convenient to trade if transactions involved a change of storage location. But in other words gold was too traditional and old-fashioned, an anachronism for New Labour.

Now gold is twice the price at which the government sold it. The cost to the taxpayer of this policy to "modernise our reserves" equals some £2 billion. You may recall that the Conservative Party irretrievably lost its reputation for economic competence in September 1992 when it spent £800m trying to keep the pound in the ERM. But alas, the media, the electorate and the opposition now take a kinder view of wasting taxpayers' money.

According to Tony Blair's comment to the House of Commons, the gold sale "was carried through perfectly sensibly and we actually got the best deal for the country". We know the second part of his statement was rubbish. But were the gold sales carried out sensibly?

Psst! Sell gold now...

On 7 May 1999 the government announced in advance that it would sell 415 tonnes of gold. This public announcement seemed to ensure that the UK would achieve the lowest possible price rather than the highest. The first auction of 25 tonnes in July was $26 per oz lower than the price at the time of the announcement!

In selling our gold the government was a great believer in overt sales. In other words, showing its hand to the market. The Treasury reckoned that predictability and transparency would increase revenue by increasing participation in the sale. The government bent over backwards to be "fair" to buyers of gold, wanting to maximise sales rather than striving to get the best price. The issue of "fairness" for the taxpayer took a back seat.

So is that the end of the story, just another example of government incompetence? Or was there a hidden agenda? There is an extremely controversial piece of research that, if true, suggests the British government is more knave than fool.

A recent report from metals and mining analysts at Cheuvreux -- part of France's largest bank, Credit Agricole -- says that the sale was in fact designed to keep the gold price down. The British Government's actions of mid-1999 are cited as clear evidence of a global conspiracy to rig the gold market.

Easy money... until gold took off

The conspiracy theory begins in the 1980s. Central banks began to lend or deposit part of their gold holdings with leading bullion banks like JP Morgan Chase, Goldman Sachs and Citibank. In return the central banks earned a fee known as the gold lease rate.

At the time this seemed a sensible use of gold. Otherwise it earned no income for the central banks. But the bullion banks who borrowed it then sold this gold into the physical market. There it was most likely turned into jewellery, and was lost from the global bullion market forever.

The bullion bank used the proceeds of these gold sales to buy a higher yielding asset like bonds. This was a classic "carry trade". Borrow at a low gold lease rate, lend at a higher government bond rate. Money for old rope, in fact... provided the gold you borrowed in the first place didn't rise in price.

Not surprisingly this transaction was very popular in the 1990s. The gold price was flat on its back. In fact, Cheuvreux reckon central banks loaned out between 10,000 and 15,000 tonnes more from their gold reserves than they've declared!

And you can see the problem. Sooner or later the bullion bank will be obliged to deliver the borrowed gold back to the central bank. It has to buy it in the physical market, incurring substantial losses at today's 25-year highs, and also squeezing the gold price higher still -- thus making the situation worse for other bullion banks that are also short of gold. The risk of a serious global 'crunch' becomes very real.

Huge short covering ahead

Was the Bank of England aware of the risks posed by a rising gold price? Cheuvreux's research cites a lawsuit filed in December 2001 by Reginald Howe, a member of the Gold Anti-Trust Action Committee (GATA), a group hitherto seen as on the lunatic fringe of the "goldbug" community, but now supported in its claims by the French bank's report.

Mr Howe charged the Bank of International Settlements, Alan Greenspan, the leading investment banks and many others with rigging the gold market -- which is illegal under US law. In his suit, he alleged that in 1999 the then Governor of the Bank of England, Sir Edward George, made the following comment to the Chief Executive of Lonmin, the gold mining company:

"We looked into the abyss if the gold price rose further. A further rise would have taken one or several trading houses, which might have taken down all the rest in their wake. Therefore at any price and at any cost, the central banks had to quell the gold price, manage it. It was difficult to get the gold price under control but we have now succeeded."

What might Steady Eddie have been referring to? The UK government's announcement that it would sell half the nation's gold reserves came just eight months after the notorious bail out of Long Term Capital Management (LTCM) in September 1998. That collapse had indeed threatened the global banking system. Cheuvreux now claims there were strong rumours that LTCM, a hedge fund, was short of 300 tonnes of gold when the company crashed. This short position is thought to have been assumed by those banks involved in the bailout operation.

In other words, the new revelations from Cheuvreux add weight to the circumstantial evidence surrounding a global conspiracy to suppress the gold price. But history tells us that governments cannot rig prices forever. At some point, the free market will out.

The US could not hold the gold price down at $35/oz in 1971. The Tin Council failed to hold up the price of tin in 1985. And the British government, thankfully, couldn't stop the pound falling out of the ERM in September 1992.

Why gold shot higher last year

The scale of official gold reserves that have been lent on to bullion banks mean there is a huge 'short' position which needs to be covered by gold purchases in the physical market. Indeed, this short covering seems to be underway.

From mid-2004 to mid-2005, the central banks' official short position in the market fell by 2,430 tonnes. During the same period some 232 tonnes of new mined gold was delivered back to the central banks. So there was short covering of gold of some 2,198 tonnes. This figure dwarfs official central bank sales, which would have been 500 tonnes at most. No wonder the gold price shot up during this period!

And according to Cheuvreux there is much more short covering to come. Its conservative estimate of the central banks' total short position is 10,000 tonnes. Only a fraction of this will be met by new production. The rest will be made up of either physical purchases of gold or the bullion banks' cash settling. In either event, the central banks must give up any hope of getting their gold back.

Or so the story goes. What do other members of the gold market think of Cheuvreux's claim? There has been no official statement rejecting the thesis. But the word in the City is that no one in the gold market believes it. It's a crackpot piece of research playing into the hands of the conspiracy theorists.

Indeed, a spokesman at the World Gold Council believes the research has zero credibility. But what's for sure, is that the Cheuvreux story is not remotely priced into the value of gold today.

In other words, Cheuvreux's thesis may indeed be proved as nonsense. But the gold price will not flinch if this is the case. And you can conclude, as we did in 1999, that the British government was simply incompetent in disposing of half the nation's gold.

On the other hand, however, Cheuvreux's claims -- if correct -- mean that Britain sold gold to shore up the global financial system. The verdict of government incompetence would be changed to one of duplicity.

There are plenty of other reasons to hold gold -- as a hedge against inflation, an alternative asset to paper currencies, and as a safe haven in times of heightened geopolitical tension. But in holding gold you are also paying nothing for the option that Cheuvreux's controversial thesis might be true! If you haven't bought gold already, we advise you take a position in the physical market, buying gold coins that trade for a small premium to the spot price.

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Original article at The Daily Reckoning, March 22, 2006

by Brian Durrant

A Cambridge economics graduate with nearly 25 years experience in the City, Brian Durrant is investment director of The Fleet Street Letter, (founded 1938). He has worked in stockbroking, the foreign exchange markets and headed the research department at one of London's leading futures and options brokers.