Introduction

Although the Fed’s open market purchases of securities (always net) affect only the short end of the yield curve directly, through the transmission of risk-free bond speculation they will affect the rest of the yield curve indirectly. Thus the entire spectrum of interest rates will keep falling in consequence of the Fed’s open market purchases of Treasury bills (or equivalent). This is a powerful if unrecognized force in the economy causing a chain-reaction as follows:

1. risk-free bond speculation causes interest rates to fall,
2. falling interest rates cause a severe erosion of capital throughout the productive apparatus,
3. erosion of capital causes a falling trend in prices,
4. falling prices further increase the downward pressure on interest rates.

Thus a vicious spiral of falling interest rates and falling prices is engaged, threatening to push the economy into the abyss of deflation. Mainstream economics lacks a valid theory of speculation. Hence it has a blind spot, failing to see the destructive nature of open market operations.

Risk-free bond speculation

Typically, bond speculators carry on interest arbitrage along the entire (normal) yield-curve. They sell the short maturity and buy the long, hoping to capture the difference between the higher long rate and the lower short rate of interest (borrowing short and lending long). This arbitrage is not risk-free per se as it has the effect of flattening, and possibly inverting, the yield curve. As a result of inversion it is turned from a rising curve into a falling one, while turning the speculators’ profits into losses.

However, as a direct result of the open market operations of the Fed (introduced clandestinely and illegally in the 1920′s through the conspiracy of the US Treasury and the Fed, long before the practice was legalized ex post facto in the 1930′s), interest arbitrage has been made risk-free. Astute bond speculators with their long leg in the bond market can profitably mimic Fed action in the bill market with their short leg. This never fails. Speculators know that, sooner or later, the Fed has to answer nature’s call and will go to the bill market as a buyer in order to replenish the money supply. This is their signal to sell. On rare occasions the Fed would be a seller. This is their signal to buy.

This copycat action is an inexhaustible source of unearned profits for the speculators. Thanks to the Fed’s open market purchases, they are always able to replace their fast-maturing bills with fresh ones so as to maximize their bond/bill spread. The more aggressive the Fed is in increasing the monetary base, the wider the spread and the greater the bond speculators’ profits will be.

Absolute bad faith

After the F.R. Act of 1913 was quietly overthrown when Congress was not looking, the Fed has been revolutionized. According to the original Act the earning assets of the F.R. banks were to be restricted to real bills, that is, short term commercial paper originating in the production and distribution of consumer goods. Treasury paper was not listed in the Act as an eligible asset. This was not an oversight. No part of F.R. credit outstanding was supposed to be backed by government debt. If a F.R. bank was found short of eligible paper in balancing its note and deposit liabilities, it did not matter how much the overflow of Treasury bills was in its portfolio, it had to pay stiff and progressive penalties.

The conspiracy between the U.S. Treasury and the Fed is to be seen in the fact that the former has ‘forgotten’ to collect the penalty from the latter. Indeed, why should the Treasury penalize its best customers for buying its staple product? By 1920 you could not find a real bill in F.R. portfolios with a magnifying glass. Nor was a serious effort made to return to the norms of the original Act after the end of the hostilities in starting rediscounting bills once more.

The conspiracy has gone right to the heart of the U.S. monetary system. In 1913 legislators were assured that they were voting for a commercial paper system that could never become an engine of monetizing government debt. Should it try, it would be confronted with unacceptable losses. Later, when time came to legalize the illegal practice, the introduction of open market operations was presented as an innocent house-keeping change, a technical matter relating to banking practice. The fundamental issue, the wisdom of allowing the Fed to monetize government debt, was hushed up. Congress, let alone the general public, was never given a chance to scrutinize or debate it. Monetization of government debt was legalized through the back door, through chicanery, and through absolute bad faith. It was made the centerpiece of the money-creating process, in a complete reversal of the intention of the original Act. Is it any wonder, then, that the new monetary system born in sin has brought disaster to the nation in due course?

Nature abhors risk-free speculation

Critics focus their criticism on the way the Fed creates money through sleight of hand. But there is a much larger issue here that goes unnoticed and has escaped attention. Open market purchases have made it possible for the Fed to usurp unlimited power in suppressing the rate of interest on allmaturities through the transmission mechanism of risk-free bond speculation, while maintaining the illusion that it had only a very limited power of influencing the overnight rate of interest. The impression created is that the world can rest assured that all other rates are true market rates. Nobody took the trouble dispelling this illusion. Nobody has investigated the consequences of bond speculation in the wake of open market operations. The ‘innocent house-keeping change’ opened up a bottomless pit for the national economy, as it has granted unlimited power to the Fed to suppress all interest rates along the yield curve, all the way to zero.

Just as nature abhors vacuum, it also ‘abhors’ risk-free speculation. It exacts an exceedingly high price from violators, sometimes after a long delay, when retribution is least expected.

The punishment for opening Pandora’s box of risk-free speculation was devastating, as demonstrated by the Great Depression of the 1930′s. In that episode risk-free speculation made bond prices rise and interest rates fall beyond any reasonable limits. Speculators abandoned the commodity market as too risky, and flocked to the bond market where all bets were on the house. Commodity prices fell, along with interest rates, through the whole spectrum. The consequences were apocalyptic.

Falling interest rates as a destroyer of capital

My thesis that falling interest rates destroy capital across the board is admittedly controversial. I would welcome its examination ‘without fear and favor’ by a competent and unbiased panel. We must look at two related effects of falling (as opposed to low but stable) interest rates:

1. the increase in the liquidation value of debt,
2. the fading of depreciation quotas.

The proposition that the bond price varies inversely with the rate of interest is uncontroversial and universally accepted. It describes the effect from the point of view of the creditor. Yet people find it hard to comprehend the equivalent proposition describing the very same effect from the point of view of the debtor, namely, that the liquidation value of debt varies inversely with the rate of interest, in particular, lowering the rate of interest will increase the liquidation value of debt. There is no difference between the meanings of the two statements. The bond price is just the liquidation value of debt evidenced by the bond. Falling interest rates make the burden of debt increase.

The depreciation quota of a producer good is an accounting tool revealing how much of its value is being ‘used up’, and needs to be replaced through amortization, in any particular year. It is comparable to the annual yield of capital invested in a bond. When looked at in this way, it becomes clear that falling interest rates should make the revision of depreciation quotas upwards mandatory. If this rule is ignored, there will be a shortfall in amortization. Sufficient funds will not have been set aside to pay for the purchase of the replacement at the end of the useful life of producer goods.

Present accounting standards ignore both effects (i) and (ii). This is the cause of concealed capital erosion acting insidiously. Losses are masked as profits, and phantom profits are paid out as dividends and managerial compensation. The process of capital erosion is accelerated. Inevitably, the result is deflation, depression, or worse.

We have seen that open market operations of the Fed serve as a powerful deflationary force in the economy causing interest rates to fall and capital to erode. We shall now see that falling interest rates cause prices to fall as well. It engages a vicious spiral pulling the economy into the abyss.

Erosion of capital causes a falling trend in prices

The erosion of capital affects all producers, some of whom will succumb while others will fight for survival by trying to get out of debt. They will aggressively cut prices in the face of weakening demand.

Herein we have a classic example of central bank action being counter-productive. The central bank wants to snatch the economy from the jaws of deflation by increasing the money supply. Its preferred method is the open market purchases of short-term government securities. But through the transmission of risk-free bond speculation interest rates keep falling for all maturities. Capital invested in production is eroding faster as a result. The burden of debt is increasing. Producers are squeezed. They try to get out of debt by selling more of their product. In desperation they cut prices, but to no avail. The vicious circle is complete.

The Austrian theory of the boom-bust cycle

The suppression of the rate of interest through monetary policy and the resulting malinvestments made by entrepreneurs is a central theme of the Austrian School of economics. Our analysis is in the same tradition. In exposing the actual transmission mechanism that converts the suppression of short term rates into the suppression of the longer term rates, it carries the analysis further. It points out that open market purchases of the Fed make bond speculation risk-free with the result that all interest rates will fall simultaneously. It turns out that it is not necessary to bring in the malinvestment argument. After all, entrepreneurs could learn from past experience and fine-tune their investments taking the distortion in the rate of interest into account. Could the bust be avoided if they did? Our explanation of deflation and depression in terms of destruction of capital, brought about by the falling interest rate structure, avoids any reference to possible malinvestments and is, therefore, superior.

The Achilles heel of Keynesianism

Our destruction of capital argument also has the advantage that it reveals the Achilles heel of Keynesianism preaching, as it is, the dangers of ‘oversaving’ and ‘underconsumption’. These concepts are vacuous. There is no reason why a society should not be able to satisfy the needs of those of its members who must be net savers (typically the juniors), and those who must be net consumers (typically the seniors). The Achilles heel of Keynesianism can be found in its treatment of capital, in particular, in ignoring the danger of capital erosion. Keynesianism is oblivious to the fact that, if capital consumption occurs for any reason, then the resulting deficiency must be compensated for by the accumulation of new capital. Without it society cannot continue living at the same level of comfort and security. If it tries, it makes the crisis of under-capitalization even more critical.

The greatest mistake of Keynesianism is to teach that the cause of the Great Depression was falling prices due to oversaving. But falling prices were not the cause: they were the effect. The cause was falling interest rates, for which the fiscal and monetary policies advocated by Keynes were directly responsible: the unbalancing of the budget, inordinate increases in debt, and the monetization of government debt by the central bank. The Keynesian idea that open market operations will not and cannot have devastating side effects has become a dogma. This dogma must be discarded.Open market operations do have consequences.

Deflation or hyperinflation?

A frequently asked question is whether the international monetary system based on irredeemable currency is facing a deflation similar to that of the 1930′s, or whether it is facing a Zimbabwe-type hyperinflation.

A relentlessly increasing money supply is not the only prerequisite for hyperinflation. There is another: the lack of suitable outlets for the bloated purchasing power. As risk-free bond speculation made possible by open market operations shows, no matter how much purchasing power is being created by the world’s central banks, speculators will always find rising bond values safer to bet on than on rising commodity values. In the absence of wars, or civil wars, destroying stores of consumer goods as well as the park of capital goods to produce, the forecast is deflation, not hyperinflation.

It follows that in combating deflation the Obama administration is resorting to measures that are ineffective, if not outright counter-productive. In particular, more government debt is poison for the economy. Its monetization by the Fed will only feed bullish bond speculation (and possibly bearish commodity speculation) while doing nothing to rebuild the impaired capital base of industry and finance. Bullish bond speculation is responsible for the falling interest-rate structure and destruction of capital. The economy needs to be stimulated, yes, but increased government spending is the wrong way to that goal.

The right way is through stable interest rates, more savings, and the accumulation of more capital.

If it were not so tragic, one could rub in the irony that Keynesianism, in trying to push the world into the pit of inflation, has only succeeded in pushing it into that of deflation – the very same pit it was so anxious to avoid.

July 19, 2009.

I have received a deluge of mail from readers of my latest article on the gold basis and the threat of the coming permanent backwardation in gold. I truly appreciate the interest of my readers in learning my thoughts on the subject. I regret that it is not possible for me to answer these letters individually; I make an attempt here to answer one or two, where the questions are general enough so that my answers may benefit all readers.

Hello Antal!

I have questions about your ‘Dress Rehearsal for the Last Contango’.

Will not gold at $1,000+ per ounce restore gold holdings registered at Comex warehouses? If not, why not?
When the gold basis goes negative, could it not subsequently go back to positive, assuming the price rises to over $1,000? If not, why not?
Why must gold backwardation, once established, become permanent?

I should like to hear your reply to these questions. I am really very interested in understanding fully the implications of the vanishing basis for gold, and I hope you can provide me with your answers to my questions.

With warm regards, Victor
Dear Victor,

For a full discussion on the gold basis and the permanent backwardation in gold you must come to Canberra, Australia, where the Gold Standard Institute will have a seminar in November. This Seminar is second in a row, devoted exactly to these topics.

Last year’s Seminar was a great success; this year’s will be an even greater one. I am confident to say that Canberra is the only place in the world where you may get scientific information on gold contango, gold basis, gold warehousing, bimetallic arbitrage, and the prospects of permanent gold backwardation, as well as answer to a host of tantalizing questions that arise from these. We shall have an expert on hand from the Perth Mint. And, as an absolute first, the manager of Masters Fund, a unique gold fund just coming on stream, will be in attendance to answer questions. I am proud to say that I have been associated with this Fund from inception throughout the incubation period. The Masters Fund is offering exclusive features not available from any other fund, such as:

The guiding star of the Fund is not the dollar price of gold, but the gold basis which is much less open to manipulation, and much more relevant to an accumulation plan;
The gold in the Fund bears a return in gold, so profits are measured not in terms of the U.S. dollar but in terms of gold itself;
Any appreciation of the Fund’s value in U.S. dollar terms is additional, but the maximization of dollar value is not a prime objective;
The gold in the Fund is never put out on lease or on loan, nor can it be pledged as collateral, but stays on the premises at all times under the full control of the Fund. It has never happened before that you could collect the return on capital unless you were willing to relinquish temporary control over it and thereby assume the risk of losing it. This could be important at a time when wholesale defaults on paper gold contracts may engulf the world;
The principle on which the Fund operates is valid whether the monetary metals are in a bull market or whether they are in a bear market;
The Fund is especially recommended to those individuals who are in the habit of measuring the value of their assets and their own net worth in gold units, rather than irredeemable paper units such as the US dollar;
The Fund is structured in such a way as to take full advantage of the coming permanent gold backwardation, when all other gold funds will be grounded.

Of course, false alarms can and do occur, and it is possible that gold goes into backwardation and then promptly comes out of it. It has happened before. But here we are looking at a 35-year trend, embracing the entire history of gold futures trading. The trend has been that, as a percentage of the prevailing rate of interest the basis has been falling from practically 100% to practically 0%.

You and I know the reason for this: it has to do with the vanishing of all newly mined gold into private hoards at an accelerating pace; the insatiable appetite in the world to snap up all available gold by well-heeled governments and individuals who no longer believe in the tooth fairy residing in the Federal Reserve.

You have to remember that the basis is widely used as a guide in the huge arbitrage operations between gold holdings and dollar balances and in the gold carry trade. To participate in this arbitrage you must have gold on deposit in Comex warehouses. But with the vanishing of the gold basis the profitability of this arbitrage as well as that of the gold carry trade has been drying up, which explains the dwindling of warehouse stocks.

Another consequence of the vanishing of the gold basis is that it makes the risks involved in the gold/paper arbitrage rather lopsided, as far greater risks are assigned to short positions on gold and long positions on the dollar, than on long positions on gold and short positions on the dollar. The arbitrageurs are very much alive to this lack of symmetry, and are increasingly unwilling to put their gold in harm’s way. They are fully aware that we are approaching an historic milestone, one that has never been passed before: the milestone marking the last contango. As a consequence of this lopsidedness the gold futures markets can no longer coax gold out of hiding. In vain do futures markets promise risk-free profits for taking over the carry from the individual.

Here is the deal they offer you: give us your cash gold in exchange for gold futures that we’ll let you have at a deep discount, so that you can pocket risk-free profits. The offer is increasingly declined. There was a time when a drop in the basis would pull in gold from the moon, figuratively speaking. No more. Arbitrageurs no longer believe that… gold futures are fully exchangeable for cash gold.

Gold backwardation is virtually inevitable and when it comes, it will be irreversible. Why? Because it signifies a crisis of the first magnitude: the general disappearance of gold from trade for reasons of lack of confidence. No one will give up gold, because one is no longer confident that he can cet it back on the same terms. Vanishing confidence is like a runaway train The only thing that might turn this runaway train around is a steep rise in US interest rates. However, this is not in the cards. It would ruin what is left of the US economy. It would also cause the bond market to collapse, sending the dollar down the drain.

I do not see the collapse of the bond market happening anytime soon. The US Treasury and the Federal Reserve can muddle through this crisis, and possibly beyond, by making bond speculation risk free in order to maintain demand for Treasury paper.

Having said that, I don’t think the guys at the US Treasury and at the Fed understand the gold basis and the seriousness of the threat of permanent gold backwardation. They are just trying to hold the line at $1,000 for whatever psychological value it may have, for as long as they can. It’s the same old tug of war, they think.

It is not. Once the $1,000 level is breached, there may be some ‘profit-taking’, to be sure. But, because of the zero basis, those who take profits will look rather foolish. Last contango – last profit taking.

Be prepared for a great wave of defaults on paper gold obligations.

Certainly, the lessees of central bank gold will default. Comex will close its gold pit for good, and outstanding contracts will be settled on a cash basis. I will be surprised if any gold ETF shareholders will see a grain of gold coming their way out of the rubble left by the default. Comex gold certificate holders will be lucky if they can get a fraction of their gold back from the warehouses – after a lengthy wrangle. Too many claims have been issued on the same lump of gold.

Under these circumstances it is difficult to see how anyone could wish to deposit gold in a Comex warehouse to restart gold futures trading. The market for slaves has disappeared after emancipation never to come back again. The gold futures markets will disappear, utterly (and deservedly) discredited. Like the slave markets, they will never come back.

Yours faithfully,

Antal
August 26, 2009

Fool’s gold basis

A year ago I conducted a Seminar on the gold basis and backwardation in Canberra, Australia. I suggested to my audience that the gold basis (premium in the nearby futures on spot gold, with negative basis meaning backwardation) as a “pristine indicator that, unlike the gold price, cannot be manipulated or falsified by the banks or by the government. Thus it is a true measure of the perennial vanishing of spot gold from the market, never to return, at least not as long as the present fiat money system endures.”

That was then. Today we are one year older and that much more experienced. We now know that the banks and the government have in the meantime found a way or two to manipulate the gold basis as well. Next month I have another Seminar coming up in Canberra. I shall address the problem of gold basis, giving a full account of what we know about the efforts of the powers that be in trying to falsify this most important indicator, the guiding star of refugees who have entrusted their fate to a golden dinghy on a stormy sea. To the government, the gold basis is like the naughty child who blurts out unpleasant truths. He must be gagged and silenced at all hazards. Fool’s gold basis is even more important than fool’s gold in terms of the number of people victimized.

The ‘Let’s get physical’ movement could trigger a chain reaction

A prime suspect is the gold basis calculated using COMEX futures prices, or the forward gold price of the London Bullion Market Association (LBMA). Further suspects are: certain gold Exchange Traded Funds (ETF’s) such as GLD and their weekly updated bar lists; certain central banks such as the Bag Lady of Threadneedle Street (nickname of the Bank of England) that has rushed to the rescue of her agents, the bullion banks, trying to bail them out by offering substandard (22 carat) gold in settlement of contracts at the verge of being defaulted. Substandard gold stinks, as I shall explain below.

There seems to be circumstantial evidence that this month the gold exchanges are unable to honor their expiring contracts for which delivery notices have been issued in September. It has occurred in spite of a robust, even increasing, contango. Furthermore, circumstantial evidence exists that counterparties to these expiring contracts for future delivery – bullion banks, to be precise, the name of J.P.Morgan and Deutsche Bank being prominently mentioned – have offered bribe money up to 125% of the quoted spot price to holders of long contracts if they would take settlement in paper, on condition that the embarrassing affair will be kept secret. If true, these maneuvers are motivated by the desire to conceal the real gold basis, and to deny that gold is in or approaching backwardation. If the truth were widely known, then there would be a run on the bullion banks. The ‘let’s get physical’ movement would trigger a chain-reaction culminating in all offers to sell physical gold being permanently withdrawn around the globe. ‘Gold would not be for sale at any price’, whether quoted in US or in Zimbabwe dollars – or, for that matter, in any irredeemable currency – the only kind of money people are allowed to have nowadays. The curtain would fall on the ‘Last Contango in Washington’. The day of permanent gold backwardation would dawn. The chapter on a reactionary episode of history, irredeemable currency, allowing the Treasury and its central bank to create unlimited liabilities out of nothing which they have neither the means nor the intention to honor, but could use them for check-kiting purposes to mesmerize gullible people around the world, would be closed and become but a bad memory.

“Honey, I’ve shrunk the bar-list!”

We must guard ourselves against falling victim to the rumor-mills, while keeping our eyes peeled for the very real possibility that the growing shortage of physical gold can no longer be papered over with paper gold (pun intended). Another story is about GLD, a leading gold ETF, which publishes its bar-list every Friday at the close of business, reporting the serial number of every bar in inventory. The list is customarily well over a thousand pages long. But, lo and behold, on Friday, October 2, and on Friday, October 9, the bar-list shrank to a mere couple hundred pages, with no explanation offered. Could it be that the management of GLD has taken a bribe, and replaced physical gold in inventory by paper gold, in order to save the face and skin of the bullion banks that have gone naked short and subsequently got cornered?

If so, it won’t get very far. The leadership of the US House of Representatives may well be able to put in deep freeze the motion of Dr. Ron Paul, seconded by over 250 other congressmen on both sides of the aisle, to audit the Federal Reserve, but it has no power to stop the auditing of the ETF’s or bullion banks as required by contract law. According to some reports independent auditors, at the insistence of parties holding expired forward purchase contracts to deliver gold, are descending on ETF’s and check their vault’s contents against their books. The noose is tightening around the neck of fraudulent banksters caught in the short squeeze.

Archimedian test

Reports are circulating that similar audits of certain Asian depositories have already produced ‘good’ delivery bars (400 oz or 12.5 kg gold bricks) that have been gutted and stuffed with tungsten – a metal whose specific weight approximates that of gold, so that the famous test of Archimedes (fl. 287-212 B.C.) based on the Law of Buoyancy, designed to expose fraudulent goldsmiths, would be inapplicable. Isn’t it strange that criminal law punishes the fraudulent stuffing of gold bars, but allows the stuffing of gold assets in the balance sheet with paper gold? After all, the specific value of tungsten is much higher than that of paper!

According to a well-known anecdote, King Hiero II of Syracuse ordered his goldsmith to make him a new crown in the shape of a laurel wreath out of solid gold. When the finished crown was delivered to him, the king had reasons to suspect that he had been short-changed by the goldsmith who presumably diluted the gold with base metals. He called upon Archimedes to make the determination but without damaging the crown. After some hard thinking Archimedes solved the problem. He could determine the volume of the crown by submerging it in water, and from the volume and weight he could calculate the crown’s density. Comparing it to that of gold, the fraud would be exposed if the density of the crown were lower. It is evident that, if the goldsmith had had a metal at his disposal of the same density, but cheaper than gold, then Archimedes’ test would have been inconclusive. It is this property of gold that makes it second to none among the metals, along with other similar fine properties, explaining why it is a most desirable form of wealth.

The revenge of the looted coins

In 1933 F.D. Roosevelt did not stop at the mere confiscation of the constitutionally mandated gold coins of the realm. He sent them to the refinery in order to melt them down. He wanted to expunge the evidence from history that this great republic once had the largest pool of circulating gold coins anywhere, ever. Roosevelt betrayed his oath that he would uphold the U.S. Constitution and went ahead to rob the citizenry by calling in the gold replacing it with Federal Reserve notes, the value of which he promptly cried down by 56 percent, under the disguise of monetary reform. The melted gold was given the shape of gold bars and was stored in Fort Knox, West Point, and other depositories.

Careful as though Roosevelt was to cover his trail in getting away with the loot, he has made one major blunder. He failed to make the looted gold fungible. The coins were not made of pure gold: they were an alloy 22 carat in fineness. The reason was to make them stand up to wear and tear better in circulation. All countries striking coins for general circulation employed an alloy. Roosevelt thought that he could save the cost of refining the melted gold to the international standard of 995 fine (24 carat) so the gold bars in Fort Knox are only 22 carat fine. In consequence these gold bars are not fungible. They are easily identifiable as contraband, the proceeds of the Great Gold Heist of 1933. The shear quantity of this looted gold makes it impossible to refine it at this late hour. The U.S. gold stinks, and will keep on stinking.

The memory of the Crime of 1933 comes back to haunt the government that committed it. For 75 years nobody suspected that one day these gold bars may be needed to pacify the market. Everybody thought that they could rest in peace in the depositories till doomsday. But then, as the proverb says, ill-gotten goods seldom prosper. The Great Financial Crisis of 2007 struck and the dollar got into hot water. The U.S. Treasury ran out of fungible gold and had to dip into its hoard of looted gold. It is too late now; the bad odor cannot be expurgated from the U.S. gold hoard. Should this gold ever show up at an audit, or as bribe money, it will immediately be recognized. Everybody will see that it originated from the Great Gold Heist of Roosevelt and that the shame of the U.S. government is attached to it. Worst of all, it will also reveal that the U.S. has fallen upon hard times. The looted gold was released in desperation, in trying to stem the tide of burgeoning gold backwardation.

The result is that every time 22 carat gold pops up anywhere in the world, for example, as an offer to pacify angry possessors of expired gold futures contracts, it will be new evidence of the fact that Uncle Sam is cornered and tries to bribe his way out of the corner with looted gold. If Uncle Sam is trying to pay the blackmail on behalf of his cohorts the bullion banks, in offering 22 carat gold in settlement of contracts calling for 24 carat fineness, then the world will immediately know what’s up, even if the substandard gold is offered through intermediaries. Everybody will know that Uncle Sam is trying to cover up, or fend off, backwardation to prevent the gold basis from going permanently negative. The telltale sign will haunt him and make the gold crisis worse, not better. Most of the possessors of expired gold futures contracts will refuse to take substandard gold for settlement, but neither will they keep Uncle Sam’s secret. Apparently there are already two known instances where the looted gold turned up. Central banks, in coming to the rescue of their agent bullion banks that were caught red-handed in being naked short in gold, offered 22-carat gold to bail out their agents. This fact in itself makes the quantity of gold available for resolving the gold crisis smaller. Permanent backwardation in gold, the Nemesis of irredeemable currency, cannot be postponed much longer.

Blight on Humanity

Rob Kirby, the best sleuth we have to uncover government hanky-panky in the gold market, has castigated the cover-up of what he considers a severe backwardation in no uncertain terms. He calls central banks for their complicity in the cover-up a blight on humanity. In his opinion, the central banks are aiding and abetting the plunder of the sovereign assets of their countries to bail out their agents or friends in an attempt to “sweep the whole bloody mess under the carpet”. This assessment is apt. It is no exaggeration to say that the regime of irredeemable currency is a blight on humanity. The Uncle Sam will never be able to live down his shameful role in plunging the whole world into the monetary abyss.

Central banks are also guilty of corrupting the young – a crime that was punishable by death in Athens at the time of Socrates. They have hijacked monetary economics lock, stock, and barrel. They have commissioned scribes for hire to rewrite it as a eulogy of their sordid trade, the creation of fiat money. Graduates of our universities are no longer taught that this regime has a 100 percent mortality rate through the sudden death syndrome, pauperizing the population in the process. The role of gold in history is falsified and distorted. People are told that harking back to gold money is a sign of backwardness and reactionary thinking. Modern money is managed money – as long as they themselves are entrusted with its management. In this view the U.S. Constitution is a backward document not worth bothering with, so they don’t bother with proposing a constitutional amendment changing its monetary clauses to conform it to present practice.

Aristotle on alibi

An axiom of Aristotle states that no substance can be present at two different places at the same time. The reason for gold’s monetary role is rooted in this very axiom. The same paper promise can be present in the asset column of the balance sheets of any number of individuals. The same gold coin cannot. This eliminates the possibility of a miraculous proliferation of money – putting latter-day money changers out of business. But once gold is removed from the monetary system, the miraculous proliferation of money starts in earnest. Central bankers will distribute it, if need be, from helicopters hovering overhead. The proof that this is beneficial to society is ad hominem. In this way, so the argument goes, the niggardliness of nature to release only so much gold per annum from the gold mines can be overcome. Money will get into the hands of those who need it most. They will certainly spend it. Never again will the economy seize up because of shortage of money.

The Quantity Theory of Money is a false doctrine because it describes the economy in terms of a linear model, when in reality the world runs on a highly non-linear pattern. Therefore we need a better theory to show that the miraculous proliferation of money is bound to come to a sorry end. It has been my ambition to construct a better theory. I am pleased that my theory of the vanishing of gold basis, and the ultimate permanent backwardation of gold under the regime of irredeemable currency has found resonance in some blogs and discussion groups, even if it is still taboo in the media and academia.

We have made great progress since last year’s Seminar in Canberra. This year’s Seminar will discuss the gold basis in the light of the very latest developments. The gold basis is not dead, it just needs to be correctly interpreteded. I shall show it to my audience how to do that through uncovering the hidden premium in the price of 24 carat gold available for immediate delivery; through the spread between the share price and the NAV of the gold ETF’s; through the popping up of 22 carat gold bars offered as bribe money, and other miscellaneous signs of a very real physical short squeeze in the market for monetary gold.

See you in Canberra in November!

October 15, 2009

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References:

A.E. Fekete, Red Alert: Gold Backwardation!!!, www.professorfekete.com, December 5, 2008

Rob Kirby, Backwardation: Facts from Fiction, www.financialsense.com, December 8, 2008

Rob Kirby, Central Banking: A Blight on Humanity, www.financialsense.com, October 9, 2009

Rob Kirby, Blight on Humanity, Addendum, www.financialsense.com, October 15, 2009

According to John Maynard Keynes (1883-1947) the deeper roots of the gold standard are to be found in psycho-pathology.

There is something pathological in man’s desire to palm the metal. Keynes says
that whenever he is digging to find the rational basis for man’s wanting gold, he always runs into Virgil’s dictum from the Aeneid: Auri sacra fames, “that accursed hunger for gold”, at which point he is forced to give up and “pass on the case to the psycho-pathologist with a shudder”.

Keynes’ jeremiad pretty well sums up the official position on gold to-day. You may try, as I have, to engage politicians and mainstream economists in a discussion on the subject of the gold standard, and get a polite refusal saying that their plate is full with ‘real’ problems, leaving no room and time for ‘imaginary’ ones.

In spite of Keynes and officialdom, there is a scientific theory of the gold standard. Gold is not wanted because of a bestial instinct in man. Nor is it desired because it is scarce. After all, there are substances even scarcer than gold. Gold is in general demand because its marginal utility is constant (or, at least, it declines more slowly than that of any other substance). This is a technical expression that could be rendered in plainer English by saying that while the satiation point for most substances is not too far, for gold, it is receding farther than for any other.

It is clear that there must be a substance with this property; it just so happens that it is gold that fills the bill. It is also clear why the substance with the fastest receding satiation point is important economically. It is this property that makes gold ‘most hoardable’ or ‘most marketable in the small’.

Man is mortal and subject to the curse of senescence. He needs a substance that can help him to transfer wealth over time, that is, a substance he can hoard in confidence in order to provide for his old age.

Here is another example: man has a need to transfer wealth over time as he wants to provide for the education of his offspring. This is especially important at a time when the credit system breaks down (sounds familiar?), or when no one can trust the currency any more for fear of depreciation or debasement. If the government bans ownership and trading in gold, as it has done in history on certain occasions, another substance will take over the role of the most hoardable commodity.

We may approach the problem from the other end by posing the following question: what is the ultimate extinguisher of debt? If there is debt, then there must be a way to liquidate it.

Granted that one type of debt can often liquidate another type; we still need an ultimate extinguisher of debt. If we weren’t allowed to have one, then debt would sooner or later start its fast-breeding accelerator cycle and toxic debt would ultimately overwhelm the system (sounds familiar?)

The ultimate extinguisher of debt is gold. It is that financial asset that has zero counterparty risk. All other assets do carry such risks since that selfsame asset must also occur as a liability in the balance sheet of someone else.

 

The Gold Standard Institute

If you say that the national currency backed by the wealth of the country is the ultimate extinguisher of debt, then you need to be reminded that the writ of the government stops at the border. There is no way to legislate legal tender that is enforceable abroad.

The theory of interest is a part of economic science that has never achieved a “state of finality” in the sense that the majority of economists would accept it, at least in its broadest outlines, as valid.

The theory of interest is still very much at the percolating stage.
Ludwig von Mises (1881-1973), a solid gold standard man, denies that gold has constant marginal utility. He says that this would imply ‘infinite demand’ for gold which is contradictory. In this instance, and in very few others, the great Mises is wrong in error. As an alternative, is it necessary to mention Mises at all here? It would be better not said at all I think. It is true that for all commodities the obstruction to infinite demand is declining marginal utility. Gold is an exception, the only one there is. For gold, the obstruction to infinite demand is not declining marginal utility but the phenomenon of interest. As the rate of interest is increasing, ever more people will give up their gold in exchange for income in the form of a stream of interest payments.

It is important to note here that the converse is also true. As the rate of interest is falling, ever more people will find the income from interest payments insufficient and will want to hold gold.

Yes, they do want to palm gold, as opposed to paper promises to pay gold. There is nothing psycho-pathological about that. If people dissatisfied with the low interest income accepted a wad of paper money in exchange, then they would be jumping from the frying pan into the fire.

Their protest against the interest rate being too low ended up settling for zero interest which was as low as it could go, but it was exactly what they would get on their investment in paper money.

Mises also says that a promise by a credible promissor to pay gold coin to bearer on demand is a full and equal substitute for the gold coin in every conceivable economic transaction as it is accepted in lieu of the gold. He concludes that paper money is a present good just like the gold coin itself.

Even if no longer redeemable in gold, according to Mises, paper money is a present good rather than a future good. Mises is wrong again. However you look at it, a gold certificate payable to bearer on demand is no more than a future good, never a present good. Here is the reason why. The marginal bondholder, who has set out to register his protest against the rate of interest being too low by selling his bond, will accept the gold coin in payment but will refuse to take the gold certificate.

I quote from the great American monetary scientist, Benjamin M. Anderson (1886-1949), who in 1948 wrote under the caption The Tyranny of Gold as follows: “Gold needs no endorsement. It can be tested with scales and acids. The recipient of gold does not have to trust the government stamp upon it, if he does not trust the government that stamped it. No act of faith is called for when gold is used in payments, and no compulsion is required.…

“Men everywhere, governments everywhere, and central banks everywhere are glad to get it. When paper is offered instead of gold, it will be accepted on faith if the government or the bank which has issued the paper has proved itself worthy of confidence by a satisfactory record of redeeming the paper in gold on demand.…

“Complaints are always made about gold and the behavior of gold when there is irredeemable paper money. Under Gresham’s Law, gold is hoarded, or leaves the country. It ceases to circulate, leaving the dishonored promissory note in possession of the field. Gold will stay only in countries which submit to its discipline. Gold is an unimaginative taskmaster. It demands that man and governments and central banks be honest. It demands that they keep their promises on demand or at maturity.

It demands that they keep their demand liabilities safely within the limits of their quick assets. It demands that they create no debts without seeing clearly how these debts can be paid.…

” If a country will do these things, gold will stay with it and will come to it from other countrieswhich are not meeting the requirements. But when a country creates debt lightheartedly, whena central bank makes rates of discount low and buys government securities to feed its money market, and permits an expansion of credit that goes into slow and illiquid assets, then gold growsnervous. Mobile capital funds of all kinds grow nervous. There comes a flight of capital out of thecountry. Foreigners withdraw their funds from it, and its own citizens send their liquid funds away for safety.…

“When suspension of gold payments comes, speculators in the foreign exchange market treatpaper currency most disrespectfully. They sell it short. They buy it only at a discount. The amount of discount in a free gold market or in a free foreign exchange market will be governed primarily by speculative expectation as to whether and when resumption of gold payments is coming, whether orwhen the government and the central bank will reverse its unsound policy and work back towardorthodoxy. Gold is blamed, speculators are blamed, “hot money” is blamed…“The prestige of a great government and a long-established government can go far in upholding thevalue of its paper money even if rational foundations for the value of paper money have waned…

“A country which is afraid of hot money, money which may suddenly jump to another country, has avery simple way of avoiding this danger. It does not need to control capital movements. It can protectitself against this danger by having a sound currency, firmly anchored to gold at a fixed rate, by keeping control of its money market so that its demand liabilities do not grow excessive in relationto its gold, by keeping a balanced budget – by making a financial environment in which money coolsoff and wants to stay…“Gold’s greatest competitor is the confidence men have in the paper promises of governments andcentral banks to pay gold, and you could use that promise as a substitute for gold. The devaluation of the dollar has shaken that faith…

 

“There is no need in human life as great as that men should trust one another, and should trusttheir government, should believe in promises, and should keep promises in order that future promises may be believed in, and in order that confident cooperation may be possible. Good faith – personal,national, and international – is the first prerequisite of decent living, of the steady going onof industry, of governmental financial strength, and of international peace.”

No other institution has been subjected to more bad-mouthing and verbal abuse than the gold standard.

An enormous amount of propaganda was deployed in order to discredit it by governments and banks. This is not surprising if we contemplate that the dishonored promises of banks to pay gold have immediately been promoted to legal tender status upon the suspension of the gold standard.

Moreover, academic scribblers could expect handsome stipends and other rewards such as early promotion if they are willing to sell their pen at the bid of governments and central banks. When governments, strong in gold, broke their promise to pay gold to widows and orphans to whom they have sold government bonds with a pledge to pay gold coin of the present standard of value; and also broke their promise to redeem their paper money in gold coin of the present standard of value, it represented an act of absolute bad faith. It was dishonor.

The dishonor had to be covered up. Thereupon an adventurer, one John Maynard Keynes, comes along with a handy theory suggesting that the gold standard is pure superstition masked as science.

He claims that prior saving is not really a prerequisite for spending, provided that you have a pliant central bank with an efficient printing press. He claims that interest could and should be abolished through the “euthanasia of the rentier”. He says he could take care of gold hoarders and eliminate gold from the monetary system, for being such a nuisance as the perennial obstruction to bad faith in high finance. He says he knows how to discredit the gold standard for once and all. Unfortunately for the government, Keynes died before he could reveal his secret.

Governments and their pliant central banks were eager to take the advice of Keynes. They sabotaged the gold standard by feeding the rumor-mills suggesting that the national currency will be presently devalued. When gold disappeared from circulation as a consequence, they threw up their hands in a hypocritical gesture saying: “See? It does not work. Gold does not behave. You can’t run a gold standard, given that accursed hunger for gold.”

The golden thorn in the flesh is still bothering devaluation-happy governments. The golden corpse still stirs. There is still this unfinished business, to take care of the gold hoarders. During the French Revolution they did it by enlisting the guillotine as an instrument of monetary policy. If they found you with undocumented gold, then your head would be chopped off in summary justice.

But maybe, just maybe, public opinion can force a Great Debate on the merits of the gold standard, a debate that has been resisted during the tenure of Keynesian economics for the past 75 years. It is time to take stocks. Keynesian economists promised an end to bank runs, to deflations, depressions and lasting economic contractions on condition that they were allowed to demonetize gold. Gold was duly demonetized, but the Keynesians could not deliver. The worst depression of all times has burst upon the world on their watch in 2007, causing the greatest economic contraction, unprecedented economic pain, and untold damage to the social fabric, of which we have seen just a sample so far.

The Gold Standard Institute was established to prepare the worlds for this Great Debate. We are ready for a showdown now; are also the Keynesians?

One of the tasks the Gold Standard Institute will face is to deal with the views of the deviant friends of the gold standard, and convince them of the errors of their ways. Let me just briefly mention four points at issue for starters.

The main excellence of the gold standard is not that it can stabilize prices, which is neither
possible nor desirable. The main excellence of the gold standard is that it can stabilize the rate of interest, which is all the stabilization the economy needs. Once this is done, other economic indicators including prices will be imparted as much stability – or flexibility – as is necessary for the smooth operation of a healthy economy.

The so-called 100 per-cent gold standard is a pipe-dream that would not survive the first Christmas shopping season. The theory of the gold standard, properly conceived, admits self-liquidating credit. As Adam Smith’s Real Bills Doctrine reveals, short-term commercial paper drawn on fastmoving goods to the ultimate gold-paying consumer is the second best thing to the gold coin itself.

Its emergence is spontaneous and contemporaneous with the emergence of new merchandise demanded most urgently by the consumers. It is not inflationary because together with the removal of the merchandise from the market the short-term credit is extinguished through the release of the gold coin of the ultimate consumer. It is the best earning asset that a commercial bank can have.

In launching a gold standard you cannot ignore self-liquidating credit. If you do, you are inviting a humiliating failure, giving occasion for schadenfreude in the enemy camp.

The Quantity Theory of Money is a linear model that may be valid only as a first approximation.

The real world is far from being linear, however. To the extent this is true, the Quantity Theory of Money is false.

The essence of the gold standard is not the fixing of the gold price. It is the taking the power to create money out of the hands of unelected bureaucrats and putting it into the hands of the people themselves, where it belongs according to the U.S. Constitution. It did not establish a central bank; it established the U.S. Mint and opened it to the free coinage of gold (and silver). This gave the power to people: those who felt that there was not enough money in existence could take new gold from the mines, or old gold from jewelry and plate, to the Mint and convert it into the coin of the realm.

Talking about fixing the gold price would be putting the cart before the horse. It is just the other way round: the price of paper instruments is fixed in terms of the gold coin of the realm.

These are the best of times, and these are the worst of times. Best of times because, for the time in 75 years, it is possible to come out with a forceful defense for this magnificent institution that no one designed or planned, but that developed spontaneously creating a great harmony in the economy, matching investments with available savings and production with existing demand: the gold standard.

Worst of times, because great damage to the world economy and finance has already been done, and more damage will still be done by the destructive forces of society responsible for exiling gold from the monetary system for the past 35 years. The Gold Standard Institute has a formidable task ahead in carrying the torch to show the way out of the present darkness.

I send my hearty welcome to the Gold Standard Institute on occasion of its début wishing it a prosperous future. I pledge my support in the task of saving our great monetary heritage: the theory and practice of the gold standard, and in educating the world about the sound principles of money and banking.

---

Antal E. Fekete
Professor of Money and Banking
San Francisco School of Economics
March 22, 2009

 

As It Appears Sixty Years Later

In Two Parts. Part One: Euthanasia of the Pension Funds

On February 23, 1950, The Commercial and Financial Chronicle published an article from Ludwig von Mises with the above title. In it the author concentrated on the threat of inflation as the greatest danger to pension rights. Sixty years later another danger is looming large on the horizon: the threat of deflation, and a new examination of the pension problem is timely.

Deliberate Dollar Debasement

In 1950 Mises looked at the pension problem from the point of view of the shrinking purchasing power of the dollar, a consequence of what he called the deliberate policy of currency debasement by the U.S. government. In 1950 a pension of $100 per month was a substantial allowance, he noted. Shelter could be rented for a month for less than $30 in most parts of the country. (In 2010, $100 hardly buys one night’s stay at a decent hotel.) In 1950 the Welfare Commissioner of the City of New York reported that 52 cents would buy all the food a person needed to meet his daily caloric and protein requirements. (In 2010, $100 barely buys a cup of coffee and a muffin for every day of the month.) Of course, currency debasement does far more damage than simply eroding the purchasing power of pensions. As Mises observed, it also leads to the insufficiency of capital accumulation. Companies report phantom profits that mask losses, since depreciation quotas understate the wear and tear of productive equipment. Savings are hardly adequate to pay for capital maintenance, let alone new capital or technological improvements in production – the only source from which pensions to an increasing labor force can be paid. When young workers who now join the labor force are ready to retire, the necessary funds to pay their pensions will simply not be available.

Capital destruction due to declining interest rates

I have written extensively about the proposition, one that mainstream economists doggedly refuse to discuss, that a falling interest rate structure has a deleterious effect on accumulated capital. Capital is destroyed across the board simultaneously and stealthily. By the time the damage is discovered, it is too late to do anything about it and firms go bankrupt in droves. The falling trend of interest rates is the unrecognized cause of the depression that is presently devastating the world economy – just as it also was 80 years ago.

Nowhere is the erosion of capital caused by falling interest rates more obvious than in the case of the capital of the pension funds. They must earn adequate return on their investments, but a falling rate of interest frustrates this effort. At the lower rate the original schedule of capital accumulation cannot be met.

Those who disagree argue that if the present value of a future stream of payments is lower when discounted at a higher rate, then it must be higher when discounted at a lower rate. Thus the steady future receipts of a pension fund from payroll contributions will have a higher value under a regime of falling interest rates. There is no need to argue this point. It is clear that the fund must be around to be able to collect future contributions enhanced by a fall in interest rates. Many of them won’t be, as they will have succumbed to capital squeeze caused by the very fall of the interest rate that is supposed to be their savior. At any rate, rules of sound accounting do not allow pension funds to treat expected future payroll contributions as if they were cash payments in the process of clearing.

The repercussions for society are devastating. Just as the aging segment of population in the industrialized countries becomes vitally dependent on its pension income, the falling rate of interest undermines the pension plans. In many cases the money to pay out pensions won’t be there. For the rest, payout reductions will be inevitable. Defined-benefit pension plans will have to be discontinued. Of course, the problem is even more acute in the case of unfunded pension plans such as Social Security, the pension plan of the military, or that of the civil service of the federal, state, and municipal governments. Under these plans the contributions of the active members directly pay the pensions of the retired ones. We shall see below that such plans exhaust the definition of a Ponzi scheme.

The Great Milch-Cow

When a large segment of the population is facing a drastic cut in income, and especially since most retired people have no alternative and cannot augment their diminished pension with income from other sources, consumption falls back and lower demand will have further deflationary consequences on the economy. Yet this problem, just as the kindred problem of the erosion of the capital of productive enterprise, is ignored by the profession of economists and that of the accountants. They apparently believe that the Great Milch-Cow, the government, will always be there and able to cover any shortfall.

The decades long slide of interest rates is far from over. As I argued in my other articles, large-scale monetization of government debt in the wake of every new bail-out plan and stimulus package is going to impart a falling (rather than a rising) trend to the interest rate structure, due to the opportunity it creates for risk-free profits. Bond speculators ambush the Federal Reserve on its periodic trips to the bond market to make its regular open market purchases of government bonds in order to increase the money supply. They buy the bonds beforehand in order to dump them after the Federal Reserve has bought its quota. They pocket the difference. These risk-free profits explain a large part of the present deflation: the rising bond prices (read: falling interest rates) as well as falling prices. The new money that the Federal Reserve has created through its open market purchases will not flow to the commodity, real estate, or equity markets as hoped by the policy makers. It will stay in the bond market where risks are the smallest, and will be financing further bullish bond speculation. The ultimate result will be a further fall in the rate of interest, exposing the pension funds to even greater dangers.

Note that these dangers are in addition to the threat to the value of pensions undermined by past inflation, about which Mises was warning sixty years ago. It could be further undermined in case the reckless increase in government debt scared bond speculators and other investors, including foreign holders of the debt of the U.S., for example, the Chinese government. Should they start dumping the bonds, they would push interest rates and commodity prices to much higher levels.

Pensions are doomed whatever the government does. Whether interest rates go up or whether they go further down, the pensions are at risk. In the case of rising interest rates their value will be decimated. In the case of falling interest rates pension contributions will not be able to earn a return necessary to accumulate the capital needed in order to pay defined-benefit pensions.

The relevance of the gold standard to the pension problem

As we can see, at the heart of the problem is the destabilization of the rate of interest due, first, to sabotaging and, then, to destroying the gold standard by the government. There is no known way to stabilize interest rates but by defining the value of the unit of currency as a fixed quantity and fineness of gold. In this way the amount owing on deferred payments will be fixed. Any breach of promise of future payments will be immediately obvious as soon as it occurs. The difference is this, and a very important difference it is: a promise to make future payments in irredeemable currency is a meaningless promise, because breaching it can be – and will be – camouflaged in many ways.

This spells catastrophe. The retired segment of the population will be plunged into penury. The only way to avoid this is to stabilize the rate of intereststructure through the rehabilitation of the gold standard with all deliberate speed.

A fall in the rate of interest has a direct effect of decreasing the return to capital of the pension funds. This decrease should be compensated for by increasing payroll deductions. It is clear that this is never done. What is not clear is whether the reason for this omission is ignorance on the part of the economists’ and the accountants’ profession, or whether it is due to a political decision. Is it possible that the government, motivated by the principle ‘let the sleeping dog lie’. Certainly, the government does not want to alarm the people and put wind into the sails of the budding movement demanding the immediate return to the gold standard, even though this is the only way to stabilize interest rates thus making pensions affordable again.

The last vestiges of the gold standard were unilaterally discarded by the government of the United States in 1971. This event was coincident with the onset of the greatest gyration in the rate of interest on a world-wide scale. In a decade interest rates shot up to two-digit figures in the high teens. Then a slow decline started in the 1980′s pushing interest rates relentlessly towards zero. The first move (rising interest rates) was accompanied with a great surge of inflation, wiping out a large part of the value of pension rights. The second move (falling interest rates), which is still continuing, has brought deflation. It has not yet fully manifested its corrosive effect on the pension funds as yet. Even so, the forces that drive the rate of interest to zero are squarely responsible for the erosion or destruction of all capital, including the accumulated capital of the pension funds.

Although historians do not advertise the fact, a lot of pension funds went bankrupt in the 1930′s, and the remaining ones had to scale back the amounts they had contracted to pay to their pensioners. Economists failed to offer an explanation for this universal phenomenon. Yet the explanation is clear: the accumulated capital of the pension funds was badly impaired, and in some cases completely wiped out, by the falling interest rate structure. Exactly the same causes are operating right now, and exactly the same effects will follow. The only difference is the larger scale of capital destruction in the present episode.

Indexed pensions = Ponzi pensions

In recent years the pension problem has been swept under the rug. During the past sixty years experts have invented ‘indexing’ as the cure for the erosion of pension rights. Indexing means that pensioners can be compensated for the erosion of their pensions due to inflation by making yearly adjustments upwards tied to some index numbers ‘measuring’ inflation. This means that the powers that be are aware of the pension problem. They are willing to treat the symptoms, but they still refuse to treat the real cause of the disease. Their outlook on inflation as being ‘nature given’, beyond the power of man to address, is hypocritical and devious.

The basic idea of indexing pensions is that the redistributive society will always have the wherewithal to validate all pension rights, since the government can borrow and tax without limit. Funding pensions is an anathema to Keynesian economics. The ‘modern’ way of financing pension rights is to make pensions ‘pay-as-you-go’. This is euphemism for Ponzi pensions, whereby currently active workers are made to pay the pensions of retired members. Present workers will be compensated after their retirement by the contributions of members then active.

This is clearly fraudulent as it makes a hypothetical third party bear the full brunt of the arrangement. People are brought into the compact without their concurrence. Some of the members who will pay the pension of the now active workers may not have been born yet! The key point is: contributions are not capitalized upon receipt but are instead dissipated. Pension contributions must be capitalized in order to make them a meaningful source of future pensions. Current workers pension rights could be subject to veto by tomorrow’s workers, should they find this arrangement unfair. Only fully funded pensions are secure (and what use is a pension if it is not secure?) and it is only under a gold standard that such security can exist.

Any other arrangement may unravel, as the victims of the redistributive society may one day wake up and revolt.

John Maynard Keynes, in a bout of sincerity, blurted out a phrase that only now has revealed its true meaning: the euthanasia of the rentier. It gives away the “shabby little secret” of the redistributive society: robbing the pensioners who can no longer take ‘strike action’ and with the proceeds throwing dust into the eyes of the rest of the people.

Deflation and the pension problem in Japan

The United States is following Japan down the garden path to zero interest. Therefore it is instructive to look at deflation and the pension problem in Japan in order to see the shape of things to come. Consider the plight of JAL, Japan Airlines. The economic slowdown hit travel and cargo traffic hard. Saddled with the equivalent of $15 billion in debt and a massive pension fund deficit, the airline was forced to apply for “mediated debt restructuring” – euphemism for Chapter 11 bankruptcy. Asia’s largest carrier by revenue said in its earnings report that there was a great deal of uncertainty about its ability to continue as a going concern. It has applied for help to the Enterprise Turnaround Initiative Corp., a government-backed fund. However, capital injection or additional financing or additional financing alone would not improve the carrier’s prospects, as asserted by the November 14, 2009, news report of Reuters, because of its severely underfunded pension plans. JAL president Nishimatsu met with the leaders of the airline’s retirees association to seek their approval on pension payout reductions. Media reports say that the leaders have expressed their desire to cooperate in some ways with management to save the airline, but many retirees are expected to oppose strongly the proposed pension cuts.

The cancer of depression has been metastasizing across the Pacific through the yen-carry trade foolishly encouraged by the Federal Reserve and the Bank of Japan as a way to push interest rates even lower in the United States. Rather than analyzing the Japanese example and drawing the appropriate conclusions, American policy makers have an irresistible itch to follow Japan’s jump into the abyss of the Black Hole of zero interest. The result, perfectly predictable, is catastrophic.

What should American labor leaders do?

American labor faces the greatest challenge ever. Its achievements on the wage front and on the pension front are at stake, due to inane government policies of destabilizing the rate of interest, causing an unprecedented destruction of capital, in particular, destroying the capital of pension plans.

If the labor leaders want to preserve the achievements the labor movement, they must address the root cause of the problem: the regime of irredeemable currency. Interest rates can be stabilized and pension plans can be saved only through outlawing of the irredeemable dollar.

We are currently on a course that will result in the destruction of pension funds. If not wiping them out altogether, the irredeemable dollar will drastically reduce the pension rights of the workers. This is a wake-up call. The unions must act now and demand that the Supreme Court of the United States declare Federal Reserve credits and notes unconstitutional. The manner in which these are presently issued is the root cause of our economic instability and the vicious swings between inflation and deflation. The unions must demand through legal challenges in the courts that wages, salaries, and pensions be paid in constitutional dollars, that is, dollars redeemable in the coin of the realm, defined as a fixed weight and fineness of gold and silver.

The U.S. Mint must be open to the unlimited coinage of gold and silver free of seigniorage charges. To prevent future tinkering with the monetary system by charlatans, the metallic value of the dollar ought to be enshrined in the Constitution, so that any change in the gold content of the dollar would take a constitutional amendment – rather than an executive proclamation.

U.S. government bonds must be deprived of their monopoly position and they must be exposed to competition with the gold coin before the saving public. This is indispensable for the stabilization of the rate of interest, but no less for the health of the pension funds. Government bonds are unsuitable for pension funds to hold on capital account. In case of a demographic shift such as that when more people leave the labor force with pensions than those entering it while joining pension plans, the net selling of government bonds from portfolio may collide with selling by the government, causing an unwarranted rise in the rate of interest. In the case of net selling of corporate bonds from portfolio the same problem does not arise. In fact, it should be treated as a signal for the corporations to retrench.

If the American labor leaders fail to challenge the constitutionality of the irredeemable dollar, and ask the Supreme Court for the protection of the pension funds on constitutional grounds, then a century of gains on the pension front will be irretrievably lost. Penury for the retired segment of the population will follow. The plight of the JAL pensioners is not some kind of exception: this is the future norm unless the current irredeemable currency system is replaced with the gold standard.

aefekete@hotmail.com

January 3, 2010.