This is a wonderful article that cuts through to the bone of the ‘what should monetary policy be’ debate. Amongst other gems, there is a great analogy in there…
First published here January 1, 2013
By Keith Weiner
The Root of the Problem is Debt.
Worldwide, an incredible tower of debt has been under construction since 1971, when President Nixon defaulted on the gold obligations of the US government. His decree severed the redeemability of the dollar for gold and thus eliminated the extinguisher of debt. Debt has been growing exponentially everywhere since then. Debt is backed with debt, based on debt, dependent on debt, and leveraged with yet more debt. For example, today it is possible to buy a bond (i.e. lend money) on margin (i.e. with borrowed money).
The time is now fast approaching when all debt will be defaulted. In our perverse monetary system, one party’s debt is another’s “money”. A debtor’s default will impact the creditor (who is usually also a debtor to yet other creditors), causing him to default, and so on. When this begins in earnest, it will wipe out the banking system and thus everyone’s “money”. The paper currencies will not survive this. We are seeing the early edges of it now in the euro, and it’s anyone’s guess when it will happen in Japan, though it seems long overdue already. Last of all, it will come to the USA.
The purpose of this article is to present the early warning signal and explain the actual mechanism to these events. Contrary to popular belief, it will not be that the central banks increase the quantity of money to infinity. The money supply may even be contracting (which is what I expect).
To understand the terminal stages of the monetary system’s fatal disease, we must understand gold.
First, let me introduce a key concept. Most traders define “backwardation” for a commodity as when the price of a futures contract is lower than the price of the same good in the spot market.
In every market, there are always two prices for a good: the bid and the ask. To sell a good, one must take the bid. And likewise, to buy the good one must pay the ask. In backwardation, one can sell a physical good for cash and simultaneously buy a futures contract, and make a profit on the arbitrage. Note that in doing this trade, one’s position does not change in the end. One begins with a certain amount of the good and ends (upon maturity of the contract) with that same amount of the good.
Backwardation is when the bid in the spot market is greater than the ask in the futures market
Many commodities, like wheat, are produced seasonally. But consumption is much more evenly spread around the year. Immediately prior to the harvest, the spot price of wheat is normally at its highest in relation to wheat futures. This is because wheat inventories in the warehouses are very low. People will have to pay a higher price for immediate delivery. At the same time, everyone in the market knows that the harvest is coming in one month. So the price, if a buyer can wait one month for delivery, is lower. This is a case of backwardation.
Backwardation is typically a signal of a shortage in a commodity. Anyone holding the commodity could make a risk-free profit by delivering it and getting it back later. If others put on this trade, and others, and so on, this would push down the bid in the spot market, and lift up the ask in the futures market until the backwardation disappeared. The process of profiting from arbitrage compresses the spread one is arbitraging.
Actionable backwardations typically do not last long enough for the small trader to even see on the screen, much less trade. This is another way of saying that markets do not normally offer risk-free profits. In the case of wheat backwardation, for example, the backwardation may persist for weeks or longer. But there is no opportunity to profit for anyone, because no one has any wheat to spare. There is a genuine shortage of wheat before the harvest.
Why Gold Backwardation is Important
Could backwardation happen with gold?? Gold is not in shortage.. One just has to measure abundance using the right metric. If you look at the inventories divided by annual mine production, the World Gold Council estimates this number to be around 80 years.
In all other commodities (except silver), inventories represent a few months of production. Other commodities can even have “gluts”, which usually lead to a price collapse. As an aside, this fact makes gold good for money. The price of gold does not decline no matter how much of the stuff is produced. Production will certainly not lead to a “glut” in the gold market pulling prices downward.
So, what would a lower price on gold for future delivery mean compared to a higher price of gold in the spot market? By definition, it means that gold delivered to the market is in short supply.
The meaning of gold backwardation is that trust in future delivery is scarce.
In an ordinary commodity, scarcity of the physical good available for delivery today is resolved by higher prices. At a high enough price, demand for wheat falls until existing stocks are sufficient to meet the reduced demand.
But how is scarcity of trust resolved?
Thus far, the answer has been via higher prices. Higher prices do coax some gold out of various hoards, jewelry, etc. Gold went into backwardation for the first time in Dec 2008. One could have earned a 2.5% (annualized) profit by selling physical gold and simultaneously buying a Feb 2009 future. Gold was $750 on Dec 5 but it rocketed to $920—a gain of 23%–by the end of January.
But when backwardation becomes permanent, then trust in the gold futures market will have collapsed. Unlike with wheat, millions of people and many institutions have plenty of gold they can sell in the physical market and buy back via futures contracts. When they choose not to, that is the beginning of the end of the current financial system.
Think about the similarities between the following three statements:
“My paper gold future contract will be honored by delivery of gold.”
“If I trade my gold for paper now, I will be able to get gold back in the future.”
“I will be able to exchange paper money for gold in the future.”
The reason why there was a significant backwardation (smaller backwardations have occurred intermittently since then) is that people did not believe the first statement. They did not trust that the gold future would be honored in gold.
And if they don’t believe that paper futures will be honored in gold, then they have no reason to believe that they can get gold in the future at all.
If some gold owners still trust the system at that point, then they can sell their gold (at much higher prices, probably). But sooner or later, there will not be any sellers of gold in the physical market.
Higher Prices Can’t Cure Permanent Gold Backwardation
With an ordinary commodity, there is a limit to what buyers are willing to pay based on the need satisfied by that commodity, the availability of substitutes, and the buyers’ other needs that also must be satisfied within the same budget. The higher the price, the more that holders and producers are motivated to sell, and the less consumers are motivated (or able) to buy. The cure for high prices is high prices.
But gold is different. Unlike wheat, gold is not bought for consumption. While some people hold it to speculate on increases in its paper price, these speculators will be replaced by others, who hold it because it is money.
Gold does not have a “high enough” price that will discourage buying or encourage selling. No amount of price change will bring back trust in paper currencies once the gold owners have lost confidence . Thus gold backwardation will not only recur, but at some point, it will not leave its backwardated state.
In looking at the bid and ask, one other observation is germane to this discussion. In times of crisis, it is always the bid that is withdrawn -there is never a lack of asks. Permanent gold backwardation can be seen as the withdrawal of bids denominated in gold for irredeemable government debt paper (e.g. dollar bills).
Backwardation should not be able to happen at all as gold is so abundant. The fact that it has happened and keeps happening means that it is inevitable that, at some point, backwardation will become permanent. The erosion of faith in paper money is a one-way process (with some zigs and zags). But eventually, backwardation will become deeper and deeper (while the dollar price of gold is rising, probably exponentially).
The final step is when gold completely withdraws its bid on paper. Paper’s bid on gold, however, is unlimited, and this is why paper will inevitably collapse without gold.
The Mechanics of the Collapse of Paper
Let’s look at what will happen to non-monetary commodities when gold goes into permanent backwardation.
People who hold paper but who desire to own gold will discover gold-commodity arbitrage. They can buy crude or wheat or copper for paper, and then sell the commodity for gold. This will drive up the price of crude in terms of paper, and drive down the price of crude in terms of gold. The crude price in dollars will rise exponentially and its price in gold will fall exponentially.
For example, today the price of a barrel of crude in terms of paper is around $100 and an ounce of gold priced in crude is 17 barrels. It is possible to trade $1700 for one ounce of gold this way. Right now, there is no gain to this trade. Anyone buy an ounce of gold directly for $1700.
But when gold is no longer offered for dollars, this indirect way will be the only way to buy gold. The more this trade is used, the more that both the dollar and gold prices of a commodity will be moved, up and down respectively. Let’s look at an example. If the price of crude in paper rises to $2000 and the price of gold in crude rises to 150 barrels, then one would need $300,000 to trade for one ounce of gold this way. There will always be a gold bid on crude, but it doesn’t have to be high.
Of course, this window will shut sooner or later. Producers and hoarders of commodities will refuse to sell for dollars when they understand gold-commodity arbitrage, not to mention once they see the dollar losing value so quickly. And while this is happening, everyone is running to the stores to trade paper for whatever goods they can get their hands on. This is the “Crack Up Boom.” The currency will no longer be acceptable in trade.
Permanent gold backwardation leading to the withdrawal of the gold bid on the dollar is the inevitable result of the debt collapse. Governments and other borrowers have long since passed the point where they can amortize their debts. Now they merely “roll” the debt and the interest as they come due. This leaves them vulnerable to the market demand for their bonds. When they have an auction that fails to attract bids, the game will be over. Whether they formally default or whether they just print the currency to pay, it won’t matter.
Gold owners, like everyone else, will watch this happen. If government bonds holders sell their securities in response to this crisis, they will only receive paper backed by that same government and its bonds. But the gold owner has the power to withdraw his bid on paper altogether. When that happens, there will be an irreconcilable schism between gold and paper, with real goods and services taking the side of gold. And in a process that should play out within a few months once it gets started, paper money will no longer have any value.
Gold is not officially recognized as the foundation of the financial system. Yet it is still a necessary component. When it is withdrawn, the worldwide regime of irredeemable paper money will collapse.
An interview with the super-lucid Dr. Keith Weiner on how the Gold Standard is being re-introduced right now.
It is an excellent encapsulation of the market orientated approach that has occupied the Gold Standard Institute for the past twelve months.
Dr. Keith Weiner of the Gold Standard Institute US presents the concept of Gold bonds to an Ad Hoc Committee of the Arizona House of Representatives…
The Arizona House of Representatives has convened an Ad Hoc Committee on Gold Bonds. The purpose is to explore if and how the state could sell a gold bond.
This is an exciting development, as the issuance of a gold bond would be a major step towards a working gold standard.
Dr. Keith Weiner is a member of the committee. At the first meeting, he gave a proposal for how a gold bond could work to the benefit of the state and the people.
Here is video of the committee meeting. Dr. Weiner’s presentation begins around 18:18.
The sound quality is not great in parts, but most problems are fixed by the time that Dr. Weiner makes his presentation. It’s quite long, but well worth the listening.
It goes without question, among economists of the central planning mindset, that if a central bank can just set the right quantity of dollars, then the price level, GDP, unemployment, and everything else will be right at the Goldilocks Optimum. One such approach that has become popular in recent years is nominal GDP targeting.
How does a central bank affect the quantity of dollars? In discussing a nominal income targeting, Wikipedia gives the usual laundry list of how to do their magic: “…interest rate targeting or open market operations, unconventional tools such as quantitative easing or interest rates on excess reserves and expectations management…”
Other than expectations management—which is just telling the market “blah blah blah”—managing an income aggregate is about manipulating one interest rate or another.
In the real economy, people don’t factor the quantity of dollars into their economic calculations. If you are in the grocery store to buy apples, you do not think about M0 money supply. Whether you are a farmer or miner, whether you operate a factory or trucking company, or even a bank or insurer, the money supply is irrelevant to you.
By contrast, the interest rate figures in every economic calculation in the economy. How much to borrow, how much to save, and how to assess the tradeoff between consumption and investment are all dependent on interest. The rate of interest is a factor in every price and the relationship between all prices in the economy.
For example, to grow apples you need land and you must plant trees. Then you have to wait for the trees to mature before they bear fruit. This requires an investment up front, in expectation of earning a return in the future. How high does this return need to be? It depends on the interest rate.
This decision, made by thousands of current and potential apple farmers, determines the price of apples in the grocery store. And this, in turn, determines the decisions of consumers to buy apples, to buy something else, or to do without fruit if they cannot afford it.
Whether the interest rate is manipulated upwards, whether it is forced downwards, or whether it is artificially locked in stasis, every price in the economy is affected and everyone’s decisions are altered by the rate of interest. I have written a lot on the perverse incentives caused by interest rate manipulation, but today I want to focus on a different aspect of the problem.
So, let’s perform a little thought experiment. Suppose a business must pay 20% interest on its capital. If it somehow manages to eke out a 21% rate of profit, it forks over 95 percent of what it earns to its lenders. If it can’t earn at least 20 percent, then it ends up feeding its capital to its creditors.
Now consider a perverse world where enterprises can borrow at -5 percent. They literally repay investors less capital than they borrow. This case is the opposite of the one above; Lenders feed their capital to enterprises.
If interest is too high, the Fed is sacrificing entrepreneurs to investors. If interest is too low, then investors are sacrificed to entrepreneurs. Either way, our monetary planners pervert lending into a win-lose deal.
So what’s the right rate of interest?
Only a market to determine that. Central planners have never gotten it right, are not right now, and will never get it right. They do, however, inflict collateral damage.
Market Monetarism—the idea of central planning of credit based on a GDP target—promises improved outcomes over what would happen in a free market. However, it’s no better than conventional Keynesianism or Monetarism.
We should not be debating different approaches to central planning. We should be rediscovering the idea of a free market in money and credit.
 Most commonly this is called money supply. However, there are two problems with this. One, the dollar is credit not money. Two, it is not a supply in the sense of flows—e.g. corn supply or oil supply. It is a measure of stocks, Unlike corn or oil, dollars are not consumed in a transaction.