Why Central Banks Hate Physical, Love "Earmarked" Gold, And What Is The Difference

Several days ago we showed the dramatic conclusion of what happened to Czechoslovakia's gold which had been placed at the Bank of England for safekeeping days after Germany annexed the central European republic ahead of the start of World War II. We hate the spoil the punchline for those who haven't read the post yet, but the her it is: it was gone; it was all gone.

And all of this happened with the explicit assistance of the Bank of International Settlements which was formed in 1930 to promote the free flow of capital and global economic growth. Instead, time and again, what the BIS has proven its only mission to be, is to facilitate the spread of intangible assets and fiat currencies while it quietly confiscates, sequesters and aggregates (for a select group of individuals) he world's physical assets. Mostly gold.

In fact, until the advent of the BIS, gold held by central banks came in one version. Physical.

It was only after the BIS arrived on the scene did gold's macabre doppelganger, so-called paper, registered or "earmarked", gold emerge for the first time.

Courtesy of Adam LeBor's book exposing the history and inner workings of the BIS, "The Shadowy History of the Secret Bank that Runs the World", below is a brief story of how earmarked gold came into being.

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The Czechoslovak gold affair also highlighted how the bank’s increasingly sophisticated gold operations were growing in reach and importance. The BIS’s gold trades were a primitive forerunner of today’s globalized economy where vast sums instantly fly back and forth at the touch of a keyboard. The technology available in the 1930s was far more primitive, but the principle of buying and selling assets sight unseen and without taking physical possession is the same. This development of a free gold market between central banks via the BIS was significant. Had all the Czechoslovak gold been held in an account at the Bank of England in the national bank’s own name, rather than at a BIS account, it is doubtful that any would have reached the Reichsbank.

The BIS offered central banks a unique service, one unavailable to private companies or individuals who were not allowed to hold accounts there. The BIS held two kinds of gold deposits: bank deposits and earmarked gold. The first was gold deposited there by central banks. In 1936 this accounted for around 14 percent of deposits. (The actual bars of gold were held at the Swiss National Bank in Bern.) The second category was known as “earmarked” gold— gold that was physically held in another bank but that was credited to the BIS’s account (as the Czechoslovak gold in London had been).

The BIS held collective gold accounts at the Bank of England and the New York Federal Reserve. These accounts were subdivided into subaccounts for central banks, which owned the gold, although the gold was physically stored in London or New York. Neither the Bank of England nor the New York Fed was supposed to know which central bank owned the sub-accounts held in the name of the BIS, although as Norman’s correspondence over the Czechoslovak gold affair shows, they did. So if the Bank of France (sub-account X) wanted to transfer funds to the Bank of Hungary (sub-account Y), the BIS simply instructed the Bank of England to make the necessary deposit from sub-account X to sub-account Y. Earmarked gold, as Toniolo notes, “allowed for cheap and confidential transactions between central banks, as the transfer of property merely entailed a bookkeeping change by the BIS.” This was a growth industry for the BIS— in 1935– 1936 earmarked gold movements totaled more than 1,121 million Swiss gold francs. By 1938– 1939 that sum had increased to more than 1,512 million.

BIS managers and directors were immensely proud of the bank’s innovative, new mechanisms for gold and foreign currency trades. But the principle behind earmarked accounts was not nearly as new as they believed. Few, if any, of the BIS directors had ever heard of the island of Yap, in Micronesia. But centuries ago its inhabitants had invented a similar system, one based on large limestone discs. The discs, known as fei, were quarried on a neighboring island and brought back to Yap by boat. The discs, the islanders decided, represented substantial wealth— enough, for example, to pay for a daughter’s dowry. But the “currency” was extremely heavy and almost unmovable. So it stayed in its place, and only the ownership changed with the agreement of the buyer and seller. In fact the stone did not even need to be present on the island. The locals’ oral tradition tells of one disc that fell off the boat into the sea. Rather like the gold deposits at the BIS accounts in London or New York— or indeed any bank nowadays— the physical existence of the submerged fei was taken as a matter of faith. The islanders simply passed the ownership of the submerged disc back and forth— until 1899 when the Germans arrived and colonized the island of Yap.

The islands’ new rulers demanded that the inhabitants repair the walkways that linked the different settlements. The locals ignored their orders, and eventually the Germans decided that they must be fined. Painting a large black cross on the most valuable fei and declaring them to be the property of the government exacted the fine. It worked. The islanders quickly fixed the paths, the German officials removed the crosses, and the islanders once again had possession of their capital assets.

To the sophisticated financiers of the twentieth century, such an episode would have seemed charming but irrelevant. But as Milton Friedman later noted, it was very relevant indeed. Neither gold nor stone discs have any inherent value. Their worth is completely arbitrary, the worth that we give them. The painting of the Yap islanders’ stone discs had precise parallels in 1932 when the Bank of France decided to sell its dollars. The bank feared that the United States would not adhere to the traditional gold standard at $ 20.67 for an ounce of gold. It asked the Federal Reserve of New York to use its dollars held there to buy gold. As it was expensive and risky to ship the gold across the Atlantic, the Bank of France asked the New York Fed to simply store the Bank of France’s newly acquired gold at its account there. Friedman described what happened next:

In response, officials of the Federal Reserve Bank went to their gold vault, put in separate drawers the correct amount of gold ingots and put a label or mark on those drawers indicating that they were the property of the French— for all it matters they could just have done so by marking them “with a cross in black paint” just as the Germans did to the stones. 

This event — or arguably non-event— had serious consequences. The French sale of dollars drove the exchange rate down, while the franc strengthened, even though nothing had actually happened. What was the difference, asked Friedman, between “the Bank of France’s belief that it was in a stronger monetary position because of some marks on drawers in a basement more than 3,000 miles away and the Yap islander’s conviction that he was rich because of a stone under the water a hundred miles or so away?” Evidently, not very much.