Yesterday (September 13th), Barron's Online posted a most interesting item entitled, "A Secret Time Bomb Made of Gold."

We had written about this subject on January 24th, some nine months ago, but emphasizing a slightly different point. Our title was, "The Great Government "Gold Bluff" starting to Unravel."

The recent Barron's article refers to, "A little-known fountain of free money called the "gold carry trade" is in danger of drying up. And if it does, then markets from gold to bonds and even stocks can be in for a wild ride."

As we stated in our January article, we feel it will be even worse. But, for the moment, let us focus on Barron's.

The Barron's article explains that the gold carry trade is similar to the yen carry trade and goes on to say that, "Central banks are sitting on huge supplies of gold that earn them no interest and cost them money just to store securely. To earn them a little revenue on these static assets, they loan their gold to banks called buillion banks, at a ridiculously low interest rate on the order of 1 percent."

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As we understand it, these so-called "buillion banks" include major investment banks such as Goldman Sachs (manager of the "Global Alpha" fund, engaged in the yen-Australian dollar carry trade and down by 44 percent from its peak in March 2006) and Morgan Stanley.

As Barron's explains, "The banks turn around and sell the gold in the market, typically in the London buillion market, and invest the proceeds in a higher paying asset, such as long-term Treasury bonds. If bonds pay 4.6% then the banks earn an easy 3.6%.

The problem, states Barron's, is that"if the gold price starts to rise, profits can be wiped out or turned to losses. And in today's markets, a falling dollar not only boosts gold prices, it also makes Treasury bonds less attractive to foreign investors. That reduces demand and weakens prices to create a potential double-edged sword for carry traders."

We entirely agree with this observation by Barron's.

However, there is another most important issue involved that is not covered in the Barron's article — the proper accounting for the gold in the vaults of central banks.

This is extremely important as it points directly at the vital issue of "monetary confidence" that we are likely to be in need of as we face the immediate economic and financial future.

Gold is not just a hedge against inflation. It is also a hedge against a collapse of confidence in the increasingly delicate issue that is "monetary confidence."

[Editor's Note:Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.]

One of the key elements that maintains confidence in any fiat (paper) currency is that the central bank has plenty of reserves (especially of ‘real" money, or gold) to stave off emergencies.

If our Fed does fail to shield behind its legal, political "independence" and buckles under to the current clamor for a rate cut, our dollar could plunge.

Our dollar is still a major reserve currency though out the world.

Any further dramatic collapse of our dollar could cause a monetary panic in much of the entire world.

Of course, gold would skyrocket. But that would still be only half the story.

The next vital question would be, "How much of the gold in the vaults of central banks actually still belongs to those central banks?"

Much of the gold lent to the buillion banks, who on-sell it into the market, belongs to third parties. The gold is removed from the vaults of the central banks and replaced by the IOU's of the buillion banks.

Many of these same buillion banks have unknown amounts of "toxic subprime waste" sitting on their books at unknown prices.

The lax accounting rules of the International Monetary Fund (IMF) have allowed the central banks to include, under the board accounting category of "Reserves" even the paper IOUs representing the gold that they have leased to the bullion banks and has been "on-sold' to third parties.

Our researches show the total amount of gold "leased" out by the central banks, in return for the IOU's of the buillion banks, is estimated to be some 17,000 tonnes of gold.

To put that figure into perspective, we understand that the central banks together hold some 32,000 tonnes of gold held in their vaults. But it includes the 17,000 tonnes worth of paper IOU's.

If these figures are correct, it means that only about half the gold published in the "reserves" of central banks, is actually "on the bank"!

This is a question about which the central banks are extremely vague in their answers — little wonder!

We believe that our dollar is already in a precarious position. If it should collapse further, it could precipitate an international monetary crisis, calling into question the value of paper money. That would be catastrophic.

We therefore hope that, next week our Fed will encourage confidence, possible by further lowering its Discount rate. This may encourage an important "feel good" factor and a fall in LIBOR, giving the subprime market a much needed boost. It would also buy time for the free market to count the cost of the recent liquidity driven boom in reckless lending and re-price the remaining assets accordingly.

We hope and pray that they will not lower their crucial Target Rate (currently at 5.25%) and prompt a downward plunge in our dollar and thereby, risk an international monetary crisis, slap in the face of a looming recession.

Our more conservative readers will have been accumulating gold for some time.

We believe the holders of gold could be on the threshold of profits — very big profits.

Editor's note:
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Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.