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Home > Authors > Keith Weiner > Page 12

Gold is Money and Nothing Else. Why?

March 9, 2012 by The Gold Standard Institute International

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http://keithweiner.posterous.com/

The title of this essay is a quote from JP Morgan. Despite being officially vanquished from the financial system, people have not treated it as a barbarous relic or a commodity like frozen pork bellies. My goal in this essay is to explain why.

Gold is a physical good, a commodity. Unlike fiat paper money, gold cannot be debased, requiring through all of history about one gold ounce worth of effort to extract from the ground.

More importantly: gold is what it is. It is not dependant on a counterparty to perform, a government regime to remain in power, or any other future events. If one has an ounce of gold, then one has an ounce of gold, full stop.

And it is an extinguisher of debt. If one borrows real value from someone else, it is important that the debt can be repaid. If one hands to one’s creditor an amount of gold equal to one’s debt, then one has eliminated the debt. If one pays in paper, one transfers the debt to a bank or perhaps the central bank. But the debt is not extinguished, and system-wide debt grows exponentially until its crashes.

There are many physical commodities that cannot be debased, do not depend on a counterparty’s future performance, and which would extinguish debt if used in payment. Why was gold selected?

There are several properties that are desirable for a monetary commodity. While people have used rice or even cattle as money, both are foodstuffs which can rot or degrade over time. Iron would have this problem also.

As the commodity itself is the value, and not some regime’s imprint on it, it must be dividable into the smallest pieces to fit any transaction. It would be highly convenient to be ale to recombine these pieces to prevent the entire money supply being turned into sand. A related characteristic is that any piece is equivalent to any other of equal weight.

Only a metal can meet these requirements. And in particular gold does not tarnish, even slowly. When the next physical requirement is added, gold emerges the clear winner. The monetary commodity should have enough value that one can carry considerable value on one’s person, even over great distances, without the necessity of trusting others.

The last physical requirement is that there must be enough of it that the people can have some. An exotic, unobtainable item is not suitable for use as money.

In fact, gold is the most abundant commodity known to man. One does not measure abundance in terms of absolute mass or volume, but in terms of stocks to flows (inventory to annual production). There is around 80 years of current mine production in human hands. No other commodity (except silver) comes even remotely close, having stocks to flows ratios less than one year.

Economists use the concept of marginal utility. How much less does one want the next unit of a good compared to the current unit. For example, if one is walking through a desert, one wants the first liter of water. And maybe one wants a second and third. But before one gets to 100 liters, one wants no more. Economists say that the marginal utility of water declines rapidly to zero.

What does it say that people have kept 80 years of gold mine production in inventory? The marginal utility of gold does not decline (or if it does, it declines so slowly as not to resemble the decline of any other good). In fact, the marginal utility of gold—the value one places on the next unit—is no lower than the utility of the highest good that one might buy with the gold. Gold’s marginal utility may be higher because one can save gold to buy something next year that is not even available this year.

There is another property, not a physical property, but an economic property that is essential to the monetary commodity. This property is a requirement for the commodity to be actually used in trade. To understand, look at the evolution of money in ancient times.

Before money, there was the problem of “coincidence of wants”. The chicken farmer wants to buy a pair of shoes so he goes to the cobbler. But the cobbler does not want chickens. No direct trade is possible. Most trade is only possible indirectly, i.e. if both parties adopt the use of money. In order for this to occur, one commodity must emerge which is more marketable than all others. Economists define marketability as the efficiency of buying and selling it, i.e. the bid-offer spread. The spread for gold, even today, is the narrowest (around half of the S&P 500).

Two related concepts are liquidity and hoardability. As someone attempts to buy a larger quantity of a good, he lifts the offer. The larger the quantity, the more the offer is lifted. The net effect is that the bid-offer spread widens as the quantity increases (similarly, if one tries to sell a large quantity, the bid is depressed). Liquidity refers to the commodity’s resistance to this spread widening. Gold has the greatest liquidity.

If someone tries to buy or sell a really small quantity, the spread also widens. There are real costs to breaking a commercial-sized lot, and handling costs are almost the same whether one is dealing with a full lot or a tiny quantity. Small quantities are essential to one kind of important economic activity: savings kept by wage earners. Over an entire working career, a wage earner may keep 1% or 5% of his weekly wage. If the spread is wide, then he loses value coming and going. Hoardability refers to a commodity’s resistance to the spread widening as the quantity gets smaller. Nothing has better hoardability than gold, except silver.

In summary, civilization requires money because direct barter trade is too inefficient. Money must be a commodity because only a tangible good can extinguish a debt. Gold was selected over a period of thousands of years as being the commodity which best fit the need for money. If governments repealed the laws that forcibly keep people from using it, then gold will resume its role as money par excellence . There is nothing else like it.


© Keith Weiner, 2011

Filed Under: Gold and Silver, Keith Weiner, Popular Economics

Falling Interest Rates and Duration Mismatch

March 8, 2012 by The Gold Standard Institute International

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http://keithweiner.posterous.com/

Since 1982, US Treasuries have been in a bull market. This is Exhibit A: the yield on the 10-year Treasury bond (the yield and the market price of the bond are inversely related, like a teeter-totter).

This statement should not be controversial. But outside Austrian circles, most people don’t understand that this structural decline is engineered by the Federal Reserve. But speculators—and would-be “vigilantes”—know that the Fed often practices their so-called “open market operations” to buy bonds. Why get caught in front of that steamroller, when it’s so easy and so fun to ride it instead?

Note: this does not imply any particular “insider knowledge”. A long-term bull market is very forgiving, and it hardly matters when you buy in—especially in an asset that pays a dividend, and which will not default. That said, it should not be surprising whenever the best professionals who are risking their own money are up against salaried bureaucrats in a game of cat-and-mouse, the former will always win (especially when the latter may be hoping for a more lucrative job in a few years).

Zero Hedge has run a series of articles exposing a scandal that the Fed meets regularly with the big financial players who buy Treasury bonds and discloses bond purchases to them in advance. They have also published lists of specific bonds that will be purchased, and their success rate in guessing is well over 80%.

Since falling interest rates mean a rising bond price, it is great fun for bond speculators! They get “free” capital gains. Oh, wait.

Is there such a thing as free money?

No, actually the money comes from the capital account of the bond issuer. The speculator carries the bond on the asset side of his balance sheet. The issuer carries it on the liabilities side. No matter whether the issuer marks the liability to market, or not, the loss is taken. It is very real.

The loss of capital can be seen in every case where a company borrows money to expand its production. Then the Fed pushes the rate of interest lower. Then a competitor can borrow more money for the same monthly payment, and outcompete them with a lower cost structure. This same dynamic applies to hotels, restaurants, and every other business that tries to attract customers. Businesses that borrowed more recently have fancier buildings than those who borrowed earlier, at a higher interest rate.

Corporate executives have a choice. The right thing to do is accurately assess the useful life of the tool, hotel, or whatever they are going to buy with the money. And sell a bond with the same duration. The bond is repaid with some of the revenues generated by the asset.

But this is suicide in a long-term structural falling interest rate environment, as I showed above.

Companies have another alternative. They can borrow short-term money and rely on the markets to be able to roll the debt each time it comes due. This avoids the problem of falling interest rates, because each time they roll the debt, they get the benefit of the new, lower interest rate (and the rate on short-term borrowing is ultra-low anyways).

But they create another problem for themselves. If, for whatever reason, the bid on short-term bonds falls, the company cannot roll its debt. And it then must face a crisis that can force it to seek creditor protection.

The falling interest rate structure creates a no-win choice between losing capital vs. duration mismatch and the certainty that sooner or later the company could be wiped out. Duration mismatch works no better for industrial companies than for financials.

The only solution to this problem is a proper gold standard. Under gold, the rate of interest stays within a very small range, and thus borrowers can plan long range without having to choose the tiger or the tiger.

Professor Antal E. Fekete has been working to expose the destruction caused by irredeemable paper money, and the flaws of the system including falling interest rates. He has defined a proper, unadulterated gold standard including its clearing mechanism: real bills. The Gold Standard Institute was founded to promote and advocate this gold standard and is proud to have Fekete on its board.


© Keith Weiner – August 2011

Filed Under: Gold and Silver, Keith Weiner, Popular Economics

S&P Downgrade of Uncle Sam

March 8, 2012 by The Gold Standard Institute International

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Government debt paper is debt paper. Money — gold — is money.

By now, everyone knows that S&P downgraded the debt of the USA from their top rating, AAA, to their second-highest grade, AA+. Most of the commentary has been of the pin-the-blame-on-the-donkey variety. For all most people know, this is the collapse of the currency and the financial system and their biggest concern is that Obama may not win the 2012 election. If this were truly the collapse, I submit for your consideration that we will all have bigger things to worry about!

So, I thought I would look at this from a different angle. My conclusion is simple. On the one hand, there is no question that the US dollar will collapse. This is not only inherent in any irredeemable paper money, but also the inevitable result of any government and financial system that runs perpetual and accelerating deficits. But this is not what S&P is considering! If it were, they would re-rate all dollar-denominated debt at their lowest level. They would then look at the dollar derivative currencies (e.g. eur, gbp, yen, etc.) and realize that a derivative cannot survive the destruction of the underlying currency. So they would do the same to the sovereign debt of the issuers and all debt denominated in those currencies. Then they would lay off their staff, awaiting the return of gold-denominated bonds.

Dollar collapse aside, consider that in 1913, when Wilson created the Federal Reserve, a dollar was worth roughly 1/20 ounce of gold. In 1933, Roosevelt devalued the dollar to 1/35 of an ounce. In the 1960s, the US government was obliged to give up more and more of their gold hoard to “defend” this level, because by then the real value of the dollar had fallen well below 1/35 ounce. We can’t know how much it had fallen because the government interfered with the process of price discovery.

After Nixon officially defaulted on the gold obligations, the dollar’s collapse accelerated. By 1981, the dollar was worth 1/600 ounce (ignoring the spike into what turned out to be a mania). Today, the dollar is worth less than 1/1700 ounce of gold.

I am not aware of anyone who thinks that the government will get the dollar’s fall under control. Any Keynesian or Monetarist will even tell you that it’s good for the dollar to fall. And we Austrians are saying that not only is it bad, but it’s happening and it’s accelerating.

If the S&P rating was intended to account for the value of the currency that the debtor uses to repay its bonds, then how could S&P give the USA an investment-grade at any time under any circumstances? If the dollar is losing 5 to 15% of its value per year, this represents a significant default over the duration of a 10-year bond!

And, for that matter, the same dilemma would apply to corporate bonds, municipal bonds, etc. Obviously S&P does not look at the dollar, and its constant propensity to fall, as part of its rating process.

To summarize my points so far, the dollar has been steadily eroding for 100 years, and this is a trend that those in charge defend as being good and necessary. And the dollar will collapse under the weight of unpayable debts. This is the fatal flaw of an irredeemable debt-based currency, and the end is in sight if not imminent (see Permanent Gold Backwardation: Why a “Crack Up Boom” Is Inevitable).

In this light, the S&P downgrade is meaningless.

On the other hand, in the world of the irredeemable currency, what does it mean for a bond to be paid back? It means that the debt is transferred from one party to another party. If a corporate bond is repaid, the corporation redeems it using dollars (i.e. Federal Reserve Notes). Dollars are the liability of the Fed. The debt is simply transferred. First, the corporation owes you. Then the Fed owes you.

This is an insane system, but at least there is an arms-length transaction between unrelated parties. It is possible to discuss default, attempt to qualify (if not quantify) the risks of default, etc. Default or non-default: these are the only two possible outcomes for the bond at maturity. One of them will occur, and which one occurs is of utmost importance to the bond buyer. The goal of the ratings agency (assuming repeal of the 1970’s era law making them work for the bond issuer) is to assess the risks of a bond being paid or not.

However, Treasury bonds are payable in Federal Reserve Notes which are backed by … Treasury bonds. It’s circular, it’s a check-kiting scheme, and it’s a Ponzi scheme.

There is no risk that there won’t be Federal Reserve Notes to pay the bond holder. Both the bonds and the notes that are used to pay them off are inextricably tied! The point I am making here is that the very concept of “rating” such bonds is meaningless. There is no objective (or otherwise) standard of measure to use in rating them.

It would be like asking how much gold is an ounce of gold worth? How many dollars is a $100 bond worth? These are tautologies.

This is just one of the perverse “unintended” consequences of trying to use irredeemable paper currency. Government debt paper is debt paper. Money (gold) is money. The two are the same, like oil and water are the same.

The world needs to return to a proper, unadulterated gold standard including bonds redeemable in gold. And this must include repealing the laws that grant a cartel to the three ratings agencies (S&P, Moodys, and Fitch), so investors can hire any firm to help them with due diligence on the bonds they buy.

Filed Under: Gold and Silver, Keith Weiner, Popular Economics

What is the Dollar Really Worth?

March 8, 2012 by The Gold Standard Institute International

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The dollar valued in terms of gold:

Behind this pithy graphic is a serious issue. How do we measure value?

The paper currencies are (at best) elastic. Using a dollar to measure value is like using a rubber band to measure length.

Most people accept the Monetarist notion of using consumer prices to deflate the dollar. But consumer prices are subject to myriad and diverse forces (e.g. ever-improving efficiency; fewer labor hours and less land are needed to produce a ton of wheat today than in 1911).

Using consumer prices to “adjust” the price of gold would be like lining up a bunch of gummy bears next to the reference meter rod (under glass in Paris, it’s made of a platinum-irridium alloy). Be careful to estimate the fraction of a bear at the end.

Gold is the objective measure of value. This is because its stocks to flows (ratio of inventories to annual mine production) is higher than any other commodity by far. Despite ever-growing inventories throughout the ages, its value held up.

This is true for the dollar also: its value should be measured in gold. 100 years ago, the dollar was worth 1/20 ounce. Today, it is worth about 1/1800 ounce.

This graph is for all of those calling a “top” in the gold “bubble”.

The dollar hasta bounce. Gotta. Inevitable. Right?

Filed Under: Gold and Silver, Keith Weiner, Popular Economics

Operation Twist: The Consequences

March 8, 2012 by The Gold Standard Institute International

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For months, even before the end of QE2, analysts and prognosticators have been saying the Fed will have to do another QE and another, endlessly. These folks were surprised when it didn’t come last month, and predicted confidently that it would come this month especially because Bernanke extended the September meeting to two days. I said then, and I still believe it, that QE3 will come, but not as quickly as most people think (or hope).

So today, the Fed gave us, in addition to their normal pap about “downside risks” and “exceptionally low rates” forever, two new policies: (1) they will sell $400B worth of Treasurys of 3 years or shorter maturity, and buy $400B worth of Treasurys with 6 to 30 year maturity; and (2) the Fed will reinvest the proceeds when mortgages it owns are paid.

The markets became very volatile after the announcement. When the dust settled, we had S&P down 3%, every currency, including the yen, down substantially on the day (much less from the day’s highs around 3:30 p.m. EDT), copper down hard, crude, and even gold and silver down, down, and down. Copper and the precious metals continue to sink as I write this.

Obviously, the Fed’s decision disappointed and underwhelmed market participants. It has become a cliché to say that there is a “Bernanke Put”, i.e. he won’t let stocks fall. One commenter said that today’s decision moved the Put farther out of the money.

I don’t think that the Fed cares about the stock market, in particular. I think it cares about its member banks interests, in this case their balance sheets.

The Fed might care about the stock market if it is a means to its ends, as in the following chain. If stock prices rise, then investors feel wealthier. If they feel wealthier, then they buy homes and invest in businesses and commercial real estate. If they buy and invest, this firms up asset prices. These are the assets on bank balance sheets, so firming up the prices will bolsters said balance sheets.

So today the Fed threw the stock market under the bus, or at least allowed it to go under the bus. Let’s look at what the Fed did in lieu of more outright printing.

The simpler of the two policies is: the Fed will reinvest the money it gets from mortgages that are paid or prepaid. This is nothing more than the Fed saying they will continue to hold their balance sheet at its current size. They do not want to withdraw liquidity. One theory says this paves the way for Treasury to announce a giant refinance for everyone. We shall see.

“Operation Twist” as the financial blogosphere has been calling it is simple in its mechanics. Sell short duration, and buy long duration, Treasurys. I don’t believe they will sell anything. They surely do not want the interest rate on the short end of the yield curve to rise, much less for the yield curve to invert. But perhaps demand is so strong that they haven’t had to manipulate short end anyways for months? I don’t know and they aren’t saying.

By plowing money into the 6-30 year maturities, they will push up bond prices there. Since the interest rate and the bond price are a see-saw, mathematically and rigidly related, this will push down the rate of interest on 6+ year bonds. The Fed thinks that this will spur more borrowing and lending. The theory is that with lower rates, businesses will make a case to borrow for new projects– however, they have many reasons not to. And, investors will be forced to take more risk to earn a decent yield. Maybe, but I remain doubtful.

It will, however, have other consequences. Such as the following:

  1. The spreads between municipal or corporate bonds to Treasurys will widen. Yields on munis/corps will go down , but not as much as Treasurys (there isn’t a growing risk of sovereign defaults as with munis).
  2. Bond speculators (is there any such thing as a genuine saver who has been buying 30-year bonds to hold for three decade?) will be rewarded with capital gains.
  3. The capital that goes to bond speculators comes out of the capital accounts of the bond issuers. It’s a zero-sum game. When interest rates rise, bond speculators lose and bond issuers gain. When rates fall, the opposite.
  4. One of the banks’ (illicit) source of risk-free profits is reduced. Yield curve arbitrage, borrowing short to lend long, will become less profitable.
  5. Where bond issuers have access to the markets to “roll” their liabilities, the new payments will be lower. In theory this would allow them to borrow more (which is what the Fed intends). In practice, we shall see. Certainly governments will borrow more, as there is little or no personal downside to the politicians who make such decisions.
  6. Any borrowing that only makes sense because the interest rate was further reduced is, almost by definition, malinvestment. Such borrowings will not be paid back. Car buyers would do well to consider the total cost of ownership over the life of that 84-month 15% interest loan with the balloon at the end and “affordable” payments. The same is true with government and corporate borrowers: there are other considerations than monthly payment.
  7. Assuming any business does borrow at the new, lower rate, it will have a permanent competitive advantage over its competitors who borrowed at the old, higher rate. The new borrower will either be able to produce the same good at lower cost (due to lower debt service) or be able to attract customers to the new restaurant, hotel, resort, cruise ship, shopping mall, etc. Customers love higher ceilings, lavish landscaping, opulent gilding dripping from the marble columns, etc.
  8. Thus capital destruction will continue and accelerate.
  9. The process of halving of interest rates will continue. It is just as damaging to go from 1.5% to 0.75% as it was to go from 12% to 6%.
  10. Debt accumulation will continue.
  11. All, of course, until it cannot continue.

Keith Weiner is a PhD candidate studying under Professor Antal Fekete, from whom many of these ideas originally came.

Filed Under: Gold and Silver, Keith Weiner, Popular Economics

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