirm that I have no knowledge of any ‘gold
swaps’ by either the Federal Reserve or the ESF. I believe that my
remarks, which were intended as a general description of the authority
possessed by the secretary of the treasury to utilize the ESF, were
transcribed inaccurately or otherwise became garbled.”

That doesn’t pass the smell test. Mattingly’s comments “were
transcribed inaccurately or otherwise became garbled”? This is the same
organization that lied to Congress for 17 years about the existence of
any transcripts or recordings of the FOMC meetings. So do we believe
him?

Notice the very clever inference — “I can confirm that I have no
knowledge of any ‘gold swaps’ by either the Federal Reserve or the
ESF.” He doesn’t specify what type of “knowledge” he is talking about.
Is it knowledge that any swaps were ever made or is it knowledge of the
details of swap arrangements that were made? In any case Mattingly is
professing not to know; he is not denying that any swaps have occurred.

The following discussion took place at the July 1991 meeting of the FOMC –

http://www.federalreserve.gov/monetarypolicy/files/FOMC19910703meeting.p…

* * *

ALAN GREENSPAN: Why have commodity prices failed to decline as much
as they ordinarily would during recession periods? Now, it also looks
as if commodity prices are not spiking upward in a recovery like they
ordinarily would. So we have a different picture in commodity prices
than I’ve seen in a recession and, frankly, I’m very puzzled by it. At
the same time that commodity prices do not show the extent of the
recovery, I think it’s somewhat strange that gold prices failed to move
down. Given central banks’ reduced willingness to own gold, or given
what I see as a reluctance in the foreign central banks and others to
hold as large gold stocks, given countries in southeast Asia who have
changed their attitudes [toward gold], and given the Soviet Union
[sales], I don’t understand why gold prices do not come down. It
suggests to me that there may be some what we call ‘crazies’ out there
who believe that gold is a good [inflation hedge]. And I guess I think
that [inflation concern] is in the long bond.

* * *

Greenspan thus labels as “crazies” those investors who want to
protect their wealth against the promiscuous money creation of his
Federal Reserve. In 1966 Greenspan wrote an essay titled “Gold and
Economic Freedom” in which he recognized the unique properties of gold
as an inflation hedge –

http://www.321gold.com/fed/greenspan/1966.html

“In the absence of the gold standard, there is no way to protect
savings from confiscation through inflation. There is no safe store of
value. If there were, the government would have to make its holding
illegal, as was done in the case of gold. If everyone decided, for
example, to convert all his bank deposits to silver or copper or any
other good, and thereafter declined to accept checks as payment for
goods, bank deposits would lose their purchasing power and
government-created bank credit would be worthless as a claim on goods.
The financial policy of the welfare state requires that there be no way
for the owners of wealth to protect themselves.

“This is the shabby secret of the welfare statists’ tirades against
gold. Deficit spending is simply a scheme for the confiscation of
wealth. Gold stands in the way of this insidious process. It stands as
a protector of property rights. If one grasps this, one has no
difficulty in understanding the statists’ antagonism toward the gold
standard.”

And clearly once Greenspan had sold his soul to the devil and become a “statist” himself, he joined the antagonists of gold.

The following is a very enlightening discussion at the July 1995 FOMC meeting –

http://www.federalreserve.gov/monetarypolicy/files/FOMC19950706meeting.p…

* * *

CHAIRMAN GREENSPAN. I think I’ve got it! [Laughter] You are telling
me that the SDR [Special Drawing Rights] certificate comes out of the
Treasury and we cancel the Treasury obligation and it is wholly an
asset swap so that the debt to the public of the U.S. Treasury goes
down by that amount. Is that what happens? That solves President
Jordan’s problem too! [Laughter]

MR. JORDAN. Can I follow up on that? The same thing happened when we
changed the price of an ounce of gold from $35 to $38 and then to
$42.22. The Treasury got a windfall of about $1 billion to $1.2 billion
in both of those so-called devaluations. So an issue on this is: What
was the dollar price of SDRs that we monetized? You say I have an asset
on my balance sheet and I don’t know what the value of it is.

CHAIRMAN GREENSPAN. It’s about $42.

MR. TRUMAN. It’s $42.22; it’s equivalent to the official price of gold.

MR. JORDAN. We do this at the official U.S. Treasury price of gold?

CHAIRMAN GREENSPAN. Do you mean that we can lower the debt to the
public by moving the price of gold up to the market price? That could
cut the debt back by a not insignificant amount!

MR. JORDAN. I have been trying not to mention that publicly for fear that someone might want to do it.

CHAIRMAN GREENSPAN. It’s probably too late; we just mentioned it.

MR. JORDAN. It will become known five years from now!

MR. LINDSEY. Five years from now it will be read in the transcript for this meeting.

MR. BLINDER. By which time it already will have been done.

* * *

This exchange is extremely significant because it recognizes that
external debt of the United States eventually will have to be balanced
with the amount of gold claimed to be held by the Treasury.
Interestingly enough the Fed doesn’t want this information to be known,
as this would essentially devalue the dollar overnight and give instant
hyperinflation. But as Greenspan points out, it would inflate away the
debt.

The five-year delay in releasing information to the public is
clearly viewed by the Fed as a way to disadvantage the public. When the
Fed and Treasury are forced by market conditions to balance the U.S.
government’s debt with its gold holdings, the dollar will be massively
devalued and gold will be multiples of its current price. This would
certainly make it advantageous to be one of the “crazies,” as Greenspan
affectionately calls gold investors.

I think the true crazies will be shown to be those people who have
drunk the Kool-Aid to believe that a currency can maintain its
purchasing power when the central bank confesses to employing a
confidence trick — that it is “behaving” as if there were real
reserves underneath its currency system.

What can be concluded from these insights into the deliberations of the FOMC?

– On several occasions the Fed discussed targeting gold prices with its policies.

– The Fed admits that propaganda is effective against gold
investors, insofar as just mentioning the possibility of selling gold
can drive down the gold price.

– The Fed at least contemplated interfering in the gold market, and
on a massive scale. The Fed admits that the U.S. government has sold
gold with the intention of reducing gold’s price.

– The record shows that the Fed opined that the statutes of the
Exchange Stabilization Fund have legitimized “the gold swaps.” Despite
claims that this statement has been inaccurately transcribed or
garbled, recent information suggests otherwise. In response to GATA’s
request to the Fed last year under the Freedom of Information Act for
access to Fed documents about gold swaps, Fed Governor Kevin M. Warsh
confirmed that the Fed does indeed have gold swap agreements with
foreign banks:

http://www.gata.org/node/7819

– The Fed does not want it to be known that the external debt of
the United States could be substantially reduced by revaluing official
gold at the market price, lest someone wants to do that. This is an
admission that the official U.S. price of gold of $42.22 per ounce is a
matter of smoke and mirrors. The ability of the Fed and Treasury to
create money is linked to the only liquid collateral they have, gold.
The gold price that is required to make the value of U.S. gold equal to
the dollars issued is multiples of the current price, and is heavily
dependent on how much unencumbered gold the Treasury still holds.

– The Fed expressed the utility of having the virtues of a gold
standard without using gold itself. Greenspan later confirmed that the
Fed was behaving as if it was on a gold standard, as if there were
“real reserves” underneath the system. This supports GATA’s claims that
the gold price has been suppressed by an increase in the supply of
“paper gold” — gold that investors believe they have bought and own
but is really no more than a certificate saying they own the gold. This
is the case with the London Bullion Market Association’s unallocated
gold accounts, unbacked exchange-trade funds, pool accounts, and gold
derivatives.

The demand for real physical gold bullion is surging in the face of
an impending daisy-chain of sovereign debt defaults. This threatens to
expose the confidence trick — that much more gold has been sold than
exists. I have explained this in a previous essay, “The Tiny Market
that is the World’s Biggest”:

http://www.gata.org/node/8248

The Federal Reserve can “behave” as if there are real reserves under
the U.S. dollar, but there are none. A study of the heavily redacted
and edited minutes of the Federal Open Market Committee reveal a
penchant for targeting and manipulating gold prices, and deceiving
Congress and the public.

The words of Alan Greenspan from “Gold and Economic Freedom” could not be more relevant:

“This is the shabby secret of the welfare statists’ tirades against
gold. Deficit spending is simply a scheme for the confiscation of
wealth. Gold stands in the way of this insidious process. It stands as
a protector of property rights. If one grasps this, one has no
difficulty in understanding the statists’ antagonism toward the gold
standard.”

Like clowns at a rodeo, there are too many academics creating a
distraction discussing whether we will have deflation or inflation. We
are now in an era of unprecedented deficit spending — which means that
confiscation of wealth will also be unprecedented. One of the most
prolific money creators of all time has told us what to do to prevent
it: Buy gold. But buy real physical gold, not a gold receivable.

—–

Adrian Douglas is publisher of the Market Force Analysis letter (www.marketforceanalysis.com) and a member of GATA’s Board of Directors.

More articles from Zero Hedge….

The Daily Reckoning

Well Friday was a snoozer in New York. Markets didn’t make new highs. But they didn’t crash either. The S&P 500 remains near a 17-month high. And by most accounts, everything is fine in Greece, everything is fine in China, and the whole world is convalescing nicely from the last two years of crisis.

Or not.

Last week, we took up the case for why a second wave of falling asset prices would happen sooner and not later. You’d get the one-two combination of more deleveraging and falling stocks and bonds, followed by a massive government-induced inflationary campaign. Today, you’ll see why we think it is a matter of months before this happens.

First though, whose gold is China buying? It’s own!

Gold prices were down on Friday again and gold is 3.6% off its recent high. Old yellow metal is trading at around $1,101.70, according to the April futures contract. The sense of urgency over the Greek crisis has eased. And no one thinks China is going to buy IMF gold. Why?

Speaking last week at the National People’s Congress, China’s foreign exchange regulator Yi Gant told a press conference that, “currently a few factors limit our ability to increase foreign-exchange investment in gold.”

As we wrote in a note this weekend, most analysts immediately took that to mean China would not be a buyer of the 191.3 metric tons of gold the International Monetary Fund announced it would sell on February 17th. And if China were out as a major buyer of gold on international markets, speculators reckon that the gold price is in for a fall.

Yet China bought almost 50% of the gold purchased by central banks in 2009. So where did that gold come from?

China purchased 454.1 tons of gold on its domestic market last year. It didn’t have to go shopping overseas. China can buy its own home-grown gold because for the last three years in a row, it’s been the world’s largest producer. China produced over 300 tonnes of gold for the first time ever in 2009, according to the China Gold Association.

That means that last year’s domestic gold consumption exceeded mine supply. Were Chinese authorities buying above ground gold too? The number of producing gold mines in China has fallen from 1,200 in 2002 to 700 in 2009. You can see China is scrambling to produce as much gold as fast as it can.

This could be a case of a “Do as I do, not as I say.” Why bid up the price of gold on international markets when you can buy your own domestically produced gold? As a senior People’s Bank of China figure reportedly said that, “China should formulate a long-term plan and constantly and secretly increase its gold holdings… PBoC should try to buy as much gold as possible from China’s annual gold output of almost 300 tons, while the gold needed by industries and residents could be imported.”

But the case for gold is pretty simple. To paraphrase fund manager David Einhorn, if you believe monetary and fiscal policy across the world are sensible, sell gold and buy Treasuries. If you believe monetary and fiscal policy around the world are bad, sell Treasuries and buy gold. You don’t have to a cult follower or a true believer to profit from that kind of trade.

Gold made its big move in 1980. It peaked at $850 in early January. What’s interesting is that ten-year U.S. Treasury yields didn’t peak (at around 16%) until over a year later, in June of 1981. The speculators blew the top off the gold market well before they were sure Paul Volcker had a lid on inflation. Once it became clear punitive U.S. rates would kill inflation, the gold bull died.

But wait! U.S. rates went up because the Fed was fighting inflation. And it was fighting inflation because…there was inflation! How can we expect gold to rise on higher rates if there’s no inflation to fight?

The answer is that the Fed’s quantitative easing program is set to end this month. Over the last year, the U.S. central bank has spent over $1.25 trillion buying mortgage-backed securities. This has kept ten-year U.S. interest rates low and mortgage credit flowing to the American housing market. The Fed has said that program will end by the end of this month.

What will happen next? Already we’ve seen investors crowding into the short-end of the U.S. Treasury market. Treasury notes with maturities of three-years less are a nice, near-cash, highly-liquid alternative to taking any risks anywhere else. Hence lower short-term U.S. interest rates, driven partly by the Fed and partly by the market.

With the Fed set to end its QE program, we’d expect market forces to assert themselves in the bond market. You’ll get a steeper yield curve. Without the government gaming the trade, investors are going to price U.S. bonds based on the soundness of U.S. fiscal and monetary policy. In this scenario, we think gold will attract more speculators (although the big ones like George Soros have already positioned themselves for this move.)

The news that European finance ministers have agreed, in principle, to a bailout of Greece, might take even more urgency out of the sovereign debt crisis theme. And that, in turn, might even drive the gold price lower. But all these things are prelude to a bigger crisis. Papering over the insolvency of the Welfare State can only last so long – and we think the dominos will begin to fall in months, not years.

In the meantime, though, the continued de-leveraging of the private sector means even larger public sector deficits. According to flow of funds data released the by the Federal Reserve last week, both U.S. household and businesses reduced debt in 2009. The government added debt.

In fact the Fed data show that U.S. households reduced debt on an annual basis for the first time ever in the history of the data series, going back to 1946. Household debt levels shrunk by 1.7%, with mortgage debt declining by 1.6% and credit card debt declining 4.6%.

It’s obvious at the household level, where the employment picture is awful, that Americans are preparing for less spending and less income growth. They are not borrowing from future earnings to sustain current living standards. The worm has turned.

And you can’t blame businesses for reducing debt by 1.8% either. Why borrow if you’re not going to increase capital spending or employment growth? There’s a political issue here too. You could argue that business investment is cyclical and will go up eventually. But with the U.S. Congress deadlocked over health care legislation (that if passed might be repealed by the next Congress elected in November), there is a lot of uncertainty. You could also call that political risk.

Into the household caution and business uncertainty, the Federal government increased debt by 22.7% in 2009. It was below the 2008 record of 24.2%. But it’s clear that as the private sector deleverages, the government – under the misguided Keynesian assumption that it must support demand – is trying to fill the breech with borrowed money.

This sets the stage for the next episode of the U.S. dollar crisis. Right now, that may look remote, given the easing of tensions in Europe. But don’t get too complacent. The underlying fundamentals of the dollar suck. With the Fed’s QE program set to end this month, a veritable monetary Pandora ’s Box will be opened.

Of course the Fed could just announce it’s extending its QE program. But what effect would that have on the dollar? On gold? On oil? And how does Australia fit in all of this? More on that tomorrow…

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• The Story Behind China Dumping its US Treasury Debt
• China is a Key Driving Force in the Gold Market
• We Can Expect More and More People to Want to Own Gold
• Is China Trying to Back its Currency With Metal?
• Fall in Commodity Prices Will Reduce Inflationary Forces

More articles from The Daily Reckoning….