Last year Lord Wolfson announced the Economics Prize Contest of 2012. At stake was the £250,000 Wolfson Economics Prize the richest economic award after the Nobel Prize. The essays were to address the sovereign debt crisis in Europe, in particular, the problem how to ensure the stability of the new European currencies after the possible dissolution of the euro-system. The five essays short listed for the award were published on April 3. The winner will be announced in July.

The present author submitted his essay without the slightest illusion that he may win, or that he may even be on the short list of the 5 hopefuls. His only motivation to participate in the contest has been to test whether the Establishment is now ready to accept the suggestion that it was no accident that the “Big Bang” of debt explosion occurred on the very same day, on August 15, 1971, when gold was exiled from the international monetary system. A glance at the chart of total debt will make the validity of that suggestion plausible.

As witnessed by the tables of contents of the five short-listed essays, only one of them mentions the gold standard explicitly, and that in the voice of disdain. Jonathan Tepper’s essay charges that “the gold standard has recessionary bias” and that “it puts the burden of adjustment on the weak currency country rather than on the strong”. Since the distinction between a ‘weak’ and a ‘strong’ currency under a gold standard is invalid, this can only mean that the gold standard is hereby charged with putting the burden of adjustment on the financially irresponsible instead of the financially responsible country. What is wrong with that? Could it not be that, perhaps, Europe’s and the world’s present troubles originate from the fact that the irredeemable paper currency system has shifted the burden of adjustment to the financially responsible countries, thus providing incentives for financial irresponsibility?

It was Milton Friedman on whose advice Richard Nixon discarded the fixed exchange rate system based on gold in favor of the ‘floating’ exchange rate system based on the irredeemable dollar. Friedman suggested that floating is an effective adjustment-mechanism of international trade. Imbalances are automatically rectified. The currency of the deficit country depreciates while that of the surplus country appreciates. As a consequence imports of the former become dearer and are throttled,meanwhile those of the latter become cheaper and are boosted. The process continues until balance is restored.

There is no need to deny the intellectual seductiveness of this ‘theory’.However, it has a fatal flaw without any redeeming features. It ignores the marginal terms of trade, that is, the ratio of additional imports to additional exports. In other words it ignores the change in additional imports that the unit of exports will buy. Note that it can be negative, as it always is in case of a devaluing country. For example, if the unit of export is one passenger car, then the devaluing country will have to export more cars to maintain the same level of imports.

Rather than restoring trade balance, floating makes the imbalance worse. It makes the terms of trade of the deficit country deteriorate. Whatever ‘benefits’ the deficit country may derive from devaluation are strictly ephemeral. They vanish as soon as the inventory of imported ingredients that go into exports runs out. Thereafter the devaluing country has to pay more, not less, for ingredients essential for exports. It will see its deficits grow rather than contract. In effect, the devaluing country is selling its valuable resources abroad at ‘fire sale prices’.

No wonder that the alleged benefits of devaluation are entirely illusory. History bears out theory. The US has been running a trade deficit vis-à-vis Japan for half a century. Since 1973, following Friedmanite precepts, the dollar’s value was beaten down 5-fold (!) against the yen. Instead of falling, the US trade deficit with Japan has increased 10-fold.

This shows that the system of floating exchange rates based on the irredeemable dollar is no valid substitute for fixed exchange rates based on gold if the goal is to achieve trade balance. Financial profligacy is independent of the monetary system under which it is practiced. It is nature-ordained that the burden of adjustment fall on the profligate country.

History will pass judgment on the prejudice of the jury of the Wolfson Economics Prize Contest 2012. The jury has failed to find a single submission worthy of mention among the 425 received that makes the connection between the sovereign debt crisis and the expulsion of gold from the international monetary system in 1971. In doing so the jury has failed to make a contribution to the solution of the crisis. Most likely it has made a contribution to its prolongation.

Note. The author’s submission to the Wolfson Economic Prize Contest 2012 entitled: How to Ensure the Stability of the New European Currencies? can be accessed on the website: http://www.professorfekete.com/articles/AEFSYNOPSISWolfsonEntry.pdf.

April 9, 2012.

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ANNOUNCEMENT

New Austrian School of Economics

Munich, Germany

August 2012 (exact dates will be announced soon)

Title of the course:

CRITIQUE OF MAINSTREAM AUSTRIAN ECONOMICS

Marginalism; Marketability; The Real Bills Doctrine vs. the Quantity Theory of Money; Interest versus Discount; The True Role of the Gold Standard

This course is a seven-day, twenty-lecture session. Its topics are not recycled but new material. Its completion will earn one credit of the four needed towards a Bachelor of Monetary Science (BMSc) degree handed out by Prof. Fekete.

It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. Previous courses are not a prerequisite.

For further information or in order to register for the course you can get in contact with the organizers Ludwig Karl and Wilhelm Rabenstein via mail (nasoe@ kt-solutions.de) or phone ( +49 – 170 – 380 39 48 , before calling please consider a possible time lag).

You might also want to take a look at the New Austrian School of Economics on Facebook: http://www.facebook.com/newasoe

http://professorfekete.com/articles%5CAEFAFootnoteToTheWolfsonEconomicsPrizeContest.pdf

http://www.professorfekete.com/articles/AEFPositionPaper1.pdf

The Quantity Theory of Money

James Turk’s article Hyperinflation Looms dated April 20, 2010, is based on Quantity Theory of Money (QTM). It draws an analogy between Weimar Germany of 1923 and the United States of 2010. Both precepts are invalid. As far as the QTM is concerned, it suffices to point to the very fact, admitted by Turk, that it is possible to have a shortage of money simultaneously with the overworking of the printing presses. Hyperinflation is not the same as the ultimate inflation of the money supply. It is the ultimate depreciation of the currency unit. The two concepts are far from being the same, QTM notwithstanding.

The reason why QTM fails is that money is not one-dimensional. It is in fact two-dimensional. Quantity is one, and the velocity of circulation is the other dimension. Central banks control the former, and the market firmly controls the latter. As long as fair weather lasts, velocity may be ignored. But as soon as the weather grows foul, velocity returns with a vengeance. If it increases, we talk about inflation. If it decreases, we talk about deflation. In the extreme case the increase in velocity may start feeding upon itself and velocity could grow beyond any limit. People buy anything they can lay their hands on because they expect prices to rise further. This is hyperinflation, wiping out the value of the currency unit. It is an irreversible process: once fiat currency loses its value, it is lost for good. The pendulum has stopped swinging. If there is a bounce, it is the dead-cat bounce.

But it is also possible that, at the other end of the spectrum, the shrinkage in the velocity of circulation refuses to stop and starts feeding upon itself. People postone buying indefinitely because they expect prices to fall further. This is hyperdeflation. It manifests itself in the ever rising value of the currency unit. It is important to remark that it can happen while some prices are still rising. Other than gold, food and energy are two important exceptions. People have to eat, and they want to keep themselves warm and mobile, no matter what. Paradoxically, this may reinforce deflation. Because of rising food and energy prices people will have that much less to spend on other goods, accelerating price declines in other sectors. This defeats the arguments of Turk and others who try to refute the case for deflation by pointing to high or rising cost of food and energy.

The point in either pathology of money is that the government is helpless. Once the point of no return is reached, there is nothing governments can do to convince people that the process will end – short of opening the Mint to gold and/or silver. As far as people are concerned, the feedback from their experience tells them to expect more of the same.

I am not trying to adjudicate between the two schools of thought, one asserting that hyperinflation and the other asserting that hyperdeflation of the dollar is inevitable and imminent. I am merely trying to point out certain facts about deflation that most people are unaware of, or tend to ignore.

Let me state first that it is not impossible for the dollar to go into hyperinflation during the next 12-month period. For example, consider the case of a shooting war between the U.S. and Iran in the Persian Gulf. After an initial euphoria the American military could start suffering setbacks on the ground, in the sea and in the air, simply because of the longer lines of communication from the home base, and also because of the disadvantage of the aggressor in face of patriotic zeal on the part of the defenders (c.f. Vietnam). In this scenario hyperinflation of the dollar could be a possible outcome. But short of war threatening to destroy supplies and producing facilities the word ‘hyperinflation’ rings hollow in the ear.

Post-World-War I Germany versus Post-Cold-War U.S.

To draw a parallel, as Turk does, between Weimar Germany and present-day U.S. is, to say the least, grotesquely unrealistic. In 1923 the once mighty German army was defeated and disarmed, the navy was scuttled, the territory of the country was badly truncated by the peace treaty of Versailles, the Rhineland was under military occupation while the rest of the country was still under a partial blockade. No speculator would touch the falling Reichsmark, except to short it.

By contrast, the United States in 2010 has an army, navy and air force that can be put on high alert in a matter of minutes. Its military bases pockmark the face of the globe. The over-riding fact is that the whole world is still anxious to sell its wares on the American market, and is happy to lend back to it the proceeds of the sale in order to finance future U.S. purchases. Furthermore, it is a fact that the bond market trading U.S. Treasury debt is still the largest and most liquid in the world. Significantly, it still has room to go up – thus offering speculators juicy profits at a time when the bloom is off the stock and the real estate markets. How can you compare the circumstances of a beggar with those of the emperor – prodigal and bankrupt as though the latter may be?

All the signs around us point to deflation. The money supply is being pumped up on an unprecedented scale, but all it does is pushing on a string. You cannot make a case, as Turk is trying to do, out of the fact that the price of crude oil doubled as compared to its recent low. Another fact, more startling, is that the price of crude oil has declined 45 percent as compared to its all-time high. We must see the general decline in world prices, even though in some cases they may be disguised as a loss of pricing power of the producers. True, list prices have not declined, but nobody trades them. They are for window-dressing only.

Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction – wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.

But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators.

When he was forced out of business by the courts, and his customers lost everything they invested, Charles Ponzi declared that he would have paid them to the last cent as contracted if they had let him. There is no reason to doubt his sincerity. Now, 90 years later, Charles Ponzi’s dream has come true. The US government is duplicating Ponzi’s scheme in the bond market. The only difference is that the stake is much higher: it is the national, nay, the world economy! And, most importantly, this time there is absolutely no danger that the courts will stop the racket. The world begs to be fooled.

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Antal E. Fekete
May 5, 2010

And Its Implications for the International Monetary System

http://professorfekete.com/articles/AEFTheVanishingOfTheGoldBasis.pdf

The gold basis is defined as the difference between the nearby futures price and the cash price of gold in the same location. A positive basis is called contango; a negative one, backwardation. Since there were no organized futures markets in gold prior to 1971, the history of gold basis is confined to the last 35 or so years.

Gold futures trading started on the Winnipeg Commodity Exchange in Canada in 1971 at a time when ownership and trading of gold was still illegal in the United States. Upon becoming legal the bulk of gold futures trading moved to New York and Chicago.

For all these 35 years the gold markets have been in contango (with minor exceptions due to temporary friction in the delivery mechanism). The basis cannot theoretically exceed the carrying charge (the lion’s share of which is interest, usually calculated on the basis of LIBOR). If it did, speculators would be able to pocket risk-free profits in buying the cash gold and selling the futures contract against it. This arbitrage would quickly push the basis back to the level of carrying charge. By contrast, should the market ever go to backwardation, there is no theoretical limit below which a negative basis could not fall. One should see clearly the economic significance of gold backwardation. It is an unmistakable indication of shortages of deliverable supplies.

On the face of it, backwardation in gold would be a rank aberration of the world economy as most of the gold produced throughout the ages is still in existence in marketable form. For this reason profit is to be made by selling cash gold while replacing it through buying the much cheaper futures contract. If people hesitate to do it, there must be a reason. Indeed, the reason is the lack of confidence that paper gold can be exchanged for physical gold at maturity as specified by the futures contract.

The basis for agricultural commodities shows a clear annual cyclical pattern that closely follows the crop year. It starts with contango just after harvest, and ends with backwardation when supplies are drawn down just before the new crop is brought in.

The behavior of the gold basis lacks this cyclical pattern characteristic of the markets for agricultural goods. Contango obviously follows the fluctuations of the interest rate up or down, the adjustment being practically instantaneous. But, in addition, there is a rather curious phenomenon that can be described as the secular vanishing of the gold basis. This means that, as a percentage of the carrying charge (interest) the gold basis has been steadily eroding and by now has all but reached zero. Reversals in the trend, if any, are minor and temporary. It is difficult to imagine any combination of circumstances in which there could be a major reversal in the trend of the gold basis, unless there was an explosion of interest rates.

It is incumbent upon economic theorists to explain the peculiarity of the secular vanishing of the gold basis, which is not observed in the case of the basis of other non-agricultural commodities such as the base metals, for example.

The overwhelming fundamental fact about gold during the past half a century is the steady and relentless absorption of new supplies from the mines through individual hoarding demand. Half a century of gold production at peak rates of output has disappeared without a trace and is by and large unaccounted for. This is more gold than had ever been produced previously. At the same time also absorbed was whatever monetary gold governments and central banks have in their wisdom dishoarded. It can hardly be doubted that if further supplies of monetary gold were dishoarded, it would be easily absorbed as well, and any setback in the price of gold on that account would be temporary. One should also remember that net dishoarding of gold by governments and central banks is a thing of the past. Countries such as China, Russia, Brazil, to mention but a few, are on record as wanting to buy all the gold they can without unduly disturbing the price. This means that the combined net private and official demand for gold will be insatiable for the foreseeable future. This is in full agreement with the secular vanishing of the gold basis.

The burning question is what happens when gold markets go to permanent backwardation, as is likely if present trends continue. Clearly, the gold futures markets will be no longer viable as they are presently constituted. The main source of gold for investment purposes will be permanently shut, as a negative gold basis means that all offers to sell cash gold have been withdrawn. To see this we have only to remember that paper gold promising future delivery can no longer be trusted under the regime of a negative basis, as explained above.

The huge volume of trade in paper gold would disappear with the advent of permanent backwardation. The demise of the paper market means that governments and central banks have abruptly lost their power to control the price of gold. They would no longer be able to sell unlimited amounts of futures contracts. Paul Volcker has admitted in public that he made a mistake as Chairman of the Federal Reserve in allowing the dollar price of gold to rise as far and as fast as it did in 1979-1980. By implication, he and his successors have learned from his “mistake” and succeeded in subsequently driving down the dollar price of gold during the period 1981-2001, or to contain increases during the period from 2001 onwards. They did it through offering unlimited amounts of paper gold in the futures markets. As we approach the landmark of permanent backwardation, the question arises how will the Federal Reserve control the gold price once the facility of gold futures trading is gone.

Another question is how the gold mining industry will react to the disappearance of the futures market. There is a possibility that they will stop selling gold against dollars altogether until normalcy returns to the market. However, an announcement to withdraw the offer to sell newly mined gold would make the upheaval in the gold market even worse.

The implications for the international monetary system, in which the U.S. dollar is supposed to play the role of ultimate means of payment and extinguisher of debt, are devastating. The international monetary system is facing its greatest crisis for the past forty years as it confronts the threat of permanent backwardation in gold. Yet there is no sign that the financial press, or academia, let alone the U.S. Treasury and the Federal Reserve, take notice. They appear to think that the futures price of gold has no more relevance to the international monetary system than that of frozen pork bellies. They are under the illusion that gold has been demonetized. It has not. Not by the people anyhow, who had monetized it in the first place.

This crisis is a gold crisis, just as the last one in 1968 was. If anything, this one is the more serious of the two. In 1968 the crisis could be “papered over”, literally, by making the dollar irredeemable. Debt could still be liquidated in paper dollars because paper gold was still available. Presently this availability is the residual extinguisher of debt. Without it the debt markets could not function because bonds would, in effect, become irredeemable.

In 1968 policy-makers at the Treasury and the Federal Reserve were granted a “breathing space” during which they could devise a new international monetary system that would provide for orderly liquidation of debt. One hopes that they have used this breathing space fruitfully, and they have by now contingency plans ready for implementation when permanent gold backwardation engulfs the system and paper gold is no longer available, effectively removing the last “pacifier” from the debt markets.

It is not an encouraging sign that the planning, if any, has been done behind closed doors. There should have been an open debate on the debt crisis that threatens the world as gold markets go to backwardation. A blueprint for a new international monetary system should be drawn up publicly, with the participation of economists of all stripes and persuasion. Monetary reform should not be the exclusive turf of Keynesians and Friedmanites, according to whom there are compelling reasons to dismiss the gold standard out of hand as unfit, both conceptually and in practice, to play any role in a future international monetary system. They argue that its “disciplines” would be politically unacceptable in today’s world.

However, there is no way of telling what is politically acceptable and what is not in the throes of a great depression, with double digit unemployment, past the teens, when law and order is about to break down. Our debt crisis and the threat of gold backwardation are not unrelated . Aggregate debt as it exists in the world today is comparable to a runaway train on a down-sloping track. The train started picking up speed back in 1971 when the golden brakes were disabled. By now it is accelerating beyond any safe speed limit, and a crash appears inevitable. In order to slow the train down one needs an ultimate extinguisher of debt that is universally acceptable as a means of payment. The dollar no longer answers this description. Gold does. Everything else has been tried “to paper over” debt, all in vain. Already, the debt crisis wiped out an enormous amount of wealth indiscriminately, causing great economic pain. We ought to remember that if all the remaining paper wealth is wiped out, gold will still survive intact. It is the only financial asset that has no counterpart as a liability in the balance sheet of someone else. That is its main excellence, a property lacking in all other financial assets.

The hour is late. It calls for statesmanship. This is no time for finger-pointing and rancor. Having recognized the threat of gold backwardation for what it is: the greatest financial crisis in all history, we should act responsibly. If we do, it will be our “finest hour”.

aefekete@hotmail.com

June 23, 2009.

The Obama Administration is Looking at the Wrong Ratio

The Obama Administration has raised the ante in combatting the recession by increasing the debt of the government to levels that were previously considered unthinkable. It is explaining away the weakening financial structure of the country by saying that aggregate debt has not increased much relative to GDP and is therefore not excessive.

This argument is false to the core. One cannot take comfort in past increases of GDP to justify future increases of debt. The fact is that the increase in debt has been the major motive power behind the increase in GDP and prices. It cannot, therefore, be tested by its own results. The real test is the burden of debt. The economic advisers of president Obama forget that the GDP and prices may well decline, but the debt remains fixed. This means that, given the decline, even without further increases in aggregate debt the financial structure will deteriorate. How much more must it then deteriorate when all caution concerning the threat from excessive debt is thrown to the winds!

The argument about stimulating the economy with the proceeds of selling more government debt is equally false. It misrepresents the long-run economic effect of debt on the capacity to produce. If we stimulate the economy beyond its natural level by increasing debt, then we create a capacity that will not be required, and we induce a price and wage level that will not be possible to maintain when the debt spiral ceases. In this way government stimuli create latent pressures for future price, wage, and output declines, increasing the debt burden to a much greater extent than was originally envisaged.

Some people say it does not make any difference whether the money spent has come from debt or equity. This is fallacious because debt creates rigidities that are hard to adapt to declining prices and output. There will be some very unsettling effects. When people are scrambling for liquidity in self-defense, as they do now, debt will make them extra cautious about increasing their spending. This, in turn, makes conditions worse which will then make the debt more burdensome still, etc., creating a snowball effect. In adapting to adverse conditions the greatest enemies are fixed costs, such as interest, depreciation and, above all, debt which is not only hard to refinance but it also limits flexibility. If equity was used instead of excessive debt, then the snowball effect of adjusting to adverse conditions would be far less.

By virtue of pricing power the granting of “cost-of-living adjustments” to labor is easy and logical, provided that the cycle is in its upswing, so things are kept in fair balance. By contrast, reverse adjustments are very hard to make on the downswing. Therefore rigidities and maladjustments accumulate much faster, and they result in a much more precipitate decline as compared to the preceding rise in output.

The Obama administration is looking at the wrong ratio. Instead of the ratio of total GDP to total debt it should watch the ratio of additional GDP to additional debt, that is, the amount of GDP contributed by the creation of $1 in new debt. This ratio shows how effective debt is to make the economy grow at the margin, and for this reason it may be called the marginal productivity of debt. As long as it is well above 1, the creation of new debt has an economic justification. It shows that the economy can have a healthy growth. But a falling marginal productivity is a danger sign. It shows that the quality of debt is deteriorating. Should the ratio fall below 1, it is “red alert”. The volume of debt is rising faster than the national income. The country is living beyond its means and is consuming capital.

In the worst-case scenario the marginal productivity of debt may fall into negative territory. This means that the economy is on a collision course with the iceberg of debt. Not only does more debt add nothing to GDP, in fact it causes contraction and greater unemployment. Debt creation must cease at once as a matter of utmost urgency. The condition of the economy can be compared to that of a patient suffering from internal hemorrhaging that must be stopped immediately.

Several observers calculated the marginal productivity of debt tracing it back for the past fifty or sixty years. One of them, Barry B. Bannister of Baltimore published his results on his website bbbannister@stifel.com. While the calculations of various observers have yielded various results, they all agree that the marginal productivity of debt has been falling and will reach 0 if it has not already done so. The discrepancy is due to the difference in defining net financial debt to avoid double counting. For example, Bannister is netting out all except the first round debt in the derivatives tower and, as a consequence, his calculations predict a further decline in the ratio but it will not become negative before 2015. Others argue that the layers of the derivatives tower are essentially higher levels of debt re-insurance which cannot be netted out because every higher level means the introduction of new risks. Accordingly, their calculations show that zero marginal productivity of debt was reached back in 2007 and since then the ratio has been negative and falling further.

In spite of disagreements and discrepancies, these studies agree that the present crisis is a debt crisis, and any further addition to aggregate debt runs the risk of making the economy contract further. Under these circumstances the Obama administration’s economic policy is self-defeating. More debt is poison to the economy. The internal hemorrhage will continue, nay, it will get worse.

The correct policy should allow insolvent firms and banks to be liquidated without interference from the government. There should be a resolute policy to strengthen the capital structure of the remaining firms and banks. It is imperative that the level of aggregate debt be progressively reduced until a marginal productivity of 1 or higher is restored. It follows that the balance sheet of the Federal Reserve banks should be contracted rather than expanded.

Why is a negative marginal productivity of debt a sign of an imminent economic catastrophe? Because it indicates that the economy is literally devouring itself through the consumption of capital. Production is no longer supported by the prerequisite quantity and quality of capital goods. The responsibility for this belongs to the fast-breeder of debt. It may give the economy a sense of euphoria during the upswing of the cycle, but is devastating in a downswing.

In March, while he was the president of the European Union, the Czech prime minister Mirek Topolanek publicly characterized president Obama’s plan to spend nearly $2 trillion to ease the U.S. economy out of its recessionary hole, as “a highway to hell”, and he predicted that “it will undermine the stability of the global financial market”. While undoubtedly it was an undiplomatic gaffe and a display of extreme impoliteness, the caretaker prime minister did nothing but blurted out unpleasant truths.

It would have been more polite and diplomatic if Mr. Topolanek had couched his comments in the following tenor: “the stimulus plan was made in blissful ignorance of the marginal productivity of debt which is negative and falling. In this situation more debt will only stimulate deflation, economic contraction, unemployment, and it will lead to further weakening of the global financial structure.”

June 24, 2009.

Twenty-five years ago I visited Comex at the World Trade Center, watching the feverish activity in the gold pit from behind the glass wall in the gallery. A gentleman standing next, unknown to me, remarked: “One day this make-believe charade will come to a bad end. All that these guys are doing down there is creating ever more claims to the same lump of gold – just as governments have been doing before they met their ignominious fate.”

Later that day I went to see the Director of Research of Comex. During our chat that lasted about an hour he intimated that he was greatly disturbed by the mystery that the gold basis has been steadily declining year in and year out. Perhaps it was the fact that he could not solve the puzzle that bothered him so much that he quit his job a few months later.

I must confess that I could not solve that puzzle myself until the Twin Towers of the World Trade Center came tumbling down many years later. For me it was a symbolic event, conjuring up the unknown gentleman and bringing back his cryptic remark. We are watching a game of musical chairs. When the music stops, paper claims to gold will be dishonored, and the gold futures markets will tumble down just like the Twin Towers.

In my earlier article The Dress Rehearsal for the Last Contango I observed that “a very strange phenomenon has been manifesting itself during the past thirty-five years, since the inception of gold futures trading. The basis as a percentage of the rate of interest, rather than remaining constant, has been vanishing and, by now, it has dropped to zero.” In the rest of that article I drew attention to the apocalyptic consequences of the prospect of permanent backwardation in gold threatening the world, which is completely ignored by the makers of monetary policy, as I had opportunity to convince myself during my recent encounter with Paul Volcker, the Chairman of President Obama’s Economic Recovery Advisory Board. As I see it, the Debt Tower will topple, just as the Twin Towers of the World Trade center have, when hit by permanent gold backwardation. The reason is that the availability of gold is absolutely indispensable for maintaining our system of irredeemable debt. Only then will bondholders, like the participants of the game of musical chairs, be satisfied that there is a goodly number of vacant chairs available, so let’s get on with bond trading, gold futures trading, and let the music roar on.

But once permanent backwardation in gold establishes itself, gold is no longer available at any price. Bondholders will scramble to sell their irredeemable bonds before they lose all their remaining value. There is no other way to pacify bondholders than letting the game of musical chairs go on, that is, continue the charade of gold futures trading putting ever more claims on the same lump of gold.

The response to my article was overwhelming. I have never realized how many people out there are following my writings on the internet so closely. I want to thank every one of you and assure you that I take this responsibility most seriously. Even if I cannot answer every message I get from you individually, I will continue to do my best to explain the results of my research in simple, understandable terms.

Let me spell out for my readers what the vanishing of the gold basis means from the point of view of the puppet-masters of the gold futures markets. It means that they are fighting a losing battle. They are desperately trying to coax gold out of hiding by offering ever higher bribes – not in terms of the price but in terms of the basis. A low basis means that they offer to take your cash gold and let you have gold futures in exchange at a discount price. (The discount is contango minus the basis, so that the two are inversely related: as the basis falls, the discount increases.) This will allow you to invest an amount equal to the price of gold (less five percent, the margin on the gold future) in any way you want and, having paid the reduced contango, you can keep the profits. The point is that you will still benefit from any advance in the gold price, same as you would if you owned cash gold. You can have your cake and eat it. Remember, in a full carrying charge market, such as the gold futures markets were at inception, no such bribe money was offered.

But, lo and behold, people who are willing to take the bribe are few and far in between. So the pot is sweetened. The basis is lowered. Maybe at one point gold will be coaxed out of hiding, once the bribe is high enough.

No such luck. When the basis gets as low as zero, it means that the discount on gold futures has gone so high that it is equal to the opportunity cost of holding gold. Therefore, again, if you give up your cash gold in exchange for gold futures, you can invest an amount equal to the price of gold (less five percent) in any way you wish, but now they let you keep your profit in its entirety. And you can still benefit from any advance in the gold price, same as you would if you had the cash gold in your hands.

This is where we are now. Indications are that the game fish still does not bite. What now? Where do the futures markets in gold go from here? Well, the pot can be further sweetened. The basis can be pushed down into negative territory. Gold could be forced into backwardation. Let’s see what that means. It means that you can sell cash gold and buy it back for future delivery at an outright discount. Somebody wants your gold so badly that he is willing to pay you for the privilege of holding it for a few days, few weeks, few months paying your storage and insurance fees. You get your gold back at a cheaper price. You make a risk-free profit on this deal. If the gold price goes up in the meantime, you benefit fully, just as if you have held on to the cash gold.

Now risk-free profits are a promise of unlimited profits because, if you are nimble enough, then you can make any number of round trips. However, opportunities to earn risk-free profits from arbitrage do not last. Other nimble speculators would jump in and their unlimited action would close the spread that gave rise to the risk-free profit in the first place. Yet I predict that, after a period of initial vacillation between backwardation and contango (due to action by misinformed traders) gold will settle in permanent backwardation.

Wouldn’t that be lovely? Risk-free profits galore. No need to bother with storage charges and insurance premiums. Just sit back and enjoy the ride to riches.

But hey, wait a minute! Is the arbitrage really risk-free? You give up your cash gold, but what if your gold futures contract expires and they refuse to return your gold? Commodity markets can change the rules of the game mid-stream. They just declare ‘cash settlement only’ for outstanding contracts. Unsaid and unstated, not even mentioned in small print, is the fact that the trap door may be slammed shut. The investor who has taken the bribe is neatly separated from his gold when the hairy godfather waves his magic wand. “Gold is pale because it has so many thieves plotting against it.” There are all too many trap doors, sprung wide open, ready to devour gold belonging to the unwary.

That’s it. That’s why more people do not fall for the bribe even when tickled with promises of risk-free profits. The promise is mendacious. There is a risk: the risk that you lose your gold and you may never be able to buy it back at any price. There is no other explanation for the fact that the promise of risk free profits does not eliminate the discount on the futures price of gold. This is the true explanation for the coming permanent backwardation in gold.

Gold futures trading is clearly a con-game, but it is in a symbiotic relation with the regime of irredeemable currency and irredeemable debt, on which our ‘democracy’ is based. So we have a double con-game. We have a smaller con-game of gold future trading inflicted upon gullible people who want to have their cake and eat it and, then, we have the much bigger, all-embracing con-game of irredeemable currency, inflicted upon the rest of us, innocent bystanders. It is inflicted by the United States government that stoops so low as to trample on the Constitution mandating a metallic monetary system for this country precisely in order to outlaw all Ponzi-schemes. The government could never muster the moral courage to propose an Amendment that would make the Constitution conform to its monetary system – as it would open Pandora’s box. Rather, it would live with the onus of being in contempt of the Constitution. The government of the United States had looted gold from its own subjects in 1933. It looted even more gold from people not under its jurisdiction in 1971. It continues to operate in the same tradition.

The larger con-game of the irredeemable dollar could not have gone on so long, but for the smaller con-game of gold futures trading from which it takes its strength. Historically, every regime of irredeemable currency has met its Nemesis in no more than 18 years. The present experiment with irredeemable currency has been going on for twice that long. Of course, gold futures trading is a relatively new invention that was not available to the managers of the assignats, mandats, or the Reichsmarks. Nor was it available to the managers of the most recent experiment with the Zimbabwe dollar. But, as the relentless fall in the gold basis clearly shows, people cannot be conned forever. The clock is ticking. Sand in the hourglass keeps dropping. When it runs out, the present experiment with fiat dollar will also meet its Nemesis, as all the earlier experiments have. That’s the good news.

The bad news is that the government of the United States persists in continuing the double con-game and Ponzi-scheme through thick and thin. It is callous to the economic damage it is causing world-wide, and it disregards the danger of permanent gold backwardation that would inflict utter economic pain on the innocent people of this country, to say nothing of the people of the rest of the world. As explained above, it would make the runaway debt-tower of Babel topple, burying people under the rubble as the Twin Towers of the World Trade Center buried people working inside.

When that happens, the government of the United States will not have the excuse that it has not been warned. I have delivered the message in person to the Chairman of President Obama’s Economic Recovery Advisory Board, Paul Volcker, when we met at the Santa Colomba Conference last July. I also consider it my moral duty to warn all the people who are willing to listen of the danger lying ahead. It is incredibly na?ve to believe that gold can be removed from the international monetary system with impunity at the stroke of a pen, as they pretended to do it in 1973. The gold corpse still stirs. When it rises from its prostrate position it will, like Gulliver, dust off the Lilliputians who like ants have been scurrying all over his body. The day of reckoning will have dawned.

Keynesian and Friedmanite economists bear a special responsibility for the disaster. They dug in and monopolized their positions at universities and research institutes. They never allowed a free discussion on the gold standard. They did everything to aggrandize and perpetuate their own power as the sole advisors on government policy.

They will not be able to live down this shame in a thousand years.